"As a general proposition, what, in general terms is the economic loss
of foolishly investing in a tax deferred annuity in a persons IRA?"
In my experience, any answer to an investment question that is
generally right, can also be generally wrong. However, I made that
very mistake a few years ago, and I can outline the most common types
of economic loss for you. For comparison purposes, I?m going to assume
that you?re talking about a variable annuity that contains stocks,
versus investing in the same stocks (ie. a mutual fund) directly in
the IRA. The principles I address below will apply to most kinds of
annuities, though the scale of the economic losses will be different.
In order to estimate the losses, I had to select one kind of
investment for comparison purposes.
The bulk of your losses will come from two sources. First, the innate
disadvantage of the mutual fund investment relative to an investment
in the ?market portfolio.? We?re talking about the opportunity costs
of opting for an investment with lesser returns. Second, money wasted
in fees to purchase annuity services in an account that is already
tax-advantaged. Since most annuities charge high fees, and many
underperform the market even before the fees are levied, such economic
costs can be quite high. The tax issue is a wash, because you
presumably have access to both an annuity and an IRA account in which
you can purchase any securities you like.
I cannot put an exact number on your costs, because they depend
entirely on your ability to pick an investment with a better return.
However, the Wall Street Journal?s mutual-fund return data from Oct. 1
can shed some light on the economic losses versus a benchmark.
Let?s assume your annuity is a large-cap blended mutual fund. For the
first stage of our discussion, we?ll ignore fees. For our purposes,
the S&P 500 Index can be considered the ?market portfolio? because it
is the appropriate benchmark for a large-cap blend fund. Any Markovitz
purists out there can feel free to argue this point with me, but from
a practical standpoint, the S&P 500 is the best choice, and certainly
the easiest from which to derive an estimate of economic losses. The
average large-cap blended fund posted a five-year annualized return of
?2.31%, versus a return of ?1.31% for the S&P 500. This differential
reflects the management fees and other built-in fees charged by every
mutual fund, as well as any value added or lost by the fund managers?
stock-selection strategies.
The economic loss from purchasing the mutual fund rather than the S&P
500 is about 1%, annualized. Of course, few people have the resources
to buy the S&P 500, so as a proxy we?ll use the Vanguard S&P 500 Index
Fund, which has historically tracked very close to the index, and has
a 0.18% expense ratio.
http://quicktake.morningstar.com/Fund/Snapshot.asp?Country=USA&Symbol=VFINX&hsection=quote&pmts=&pmts=
The index fund?s fee shrinks the economic loss by reducing the return
on the alternative investment. So the economic loss from purchasing a
large-cap blended mutual fund rather than the S&P 500 Index is about
0.82%, annualized. The actual differential will be considerably
higher, as many mutual funds have sales loads, which the S&P 500 Index
does not. Some studies estimate that the average mutual fund has a 2%
sales load, which would definitely inflate the economic loss to 2.82%.
But for purposes of our example, we?ll assume the investor is
selecting only no-load funds, generating a loss of 0.82%.
The loss will, of course, be different for other kinds of annuities,
because each group will have a different average return, and must be
measured against a different benchmark. But as a whole, mutual funds
underperform their market benchmarks over time, mostly because of
fees.
The next portion of the economic loss deals with annuity fees. The
average management fee of 1.27% for large-cap blend funds
(http://quicktake.morningstar.com/Fund/Fees.asp?Country=USA&Symbol=VFINX&fdtab=fees)
is lower than that of your average annuity. Annuities, in fact, are
known for their high fees.
http://www.consumerreports.org/main/content/display_report.jsp?FOLDER%3C%3Efolder_id=422631&ASSORTMENT%3C%3East_id=333147
http://www.fool.com/retirement/annuities/annuities02.htm
For the sake of argument, let?s assume that sales loads are a wash,
that you are just as likely to pay a sales load on a regular mutual
fund as you are on an annuity. Many studies have been done on fees,
and the numbers differ depending on who you ask. For our purposes,
we?ll assume that the average annuity charges fees 0.6% higher than
those of the average mutual fund. We?ll further assume that the 0.6%
spread applies to the large-cap mutual funds we?re considering.
Add that 0.6% spread between the average annuity and the average
mutual fund to the 0.82% spread between the average large-cap stock
fund and the Vanguard S&P 500 Index, and you have a cost of 1.42%. In
an average 2% sales load in the mutual-fund expenses, and you have a
cost of 3.42%.
Please keep in mind that the actual math is more complicated, and our
example ignores transaction costs as well as any personal knowledge
(or lack of knowledge) that an investor has about how to improve (or
reduce) returns.
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