Variable Annuity Compared to Index Funds

A Side By Side Comparison of Variable Annuity Performance to Index Funds

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As a fee-only advisor, I am not compensated to sell products. I had a client ask me to meet with him and another advisor, who was proposing a variable annuity purchase. I am sharing my analysis. All names have been changed to protect privacy.

The variable annuity proposed was for the wife, who we will call Joan. She is age 66, with withdrawals to start at her age 71. It was being proposed as a source of guaranteed income and as a way to provide a larger death benefit to pass along to the children.

Based on the benefits proposed, the fee structure on this variable annuity contract was:

  • Mortality and Expense charge: 1.1%
  • Admin charge: .15%
  • Annual fund operating expenses: .57% - 1.89% - I used a mid-point of 1.23%
  • Death benefit rider: .70%
  • Income rider: .95%

Total annual fees: 4.13%

(Learn more about variable annuity fees and expenses.)

The contract states that “the total annual charges are calculated as a percentage of the guaranteed withdrawal balance (GWB), and deducted quarterly across the variable investment options and the fixed account options”.

In this type of product there are 3 separate pots of money:

  • The actual contract value: what you get if you cash in the policy. This varies depending on the investment performance, and the investment performance has to overcome a 4.13% annual fee drag.
  • The guaranteed withdrawal balance (GWB): this is a phantom balance used to calculate the amount of annual guaranteed income you may withdraw. This is guaranteed to grow by 6% a year in the years where you are not taking withdrawals, or by market performance, whichever is greater. If GWB is increased due to market performance this is called a “step-up”. When you start withdrawals, you are guaranteed to be able to take 5% of this GWB balance guaranteed for life.
  • The death benefit: this is what is paid out upon death. It will be the higher of premiums paid, the actual contract value, or the 7th year contract anniversary death benefit.

I tested the performance of such a contract against a portfolio of index funds with an allocation of 80% stocks/20% bonds. The stock portion was allocated as follows:

  • 30% S&P 500
  • 20% Russell 2000
  • 15% EAFE
  • 15% REITS

The bond portion was allocated at:

  • 10% fixed (CD like returns)
  • 10% long term government bonds

I applied a 1.25% expense drag to the index fund portfolio, assuming the same client was working with a financial advisor that charged 1% a year and the underlying index funds had expenses that were .25% a year or less.

I looked at 3 different scenarios:

  • Market performance starting in 1973, you started off with two horrible years of equity performance, then a steady recovery
  • Market performance starting in 1982, stellar performance for many years
  • Market performance starting in 2000, we all know what the last ten years have been like.

Below are the results.

1973 Market Performance:

  • You invest $100,000 in annuity, or $100,000 in an index fund portfolio.
  • You take no withdrawals until Joan’s age 71.
  • Contract receives its 6% guaranteed growth rate on the GWB, which takes it to $133,823, which exceeds market performance over that time frame.
  • 5% of that is $6,691, which you then withdraw each and every year until her age 90.
  • If Joan had passed away in the first 3 years, the death benefit would have provided a value over the index account in the range of $12,000 - $34,000.
  • At Joan’s age 90, the contract value on the annuity is $219,416 which passes along to heirs.
  • At Joan’s age 90, the index portfolio is worth $864,152, which passes along to heirs.
  • You took the same amount of income out of both the annuity and the index portfolio. ($6,691 from age 71 – 90)
  • If annual step ups are given after the withdrawals have started, then those are not reflected in this analysis, but would apply. It is unlikely they would materially affect the relative performance of one strategy over the other.

1982 Market Performance:

  • You invest $100,000 in annuity, or $100,000 in an index fund portfolio.
  • You take no withdrawals until Joan’s age 71.
  • In this scenario the annual step up applies as market performance exceeds that of the 6% guaranteed growth rate, so your GWB becomes $178,473.
  • 5% of that is $8,924, which you then withdraw each and every year until her age 90
  • At no time did the death benefit offer additional value over the index fund portfolio.
  • At Joan’s age 90, the contract value is $78,655, but the death benefit is still $167,714. (7th year contract anniversary step up in death benefit applied) (How could the contract value be so low? Due to fees and annual withdrawals the contract value is being reduced by about $16,000 a year, but the contract value is not relevant unless you cash in the annuity.)
  • At Joan’s age 90, the index portfolio is worth $856,898, which passes along to heirs.
  • You took the same amount of income out of both the annuity and the index portfolio. ($8,924 a year from her age 71 to 90)

In both scenarios above what you have accomplished is a significant transfer of wealth from your families hands right to the insurance company.

2000 Market Performance:

  • You invest $100,000 in annuity, or $100,000 in an index fund portfolio.
  • You take no withdrawals until Joan’s age 71
  • Contract receives its 6% guaranteed growth rate on the GWB, which takes it to $133,823.
  • 5% of that is $6,691, which you then withdraw each and every year until her age 78 (I can’t run data past this age as I don’t have market returns past 2011. )
  • In 4 of the 12 years, the death benefit paid out more than the index fund portfolio, by an amount that ranges from $970 - $14,000)
  • At Joan’s age 78, the contract value is $76,667, but the death benefit is $118,000 (7th year contract anniversary step up in death benefit applied)
  • At Joan’s age 78, the index portfolio is worth $107,607, which passes along to heirs.
  • You took the same amount of income out of both the annuity and the index portfolio. ($6,691 from her age 71 to 78)
  • Of course no one knows what happens from here.

In this last scenario, at its current point in time the variable annuity is providing a death benefit of about $10,000 above that your heirs would receive from an index portfolio, and you have a continued guaranteed income stream of $6,691 a year. Note, if poor market conditions continue, and the contract value goes to zero, the death benefit becomes void, however your guaranteed income continues.

The variable annuity brochure states “in some circumstances the cost of the option may exceed the actual benefit paid under the option”.

This can easily happen when you have a 4.13% fee structure.

In an historical context, it is more likely such a product will provide a more substantial transfer of wealth from you to the insurance company than from you to your family.

Another disclaimer in the fine print said “Consult your representative or retirement planning agent as to the amount of money and age of the owner/annuitant and the value to you of potentially limited downside protection this GMWB may provide.”

Wait, I thought the primary purpose of these products was downside protection? If I read the fine print though, the company itself is acknowledging it provides “limited” downside protection.

I have one other comment, and I do not mean any disrespect to commissioned advisors. The advisor proposing the annuity suggested that if my client used this annuity, it would reduce what they needed to withdraw from accounts they had with me. This would suggest somehow that I might put my own interests (preserving assets with my company to generate higher fees) before my client’s interest. (The funds proposed to be put into this annuity were not under my management nor was I recommending the client move them to me.)

As a fee-only advisor, I have taken a fiduciary oath. To let a factor like that influence my decision would be a breach of fiduciary duty, and I find it offensive someone would try to sway me to their point of view with the approach that their strategy will preserve assets under my care.

In the broker/dealer world, the current standard is that of suitability, and such a suggestion is considered ok, as long as the overall recommendation is still suitable to the client. However, with the standards I practice under, such a suggestion is not appropriate.

My closing conclusions (opinions as this is not a formal academic analysis):

  • The fee structure in broker sold variable annuities such as the one in the analysis above is such that it diminishes the value of the guarantees the products are supposed to provide.
  • The agents or representatives selling these variable annuities often do not understand or have not reviewed how the product will perform under various historical market conditions.
  • The representatives selling these variable annuities do not seem to offer holistic financial planning, where they place their recommendations in context of the client’s entire financial situation, including their net worth, age, tax situation and income needs.