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Frequently Asked Questions |
| Variable Annuity Questions |
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| What is the difference between variable and fixed rate annuities? |
Fixed rate annuities have minimum guarantees and “fixed” (or declared) interest rates. They are meant for the conservative investor that wants to take advantage of tax-deferral within a conservative investment. Since the interest rate from year to year is pre-determined or declared annually, the investor has a good idea of what his or her account value will be from year to year.
A variable annuity, however, has “subaccounts” ranging from conservative to aggressive, designed like mutual funds, where the more aggressive investor can allocate all or a portion of their funds. There are fixed subaccount options within a variable annuity, so an investor can be just as conservative as a fixed annuity buyer, but several more investment options within the annuity. Unlike a fixed annuity, a variable annuity has “rolling” values depending on the performance of the underlying funds they’ve selected. Values may go up or down.
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| What are the sub-accounts within a variable annuity? |
| Sub-accounts are the investment portfolios offered in variable annuity contracts where premiums may be allocated. Designed much like (and often exactly like) mutual funds, they range from very conservative (like money market sub-account) to more aggressive (like an aggressive growth fund sub-account). |
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| Can I change my investments? |
| For most variable annuities, you can change your sub-account allocation as often as you want. Many products will allow you to do this free-of-charge up to a certain limit (over the phone in most cases), then charge a fee if you exceed the limit. |
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| Are variable annuities a risky investment? |
| This depends solely on the risk tolerance of the investor. Most variable annuities offer attractive death benefit options, something comparable investments (like mutual funds) may not. Risk also depends on the selection of sub-accounts by the investor. The variable annuity buyer can reduce his or her risk by blending a selection of conservative, moderate, and aggressive sub-accounts within the annuity. |
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| What charges are included in a variable annuity? |
Contract Maintenance Charge - each insurance company will assess a yearly maintenance charge to cover the administrative expenses associated with the variable annuity contract. This charge, usually assessed at each contract anniversary date and upon surrender of the contract, covers the cost of issuing the policy, as well as other administrative costs.
Administrative Service Charge - is usually expressed as a percentage of the funds invested in the separate accounts. It covers the costs of transferring funds from one separate account option to another. Also covers the cost of policy statements and the tracking of deposits in the contract.
Mortality and Expense Risk Charge - in most cases, the “M & E” charge pays for the guaranteed death benefit, ensures that the expense risks charged on the contract won’t increase, covers a guaranteed interest rate paid on one type of variable annuity subaccount and may cover the overhead expenses the insurer incurs with the annuity contract.This depends solely on the risk tolerance of the investor. Most variable annuities offer attractive death benefit options, something comparable investments (like mutual funds) may not. Risk also depends on the selection of sub-accounts by the investor. The variable annuity buyer can reduce his or her risk by blending a selection of conservative, moderate, and aggressive sub-accounts within the annuity.
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| How do variable annuities compare to mutual funds? |
The separate account of a variable annuity is made up of many sub-accounts. These sub-accounts are quite similar to mutual funds (and sometimes clones). Given the similarity and the fact that variable annuities and mutual funds are used for similar purposes, comparisons are inevitably made. Many comparisons are often flawed, however, because they tend to focus on expenses instead of performance. Comparisons should be based on performance. Obviously, expenses affect performance, but they are only one factor. All factors must be considered and that is what performance does.
Mutual Funds
Mutual funds can be long-term or short-term savings vehicles, and they may or may not be used for retirement. For purposes of comparison, we will only evaluate the mutual funds as they are used for long-term retirement savings.
There are basically three ways an investor gets a return on a non-qualified mutual fund investment: dividends, capital gains generated by the fund and capital gains generated by selling or liquidating shares. For simplicity, we’ll designate gains generated by the fund as internal and those generated by liquidation on the part of the shareholder as external. Dividends and internal gains are reported as income to the shareholder each year and are taxed accordingly. External capital gains are taxed only at the time of sale by the shareholder. If the shares sold were held longer than a year, then the shareholder enjoys long-term capital gains treatment, which may mean a lower tax rate. In addition, mutual funds take a stepped-up cost basis at death. This means that when the shareholder dies, the cost basis of the investment is the market value as of the date of death; the beneficiary is not taxed on any unrecognized external capital gains. (Keep in mind that this tax advantage only applies to external capital gains realized at death, as taxes have been paid along the way on dividends and internal capital gains.)
Variable Annuities
Annuities enjoy tax deferral because they are long-term retirement savings vehicles. This is the primary purpose they serve and, for the most part, it is the reason most people purchase them and hold them for the long term. No taxable income is generated for dividends, none for internal gain and none for external gain. In fact, not only is no taxable income created for external gains on fund switches within a variable annuity, no taxable income is generated when the contract owner switches from one variable annuity to another. With a variable annuity, a taxable event is created only when monies are removed from the contract.
| Assumptions |
- Use 5-year historical returns for variable annuity sub-accounts and mutual funds; period ending December 31, 1995. (Source: Morningstar)
- Use 5-year historical differences in variable annuity sub-accounts and mutual fund returns.
- Compare most commonly used load methods (back-end load for variable annuity and front-end load for mutual fund).
- 30% of mutual fund distributions (internal turnover) are taxed as long-term capital gains.
- 25% of mutual fund gains are deferred until external turnover.
- External fund turnover occurs every 4 years (industry average).
- Goal of both variable annuity and mutual fund is to generate maximum retirement income.
- Buyer invests $100,000 at age 50, accumulates for 15 years, retires at age 65, then takes a level distribution of income until age 80, at which time the account is depleted.
- Ordinary income tax rate of 42%, which includes federal and state taxes and the effects of the phaseout of deductions and exemptions. (For high-income individuals in high-tax states, a more accurate rate would be in excess of 50%.)
- Capital gains tax rate of 31% (includes federal and state tax).
- Back-end load for the annuity: 6%, 5%, 4%, 3%, 2%, 1%.
- 4% front-end mutual fund load
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| Variable Annuity Sub-Accounts vs. Mutual Funds |
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| Performance |
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| Average Compound Annual Returns for 5 Years Ending 12/31/95 |
| | Annuity | Mutual Fund | Annuity Advantage |
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| U.S. Equity | 17.19% | 16.64% | +0.55% |
| Bonds | 10.29% | 8.27% | +2.02% |
| Int'l Equity* | 8.43% | 10.54% | -2.11% |
Returns are net of all fund fees and expenses, all sub-account fees and expenses and all mortality and expense charges.
*Note: At this time, there are very few international sub-accounts in variable annuities; therefore, the statistical significance of the international comparison is questionable.
Source: Morningstar
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Results
The first set of results below show a variable annuity and mutual fund when 100% of the assets of each are invested in equities; the second shows the results when the assets of each are invested 50% in equities and 50% in bonds. Note that all results are after accounting for fund fees, sub-account fees and mortality and expense charges.
| 100% U.S. Equity |
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| | Annuity | Mutual Fund |
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| Initial Deposit: | $100,000 | $96,000* |
| Account value at 15 years: | $1,079,800 | $458,800 |
| After-tax annual income for years 16 thru 30: | $104,000 | $53,700 |
| Account value at year 30: | $0 | $0 |
| Annual annuity advantage: | $50,300 | |
| *After accounting for 4% front-end load |
| 50% Equity / 50% Bond |
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| | Annuity | Mutual Fund |
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| Initial Deposit: | $100,000 | $96,000* |
| Account value at 15 years: | $689,800 | $313,700 |
| After-tax annual income for years 16 thru 30: | $59,300 | $32,500 |
| Account value at year 30: | $0 | $0 |
| Annual annuity advantage: | $26,800 | |
| *After accounting for 4% front-end load |
Below is another way of looking at the results. In this comparison, we’ll match the after-tax payout of the variable annuity to that of the mutual fund and see how much longer the payout of the variable annuity will last. Again, the firs shows the comparison of a variable annuity and a mutual fund invested 100% in equities; the second is a comparison of these two products invested 50% in equities and 50% in bonds.
| 100% U.S. Equity |
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| | Annuity | Mutual Fund |
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| Initial Deposit: | $100,000 | $96,000* |
| Account value at 15 years: | $1,079,800 | $458,800 |
| After-tax annual income for years 16 thru 30: | 104,000 | $104,000 |
| Account value at year 30: | $0 | $0 |
| Number of years of payout: | 15 | 5 |
| Annuity advantage in years: | 10 | |
| *After accounting for 4% front-end load |
| 50% Equity / 50% Bond |
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| | Annuity | Mutual Fund |
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| Initial Deposit: | $100,000 | $96,000* |
| Account value at 15 years: | $689,800 | $313,700 |
| After-tax annual income for years 16 thru 30: | $59,300 | $59,300 |
| Account value at year 30: | $0 | $0 |
| Number of years of payout: | 15 | 6 |
| Annuity advantage in years: | 9 | |
| *After accounting for 4% front-end load |
| Variable Annuities and Mutual Funds: Comparison of Features |
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| Variable Annuities | Mutual Funds |
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| Tax deferred | Gains and income currently taxable |
| Ordinary income treatment | Capital gains treatment |
| Exclusion ratio available | Stepped-up cost basis |
| Long-term savings | Long-term or short-term savings |
| 10% pre-591/2 w/drawal penalty | |
| No stepped-up cost basis | |
| Probate avoidance | |
| Death benefit | |
| General (fixed) account usually available | |
| Lifetime income available | |
The Analysis
Based on a performance comparison, we see that the variable annuity more than holds its own to the mutual fund. Now that we’ve seen the results, it’s time to get an appreciation for why the results are what they are. Many analysts simply evaluate variable annuities as being more expensive by the amount of the mortality and expense fee. In other words, these analysts determine the performance of variable annuity sub-accounts by subtracting the mortality and expense fee (which averages approximately 1.35% of the sub-account balance) from mutual funds returns. This would mean that the sub-accounts would always be at a disadvantage compared to mutual funds. This type of analysis would be fine if it were valid. But it isn’t valid, as the above charts prove.
What accounts for the fact that sub-accounts have better performance with higher fees? First, let’s review what the extra costs are. Variable annuity insurers charge additional fees for mortality and expenses. These fees range from .4% to 1.75% of the sub-account balance, with the average being 1.35%. Some analysts assert that this is the charge for tax deferral. That is not correct. There is no charge for tax deferral. Tax deferral is granted, without cost, by the federal government to annuities as long-term retirement savings vehicles. There is no cost...period.
So, if tax deferral is free, what costs 1.35%? This is the cost to the insurer for the mortality risk of the specific death benefit and other expenses. This being the case, then the sub-account must perform 1.35% better than the mutual fund each year. How is it able to do this? Following are the reasons that variable annuity sub-accounts not only make up for mortality, but can actually outperform mutual funds:
- Longer-term investment horizons – Sub-account managers know that 100% of the monies in their accounts are destined for a long-term horizon, specifically retirement. Therefore, they can take a much longer approach than a similar fund since a similar fund will have a mix of long-term and short-term monies and more likely will be judged on short-term performance. Annuity holders tend to have investment horizons of 10 to 15 years, whereas turnover of mutual funds (external) occurs every 2 to 4 years.
- Lower cash requirements – Sub-account managers can remain more fully invested because of lower (external) turnover, less panic selling and fewer market timers. Market timers are those who attempt to predict the direction of the market in relatively short time periods. Again, because of the ling-term nature of variable annuity holders, there are virtually no market timers in this market. Additionally, variable annuity holders tend not to panic during sudden downturns and continue to hold their positions. Being fully invested tends to increase returns substantially, especially in recent years. (This has been true of both stock and bond funds.)
- Lower advisory costs and transfer fees – A mutual fund may have hundreds of thousands or even millions of shareholders. A variable annuity sub-account has only one shareholder – the insurer. Therefore, the sub-account has to carry only the expenses associated with that one shareholder. This means substantial savings. Admittedly, not all of these savings are passed on to the policyholder. Even though there is only one shareholder, there are still thousands of policyholders and these policyholders have to be serviced. But instead of being serviced by the fund, they are serviced by the insurer. Ultimately, this serves to mitigate the effects of the 1.35% mortality and expense charge and substantially increases overall performance relative to funds.
- No tax consequences for trades – Mutual fund managers are consistently attempting to increase the after-tax return of their fund. This means they must be cognizant of any trades that produce internal capital gains. Additionally, they may pass over potentially high performing stocks or bonds that generate high dividends. Sub-account managers need not worry about these issues. They are free to make any purchase or sale they wish, because these trades generate no current tax consequences for the policyholder.
- Contractual fee limits – Generally sub-account fees, including mortality and expense, are limited by the terms of the contract. The starting fees typically are equal to the lifetime maximums. This is not true of mutual funds. Most fund fees can be increased by vote of the trustees. It’s too early to say what the long-term impact of this difference may be, but it has the potential to be significant.
Combined, these reasons serve to make the positive difference with variable annuity sub-accounts. In addition, variable annuity policyholders have a death benefit and, typically, the flexibility to invest in a general account as well. It should also be noted that many of the advantages mentioned here also pertain to qualified applications. Because tax deferral is free, one need only consider other features, benefits and performance to determine if qualified monies fit in the annuity. You’ll find that they often do and are so used about 50% of the time.
The above was extracted from a publication(“Annuities”) by Thomas Streiff, CFP, CLU, ChFC, CFS and David Shapiro, CFP, CLU, ChFC.
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