Keep It Simple: Avoid Annuities

Annuity investors come out behind tax-efficient mutual funds, even with the odds in their favor

   

Annuities often sound like a retirement investment silver bullet: tax-deferred growth potential and guaranteed income for life. Everyone should have one, right?

While Vanguard’s annuity program offers a few new funds and a new withdrawal option that I’m reviewing in my latest newsletter issue, one thing that hasn’t changed over the years is my opinion.

I’m not a fan. It takes a long time horizon for annuities to make sense.

Consider two investors: One invests in a regular taxable mutual fund, and the other invests in an annuity.

I’m going to load the example in favor of the annuity. First, the annuity charges just 0.2% in additional expenses over the fund, and upon withdrawal, our annuity investor is going to pay 38.8% income tax on all his gains, but not on his original contribution.

I’ll compare that to a fund investor who’s only keeping 85% of his gains each year (his fund has just 85% tax efficiency). The taxable investor is then further taxed at a 20% capital gains rate upon selling the position.

3 7 13 annuities 288x300 Keep It Simple: Avoid AnnuitiesAs the chart to the right shows, the annuity, despite higher fees, grows much faster before taxes than the taxable account. (In this example, I’m assuming an 8% annualized rate of return for both the fund and the annuity.)

This is what we would expect, and why I advocate funding your retirement accounts to the max. Tax-deferred investing can be a powerful tool in growing your retirement assets.

But once the annuity investor takes his money and runs — and yes, I’m assuming the annuity investor cashes out completely and pays his taxes on his gains — his net value falls behind the taxable fund investor’s. In fact, it takes more than 20 years for the annuity investor to come out ahead (the point where the lines cross).

Remember that I said I was loading the example in favor of the annuity investor. If that investor had funded his annuity with pre-tax dollars, his after-tax value would be even lower (he’d have to pay taxes on his entire annuity’s value) and the comparison would look even worse against the regular taxable fund account.

So let’s return to square one.

Think about the reason you’d consider investing in an annuity in the first place: You want to avoid taxes. Well, instead of committing your money to a small selection of funds for 20 years or more — with higher minimums and expenses, locked up until retirement and liable for taxes at your “income tax” rate when you withdraw — pick a few tax-efficient funds instead.

Editor Dan Wiener and Research Director Jeffrey DeMaso publish The Independent Adviser for Vanguard Investors, a monthly newsletter that keeps abreast of recent developments at Vanguard, and the annual FFSA Independent Guide to the Vanguard Funds.


Article printed from InvestorPlace Media, http://investorplace.com/2013/03/keep-it-simple-avoid-annuities/.

©2014 InvestorPlace Media, LLC

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