It appears to me that the most expensive, tax-inefficient mutual funds are generally compared to the most inexpensive annuities to make the case for annuities. However, in a comparison of what a competent advisor would actually recommend for a taxable alternative, annuities appear to be poor choices.
To fairly compare the two (and remove compensation considerations), I used a 0.30% marginal cost which I gleaned from the cost of a Vanguard "no load" annuity. The 30 basis points are in addition to the underlying cost of the funds. This is vastly lower than the additional costs of most annuities.
Annuities made a lot more sense when the ordinary income and capital gains rates were the same. Now, annuities have to overcome both higher rates (ordinary income vs. capital gains), and higher expenses. Given a long enough time horizon, theoretically the 100% tax-deferral may overcome these disadvantages. Seeing if that is true is the point of this exercise.
The factors that impact the decision are:
- Rate of return - higher returns favor annuities, lower returns favor taxable accounts.
- Ordinary income tax bracket - lower ordinary income tax brackets favor annuities, higher ones favor taxable accounts.
- Capital gain tax bracket - higher capital gains rates favor annuities, lower ones favor taxable accounts.
- Tax efficiency of taxable alternative - tax-inefficient, high turnover investments favor annuities, low-turnover approaches favor taxable accounts.
- Time horizon - long time horizons favor annuities, short horizons favor taxable accounts.
- Annuity cost - the lower the marginal cost of the annuity over the comparable mutual fund investment the better it will compare (obviously).
Also, note that I am not talking about immediate annuities which can have a place in a portfolio as insurance against superannuation.
Here is one example:
- Investment rate of return - assumed 10% (the long-term stock market average, in reality it would be somewhat lower due to the expense ratio of the subaccount/fund, but using this relatively high number should favor the annuity).
- Tax bracket - assumed the most favorable case for an annuity, 25% ordinary income and 15% capital gains.
- Tax efficiency - assumed a 50% portfolio turnover. This is extremely inefficient and would favor the annuity. I have assumed that all gains are long-term however. This implies an advisor would not be foolish enough to select funds for a taxable account that throw off short-term gains. (In reality, I think a 10% turnover in a taxable account is more reasonable for a competent advisor.)
- Annuity cost - as mentioned earlier, I used a 30 bps marginal cost to the annuity. This attempts to remove compensation confusion from the analysis. In other words, if the total expenses are 1.15% for a fund, the annuity would be 1.45%. In this example, the net return ends up being 10% for the fund and 9.7% for the annuity.
In short, I have tried to use reasonable factors that would favor the annuity. Using the numbers above, we solve for the time horizon necessary to make the annuity a better investment than the taxable alternative. In this case, where I tried to favor the annuity, the breakeven is 26 years. In other words, a rational investor should not place any funds they will need within the next 26 years in an annuity. If we change any one assumption, it just gets worse, for example:
- Changing just the portfolio turnover to the 10% I mentioned you would need a 49 year time horizon to favor the annuity.
- If instead we just changed the net investment return to 8% instead of 10% the breakeven goes to 34 years.
- Change just the ordinary income tax bracket to 35% and the breakeven goes to 42 years.
- Change just the ordinary income tax bracket to 15% or 10% and the capital gains rate to 5% and the breakeven is NEVER.
- If we make a conservative assumption that the market will return 8% and our alternative is a passively managed investment with a 10% turnover (in essence combining 1 & 2 above), the breakeven is 62 years.
Some other factors:
- In the case of death, the heirs are vastly better off with a taxable investment because of the step up in basis. The odds of dying in the early years (when you would be likely to have losses) are trivial vs. the odds of dying in much later years (when the odds are there will be huge gains). Remember if you aren't expecting huge gains the taxable investment will be better, so it is irrational to use an annuity for "protection" for the very small chance that someone will die when it will be worse if they live.
- Taxable accounts allow tax loss harvesting much more easily and efficiently. Annuity losses have to exceed the 2% of AGI threshold and the taxpayer must itemize.
- If the client needed the money early they could be vastly worse off in potentially three ways, 1) surrender charges, 2) the time period was too short to favor the annuity alternative, 3) early withdrawal penalties for pre 59?.
- Using an annuity increases the standard deviation of returns relative to the taxable alternative. This is contrary to what is desired. In other words, for any given time horizon there is a rate of return where annuities and the taxable alternative are equivalent. If investment experience has been good (i.e. better than that breakeven) then the annuity will be the superior choice. If the investment experience has been bad (i.e. below that breakeven) then the taxable alternative would have been better. In other words, once you buy an annuity very good returns get better and very bad returns get worse. This is undesirable in most cases.
- One last comment, occasionally I will see where an advisor has placed an annuity inside of an account that is already tax advantaged. The rationale is that the client is risk-averse and wants this "protection" even with the higher costs. If the client is perfectly rational, the expected payoff is computed by multiplying the average percentage they are likely to be down (when it is at a loss) in their account times the probability of being down times the probability of dying. This figure would be compared to the marginal cost of the annuity vs. the alternative investment in the account. My preliminary figures show this is a bad bet unless the client is in their nineties because the probability of dying is too low.
Let me dilate further on #1 above. The death benefit has a value we can compute. The value will be the greatest the very first year of the annuity because the investment has a positive expected return. In other words even if some losses are bigger in years after the first one, the chance of them happening goes down even faster. Using calendar year data on the S&P 500 from 1926 through 2005, we see that the chance of being down in a one year period is 23/80 or 28.75%. The magnitude of loss averages 12.59%. Multiplying, the expected return from the insurance is 3.62%. Note the client only receives that if he/she dies. Using a mortality table we can compute what a rational investor should be willing to pay for the insurance. Here is what the cost should be at ages 45, 55, 65, 75, 85, and 95 for a male in average health (and annuity buyers tend to be in above average health): .01%, .02%, .06%, .16%, .44%, 1.00%. Given that data, an annuity shouldn't be purchased for the ?protection? until very advanced ages, but that still isn't the whole picture, because if the annuity is up, the heirs lose on the tax treatment. The odds of being up are 57/80 or 71.25%. The average amount of gain in that first year is 22.35% thus, assuming a 25% tax bracket, the expected loss from the annuity (because there is no step up) is .7125*.2235*.25 = 3.98%. In other words no matter what the mortality is, even if the client dies after the first year, the annuity ?protection? is a net loss of 36 basis points (3.62% minus 3.98%) plus the cost of the annuity unless you assume future investment performance is going to be dramatically worse than history. And, if you assume that, you shouldn't purchase an annuity anyway because they need high returns to make sense if they live!
Note that that is the best year, after year one it gets dramatically worse. This means the "protection" is on average worth much less than zero because of the bad tax treatment.
If the client is purchasing an annuity within an already tax advantaged account, ignore the second part of the analysis above and just look at the benefit vs. how much the annuity costs (the incremental cost over an alternative mutual fund). Even at age 85, the downside protection is only worth paying 44 basis points, but it declines rapidly. The value for year two would be the probability of being down (0.2875^2=0.08266) times the average magnitude ((1+0.1259)^2-1=0.23597), times the probability of death (0.1352 for a male) or 26 basis points. Years 3, 4, and 5 would be 12, 5, and 2 bps respectively. Since there are no annuities that are that inexpensive, unless the client has a very short life expectancy (less than 5 years) the annuity would not make sense in a tax-advantaged account either.
One final point, in the case where a client does need to hold very tax inefficient vehicles such as REITs, High Yield Bonds, or other fixed income investments, and they do not have sufficient ?room? in their tax advantaged accounts, and they do not need the income generated, annuities can be the correct solution to put a tax efficient ?wrapper? around those inherently inefficient vehicles.