Extra costs combined with the different tax rates applied to capital gains versus ordinary income make variable annuities a poor choice for many. This article describes how to calculate the pros and cons of a variable annuity under several alternative scenarios.
Refresher on Annuities
The Trap
Assumptions
Case 1: Marginal Tax Bracket of 31%
Case 2: 36% Tax Bracket
Case 3: Assume Cut in Capital Gains Tax
Moral of the Story
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Congratulations! You are a thrifty person who believes in saving. Better yet, you make enough money that you can save with a vengeance. Naturally, you long ago began to take advantage of the tax-deductible retirement plans available to you--IRA accounts, the 401k plans offered by corporations, the 403b plans offered by universities and other non-profits, or the Keogh and SEP plans available to the self-employed.
Unfortunately, in 1996 the maximum amount you can put aside in a 401k or 403b plan is $9500. The maximum amount you can put into a Keogh is $30,000 (or 20%--effectively--of your earnings, whichever is less). Worse, if you are a professor, or perhaps a physician employed at a not-for-profit hospital, who also consults, your 403b and Keogh contributions combined must be less than $30,000.
Bless you, because you have maxed out every tax deductible retirement plan open to you, and you still have spare savings capacity. Your friendly insurance or mutual fund salesperson has been talking up the idea of variable annuities. You fervently believe in the magic of tax-sheltered compounding returns. You are ready to write that check BECAUSE YOU KNOW YOU CAN'T POSSIBLY SAVE ENOUGH TO MAKE UP FOR THE FACT THAT SOCIAL SECURITY WON'T REALLY BE THERE FOR YOU …
STOP! Whoa--there are some subtle traps here, and no one being paid a commission has much incentive to explain them to you.
An annuity is an insurance product-that's why it has a tax sheltering feature. Specifically, the death benefit means that if the market plunges after you invest, and then you die, the vendor must make your estate whole-paying out no less than you put in, even if it's 1932 all over again. Conversely, if the market has gone up since you invested, there is no death benefit to be paid-this feature provides downside protection only.
Returns on the underlying investment vehicle are tax sheltered in that you pay no tax on those returns until you withdraw funds (tax deferred would be a more accurate term, but its use would tend to reduce commission income and mutual fund sales, so tax sheltered is more customary). Like other tax sheltered products, you must play by a strict set of rules. Under most circumstances, you cannot withdraw funds from an annuity until the age of 59 ½; else, as with IRA's, you pay a 10% penalty in addition to the tax due. Worse, many annuities also impose surrender penalties if you opt out after less than eight years.
A variable annuity typically has a stock or bond account underlying it-often, a mutual fund (an older type of annuity promised a fixed payout; because returns on stocks may vary, the term variable annuity arose). In many cases these are the same mutual funds that you can buy outside an annuity. This fact is crucial for the analysis that follows.
Locking up your savings until age 59 ½ is enough to give many people pause. After all, a comfortable retirement is not the only goal worth saving for-emergency funds, a country cottage, college tuition, world travel, etc., may all be worthwhile long term goals. But the real problem with variable annuities lies elsewhere.
So long as the capital gains rate is lower than the ordinary income rate, an annuity investment can under-perform an equivalent non-annuity investment, even after decades have passed. Imagine that: you lock up your money for years, and end up doing worse than if you had invested it normally.
For the examples below, I assume that if you didn't invest in an annuity, you would put your money in an index fund designed to replicate the S&P 500. It is reasonable to suppose that such an investment will return 10% over long periods of time, and that 3% of that will represent dividends and 7% price appreciation. We'll assume also that the annuity in question allows you to put your money in a mutual fund replicating the S&P 500 index, so that we have the tightest (and simplest) possible comparison.
We'll assume that the annuity has annual fees of 0.50% over and above those incurred by an equivalent investment outside the annuity structure
Let's further assume for case 1 that you are in the 31% tax bracket (corresponding to income of greater than $94,250 if married, and $56,550 if single). Moreover, as of March 1996, the maximum tax rate on long-term capital gains was 28%. We'll vary these assumptions across the three cases; all the other assumptions remain the same.
If there were no such thing as taxes or annuities, your investment in an S&P 500 index fund could be expected to produce a sum that can be calculated as 1.10 to the ith power-i.e., it would compound at 10% annually, with i representing the number of years the investment is held.
The result inside an annuity where that same index fund is the underlying vehicle can be calculated as follows:
The 0.50% extra fees reduce the annual return to 9.5%, and the ordinary income tax rate of 31%, which will be applied to withdrawals, is reflected by the multiplier of .69. Because the original investment is not taxed, we remove it from the portion where the tax is applied and then add it back in at the end to get the value of the investment position when all is said and done.
Now here's the expected return for holding the index fund outside the annuity
This was figured by applying the ordinary income tax rate of 31% to the 3% dividend we expect the index fund to pay, while assuming that none of the price appreciation was paid out as capital gains (a reasonable assumption in the case of an index fund). The after-tax return on the 3% dividend is reduced to 2.07% which, added to the 7% price appreciation, gives us the annual return of 9.07%.
The mathematically inclined will note that, in virtue of the power of compound interest, the annuity must eventually outperform the naked index fund, given a long enough period of time. Below are the results for the ten and twenty year time horizons that a 50 or 40 year old investor would typically consider. I assume that you put $10,000 to work at the beginning of the time horizon.
| After ten years | After 20 years | |
|---|---|---|
| In an annuity | $20,200 | $45,477 |
| Outside the annuity | $19,955 | $43,673 |
Still interested in a variable annuity? After ten years, the analysis shows you would be out only $245 as the price of foregoing the "tax shelter" (and extra hassle) of an annuity! After 20 years, the annuity does put you ahead by $1804. Put another way, if you are willing to lock up your money for 20 years, and bear the risk of substantial surrender and tax penalties should you change your mind, then you can improve your returns by about 4.1% (1804/43673) by using an annuity. Well, if that's what you want to do …
If you have the spare savings capacity described at the beginning of this article, then you may well be in the 36% bracket (over $143,600 if married, $117,950 if single). The annuity return is calculated as before; the return outside the annuity is as follows:
This reflects the 36% tax rate applied to the 3% annual dividend stream (.03 x .64=.0192). Here are the ten and twenty year results.
| After ten years | After 20 years | |
|---|---|---|
| In an annuity | $20,200 | $45,477 |
| Outside the annuity | $19,720 | $42,564 |
Annuities look a little better here (of course-tax avoidance schemes always make more sense for those in higher tax brackets). They give a somewhat better return even after ten years, and over 20 years improve your return by $2913, or 6.8%. Is that incremental return worth the substantial penalties that apply if you back out early? Before you decide, examine Case 3, where we will change one additional assumption.
You don't really think Washington is going to leave the tax system alone for 20 years, do you? As this was written, Republicans were still pushing for a 50% cut in the capital gains tax rate, making it half of the ordinary income rate (i.e., someone in the 36% tax bracket would pay 18% on capital gains). Now the expected return for investing outside of an annuity can be calculated as follows:
The annual return is the same but the tax bite at the end is much lower.
| After ten years | After 20 years | |
|---|---|---|
| In an annuity | $20,200 | $45,477 |
| Outside the annuity | $21,070 | $47,086 |
The annuity results don't change (you signed a contract, and a change in the tax law in no way releases you). Because of the much lower capital gains rate, however, you are now worse off if you went the annuity route. Can you imagine how that would feel, to know you were locked into a losing investment for years to come, because of a small change in the tax laws? Just ask people who invested in tax shelters prior to the 1986 tax reform-they'll tell you all about how it feels.
If you've maxed out your retirement plans, and you still want to save more for the long term, put the money in a set of index funds that match your risk profile, and leave it there until you need it. That's all.
It should be apparent that a very different analysis, one more favorable to annuities, would be applied if you were planning to invest in bonds or other fixed income vehicles, and not stocks. The key to the analysis given above is the difference between ordinary and capital gains tax rates, which no longer applies in the case of fixed income vehicles.
Here the relevant comparison would be a taxable bond held in an annuity versus a municipal bond, of equivalent risk, held outside. For wealthy people trying to preserve capital through fixed income investments, the annuity might be quite effective. But we middle class folk are constantly (and correctly) advised to consider stocks as the preferred vehicle for multi-decade investments-hence, my focus in this article.