NCPA - National Center for Policy Analysis

Variable Annuities Compared with Index Funds

February 25, 2003

"Are Variable Annuities Right for Your Clients?" ask researchers James D. Peterson and Yongling Ding of the Schwab Center for Investment Research.

In an article of the same title in the January 2003 Journal of Financial Planning, they report on computer simulations comparing the long-term accumulations of the same portfolio -- the S&P 500 -- as a taxable managed fund and as a tax-deferred managed fund, or variable annuity contract. They factored in the value of the death benefit in variable annuity contracts.

Variable annuities have a higher cost burden than taxable managed funds, but compound tax-deferred. Assuming the investor is in the same tax bracket at all times, the taxable managed fund has a slight advantage for the first 15 years of accumulation.

  • At the 15th year the net, after-tax accumulation in both vehicles is virtually equal -- a $40,000 investment grew to about $137,000, plus or minus $1,000.
  • After the 15th year, the variable annuity pull ahead, and by the 20th year the difference in net returns -- the spread -- is as much as 39 basis points a year.
  • By the 25th year the net return spread is as much as 69 basis points.

Thus, a 40-year-old who invested $40,000, for instance, would accumulate an after-tax value of $314,194, a return of 8.59 percent annually. Invested in the researchers' model variable annuity, the same investment would grow at 9.28 percent to $367,718 or $53,524 more.

However, the simulation involved a low-cost variable annuity with total annual expenses of 1.43 percent a year compared to annual expenses of 0.86 percent for the taxable fund and annual taxable distributions.

Compared to a low cost market index fund, only 57 of the variable annuity funds had total annual costs low enough to give them an advantage.

Source: Scott Burns, "Variable annuity challenge," Dallas Morning News, February 25, 2003.


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