Understanding Annuities

08/06/2004 12:00 am EST


Daniel Wiener

Editor, The Independent Adviser for Vanguard Investors

With the caveat that the decision to buy a variable annuity should be made based on each individual's tax and insurance needs, Vanguard expert Dan Weiner, provides an overview of the industry and asks, "Should you buy and annuity, and if so, which one?"

"I have never been a big fan of variable annuities and there’s been little reason to change my mind over the many years that Vanguard has offered them. Annuity fees are high, the investment choices are limited, there are penalties for taking your money out and, of course, when you do make withdrawals everything gets taxed as income rather than capital gains. And recent changes in the tax code have made them even less attractive of late. Those are quite a few reasons to avoid annuities entirely. However, in certain circumstances annuities can be valuable. For instance, in some statesannuities are protected assets and cannot be taken, say, in malpractice judgments. I don’t mean to give insurance or tax advice here, but there are situations, infrequent though they may be, when an annuity’s attractiveness may increase.

"As tax deferred investment vehicles, annuities give you the benefit of continuous, compounded gains (assuming we’re not going into a long bear market) without the drag of taxes. And the amount you can put in an annuity is almost without limit. Every dollar you invest and every dollar earned in additional gains just keeps on compounding until you take your money out. Another appealing characteristic of annuities is a feature called the 'death benefit'. All in all, annuities look like a great retirement investment option. The problem is, there’s a lot less here than meets the casual eye. 

"While tax-deferral is appealing, we'd note that there are other ways to see your gains compound tax-deferred. In my view, annuities are a last resort. We have so many other options for putting off taxes. There are IRAs and 401(k)s and SEPs and 403(b)s and yes, even tax-efficient funds. Annuities aren’t as good as any of these alternatives. In addition, Vanguard's annuity expenses aren’t high by most standards, but by Vanguard’s they’re astronomical. Meanwhile, the value of the death benefit itself loses its appeal over time. Indeed, once your account is worth more than your initial investment, the death benefit becomes moot. Another 'catch' is every dollar of profit that you draw out of your annuity is taxed as income, whether that profit was earned through dividends or capital gains, both of which are currently taxed in your regular, non-tax deferred accounts at much lower rates than interest or other 'income'.

"After all these negatives, I think it’s safe to conclude that over long, long periods of time, more than 20 years or so, you may be okay making the bet on tax-deferral rather than worrying about the possibility of rising tax rates. However, an annuity still isn’t as smart an option as an IRA, Keogh, or other tax-deferred investment vehicle. We recognize that if you’re going to invest in an annuity you’d be better off picking Vanguard over the competition. Vanguard’s annuities are some of the best in the business because their fees are among the lowest in the business. Vanguard’s annuities, with their relatively low costs are an obvious choice when people tire of their old annuities or no longer must pay a penalty for a change and transfer. Here are those funds we would rate as buys:

  • Short-Term Corporate Annuity  is a clone of the taxable Short-Term Corporate Fund, and will soon be getting a makeover and will be renamed. Even in its new incarnation this will remain a great place to put money you expect to need in a couple of years—either for investing during market downturns or to extract for yourself. The returns on a money fund annuity don’t even cover expenses and inflation. This fund will serve you better, with lower risk and meatier earnings over time. For with a maximum cumulative loss of just 2.2% during the 1994 bond bear market, I think that the risk here is acceptable since you’re paid a decent premium over cash, for very little downside.
  • Balanced Annuity clones the Wellington fund, with about two-thirds of its assets in dividend-paying, large-capitalization stocks and the remainder in intermediate-term bonds. If you’re looking for a straight balanced fund, look no further. But be prepared to wait for a while before this annuity pays off compared to simply buying Wellington.
  • Capital Growth Annuity is by far the best of  Vanguard’s annuity options. Capital Growth is not so much a 'clone' as it is a fraternal twin to PRIMECAP, which is closed to new investors. That means it seeks out larger growth stocks at value prices. Currently, the annuity’s portfolio is virtually identical to PRIMECAP’s, but as this is the younger fund, it doesn’t contain all of PRIMECAP’s more seasoned holdings. But the differences are minor and, given that this is the only fund available to domestic investors who still wish to have the PRIMECAP management team handling their money, it has an added value.
  • Diversified Value Annuity  is the fund to buy if you’re looking for value. Diversified Value is run by Jim Barrow, the manager running Selected Value and the bulk of the assets at Windsor II. This portfolio is run in the Windsor II style, focused on large-cap value stocks. It In classic Barrow style, the fund holds just 45 stocks and puts one-third of assets in its top-10. Since inception Diversified Value has outpaced Windsor II despite its higher expenses, showing Barrow’s prowess as a top-tier manager.
  • Equity Index Annuity attempts to mimic the S&P 500, using the same strategy as 500 Index—owning all of the stocks in the index. With its higher expenses, this fund won’t track the S&P as closely as 500 Index (which has a rock-bottom expense ratio of just 0.18%). That’s why its five-year return, for instance, is -2.6% versus -2.3% for the granddaddy of indexing. This fund is a good all-around large-cap indexing option.
  • MidCap Index Annuity tracks the MSCI MidCap 450. I continue to believe that mid-cap stocks offer better bang for the buck over time. This is a fine option for strict, mid-cap exposure.
  • Small Company Growth Annuity is a  close fund relative to Explorer, though the annuity has substantially outperformed the taxable counterpart. This annuity may be one good example of how too many managers (Explorer) can spoil the broth as the trimmed down portfolio of 600 stocks with 10% of assets in its top-10 holdings, versus almost 1,000 stocks and just 6% in the top-10 is certainly winning the performance derby."
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