Scott Burns: How to double the yield on your savings

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Want to double the yield on your investments? And with no change in investment risks? It can be done.

This opportunity isn’t available to everyone. Then again, we’re dealing with a $1.7 trillion pool of assets. So this is something many, many people could do. I call it the Variable Annuity Departure Bonus.

To benefit, you need to be one of the millions of people who have invested in a variable annuity contract with an insurance cost of 1 percent or more. That isn’t every variable annuity, but it’s quite a few. According to Morningstar’s Principia database, some 2,004 different variable annuity contracts are available. Of that number, 1,631 include insurance expenses of at least 1 percent a year. Within that group, there are 656 contracts with insurance expenses of at least 1.5 percent a year.

Now let’s compare that to yields in the current market. The S&P 500 index is yielding about 2 percent. The total bond market index is yielding about 2.5 percent. So if you own one of the 1,631 variable annuities with an insurance cost of 1 percent a year or more, you can increase your investment income quite a bit. Simply redeem your investment and replace it with a mutual fund or exchange-traded fund that invests in the same asset class.

But wait! There’s more!

When you make the move, you can liberate even more yield — most funds in variable annuity contracts are relatively expensive managed funds. The average “all-in” cost (insurance plus fund expense ratio) of a domestic large-blend equity fund in a variable annuity, for instance, is 2.1 percent, according to Morningstar data. The same figure for a balanced fund of stocks and bonds in a variable annuity is 2.38 percent. The all-in cost for the average taxable bond fund in a variable annuity is 2.11 percent.

The corresponding figures for the index funds I frequently write about are: 0.17 percent for the Vanguard 500 Index Fund, investor shares; 0.24 percent for the Vanguard Balanced Index Fund, investor shares; and 0.20 for the Vanguard Total Bond Market Index Fund, investor shares. (Note: You can lower those expenses still more by investing in the exchange-traded-fund version rather than the mutual fund.)

So the annual cost savings can run about 2 percentage points a year. Instead of paying out virtually all of your investment income as fees to an insurance company, you actually have a shot at getting some investment income for yourself by moving to a low-cost alternative.

But what about losing the tax deferral you get from your variable annuity?

The cost exceeds the benefit. If the yield on the total bond market index is about 2.5 percent and a similar-risk fund in a variable annuity is subject to a 1 percentage point insurance fee, the “cost” of tax deferral is 40 percent of your investment income, every year. In other words, you will pay as much to the insurance company in fees as you would pay in federal income taxes if you were in the top tax bracket.

So you’d pay 40 percent in fees to the insurance company, each year, in order to defer the taxes on your reduced yield — taxes that you will eventually have to pay. Does that sound like a deal you’d make if you were sober? I don’t think so.

Few annuity salespeople push bond funds in variable annuities for that reason. According to industry data, equity funds far outnumber fixed-income funds in both numbers and assets under management.

The deal doesn’t improve at all if you consider the yield on equity funds. In that case, the average insurance cost of the domestic large-blend funds is 1.38 percent. Put that in your calculator, and it will tell you that the cost of insurance takes more than 70 percent of the dividend yield from equity investments.

Are all variable annuities such bad deals? Thankfully, no. The oldest and largest of all variable annuity sources is TIAA-CREF (Teachers Insurance and Annuity Association-College Retirement Equities Fund). Its largest fund has a whopping $117 billion in assets, all managed at a total expense of 0.49 percent a year. Indeed, its eight funds are the largest funds in the variable annuity sub-account universe.

Can any other vendor get in the ring and go head-to-head with TIAA-CREF? Yes, there are a few. But the operative word is “few.” The best known of the low-cost variable annuities comes from Vanguard. Like TIAA-CREF, its total expenses come in around 0.5 percent a year.

SCOTT BURNS is a principal of Plano-based investment firm AssetBuilder Inc. His e-mail address is scott@scottburns.com.

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