Variable annuities: still a better deal for the insurance industry than for investors

Variable annuities have a tough row to hoe. Doomed to being measured against better alternatives, they simply can't overcome the burden of their fees or the higher tax rates investors must pay on their returns.

In spite of these disadvantages, a hardworking sales force trudges on and racks up big-time sales - $41.6 billion in the first quarter of this year.

That's a lot of retirement savings. And there's the rub.

Variable annuities transfer enormous amounts of spendable investment returns from investors to the insurance industry. Using the alternative I have suggested for years - low-cost and tax-efficient index funds - would save the investing public billions.

Variable annuity sub-accounts (the individual funds investors choose inside the insurance contract) continue to trail a simple index. They did this in the worst period for index investing I can remember. Over the last three- and five-year periods, respectively, the Vanguard 500 Index fund has beaten 52 and 53 percent of its actively managed mutual fund peers. It typically beats 70 percent of its actively managed peers.

So here is the investment score.

Over the 10 years ended June 30, the Vanguard 500 index fund returned 2.81 percent annually, while the average domestic, large-blend variable annuity sub-account returned 2.02 percent. Vanguard's Total International equity fund returned 6.94 percent, compared to 6.31 percent for the average international equity sub-account. And Vanguard's Total Bond fund returned 5.42 percent, compared to 4.06 percent for the average managed sub-account that invested in bonds.

The odds of having an adviser who could pick a winning fund improved over previous years. But they are still seriously against you.

With only 1,318 of 5,488 large-blend sub-accounts beating the Vanguard 500 Index fund, you had only a 24 percent chance of doing better than the index.

In international sub-accounts, only 2,796 of 7,555 beat the Vanguard Total International fund, so you had only a 37 percent chance of doing better.

And in fixed-income, only 129 of 2,329 sub-accounts beat the Vanguard Total Bond fund, so you had only a 5 percent chance of doing better.

Basically, the deck is loaded against the investor. Ironically, these figures make the performance of variable annuities look better than they really are. Why? They don't consider taxes.

When you invest in equities directly, dividends and capital gains are taxed at a maximum of 15 percent. Put the same investment inside a variable annuity contract, and the accumulated dividends and capital gains will be taxed as ordinary income upon withdrawal.

The average variable annuity bond sub-account earned 4.06 percent, before taxes. So the same investment would be worth $14,888 before taxes, and $13,666 after taxes.

Scott Burns is a syndicated columnist. He can be reached at scott@scottburns.com.