Comparing Annuities to Mutual Funds

Conceptually, variable annuities are simply mutual funds wrapped in an instrument that permits tax on all income, whether ordinary or capital gain, to be deferred until monies are distributed. If annuitized, distributions are taxed under the rules of Code Section 72, which essentially prorates the recovery of basis over the distribution period. In addition, and more importantly, the investor may enjoy any number of a myriad of contractual guarantees in a variable annuity contract (although the details of these guarantees are highly variable across various contracts). However, an investor must pay a price for these advantages.

First, the amount of each annuity payment in excess of the amount of basis recovery is taxed at ordinary income tax rates, regardless of whether it is attributable to ordinary investment income (i.e., interest or dividends, including the potentially tax-favored qualifying dividends) or capital appreciation. Because an investor’s marginal ordinary income tax rate virtually always equals or exceeds the applicable capital gains rate (depending upon whether the gains are short-term or long-term), he/she will forfeit the favorable lower tax treatment on the portion of payments that is attributable to previously unrecognized capital gains. In addition, the taxpayer will be unable to take advantage of capital losses as they accrued (although capital losses will still offset gains within the contract, ultimately reducing the amount of growth taxed as ordinary income at withdrawal).

Second, variable annuities incur mortality and expense (M&E) charges (for other various riders and guarantees) that range from about 0.5 to 1.25 percent (and occasionally as high as 2.0 percent with additional riders, features, and guarantees) in addition to the usual fund expenses. Fund expenses average anywhere from 0.6 to 1.25 percent on equity funds, and can occasionally be as high as 2.25 percent for small cap equity or international equity funds.

Third, most variable annuities impose surrender charges if owners withdraw money within the first five to ten or more years. The charge typically declines to zero in steps of 1 percent per year. As a general rule, variable annuities are less attractive than mutual funds if there is any possibility the contract will be surrendered within the first five to seven years. For terms this short, the benefits from the period of tax deferral generally will be insufficient to overcome the additional fees and surrender charges. There are also some variable annuities offered that allow for substantially reduced periods of surrender charges (as short as three years, or even one year) or no surrender charges. However, these contracts have increased M&E charges to compensate for the higher risk (to the insurance company) of an early liquidation.

Fourth, and potentially more problematic, is the 10 percent early withdrawal penalty on distributions from annuities before age 59½. Distributions that are not part of a series of substantially equal periodic payments for the life (or joint life) expectancy of the annuitant(s) are in most cases subject to a 10 percent penalty tax on the taxable amount withdrawn from the annuity, in addition to the ordinary income tax due.

Keep in mind that, although equity mutual funds do not enjoy the same degree of tax deferral as variable annuities, they are nonetheless, tax favored investments. Although the tax on ordinary dividend and interest income earned by a fund is paid by the shareholders in the year the income is earned, the tax on capital gains is deferred until the gains are recognized, either through buy and sell transactions within the mutual fund portfolio or when the investor sells his or her shares in the fund.

Therefore, when trying to decide whether variable annuities or mutual funds are more appropriate for a particular client situation, the results (particularly the analysis of comparable returns) depend on certain critical assumptions regarding the size of the differential in fees and loads, the rate of return, tax rates on ordinary income, qualifying dividends, and long-term capital gains, the turnover rate of the underlying investments, the length of accumulation period, whether annuity distributions will be subject to a 10 percent penalty, and what income, accumulation or withdrawal benefits or guarantees are provided by the annuity or it’s riders.

In addition, the relative merit depends on how the variable annuity will be liquidated. Variable annuities are relatively more attractive if proceeds will be annuitized rather than taken in a lump-sum (because longer time periods generally favor the annuity’s tax deferral benefits).

In most cases, investors who accumulate substantial sums for retirement, either inside or outside of an annuity, do not take a lump-sum distribution, which would then trigger the immediate recognition and taxation of all deferred income or accumulated gains. Instead, they make periodic withdrawals (and/or outright annuitize the contract) which enables them to continue to enjoy the benefits of tax deferral on the remaining balance over the distribution years. This continuation of tax deferral increases the relative benefit of the variable annuity as compared to the mutual fund.

A comparison of variable annuities to other investments like a mutual fund typically assume a level annual return. However, in point of fact, we know that annual returns are not level. Although the S&P 500 index has had a long-term compound average annual rate of return of approximately 10 percent over the past seventy-five years or so, individual year returns have ranged dramatically, and substantial losses in a particular year are possible. If withdrawals need to be made from the investment, either on account of retirement (or other) spending needs, or because of a death of the account-holder, the guarantees provided by the annuity may become highly relevant. A severe market downturn shortly before a substantial withdrawal can provide an immense savings to the annuity holder as the contractual or rider guarantees are exercised.

In addition, the provision of underlying guarantees may allow an investor to otherwise take a higher level of risk than they may otherwise be comfortable with. Consequently, an annuity investor might potentially earn an average rate of return of 10 percent in an S&P 500-like investment, while the mutual fund holder might only earn an average rate of return of 8 percent, due to a more conservative investment in light of the lack of underlying annuity contract or rider guarantees. The potential for a higher rate of return to an annuity holder in light of higher investment risk taken on (mitigated by reduced total risk due to annuity contractual or rider guarantees) can substantially impact any comparison.

Because the appropriate amount of risk can vary tremendously on an individual basis, and risk characteristics can change over time, the primary factor in the decision to select a variable annuity should be its value as a risk management tool, not merely as a tax deferral method. Because of the tremendous variety of contractual and rider guarantees, with varying costs, available through commercial variable annuity providers, full analysis of the relevant options, and the client’s needs and concerns, is vital to the decision to utilize a variable annuity and the appropriate selection of a particular contract and its riders.

Reproduced with permission.  Copyright The National Underwriter Co. Division of ALM

Leave a Comment