Experts Challenge Study on Variable Annuities
The battle lines are being drawn over a new study that says variable annuities are better deals than straight mutual funds.
It’s a surprising claim, especially in light of this year’s tax-reform act. The legislation cut levies on long-term capital gains to a maximum of 20%, from 28% previously.
Variable annuities are retirement accounts in which investor dollars grow tax-free until withdrawn, at which time ordinary income tax rates apply. Because annuity dollars don’t qualify for those preferential capital gains rates, you would think they would be look less appealing when compared with investments such as mutual funds.
Not so, says the report from accounting firm Price Waterhouse. Although annuities carry higher expenses than mutual funds, the tax-deferral benefit offsets this drag within a surprisingly short four years under most scenarios, according to the study.
“The analysis . . . shows that variable annuities remain attractive investments for long-term savers relative to mutual funds,” says the report from Peter Merrill, a principal for the firm in Washington.
But is the study reliable? Few think so.
Of course, the National Assn. for Variable Annuities, a Reston, Va., trade group that commissioned the report, likes it. The study reconfirms the “superiority of the annuity product,” said Mark Mackey, president and chief executive of the association.
But other annuity watchers, including those with no ax to grind, contend the study proves nothing.
“The report makes some dubious assumptions,” said Patrick Reinkemeyer, an annuity expert at fund tracker Morningstar Inc. of Chicago. “This conclusion is in sharp contrast to what many insurance companies and industry analysts have estimated.”
Price Waterhouse’s study assumes that investors typically would pay taxes at a 28% rate during their working years, dropping into the 15% bracket in retirement, when they would pull money from either a mutual fund or a variable annuity. The accounting firm made this assumption after examining a 1996 survey of annuity owners by the Gallup Organization.
Yet the Gallup Poll doesn’t say annuity owners typically are in the 15% bracket when withdrawing money, Reinkemeyer countered. “As a result of using this suspicious assumption, the study severely understates the break-even point” at which annuities become more attractive, he said.
Steve Norwitz, a vice president at T. Rowe Price Associates in Baltimore, agrees. “It’s unlikely that somebody in a high bracket prior to retirement will be in a low bracket in retirement,” he said.
T. Rowe Price, which sells both mutual funds and variable annuities, recently performed its own study. The results show that mutual funds outperform annuities under most scenarios, especially for older investors who can’t afford to let their money compound for decades.
Another problem is that the Price Waterhouse study presumed that variable annuity owners are patient, long-term investors and that fund shareholders are not. The accounting firm assumed that annuity buyers would hold their investments long enough to avoid two key charges: a 10% tax penalty on withdrawals prior to age 59 1/2, and surrender charges of up to 9% that many insurance companies impose on early withdrawals. Investors in mutual funds face neither type of penalty.
But fund buyers were presumed to be shortsighted, switching 20% of their assets into other funds each year, triggering taxes along the way. “This gives a significant advantage to variable annuity investors,” said Reinkemeyer. “Not only does this long-term favoritism seem unjust, but the data used to support this assumption are highly suspect.”
Price Waterhouse estimated that fund shareholders move a fifth of their holdings each year, based on a 1991 study by the Investment Company Institute, a trade group in Washington. But various factors make the ICI numbers are unreliable, said Reinkemeyer.
Also, the study compares mutual funds and annuities using performance figures generated from 1987 through 1996, an exceptionally strong 10-year period for the stock market. Annuities look better during robust periods because “high returns negate much of the impact of fees,” Reinkemeyer said. Although some mutual funds have high fees and a handful of annuities have low fees, in general fees with annuities are far higher.
In a bear market, the fees become more obvious. At the least, Reinkemeyer said, Price Waterhouse would have been more realistic in using returns closer to the stock market’s long-term average of 10% a year, rather than the 13.6% figure that was used.
Also, the study evaluates mutual funds and annuities assuming that the money is pulled out in a lump sum or as part of a withdrawal plan. But what if you die before tapping the account?
The study doesn’t consider this possibility, which would tend to favor mutual funds in a big way. If you die with a paper profit in a mutual fund, your beneficiaries can elect to “step up” the account’s cost basis--a fancy way of saying they can avoid the tax bite.
“To leave money to heirs, you’re better off not having a variable annuity,” said one Los Angeles broker who requested anonymity because his firm sells them.
The Price Waterhouse study focuses on the tax ramifications without trying to place a value on several attractive annuity features. These include the ability to make tax-free switches among portfolios and a modest insurance benefit that guarantees your beneficiaries will receive, at a minimum, the amount of cash you invested--even if the account is showing a paper loss. Also, annuities allow you to lock in a lifetime income stream--a unique and valuable feature.
But in trying to prove the tax superiority of annuities, the study falls short. Mutual funds often are a better deal after all.
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Russ Wiles is a mutual fund columnist for The Times. He can be reached at russ.wiles@pni.com
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