Variable Annuity Tax Deferral: Is it worth the additional expense?
I have been in practice long enough now to have seen products change and evolve. Take the annuity for example. In the late 1980’s when I was getting started, most annuities were traditional fixed annuities. They offered fixed interest and were backed by the credit worthiness of the issuing insurance company. Fixed annuities offered two primary benefits; tax deferral during accumulation and the ability to create a lifetime stream of income. However, in order to get the lifetime income the annuity owner had to sacrifice their principal and that lack of flexibility often was a major issue so the majority of annuities were used for tax deferral.
As the stock market soared in the 1990’s, so did the popularity of the variable annuity. The variable annuity (VA) differs from a fixed annuity in that instead of the issuing insurance company paying interest, the contact value is invested into separate accounts which are similar to mutual funds. As the money was no longer part of the insurance company’s general assets, the stability of the annuity was much less dependent on the issuing company. Instead, the VA’s performance was directly linked to the performance of the underlying investments. The primary motivation for investing through a VA as opposed to other investment options was that the growth in an annuity is tax deferred until it is distributed.
The first ten years of the 21st century brought the aftermath of the tech bubble, 9-11, and the great recession. Investors who had enjoyed great returns as the markets soared became more interested in protection and less concerned about sheltering taxes. Again the financial industry innovated and developed riders to provide guarantees for income, without having to forfeit the principal, and annuity sales continued to grow.
I have watched the reasons to purchase an annuity evolve from safety to tax deferral to income guarantees. Now the industry is changing again. With the volatility in the markets over the last few years the majority of annuity companies are either cutting back on the guarantees they are willing to make, or are charging more for the same guarantees.
Recently I attended a continuing education seminar hosted by a variable annuity company. The host addressed the audience and told us about the recent changes to their products but what caught my ear was his comment “as the industry reduces guarantees or increases fees, the annuity marketplace is going to go old school. The attractiveness of VA’s is no longer the fancy bells and whistles, but instead we will be selling annuities in a return to the advantage of tax deferral.“
Critics of VA’s point out that insurance companies charge fees, above the costs of the investments themselves, for variable annuities. While there are many fee structures and each product is different, VA fees are typically 1% to 2% per year. There are also other complicating factors to consider such as surrender charges and an additional 10% excise tax for annuitants less than age 59 ½.
After hearing the comment that VA’s should be purchased for their tax advantages, I wondered if the advantages outweighed the costs and complications. I examined nine different scenarios and calculated the advantage a VA would have, considering the expense, over a non-annuity, taxable account with identical investment returns.
Investment Return
Tax Rate
Annuity Expense
Case 1
8%
35%
1.7%
Case 2
12%
35%
1.7%
Case 3
6%
35%
1.7%
Case 4
8%
50%
1.7%
Case 5
10%
50%
1.7%
Case 6
4%
50%
1.7%
Case 7
8%
35%
1.9%
Case 8
12%
35%
1.9%
Case 9
7%
35%
1.9%
In most cases the VA does offer an advantage, especially with the higher returns or in higher tax environment. However, if the investment returns are lower (cases 3, 6, and 9) the taxable account has the advantage.
This analysis ignores two important issues. The first is difficult to quantify since there is a wide variation in the marketplace, but variable annuities are meant to be long term holdings. The investment portfolio can change but most VA charge a substantial fee, called a surrender charge, for the first 3 to 10 years. Surrender charges typically maximize around 8% and reduce every year. So even in the high return, high tax situations which really make variable annuities excel, an early liquidity event can reduce or eliminate the VA advantage.
The other consideration outside the scope of this analysis is one of tax policy. Under current tax law, all gains distributed from annuities are considered ordinary income and are taxed at ordinary income tax rates. It does not matter how long the investment was held. If it comes from an annuity it is taxed as income. Gains from non-annuity accounts are taxed as capital gains. As long as the investment was held for a year or more, the current maximum long term capital gains rate is 15%. With a tax rate that low, gross returns have to be about 13% if the annuity fee is 1.7% for the annuity to break even. Long term returns in excess of 10% would be extremely unlikely.
The natural conclusion is that until taxes rise dramatically and the market experiences a secular bull market, I do not see the tax deferral of variable annuities as a strong enough benefit by itself.