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:
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:
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:
Some other factors:
Let me dilate further on #1 above. The death benefit has a value we can compute. The value will be the greatest in 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.