Does a variable annuity belong in your portfolio?

Given the stock-market losses many investors have suffered over the past few years, one feature of variable annuities may seem especially attractive: a “death benefit” that guarantees your heirs will get all the money you invested, even if the annuity has lost value.

Annuities also offer tax-deferred investing similar to that of traditional IRAs, but with no limit on who can invest or how much can be put in.

Annuities can have shortcomings, however, including high fees, restrictions on withdrawals and a slew of hard-to-understand features that make it tricky to compare one to another. Also, it’s hard to keep track of how they’re doing.

Which investors can do best in annuities?

A recent study by two Ph.Ds at Charles Schwab, the brokerage, concluded that an investor must be willing to tie her money up for the long term to make an annuity the best choice.

“Although VA investment returns are tax-deferred, it typically takes five to 15 years before the tax benefits to a highly-taxed investor outweigh the often higher fees imposed by VAs,” said Yongling Ding and James D. Peterson, writing in the Journal of Financial Planning.

They also found that variable annuities work better for investors who expect their income tax brackets to fall substantially after they retire.

“Our analysis underscores the point that VAs are not suitable for everyone,” they said.

What it offers

To back up for a second, variable annuities are like mutual funds wrapped in a small life insurance policy. Among their key features:

l Tax deferral. As with an IRA or 401(k), with an annuity there is no annual tax on investment profits, dividends or interest, so long as they are not withdrawn.

l Income taxes. There is no federal income tax deduction on contributions to an annuity. But because contributions are made with after-tax money, no tax is owed when contributions are withdrawn. Investment profits — interest, dividends and capital gains that accumulate in the annuity — are taxed at ordinary income tax rates when taken out.

l Unlimited investments. You can put as much into an annuity as you want, as often as you want.

l The death benefit. Typically, a life insurance policy protects your principal — the money you invested — minus income tax due on gains. But the protection usually covers only the investor’s heirs. The investor who must withdraw money during his or her lifetime can end up with less than he put in if the mutual fund at the heart of the annuity does poorly.

l Early withdrawal penalty. Contributions and profits that build up in an annuity generally cannot be withdrawn until the investor reaches 59 1/2, else the investment gains are subject to a 10 percent penalty. Again, this is similar to rules for traditional IRAs and 401(k)s. Many annuities exact additional penalties if investments are withdrawn within the first few years, even if it’s just to switch to another annuity.

One of the chief drawbacks to an annuity is fees. In addition to the management fees charged by the mutual fund at the core of an annuity, there is often a management fee levied by the insurance company that offers the annuity, as well as a life insurance premium charged for the death benefit.

Mutual fund vs. annuity

Using industry averages, Ding and Peterson assumed the fund fee was 0.86 percent, the annuity fee 0.73 percent and the insurance premium 0.7 percent.

Then they calculated how a hypothetical $40,000 investment would do in the annuity, using stock market performance from 1926 through 2000. They also looked at how that investment would have grown had it been put into the same mutual fund held in an ordinary taxable account.

They assumed all withdrawals from the annuity would be taxed at a 38.6 percent combined state and federal income tax rate. The taxable account would be subject to some annual taxes as well as a combined capital gains tax on withdrawals, at a 21.6 percent rate.

The first comparison assumed the investor would be in the same tax bracket after retirement as before.

The result: Though the mutual funds in each investment were identical, the higher fees charged in the annuity caused that investment to trail the taxable investment, typically for about 15 years. After that, the tax deferral gave the annuity the edge.

For example, a 50-year-old investor who put $40,000 into the taxable mutual fund would have $136,592 after 15 years. He’d have $136,036 in the annuity.

But after 25 years, he’d have $314,312 in the taxable fund, $359,988 in the annuity.

The annuity could move ahead sooner, however, if the investor’s income tax bracket fell by 10 percentage points upon retiring. Taxes, then, wouldn’t dig as steeply into the annuity’s return. In this case, it would take only about five years for the annuity to overtake the taxable fund.

Obviously, there are lots of assumptions here. If you can find an annuity with very low fees and you can tie your money up long term, the annuity might make sense. That’s especially so if you’re seeking an investment, such as a bond fund, that would trigger a lot of annual taxes if it were held in an ordinary taxable account.

But you can do perfectly well without an annuity, perhaps better. So if anyone tries to sell you one, the burden of proof is on him.