Variable Annuities: Are they a good investment?
When we hear of a variable annuity, we may think of them as
• Not a good investment due to the high fees
• A good way to defer taxes
• A way to protect against inflation
• A way to receive a higher investment return compared to fixed annuities by directing your investment (e.g., in equities)
There is confusion whether or not variable annuities are a good investment depending on who you talk to. So, let’s look at some of the logic behind the different viewpoints.
• Annuities can defer taxation on investment gains until you receive the payment
• Investment gains for annuities are taxed as ordinary income, thus forgoing lower capital gains taxes
• Annuities usually have a high commission paid to the broker/agent that the policy holder indirectly pays for in higher management and withdrawal feess
How does this work mathematically for investing in equities?
Let’s assume a 10% return over 30 years (a long time to show benefit from tax deferred status of variable annuities)
Let’s assume 15% annual capital gains tax
– thus, the return from non-annuity mutual fund is 8.5% annually (return may be higher if investment is held for several years and thus defer taxes)
- After 30 years, the return is 1.085 ^ 30 – 1 = 1056% return
Let’s assume 0.75% additional expenses for variable annuity (may will be higher unless you look to a low cost provider like Vanguard). So instead of 10% return, the return is 9.25%
- After 30 years the return is 1.0925 ^ 30 – 1 = 1321% return
- Yet, ordinary income taxes are due on the return (assume 28% tax bracket)
- 1321% * (1 – 28%) = 951% return (significantly less than 1056% return above)
So if the math doesn’t show that tax deferred status variable annuities is as beneficial as the capital gains tax rate given up, how about if the variable annuity held shorter term bonds?
Let’s assume a 5% return on short-term bonds over 30 years
With a 28% ordinary tax rate, the annual return from non-annuity bond portfolio is 3.6% (3.6%= 5% X [1 - .28])
- After 30 years, the return is 1.036 ^ 30 – 1 = 189% return
Let’s assume the 0.75% additional variable annuity fee. So instead of a 5% return, the return is 4.25%.
- After 30 years, the return is 1.0425 ^ 30 – 1 = 249% return
- Yet, taxes are due on return as ordinary income (assume 28% tax bracket)
- 249% * (1 – 28%) = 179% return (which is slightly less than 189% above)
So if the tax deferred nature does not work due to the higher fees, why would someone want to invest in variable annuities?
Insurance companies came up with death benefit that guarantees a return in premium if the policy holder dies before starting the annuity as a way to entice buyers. Thus, if the policy holder invested $100,000 and lost money (let’s say down to $90,000), the insurance company will payout the initial $100,000. This would be a benefit if the insurance company provided the benefit out of the kindness of their heart. However, they are charging you a higher fee (e.g., mortality charge) to insure it. So not only are you settling for a lower return (due to higher management fees) but are getting charged other fees (e.g., mortality charges) as well. In my opinion, it is better to get a single term life insurance policy to handle the mortality risk because a single policy is cheaper than insuring with different policies (like this return of premium). Plus, if the goal is to maximize the monthly annuity to reduce the chance of outliving your assets, it seems like the death benefit is having the opposite effect (lowering the monthly annuity to pass assets to your heirs). If leaving an inheritance is the main goal, then annuities may not be the best option.
The biggest benefit of an annuity is receiving a monthly income for the rest of your life. An immediate fixed annuity is an option where you receive a fixed monthly payment for the rest of your life. There are three large financial risks in retirement: mortality risk (living longer than expected), investment risk (rate of return less than expected) and inflation risk. With an immediate fixed annuity, the insurance company is eliminating your mortality and investment risk. The issue with fixed annuities is inflation because $1,000 today is only worth $600 in 15 years (assuming 3.5% inflation). Thus, it is harder to live off of the annuity the older you get. If buying an annuity is to protect yourself from outliving your assets (especially in your 90’s), an immediate annuity without inflation protection is not a perfect solution due to the lose of buying power. With a few fixed annuities, the annuity can increase by a fixed amount each year (let’s say 3.5%) to mimic inflation. Yet, in times of hyperinflation (let’s say 10%), the index annuity still will lose value because it is only increasing at a fixed 3.5%. So, it is still not a perfect option, yet it is closer.
The other option is the variable annuity. Here, the policy holder takes on the investment risk by allocating the investment portfolio himself in order to try to lower the inflation risk. If the investment return is higher than a fixed percentage (which is specified in the annuity agreement, let’s say 3% to 5%), the annuity payment will increase. If the invest return is less than the fixed percentage, the annuity payment will decrease. People say that this gives the policy holder protection against inflation because the annuity can increase to offset inflation. Yet, it may not be as good of projection as some may think, especially in times of increasing inflation. Why is this? If there is a significant increase in inflation, stock prices tend to decline as more people are attracted to higher bond yields. Yet, even though bond yield rates increase (to adjust to higher inflation), the price of bonds actually decreases. Thus, just as the policy holder wants his payments to increase to offset inflation, his investments may actually decrease and thus decrease his annuity payment. Thus, be aware that variable annuities will protect you from mortality risk (living longer than expected) yet it will not protect you from investment risk (because your payments will decrease if market returns are below expectation) and may not protect you as much from inflation risk as some would suggest.
I admit that I am not an expert in this area. So, if you can increase my awareness of how variable annuities can significantly reduce inflation risk, please enlighten me. I know there are some investments that have a higher tendency to increase in value as inflation increases (e.g., housing market, commodities and TIPS – Treasury Inflation Protected Securities) that can provide better protection yet is still not perfect.
As I look at the math, the tax benefit of variable annuities do not seem to justify the higher fees charged (even modest fees). Because the fees and tax situation will be different for each individual, you should review your particular facts with a financial advisor (preferably a fee based advisor who is not going to benefit from selling you their annuity product).
And, if you want the advantages of deferring taxes, then look into maxing out your 401(k) plan or IRA (including Roth IRAs) first because they tend to have better tax advantages with lower fees than variable annuities. If you want the annuity protection, then compare the immediate fixed annuity (with the fixed increase in annuity payments each year) to the variable annuity.
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September 24th, 2006 at 8:42 pm
Carnival of Investing…
Welcome to this week’s edition of the Carnival of Investing. I’m sticking with my usual method of hosting a carnival — listing a summary of each piece with the author’s reason for submitting the post to the carnival (for those…
September 25th, 2006 at 6:30 am
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December 19th, 2006 at 10:20 pm
I read your blog and am always open to critics of variable annuities, but I have to say your tax assumptions are not accurate at all. Income taxes are tiered and not taxed at a flat rate, unlike capital gains which is a steady 15% on long term gains and ordinary income for short term gains.
I also noticed, on the mutual fund example, you did not reduce the actual investment by the capital gains tax you simply removed it from the rate of return. I would think reducing the gains by the tax would be more accurate. Also, you did not illustrate short term capital gains or AMT.
Finally, you did not illustrate the final capital gains tax when the investor will actually sell the investment at the end of the term. That is an additional 15% or higher depending on tax rates at the time.
Mutual funds are taxed 3 times annual distributions on capital gains, dividends and finally another capital gains tax when you sell it. Versus a 1 time tax on the variable annuity. There was also a study showing that the average investor losses between 2.5 and 5% of their returns due to taxes they must pay on their annual distributions.
Annuities are not perfect, but living benefits and the tax deferral do work for a large portion of Americans. That is my humble opinion of course.
December 20th, 2006 at 7:06 am
Thanks Scott for your input. You are right that I simplified the example because there are over 1 million scenarios that can not be addressed. And, as always, because taxes are different for each individual, each person should have their individual situation addressed by their financial advisors.
I do agree that annuities provide a good living benefit (a monthly benefit for life). However, I do not see how variable annuities provide a better inflation risk on that monthly benefit just because it is invested in the stock market than one would receive from a fixed annuity with a annual increase (say 3% to 4%) or from a inflation indexed bond fund. From what I see, analysts blame stock market declines on a bump in inflation. So it seems the correlation is reverse (stocks decline when there is unexpected inflation), thus variable annuities do not provide inflation protection, per se.
As for taxes, there are million of ways to do them. I actually thought I was conservative in many situations. Yet, depending on the individual situation, you are right that my example may be different. However, there are a few things to consider if tax deferral is the primary reason to buy a variable annuity:
1) 401(k)s and IRAs provide the best protection at lower fees and most people are not maxing these out which they should before using other tax deferred vehicles like annuities
- Roth IRA is taxed once (at the time that salary is earned and put into Roth IRA)
- Variable annuity is taxed twice - once when salary is earned (like Roth IRA) and twice on the gains in investments (original contribution is not taxed again)
- 401(k) and IRA are taxed once when the distribution is received and with the smaller fees this is (for most) a better option than a variable annuity (unless the fees for variable annuity are so small that it compares to the fees in a 401(k) - which is currently not the case)
2) You are right that my flat tax on the annuity in retirement at 28% would be graduated (10%, 15%, 25%, 28%, 33%, 35%). Yet, if variable annuities are for higher income individuals (who are already maxing out their 401(k)s and IRAs), 28% may be a good estimate because the scenario with and without the annuity would show the difference in income between the two examples is being taxed at the higher graduated rates (25%, 28%, 33%, 35%). In my scenario, the average tax would need to be as low as 20% to get the variable annuity to produce the same return as a mutual fund (or ETF).
3) Yes, there are many examples of how mutual funds and other post-tax investments are taxed. Thus, I usually simplify it to the flat 15% capital gains rate on an annual basis. Again, I do not assume that much short-term gains because if someone is in this for tax deferral (not playing the market for short-term returns) then they would find stocks, ETFs or mutual funds that do not turn over as much producing short-term gains. And, if this is the case, the 15% reduction in returns may be conservative (with the exception of AMT which is different for everyone).
For example, let’s assume a 15 year holding period
Buy and Hold = 1.10^15 - 1 = 317.70 return * (1 - .15 tax rate) = 270% return
My assumption = (10% return * (1 - 15% tax rate)) = 8.5% return
1.085^15 year holding period - 1 = 239% return
Now, no one can have a perfect buy and hold example due to dividends and reallocation that is why I assume it is taxed each year. Yet, I do not assume short-term gains because in holding a mutual fund, ETF or stocks there is always some dividends or re-alignment. I just assume that the re-alignment is minimal (which is probably more true in an ETF that is based on a broad market like S&P 500 or Russell 1000/3000). So again, this should be run by a financial advisor for each person’s individual circumstance.
3) I do not understand your statement that I forgot to tax the mutual fund again at sale. I agree that any gains that were not previously taxed are taxed at that the time of sale. Yet, my assumption was that gains were being taxed along the way, including in the final year when withdrawn. Thus, all gains have already been taxed, so they are not taxed again.
4) With AMT, there are too many examples to go through because some years people may pay the additional AMT tax and other years can have an AMT credit that lowers their normal income tax to reflect that additional taxes that were paid in prior years.
Yet, let’s assume in my example, the 15% capital gains rate is taxed at 26% AMT. Under an annual tax on returns (turning over the mutual fund/ETF or stock), the return does not outperform the annuity
10% return * 26% tax rate = 7.4% return
After 30 years, the return is 1.074 ^ 30 - 1 = 751% return vs. 951% return for variable annuity
Yet, if a buy and hold policy is taken, the return is much better. If you can hold it for 30 years (which is highly unlikely, I agree with),
After 30 years, the return is 1.10 ^ 30 - 1 = 1744% return taxed at 26% AMT rate (or 28% for some) = 1744 * (1 - .28%) = 1255% return vs. 951% return for variable annuity
Now, the return is somewhere between 751% and 1255% depending on how long they can manage to protect the gains from tax. So it may be closer to the 951% return from variable annuity. However this does not consider:
1) That taxed paid for AMT in one year may be credited in later years when tax under AMT calculation is less than the ordinary income tax (thus the 751% low end is increased for lower taxes later on).
2) The fees in my example for the variable annuity was only 0.75% which may be conservative (many annuities charge higher rates when all fees are considered including conservatism in mortality charges)
I hope in this analysis (based on your and my input), people realize that there are many scenarios thus they need to get an independent analysis based on their income, tax structure and investment strategy (not just relying on insurance company scenarios). My goal in the article was to point out two issues:
1) People forget about the extra fee charged to manage the variable annuity in addition to the investment fees (to pay for insurance company profits and commissions) which many (but may not always) wipe out any benefits of tax deferral and that tax deferral can be gotten in other ways such as buy and hold investment policy.
2) They should challenge the assumption that variable annuities are a good protection against inflation when compared to other methods.
Thanks for your comments Scott.
March 12th, 2007 at 10:24 am
I think people tend to forget that VA’s do offer a very good level of protection. Even with the fees associated with the accounts (let’s say a 1.50% total charge including an income benefit rider), a typical balanced portfolio should have averaged over 8.5% over the past ten years (net of fees). With this being said, the ability to lock in a person’s gains every year, to have an income stream that can never be out lived and the person does not have to annuitize their account to receive this benefit makes these accounts much more attractive.
I think VA’s have received bad publicity for years and in many cases, rightly so. The old VA market (80’s and 90’s) was terrible and set up strictly to make the insurance companies money. However, the newer annuity products actually have benefits that are very attractive to most investors. They offer essentially risk-free market investing. Yes, fees are higher but they are going to be for the benefits offered.
Just something to take into consideration.