Variable Annuities vs Mutual Funds

Variable annuities have much in common with mutual funds. In many respects, variable annuities can be described as mutual funds wrapped up inside an annuity contract. Since variable annuities and mutual funds are popular investment vehicles chosen by millions of people, both their similarities and differences should be clearly understood. The best way to achieve this is to compare the two.

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Basic Framework

Mutual fund shareholders purchase shares in a fund. The shares represent proportional ownership in securities, usually stocks but sometimes bonds, a combination of both, or money-market instruments. The fund is run by a company that chooses an investment advisory firm to manage its portfolio and a financial fiduciary to serve as trustee for its assets. The managers state investment objectives and purchase sufficient numbers of securities to diversify the fund, spreading investing risk over a large number of companies and minimizing the effects of a few bad portfolio choices. Investment gains, both dividends and capital gains, are passed along directly to shareholders without being taxed as the business level, as long as over 90% of the gains are distributed to shareholders. The net asset value of the fund at the close of the trading day determines the share price at which shares trade the following day. Mutual funds, which date back to the 1920s, afford instant diversification, professional management, liquidity and trading convenience to investors. Today, over 8000 mutual funds serve American investors.

Variable annuities are contracts between insurance companies and individuals. Most variable annuities are deferred annuities, consisting of an accumulation period and a distribution period. During the accumulation period, the annuity holder makes regular payments that are compiled and invested by the insurance company. Unlike the case with fixed annuities, the investment portfolio is selected and controlled by the holder rather than the insurance company. That portfolio is chosen from a group of sub-accounts managed (or contracted for) by the insurance company. These sub-accounts are the functional equivalent of mutual funds, specializing in equities, bonds, or a combination of the two. The accumulation account can fluctuate in accordance with the portfolio’s investment performance, which will in turn vary as market conditions change. Variable annuities were created to allow investors to benefit from the market gains reaped by mutual funds while simultaneously enjoying the tax deferral and insurance-like protections associated with annuities.

Tax Treatment

Variable annuities offer tax deferral of investment gains and compounded reinvestments. Mutual funds can offer tax deferral only when the investment is sheltered by a qualified plan such as an IRA or 401(k). Moreover, even within the context of a qualified plan, a mutual fund investment will probably be constrained by contribution limits. No such limits apply to variable annuities. (Both instruments offer the ability to invest with before-tax dollars in the framework of a qualified plan, but this is highly dubious for variable annuities. Tax deferral can be had outside the plan; equivalent investments with lower costs than variable annuities can be had within the plan.) As mutual fund shareholders can attest, yearly taxation is both wounding and vexatious – so much so that late-year buyers must exercise care to avoid being taxed on unearned capital gains. However, this is counterbalanced somewhat by the state taxes sometimes levied on variable annuities.

At retirement, the accumulated investment gains are distributed to variable-annuity holders. Because the distributions are almost always made as numerous regular payments, stretched out over holders’ retirement, each distribution will consist partly of return of principal and partly of investment gain. The gains are taxable as ordinary income. On the one hand, it is likely that the holder’s tax rate will be lower in retirement than while working – in this sense, the variable annuity’s tax treatment is more favorable than that of the mutual fund. On the other hand, mutual fund gains will be treated as capital gains upon liquidation in retirement.  Capital-gains tax rates are much lower than even the lowest income tax rates, which gives a significant tax advantage to mutual funds.

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Expenses

Both variable annuities and mutual funds incur similar expenses for portfolio management, traceable to the investigation, analysis and trading of securities, and for administrative purposes. These expenses can be quite low for index funds or much larger for international funds, typically from 0.20% to 2.5%. Variable annuities, however, necessitate another layer of administration to create and run the annuity shell within which the mutual funds (or sub-accounts) reside. This shell is really two sources of additional expense – administration for the subaccounts and for the insurance elements of the variable annuity. As a first approximation, total expenses of variable annuities are significantly larger than for mutual funds alone.

Closer investigation reveals that any honest attempt to compare variable annuity expenses to those of mutual funds must first specify the nature of the mutual fund. Many mutual fund companies market their products by using salespeople (either company employees or independent contractors) who receive sales commissions that are tacked onto the net asset value of the fund as part of the selling price. Some funds are divided into A, B and C shares consisting of medium-expense shares with no sales load, low-expense shares with a contingent deferred sales charge if the shares are sold within a year or so of purchase, and no-load shares whose annual expenses include marketing expenditures (12(b)-1 charges) incurred by the fund, respectively. Still other funds impose a back-end sales load when shares are redeemed. Some of these expenses, particularly the deferred or back-end sales charges, are indistinguishable in character if not in magnitude from the surrender charges imposed by insurance companies on early withdrawals from variable annuities.

If we compare variable annuity investment with the lowest-cost mutual fund – say, an index fund with no sales charges or marketing costs – the mutual fund has a substantial cost advantage. The introduction of sales and marketing charges and higher expenses makes the choice murkier. Although it is still reasonable to presume an advantage to the mutual fund, the difference becomes harder to quantify and more conjectural.

Commentators who compare variable annuity expenses to mutual fund expenses rarely compare apples to apples – by, say, comparing a stripped-down variable annuity with no options, riders and the irreducible minimum of insurance features to the lowest-cost index mutual fund. This is asymmetrical yet logical, for people normally purchase variable annuities containing death benefits and minimum guarantees. This, in turn, suggests that the higher costs of variable annuities are overemphasized. Neither the investment products nor their owners are homogeneous; the higher costs reflect added benefits that are freely chosen by variable annuity buyers. In a competitive market economy, that is what should be expected to happen.

Insurance Elements

Much attention is paid to the fact that variable annuities generate higher expenses for their holders than mutual funds do for theirs. Much less attention is paid to the object of those expenses and its implications for the choice between the two investment vehicles. Yet there is no better way to appreciate the relationship between the two than to compare variable annuity insurance features to those of mutual funds.

Variable annuities offer a death benefit option that would allow the annuity’s assets to bypass the probate process en route to the beneficiary. Mutual fund assets can duplicate this benefit only in states that allow a mutual fund beneficiary designation of “transfer on death (tod).” Variable annuities offer riders guaranteeing minimum levels of investment performance and withdrawal, whereas mutual funds provide no assurances or performance guarantees; indeed, the funds are forbidden from doing so.

Relative Suitability

To be sure, variable annuity holders pay a price for these insurance features. Rather than viewing the two investments in hierarchical terms, it is more appropriate to see them as suitable for different types of investors. Variable annuities’ insurance features make them more suitable for older, more risk-averse investors; alternatively, they are good supplements for younger investors who have filled their quota of qualified plan investments and need other means for deferring taxes. Mutual funds are suitable for younger, growth-oriented investors for whom the variable annuity’s insurance features cannot justify their costs.

Liability Shield

One important advantage for variable annuities over mutual funds derives from the liability shield granted by many states to assets inside life-insurance products. Professionals like doctors and business owners have a clear incentive to hold wealth in annuity form. From middle age well into retirement, variable annuities are attractive because their mutual fund and bond fund sub-accounts can power a growth-oriented retirement strategy. The limited liquidity provided by annuities may be sufficient for high-income professionals striving to build their portfolios.

Relative Investment Performance

This is the area where we would expect to find the least difference between variable annuities and mutual funds. Variable annuities were created to mimic mutual funds and the subaccounts that comprise the investment vehicles of variable annuities are the functional equivalents of mutual funds. Yet some subtle and surprising differences to emerge on close inspection.

Variable annuity subaccounts are sometimes owned and operated by the issuing insurance company. Alternatively, they may bear the names of well-known “outside” mutual funds. These outside funds, while operated by the companies whose names they bear, are technically separate from their namesake funds. That is, they are managed by the outside mutual fund company for the benefit of the variable annuity’s customers. Many variable annuities feature both inside and outside funds. This raises an interesting possible point of differentiation. Many mutual fund companies also offer financial planning services to their customers. Much is made of the inherent conflict of interest involved here, since the planners often have a stronger financial interest in recommending their companies’ funds than those of unrelated companies, regardless of the expected relative performance of the funds. In contrast, this conflict of interest would not operate for an insurance company whose variable annuity product features both inside and outside subaccounts. The financial planner’s interest (and the insurance company’s) is to retain the customer’s allegiance, not in attracting investment to inside funds per se.

Research has uncovered another intriguing point of comparison between variable annuities and mutual funds. Variable annuities tend to experience fewer customer redemptions of funds, both because of the stiff surrender charges levied by annuities and because annuities tend more than mutual funds to be retirement-oriented investment products. Some research suggests that the ability to stay fully invested, rather than having to hold cash to cover possible redemptions, allows variable annuity subaccounts to outperform mutual funds.

The soundest reason to rank the performance of variable-annuity subaccounts over that of mutual funds is that academic studies attribute portfolio gains not to active management but rather to asset allocation – placing the proper amount of funds in particular asset classes. Keeping assets allocated properly requires “rebalancing” – changing the amounts allocated to the various classes when market prices change, in order to keep the proportions allocated to each class the same. With funds invested in a variable annuity, rebalancing can be done tax-deferred, as often as needed. In a mutual fund, each trade would create a taxable event. This fact inhibits many trades that would otherwise occur, thus producing less wealth than could be produced.

Summary

Considering that variable annuities were created to mimic mutual funds within the annuity rubric, it may be surprising to realize the differences between the two forms of investment. For the most part, these differences reflect the cost-benefit tradeoffs of the insurance byproducts in variable annuities.

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