Tax-advantaged investing: comparing variable annuities and mutual funds.

As part of the financial planning process, CPAs can provide valuable input to help clients select the appropriate combination of investment vehicles to achieve the client's financial goals and objectives. Both variable annuities and mutual funds merit consideration. When choosing between a variable annuity and a mutual fund, investors need to carefully define their financial goals (such as retirement fund, child's education, long-term growth) and choose the vehicle which best meets those goals.

Because of the CPA's close financial relationship with the client, he or she is in a unique position to help the client determine his goals. An understanding of these goals, along with the CPA's knowledge of the client's tax situation, means the CPA is well suited to help the client choose between these two important investment alternatives.

ALLOCATING INVESTMENT DOLLARS

Variable annuities and mutual funds often compete for the same investment dollars because, like a "family" of mutual funds, a variable annuity allows the holder to invest in a similar range of professionally managed securities portfolios. This article compares investments in nonqualified variable annuities with mutual funds by examining, under different assumptions, the holding period necessary to generate the same after-tax accumulation.

With a variable annuity, the contract holder/annuitant is typically offered investment options similar to those of a mutual fund family. Offerings normally include a money market fund, one or more stock funds and one or more bond funds. Like mutual funds, payments or premiums to fund variable annuities may be paid either as a lump sum (single premium deferred annuities) or in installments flexible premium annuities).

With a variable annuity, the investment risk is borne by the annuitant and not the insurance company. Consequently, like mutual funds, the cash value of the annuity is linked to the performance of the annuity's underlying investments. With either an annuity or a mutual fund, the participant bas the right to withdraw the accumulation at any time but with different consequences. Variable annuities are held in separate accounts, not in the insurance company's general account. This means these monies, like monies invested in mutual funds, are not part of the balance sheet of the company and cannot be used to satisfy its debt obligations.

With the effective elimination of traditional tax shelters as a result of the Tax Reform Act of 1986, insurance companies have promoted annuities as one of the few remaining tax shelters. Promotional literature typically compares a hypothetical investment in a tax deferred annuity with one in a taxable investment (such as a mutual fund). The assumption is that both the tax-deferred annuity and the taxable investment earn the same rate of return, and earnings from the taxable investment are taxed each year at a maximum rate.

A chart in the marketing brochure typically illustrates accumulations over periods of 10 to 30 years with the predictable result: The tax-deferred accumulation significantly exceeds the accumulation of the taxable investment, particularly over longer periods of time. This illustration, however, fails to consider several variables, any of which could significantly reduce the tax-deferred accumulation. These variables include the taxability of annuity earnings upon distribution, the 10% premature withdrawal penalty for distributions before age 59 1/2 and contract fees. When these factors are taken into consideration, the investor may be worse off investing in a variable annuity than in a mutual fund whose earnings are taxed annually.

FEE CHARGES

In order to compare variable annuities with mutual funds, it's necessary to compare the fees charged annuity contract holders with those charged mutual fund shareholders. As of May 1, 1989, the Securities and Exchange Commission, which regulates variable annuities as well as mutual funds, requires full disclosure at the beginning of an annuity prospectus of all expense charges imposed on an annuity holder. Disclosure of these expenses facilitates the comparison between variable annuities and mutual funds.

An investment advisory fee and fund operating expenses, which cover the costs of managing and administering the fund, are assessed investors in both annuities and mutual funds. Both investment vehicles may also charge a front-end "load" and/or a surrender charge. Purchasing a true no-load mutual fund, however, permits the mutual fund shareholder to avoid both a front-end load and a surrender charge. The majority of variable annuities can be purchased without incurring a front-end load, and a surrender charge can normally be avoided by holding the annuity for a specified period of years before cashing- out.

In a survey of expense charges of annuity contracts offered by 32 insurance companies, only 7 contracts, or about 22%, imposed a front-end load. In all cases, those that did not impose a front-end load imposed a surrender charge. For all of the annuities that imposed a surrender charge on lump sum withdrawals, the charge declined to zero within at least 12 years. In most cases, the charge declined to zero within five to eight years.

Recurring expenses are imposed on annuity contract holders but not on mutual fund shareholders. These are mortality and expense risk charges and administrative charges. The mortality risk charge guarantees that if the annuitant/ contract holder dies during the accumulation period, the designated beneficiary will receive the greater of the current market value of the annuity or the annuitant's investment in the contract (less any previous withdrawals). The expense risk charge covers unanticipated charges not covered by administrative fees. These charges are assessed as a percentage of the contract value of the annuity. Administration charges, levied by the insurance company to cover its recordkeeping costs, consist of a flat fee. Some companies, in addition to the flat fee, also charge an administration fee assessed as a percentage of the contract value.

Of the 25 annuities examined that did not impose a front-end load, the combined annual mortality risk charge, expense risk charge and administrative charge (excluding the flat fee) ranged from 0.73% to 1.49% of the annuity contract value. The average was 1.2%. The flat administrative fee averaged $27, with a range from $20 to $40. The insurance company with the lowest percentage combined annual charges (0.73%) imposed the highest flat fee ($40).

ANALYSIS OF BREAKEVEN HOLDING PERIOD

In order to decide between a variable annuity and a mutual fund, an investor should be aware of the holding period necessary to generate the same after-tax accumulation in each. An analysis determined the number of years (rounded upward to the nearest whole year) an investor has to wait until he can withdraw the accumulated sum in a variable annuity, pay the regular income tax and if applicable, the penalty, and be left with as much as would accumulate in a taxable mutual fund. Since a mutual fund is taxed annually, the comparison of accumulated values is made after subtracting the tax liability at the end of each year.

For analysis purposes, it was necessary to assume equal portfolio management performance for variable annuities and mutual funds. Although there is considerable variation in performance among variable annuities and individual mutual funds, portfolio management performance would be expected to be on average the same for variable annuities and mutual funds. This is because, when the additional fees imposed on variable annuity contract holders are factored out, variable annuities and mutual funds both consist of a portfolio of professionally managed securities.

In fact, performance is often identical because many companies (Equitable, Metropolitan, Prudential) offer both variable annuity options and a family of mutual funds managed by the same portfolio manager.

It was also assumed that an equity mutual fund experiences sufficient portfolio turnover so that any tax deferral advantage as a result of the mutual fund's postponing the sale of appreciated stock is minimal. The analysis further assumed that neither the variable annuity nor the mutual fund incurred a front-end load or a surrender charge. This assumption is realistic if the variable annuities and mutual funds acquired don't impose frontend loads and are held long enough to avoid surrender charges.

The key variables that determine the breakeven holding period are the pretax rates of return for the annuity and the mutual fund, the taxpayer's tax rate during the accumulation period, the taxpayer's tax rate at the time the annuity is shed out, whether the annuity's earnings are subject to the 10% penalty ta:x, (see the sidebar on pages 74-75 for a summary of income tax rules affecting annuities) and the annual charges imposed on an annuity in excess of those charged a mutual fund with similar risk and return characteristics.

As this analysis will illustrate, the required breakeven holding period of a variable annuity will be shorter if the following factors are present.

* A comparatively higher pre-tax return.

* Higher tax bracket during the accumulation period.

* Lower tax bracket when the annuity is cashed out.

* The 10% premature withrawal penalty is avoided.

* The annuity selected has comparatively low additional annual charges. The breakeven holding period for variable annuity was compared under three different conditions:

* The investor is not subject to the 10% premature withdrawal penalty, and the tax bracket during the accumulation period and at distribution is 35%.

* The investor is not subject to the 10% penalty, and the tax bracket during accumulation is 35%, and at distribution, 15%.

* The investor is subject to the 10% penalty, and the tax rate during accumulation and at distribution is 35%.

A marginal tax bracket of 35% is meant to approximate a taxpayer subject to both federal and state income taxes. A tax rate of 15% during accumulation was not considered since investors in this tax bracket aren't likely to be attracted to variable annuities.

For each of these scenarios, the rate of return ranges from 6% per year, compounded annually, to 14% per year, compounded annually. The excess variable annuity charges range from 0.8% to 1.8%, encompassing the combined mortality risk, expense risk and administrative charges for the vast majority of variable annuities.

RESULTS OF ANALYSIS

Exhibit 1, at right, shows the breakeven holding period when the taxpayer is in the 35% bracket during the accumulation period and at distribution, and is not subject to the 10% penalty. The table illustrates the dramatic influence the investment's rate of return has on the breakeven holding period. With excess annuity charges of 1.2% and a rate of return of 12%, the breakeven holding period of nine years is less than half the breakeven holding period of 22 years when the rate of return is 8%.

The breakeven holding period is very sensitive to excess annual annuity charges. For example, at a 10% rate of return and excess charges of 1.0% annually, there are 11 years before breakeven but almost twice that, 21 years, if the taxpayer incurs excess charges of only 0.6% more, or 1.6%. When analyzing excess annuity charges, the flat administrative fee should be factored in by converting the fee to a percentage of the annuity contract value and adding that percentage to other annuity charges already expressed as a percentage of the contract. For example, suppose someone invests $10,000 in a variable annuity contract with a flat yearly fee of $30 and a combined annual mortality risk, expense risk and administrative charges of 1.2% of the annuity's value. The correctly stated annual excess annuity charges would be 1.5% [1.2% + ($30/$10,000)].

An analysis was also done under the assumption tax rates during accumulation and at distribution are 28% and 40%. As expected, a 28% tax rate during accumulation increases the breakeven holding period and a 40% tax bracket shortens it. For example, if the investor incurs excess annuity charges of 1.2% and has a 10% pretax rate of return, the breakeven holding period is 11 years in the 40% tax bracket, 13 years in the 35% bracket and 18 years in the 28% bracket.

Exhibit 2, page 77, shows the years before breakeven when the taxpayer is in a 35% bracket during the accumulation period and in a 15% bracket at distribution. The assumption is again made that the taxpayer is not subject to the 10% premature withdrawal penalty. This scenario would be most likely to occur if the investor waited until retirement before cashing out. By being in a lower bracket at the time of distribution, the breakeven period is shortened considerably. For example, if the investor has excess annual charges of 1.2% and earns a return of 10%, the number of years before breakeven is only three.

Exhibit 31 page 77, shows the years before breakeven when the taxpayer is in a 35% bracket during the accumulation period and at distribution, and the annuity is subject to the 10% penalty. Under these conditions, the necessary holding period is lengthened considerably. Even at unrealistically high rates of return and low excess annuity charges, the breakeven period is in the double digits.

IMPLICATIONS FOR INVESTING

There are several factors that should be considered in deciding whether to invest in a variable annuity or a mutual fund. In variable annuities' favor is the contract holder's ability to take distributions in the form of an annuity and to transfer the cash value in one fund to another without tax consequences. (Transfers from one mutual fund to another, even within the same fund family, are considered sales for tax purposes.) In mutual funds' favor is their generally longer track record.

It's apparent from the exhibits that compared with mutual funds the variable annuity is suitable only for high-bracket taxpayers with long-term investment horizons who are disposed to either take annuity distributions or wait past age 591/2 before cashing out in order to avoid the 10% penalty. The variable annuity should be considered as a short-to-intermediate investment only when the investor can be assured of both avoiding the penalty and shifting to a lower bracket when the annuity is cashed out. This might occur, for example, when a high-bracket taxpayer has only a few years remaining before retirement and is certain his tax rate will decline at retirement. The variable annuity is not suitable for purposes such as financing a child's education, where the 10% penalty is likely to be imposed.

The deferral advantage of a variable annuity is more important when the annuity earns a higher rate of return. This suggests the investor should select higher yielding investment options from among the choices typically offered by variable annuities. This would include equity funds and high-yield bond funds, which are more suitable for variable annuities than traditionally lower yielding choices such as money market funds. A significant reduction in the capital gains tax rate, however, would make equity funds a less suitable choice within an annuity.

Before making a commitment to a particular variable annuity, the investor should carefully examine the prospectus to be aware of avoidable load charges and unavoidable recurring annual variable contract charges. While not all load charges are avoidable, careful planning can help the investor minimize those that can be avoided. Excess annuity charges can significantly reduce the advantage gained from tax deferral.

AN INVESTMENT FOR THE FUTURE

Since the enactment of TRA 86, variable annuities have become one of the few remaining tax-advantaged investments available. With the recent rise in marginal tax rates and the strong possibility of a future increase, investor interest in variable annuities is also likely to increase. Because of the similarity between variable annuities and mutual funds, investors should evaluate the relative merits of these two investments in light of their own financial objectives. CPAs can provide their clients with valuable assistance by helping them understand the trade-offs between the two vehicles to ensure a sound investment decision is made. n

TAXATION OF ANNUITIES

Annuities may be classified as qualified or nonqualified. Qualified annuities are purchased with pretax dollars through retirement plans such as those under Internal Revenue Code section 401(k) of section 403(b). Nonqualified annuities, the focus of this article, are purchased with aftertax dollars outside retirement plans.

During the accumulation period, the time during which premium payments are made to the insurance company, all earnings generated by underlying investments, such as capital gains, dividends and interest, are allowed to compound tax-deferred. This tax favored "inside build-up," however, is generally not allowed if the annuity is held by an entity such as a corporation.

The contract holder normally has the option of transferring the cash value in one investment fund to another fund offered by the same insurance company or changing premium allocations between funds of the same company without triggering a taxable event. Moreover, should the annuitant become disenchanted with his present insurance company, IRC section 1035 permits the tax-free exchange of the annuity contract of one insurance company for another if the exchange involves the same obligee (the person to whom the annuity will be paid).

In contrast, a mutual fund acts as a conduit through which its earnings (capital gains, dividends and interest) flow through to the individual shareholders as they are realized. Moreover, switching from one mutual fund to another, even within the same family of funds, is a taxable event.

DISTRIBUTIONS AFTER ANNUITY STARTING DATE 

The rules governing annuity distributions are covered in section 72 of the IRC and corresponding regulations. Annuity distributions received after the annuity starting date are treated partially as a nontaxable return of capital and partially as taxable income. Generally, the annuity starting date is defined as the later of 1) the date of the first annuity payment or 2) the date upon which the obligations under the contract become fixed. During the distribution phase, a variable annuity typically permits the annuitant to convert the accumulation to a series of payments whose amounts are guaranteed by the insurance company (a fixed annuity) or to an amount that varies in accordance with investment experience, cost of living indices or similar fluctuating criteria (a variable annuity).

If the series of payments, or expected return, is fixed, an exclusion ratio is computed to determine the portion of each payment that is a nontaxable return of capital. The exclusion ratio, which remains constant throughout the distribution period, is computed by dividing the aftertax investment in the contract by the expected return. The investment in the contract is defined as the aggregate amount of premiums or other consideration paid for the annuity contract minus the aggregate amount received under the contract to the extent the amount was excludable from gross income. The expected return is computed by multiplying the annual annuity payment funds managed by the same portfolio manager.

It was also assumed that an equity mutual fund experiences sufficient portfolio turnover so that any tax deferral advantage as a result of the mutual fund's postponing the sale of appreciated stock is minimal. The analysis further assumed that neither the variable annuity nor the mutual fund incurred a front-end load or a surrender charge. This assumption is realistic if the variable annuities and mutual funds acquired don't impose front end loads and are held long enough to avoid surrender charges.

The key variables that determine the breakeven holding period are the pretax rates of return for the annuity and the mutual fund, the taxpayer's tax rate during the accumulation period, the taxpayer's tax rate at the time the annuity is cashed out, whether the annuity's earnings are subject to the 10% penalty tax, (see the sidebar on pages 74-75 for a summary of income tax rules affecting annuities) and the annual charges imposed on an annuity in excess of those charged a mutual fund with similar risk and return characteristics.

As this analysis will illustrate, the required breakeven holding period of a variable annuity will be shorter if the following factors are present.

* A comparatively higher pretax return.

* Higher tax bracket during the accumulation period.

* Lower tax bracket when the annuity is cashed out.

* The 10% premature withdrawal penalty is avoided.

* The annuity selected has comparatively low additional annual charges.

The breakeven holding period for a variable annuity was compared under three different conditions:

* The investor is not subject to the 10% premature withdrawal