Variable annuities? Don't bother

By Scott Burns

Variable annuities have a tough row to hoe. Doomed to being measured against better alternatives, they simply can't overcome the burden of their fees or the higher tax rates that investors must pay on their returns. The past year has been no exception.

Despite these disadvantages, a hardworking sales force trudges on and racks up big-time sales -- $41.6 billion in the U.S. in the first quarter of this year, for example. The sales for the quarter brought the total assets in variable annuities to nearly $1.4 trillion.

That's a lot of retirement savings. And there's the rub.

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Variable annuities transfer enormous amounts of spendable investment returns from investors to the insurance industry and its sales force. Using the alternative I have suggested for years -- low-cost and tax-efficient index funds -- would save the investing public billions of dollars.

With an average cost difference of about 1.8% a year, a cool $25.2 billion a year is fattening the insurance industry rather than investors. (See "The worst retirement investment you can make.")

A comparative look at returns

Promises of tax deferrals and expert management notwithstanding, variable-annuity subaccounts -- the individual funds that investors choose inside the insurance contracts -- continue to trail a simple index. They did this in the worst period for index investing I can remember. Over the past three- and five-year periods, the Vanguard 500 Index Fund (VFINX) has beaten only 52% and 53%, respectively, of its actively managed mutual fund peers. It typically beats about 70% of its actively managed peers.

So here is the investment score.

Over the 10 years ending June 30, the Vanguard 500 Index Fund returned 2.81% annually, while the average domestic large-blend variable-annuity subaccount returned 2.02%. The Vanguard Total International Stock Index Fund (VGTSX) returned 6.94%, compared with 6.31% for the average international-equity subaccount. And the Vanguard Total Bond Market Index Fund (VBMFX) returned 5.42%, compared with 4.06% for the average managed subaccount that invested in bonds.

The odds of having an adviser who could pick a winning fund improved over previous years. But the numbers are still seriously against you. With only 1,318 of 5,488 large-blend subaccounts beating the Vanguard 500 fund, you had only a 24% chance of doing better than the index. In international subaccounts, only 2,796 of 7,555 beat the Vanguard Total International fund, so you had only a 37% chance of doing better. And in fixed income, only 129 of 2,329 subaccounts beat the Vanguard Total Bond fund, so you had only a 5% chance of doing better. Basically, the deck is loaded against investors.

The chart below compares the returns of the average variable-annuity subaccount in three major asset classes with the returns of a simple index fund for the same asset class. In all cases, the index fund has done better over all four time periods considered.

Investment	Past 12 months' returns	Past 3 years' returns	Past 5 years' returns	Past 10 years' returns	Expense ratio
Category: Large-blend domestic equities
Vanguard 500 Index Fund (VFINX)	-13.19%	4.28%	7.45%	2.81%	0.15%
Average large-blend variable annuity	-13.87%	3.52%	6.75%	2.02%	2.05%
Category: International equities
Vanguard Total International Stock Index Fund (VGTSX)	-8.06%	14.94%	18.33%	6.94%	0.27%
Average international variable annuity	-9.03%	12.77%	15.68%	6.31%	2.27%
Category: Fixed income
Vanguard Total Bond Market Index Fund (VBMFX)	7.23%	4.02%	3.77%	5.42%	0.19%
Average intermediate bond variable annuity	3.41%	2.19%	2.49%	4.06%	1.80%

Source: Morningstar Principia (data for June 30)

Taxes take an additional bite

Ironically, these figures make the performance of variable-annuity investments look better than they really are.

Why? They don't consider taxes.

When you invest in equities directly, dividends and capital gains are taxed at a maximum of 15%. Put the same investment inside a variable-annuity contract, and the accumulated dividends and capital gains will be taxed as ordinary income upon withdrawal.

Calculate what you'd have after paying taxes, as I did using Morningstar Principia, and only 12.4% of all large-blend variable-annuity subaccounts did better than the Vanguard 500 fund over the past 10 years.

It would be different for bond funds, though, right?

Yes, but no.

Had you invested $10,000 in the Vanguard Total Bond fund 10 years ago, you would have earned 5.42% annually -- before taxes. Paying taxes each year at a 25% rate would have taken your return down to 4.05%, free and clear. Your account would be worth $14,871.

The average variable-annuity bond subaccount earned 4.06%, before taxes. So the same investment would be worth $14,888 before taxes and $13,666 after taxes. That's $1,205 less than the investment that had no tax deferral.

How can this be? Simple: high fees and tax disadvantages.

Questions about personal finance and investments may be e-mailed to scott@scottburns.com. Questions of general interest may be answered in future columns. More columns by Scott Burns can be found here and here.

Published Aug. 27, 2008