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March 1993

Mutual funds, variable annuities, and direct ownership. (Personal Financial Planning)

by Green, Tracey Wilson

    Abstract- Investing in common stock through mutual funds, variable annuities or direct ownership is a good strategy for accumulating retirement funds. Common stocks present a more profitable investment alternative to savings accounts, money market funds and bonds. The primary concern of investors is choosing the best investment vehicle for common stock. The right decision can be made by following three steps, the first of which is to understand the impact of primary cost factors on investments. The second step calls for the examination of personal and financial attributes so that the most appropriate investment vehicle can be determined. The final step entails the development of strategies to increase the likelihood of greater returns for the chosen investment vehicles.

Investment in common stock through mutual funds, variable annuities, or direct ownership is usually considered by most investment counselors and financial planners to be the most appropriate means for building funds for retirement. Savings accounts, money market funds, and the investment of bonds have historically not generated the same long-term rate of return as common stocks. Aside from owning a home, real estate should not be seriously considered by neophytes. This is mainly due to the lack of liquidity and risk related to changes in the local economy.

Thus, an investor's primary focus should be in making the right investment choices in common stock. An analysis of investment in mutual funds, variable annuities, or direct ownership of common stocks shows that each alternative has merits, depending on several factors that should be examined closely. This analysis assumes that the taxpayer is already taking advantage of all tax-sheltered retirement plans and is seeking an analysis of stock ownership choices made with after-tax dollars outside of retirement plans.

The Investment Process

Choosing the right investment vehicle for common stock is a three step process. The first step is to gain an understanding of how the major cost factors (transaction costs, income taxes, and capital gains taxes) affect each investment differently. The second involves analyzing personal and financial attributes to determine which investment vehicle would be best under the circumstances. Finally, the third step is to develop a strategy regarding the selected investment vehicle to maximize the potential, long-term rate of return.

How the same three cost factors reduce the rate of return for each investment vehicle alternative is shown in Table 1. The initial investment of $2,000, and the accumulated sum from compounding at a 10% rate of return over a 20-year period are shown in the first two rows of Table 1. These figures are often used in advertisements to promote investing in mutual funds or variable annuities. Often omitted from the advertisements is the fact that the accumulated sums have not been reduced by the costs related to each investment vehicle.

Transaction Costs. The first cost factor (transaction costs) will vary significantly with each investment vehicle. An investor should estimate what percentage of capital will be used each year to pay brokerage commissions for direct ownership of common stock, sales fees and operating costs for mutual funds, and sales fees, operating costs, and the cost of the annuity contract for variable annuities. The after- transaction-costs return in Table 1 reflects a "buy and hold" strategy for direct ownership of common stock and the average cost for mutual funds and variable annuities.

Income taxes. The second cost factor will have the largest effect on the returns of mutual funds. Mutual fund investors usually pay the highest income taxes since most mutual funds have high portfolio turnover resulting in higher taxable income. The holders of a stock portfolio would pay taxes on cash dividends and on any net gains from sale of securities. Table 1 assumes a 33% income tax rate. No income taxes would be paid by the investor in a variable annuity.

While taxes can be deferred, they must eventually be paid. Table 1 assumes the taxpayer will want the accumulated funds at retirement and shows the reduced after-taxed return on the disposal of both the variable annuity and the stock portfolio. The 10% penalty tax imposed on the variable annuity holder who withdraws his or her funds before the age of 59 1/2 is not included in the figures.

Table 1 also shows that the stock portfolio will provide the highest real rate of return after inflation. However, this result is based on the premise that the taxpayer adopts a strategy to minimize transaction costs and defer income taxes. If the stock portfolio is turned over every five years, the advantage over a mutual fund or the variable annuity would almost disappear.

Financial & Personal Attributes

The personal and financial attributes affecting selection of the investment vehicle for stocks are shown in Table 2. The first financial attribute would be the amount of additional funds that the taxpayer expected to contribute to retirement. If the amount is less than $2,000 to $3,000 annually, the transaction costs in the early years would be 3 or 4% assuming some diversification. Thus, a no-load mutual fund would be much more desirable than a variable annuity or a stock portfolio because of much lower transaction costs.

Table 1 assumes an average transaction cost over a 20-year period. The fees charged by most variable annuities for administrative costs also would significantly reduce the return on small annual contributions to a variable annuity.

As the size of the contribution increases, the expected marginal income tax bracket becomes a more important factor in the analysis. For example, an investor who expected to be in the highest marginal income tax bracket during his or her lifetime should probably lean toward a stock portfolio or a variable annuity because both investment vehicles offer the opportunity to defer income taxes.

The personal attributes complicate the analysis. If the investor has a small number of working years until retirement, then the stock portfolio and variable annuity would not be favored because the return on investment could not compound enough to offset the larger transaction costs in the early years of both investment vehicles.

The other personal attributes are probably the most important factors in choosing between either direct ownership of common stock or mutual funds and variable annuities. Direct ownership of stock means that the investor must show a willingness to devote a certain amount of time and effort to do independent research on potential investments and have the emotional stability and patience to ignore any short-term difficulties that individual companies are having in the stock portfolio.

Strategies for Investment Vehicles

Once a CPA has identified the investment vehicle(s) that would be most beneficial, additional research should be done in developing an investment plan that increases the probability of higher returns for each investment vehicle. Some suggestions follow.

Stock Portfolio. A "buy and hold" strategy has been proven by numerous studies over the years to provide a higher rate of return than any other strategy of investing in stocks. Studies have also shown that investors can achieve adequate diversification (in comparison to mutual funds) by investing in ten to twelve stocks in different industries. Investors can further diversify by gradually purchasing the different stocks over time. This procedure is commonly known as dollar-cost averaging.

Some exceptions to the "buy and hold" strategy may also help to increase returns. First, if a stock has declined in value and the company's prospects have not improved over the last couple of years, sell some of the stock in order to take advantage of the $3000 a year capital losses that are allowed. Let the government share in the losses.

Second, while no one should set a rule that a stock should never be sold, it should be done with great reluctance and clear indicators that it is no longer an outstanding company. If an individual starts buying and selling stocks too often, he or she loses the edge over mutual fund and variable annuity investors by incurring additional transaction costs and taxes.

Over time an investor should gain an additional edge by investing in low-yield dividend stocks and stocks in unpopular industries. Less tax has to be paid on the smaller dividends and stocks in unpopular industries can be bought at more reasonable prices. For example, financially sound S&L's with good growth prospects can currently be bought at a nine or ten times price earnings ratio while the average stock is at sixteen times price earnings. This is called "value investing."

Mutual Funds. Before starting to invest savings in a mutual fund, an evaluation should be made of the five to ten-year track record of the mutual fund. The fund should be fairly consistent in exceeding the return of the appropriate market index. Mutual funds that consistently underperform market averages or have erratic returns should be avoided. In addition, be sure that the fund manager who managed the fund that produced the track record is still in that position.

A second factor should be the fund's operating costs. A mutual fund with high operating costs (above 1.5%) should probably be avoided. However, a fund should not be selected solely on the basis of low operating costs. A mutual fund with low operating costs does have an edge, but that edge should appear in the fund's track record in the form of above average returns.

Other factors are the size and the portfolio turnover of the mutual fund. If the size of the fund starts to exceed several billion dollars, it becomes difficult for the fund to outperform the related market index because the size of fund's holdings makes it hard to sell or buy stock without influencing the price. Low portfolio turnover means the client can defer paying taxes on any unrealized gains occurring during the year. Index funds have extremely low portfolio turnover and should be considered by clients in higher tax brackets.

From a list of mutual funds meeting the above criteria, the investor should select three or four no-load or low-load mutual funds with different investment strategies (growth, blue chip, small stocks, etc.) to reduce the volatility in the amount of retirement funds that accumulate each year. By selecting several funds, this procedure will also help to reduce the impulse to abandon the plan to use mutual funds for accumulating retirement funds when a mutual fund's investment strategy falls out of favor with investors.

































Finally, the performance of the mutual funds should be reviewed every two or three years to evaluate whether another fund should be selected or if a change in the allocation of future contributions should be made.

Variable Annuities. The same key factors (consistent track record and low operating costs) used to evaluate mutual funds should also be used to judge variable annuities. In addition, the investor should limit his or her choices to variable annuities with a number of different types of stock funds (small stocks, growth stocks, etc.) because of the usual cost (surrender charges) that will be paid when switching to another company and to achieve adequate diversification.

The next step is to obtain an accurate accounting of all the costs regarding the annuity and whether these costs are fixed during the life of the contract. Preferably, this should be done in writing. While clients will defer payment of taxes with variable annuities, high annual annuity costs can consume most of the tax savings. Try to find variable annuities that have annual annuity costs of about one percent or less.

The last step should be to check the financial rating of the company and the financial flexibility it offers at retirement. For example, both a high rating for the company and the ability to withdraw a lump sum instead of an annuity would be highly desirable. Both factors would significantly increase the probability the investor would have his or her retirement funds when needed.

Similar to mutual funds, the entire process should then be reviewed every three or four years to insure that an acceptable rate of return is being earned on the accumulated funds. This review can be accomplished by comparing each stock fund with the appropriate market index.


David R. Vruwink, PhD, Kansas State University, and Tracey Wilson Green, CPA, KPMG Peat Marwick

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