By Bruno Giordano
In the aftermath of the Taxpayer Relief Act of 1997, many people heard through the grapevine that variable annuities would no longer be a viable or practical retirement savings option. The sudden cause for concern is a result of industry speculation that tax changes would make other investment options more attractive compared to variable annuities, which may not reap all the benefits of the new tax law. No need to fret: a recent study has proven that variable annuities remain a popular and wise choice.
A survey conducted by Price Waterhouse shows that variable annuity investments are still wonderful choices for long-term savers. Price Waterhouse worked in conjunction with The National Association for Variable Annuities (NAVA) in preparing an objective analysis of how the new tax law has affected the after-tax performance of variable annuity and mutual fund investments. In gathering information for the analysis, Price Waterhouse used traditional assumptions and rates of return based on data provided by Morningstar. Keep in mind that, based on the assumptions that Price Waterhouse used, your rate of return on your investment may be slightly different.
The study was based on the following assumptions.
The mutual fund and variable annuity had the same gross return. As a matter of fact, a study done by Lipper Analytical Services in 1992 of 288 separate equity accounts found that the equity accounts in annuities outperformed their mutual fund counterparts and returned, net after all fees, 0.88 percent more in 1989, 0.4 percent more in 1990 and 1.04 percent more in 1991. My guess as to why this is so is twofold: less turnover, therefore lower operating expenses; and annuity accounts tend to be close to 100 percent invested; whereas mutual funds typically keep 10 to 15 percent in cash to meet redemption requests.
State income tax was 6 percent.
The average annuity contract holder was in a 28 percent marginal tax bracket during accumulation and a 15 percent tax bracket during distribution.
Half of mutual fund returns were subject to long-term capital gains rates, and half subject to ordinary income rates.
Variable annuity expenses were compared to actual mutual fund expenses of no-load funds, front-end load funds, and deferred-load funds.
Average returns on funds were analyzed for four different types of mutual funds: growth, balanced, income and specialty funds.
Mutual fund expenses included operating expenses, management fees, 12b-1 fees and all other asset-based costs. Variable annuity expense also included insurance charges.
The break-even period for variable annuities was determined for options such as lump sum distributions, ten-year term certain distributions, variable annuitization for life and periodic withdrawals.
The Awaited Results
The report indicates that it will take investors less than 1.2 years to break even on annuity distributions such as lump sum, term certain and variable annuitization for life distributions with the new law in effect. The systematic withdrawal option took 3.9 years to break even.
In comparing the two types of investments, Price Waterhouse factored in the insurance-related costs of variable annuities, but left out the associated insurance-related benefits provided by variable annuities. That means in reality, variable annuities are more attractive than Price Waterhouse’s model made them out to be.
Imagine how attractive variable annuities would be if the study included the value of a guaranteed death benefit and the ability to receive an annuity under the terms initially decided upon.
You may ask, Why is the Price Waterhouse model the only one that shows a dramatic difference in break-even periods? The reason is because the study assumed that people were investing in variable annuities for long-term retirement needs. Therefore, it didn’t take into account that owners may face penalties if they make withdrawals before age 59 1/2 or incur charges that may apply to short-term variable annuity investments.
Keep in mind that if Price Waterhouse had used other assumptions, the results would obviously have been different. Some of the assumptions may not even be applicable to your situation. For example, variable annuities tend to yield higher net rates of return after expenses than mutual funds. Yet the study assumed that the fund and variable annuity had the same gross return before expenses. The analysis also indicated that the break-even holding period differs across tax brackets, which in turn implies that this model may not accurately reflect how you may or may not benefit from investing in variable annuities.
Price Waterhouse’s study does in fact show that investing in variable annuities is still an attractive option. Price Waterhouse concludes: “In summary, although a large number of assumptions are necessary in carrying out any particular comparison between variable annuity investments and mutual fund investments, the analysis indicates that variable annuity investments remain a very attractive investment vehicle after the 1997 Act for a wide variety of investors seeking to accumulate long term savings for retirement” (Emphasis added is mine).
Remember that some of the assumptions that were used may or may not pertain to you. Before you make any decisions either way, be sure that variable annuities are the right option for you.
Bruno Giordano is president of Dorset Financial Services in Devon.