Free Software Projects Investment Performance

Do the tax-sheltering benefits of variable annuities outweigh their higher costs?

Annuity sales have surged in recent years, reflecting the increasing popularity of these retirement vehicles, yet it’s doubtful that many buyers performed anything resembling a thorough analysis before committing cash.

It’s hard enough to forecast the performance of mutual funds, yet annuities are a couple more steps up the complexity ladder. Comparing the two competing vehicles is tougher still.

Until now.

T. Rowe Price Associates of Baltimore has developed a computer software diskette--available for free--that tackles many of the number-crunching difficulties of evaluating mutual funds and variable annuities on a level playing field. Even computer illiterates can benefit by ordering a copy of T. Rowe Price’s “Variable Annuity Analyzer” because of an accompanying booklet that explains how annuities work.

So unusual is the software that T. Rowe Price sought, and obtained, a “no-action letter” from the Securities and Exchange Commission that essentially guarantees the agency won’t discipline the firm for dispensing what might be construed as misleading information. The SEC doesn’t like fund companies to advertise or promote hypothetical future performance.

“But the SEC figured this software was enough in consumers’ best interest to grant the no-action letter,” says Steven Norwitz, a vice president at T. Rowe Price, which sells both mutual funds and an annuity product.

Variable-annuity portfolios resemble mutual funds in that both are diversified, professionally managed pools of stocks or bonds. But in an annuity, earnings grow tax deferred until you withdraw cash. Annuities also come with other unique features, such as a guarantee that your account’s value at death won’t be worth less than what you invested. But the main reason to consider one relates to the tax-deferral angle. However, investors should be aware that Congress has considered reducing or eliminating tax deferral in annuities and may not exempt ones that already exist.

The backbone of the analyzer software is its ability to project future performance, for both mutual funds generally and the T. Rowe Price variable annuity in particular, tailored to personal circumstances. All sorts of factors can affect future values, ranging from your gender (and thus life expectancy) to tax rates to annuity-payout options.

The software won’t evaluate annuities other than T. Rowe Price’s, one of the least expensive products around.

“If you run the software and find that our annuity doesn’t work for you, a higher-cost annuity certainly won’t work either,” says Norwitz.

The analyzer software won’t generate ironclad projections, of course, because factors such as actual future investment returns and tax rates can’t be predicted years in advance. Even so, it lets you to run all sorts of “what if” scenarios, including an exercise to see how much cash an annuity would generate if you withdrew money gradually rather than in a lump sum.

Until now, most mutual fund-annuity comparisons have centered around lump-sum withdrawals only because the computations are easier, says Joseph Healy, a T. Rowe Price vice president who developed the software.

One interesting wrinkle in the software is the inclusion of tax rates for individual states. This allows you to ponder where you might like to live in retirement.

So are variable annuities better or worse than mutual funds?

“The perception of annuities is that their higher costs outweigh the tax-deferral benefits, but we found that it really depends on costs, rates of return, an investor’s holding period and other personal circumstances,” says Norwitz.

As a rule of thumb, annuities work best for people willing to use riskier types of investments and able to hang on for lengthier periods, he adds. “If you’re a conservative investor, an annuity won’t work as well as a mutual fund.”

One notable point is that T. Rowe Price’s analyzer allows for comparisons between annuities and mutual funds held in taxable accounts only.

The software won’t compare annuities to funds placed inside of individual retirement accounts, deductible or not. Yet mutual funds held in IRAs beat annuities anyway, making this type of analysis unnecessary, says Healy.

“You shouldn’t even consider a variable annuity unless you have maxed out on your company 401(k) [or equivalent] plan, have cash reserves and expect to be in a lower tax bracket,” he says.

T. Rowe Price’s “Variable Annuity Analyzer” runs on IBM-compatible microcomputers and requires a Windows 3.1 operating system. Call (800) 341-0790 for a copy.