As this new quarterly column makes clear, the answer is both yes and no. You’ll have to do the math to find the right solution for your clients
Among advisors, the role of variable annuities in a portfolio is a polarizing issue. Critics contend that VAs are expensive products with significant penalties for early withdrawal, and that investors are often stuck in contracts with limited investment choices and an insurance wrapper they don’t need. Proponents point to VAs’ tax deferral benefits and a structure that encourages long-term investing.
To The Puzzler, though, it all comes down to the math.
Our debut column concentrates on which strategies, if any, are best suited to reside in a VA contract, so we’ll consider after-tax scenarios and targeted rates of return. As you’ll see, annuities should have more appeal with aggressive and highly tax-inefficient trading styles than simple indexing.
To determine the value of a VA’s tax deferral benefits, we assume that a 50-year-old investor wishes to shelter a portfolio from taxes until retirement at age 65. The client is in the highest tax bracket and expects to remain there after he leaves his job. His advisor places him in a variable annuity that has administrative and insurance costs of 1.25% per year.
What are the scenarios under which the extra cost of a VA is outweighed by the tax deferral? As the chart shows, this varies dramatically with both the effective tax rate and the total return of the investing strategy. For example, an investment with a targeted annual return of 10% doesn’t make sense in a VA unless it is horribly tax inefficient: the axis crosses at around 34%, so the strategy’s profits would have to be almost entirely composed of short-term capital gains.
However, for strategies that target a 20% return, an investor in the highest tax bracket would be far better off in an annuity as long as the strategy was taxed at a minimum 22% rate. Because of their returns and tax treatment, REITs and high-yield bonds are good candidates for a VA, as are high-turnover small-cap growth funds.
Our analysis is far from exhaustive. We didn’t factor in state taxes, for example, or assume that the client’s tax bracket would drop after retirement, which would make the case for VAs stronger. There are a fair number of annuities with administrative and insurance charges under 1.25%. VA products also offer lots of bells and whistles that we didn’t consider.
On the flip side, advisors may want to bear in mind the significant penalties for early withdrawal from a VA, as well as the taxation of non-qualified variable annuity products that some states are now levying.
Tax pros say VAs make the most sense for investors who have maxed out their 401(k) and other retirement savings vehicles. They also work for high-income earners who want to squirrel away extra cash, or for those who may be a potential target for a lawsuit, since in most states insurance products are sheltered from creditors.
Remember, too, that VA investing favors the bold. To take full advantage of the tax deferral, investors would be better off relegating VA assets to aggressive strategies.
The Puzzler, CIO of Memphis-based Sovereign Wealth Management, can be reached at firstname.lastname@example.org.