On the surface, VAs seem heaven-sent to anyone who buys mutual funds. Effectively, they’re mutual funds that are allowed to grow tax-deferred. You put up anywhere from $1,000 to $10,000 and add to it any time you want. There’s a range of investment choices: U.S. stocks, international stocks, bonds, a balanced stock-and-bond portfolio, a fixed-income account. You pick your own mix and can typically switch whenever the spirit moves you.
Turning to mush: But there’s something about a tax deferral that turns a sensible mind to mush. VAs cost more than mutual funds–around 2 percent annually for annuities invested in U.S. stocks, compared with 1.4 percent for diversified stock mutual funds, says Jennifer Strickland of Morningstar, the Chicago-based mutual-fund research firm. Some funds charge 1 percent or less.
Insurance accounts for the extra cost (annuities are packaged by insurance companies). You pay for the built-in option to convert your VA into a monthly lifetime income. You’re also given a guarantee that your heirs will collect at least as much money as you originally invested.
These extra costs undermine your return. VA investors may wind up with less money after tax than if they had bought their mutual funds outside the annuity.
That’s especially true if you don’t hang on to your annuity very long. You normally face an exit charge if you sell within five to seven years, plus a 10 percent tax penalty on money withdrawn before 59 and a half. All withdrawals are taxed as ordinary income. So if you invest your VA in stocks (as you normally should), you get no advantage from lower taxes on capital gains.
It’s hard to know when you should choose a VA over a straight mutual fund. For a stab at some answers, I turned to T. Rowe Price Associates in Baltimore. Price is one of a handful of companies offering “no load” variable annuities, with no exit charge, no upfront sales charge and unusually low insurance fees. (You can also get low-cost no-loads from Janus in Denver, Scudder in Boston and Vanguard in Valley Forge, Pa. The discount broker Charles Schwab charges a bit more but offers a wider investment choice.)
The most useful question seems to be: if you buy a variable annuity, how long will it take for the value of its tax deferral to overcome the burden of its higher cost. Exact answers will vary with your assumptions on taxes, costs and investment returns. But Price’s results are in the ballpark: ..MR.-
If you emphasize stock investments, low-cost VAs (with insurance charges under 1 percent) might take 10 years to equal comparable mutual funds, assuming 10 percent returns. High-cost VAs, however, might take 16 years or more.
So ask yourself, how long will you hold? If you’re 55 and expect to sell at 65, a no-load VA and a mutual fund will probably pay about the same. If you sell at 70, the VA ought to net you more.
With high-cost VAs, usually sold by stockbrokers and insurance agents, you’ll have to hold past 70. Otherwise, you’d have earned more from a mutual fund.
The more of your money you put into bonds, the less likely it is that VAs will pay. To take an extreme example, say that you’re fully invested in short-term bonds at 6 percent. It would take a low-cost VA more than 20 years to outperform a mutual fund. A high-cost VA could take more than 80 years. Why would you bother?
If you have a VA, you generally shouldn’t cash it in when you retire. Instead, take the money over several years to keep the tax shelter running longer. This improves its return, compared with a mutual fund. Still, the VA might not pull ahead until you’re in late old age.
VAs win hands down, however, if you’re long-lived and take your payouts in the form of an income for life. You can cackle all the way to the bank.
Everything changes if Congress halves the capital-gains tax. Low-cost VAs invested in stocks would take 20 years to beat the returns from mutual funds, for investors who eventually cashed out. High-cost VAs would take so long they were off our charts. ..MR0-
(To evaluate whether you should buy mutual funds or VAs, call 800-341-0790 for T. Rowe Price’s free IBM-compatible software program, the Variable Annuity Analyzer. It builds in the low insurance cost of Price’s VA, but you can vary your tax bracket, fund cost and investment return.)
Saying yes: You shouldn’t even think about buying a VA unless you can answer all of the following questions “yes”: ..MR.-
Have you put the maximum into your 401(k) plan, Keogh plan or Individual Retirement Account? They come in first, because you’re investing money pretax. It also pays to add any after-tax money that your plan accepts.
Will you invest the money in stocks or high-yielding bonds? You need big gains to overcome the VA’s price.
Will you leave the VA alone until you reach 591/2?.
Will you start young enough to make the tax deferral pay? Older investors should probably buy mutual funds instead of VAs, unless they’ll turn the payout into an income for life.
Is this investment for you rather than for your heirs? When heirs sell, they owe higher taxes on VAs than on comparable funds.
Is your tax bracket high? In low brackets, VAs take many years longer to outperform mutual funds.
The surprising conclusion: most investors probably don’t need VAs. They’ll be irrelevant if the capital-gains tax drops.
