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It's no secret that variable products cost more than mutual funds. The average annual expense ratio for variable annuities (VA) is about 2.4% (or 240 basis points), compared with 1.5% for variable universal life (VUL) and variable life (VL) policies.
Compare those costs with the average annual expense ratio for stock mutual funds of 1.4% and 1.1% for bond funds, producing an overall average of 1.3% for all 26,529 stock and bond mutual funds in the Morningstar Principia database.
Variable products are contracts of insurance as well as investment products that use mutual funds as the underlying investment vehicle. Because they're two products in one, variable annuities and variable life insurance have higher expense ratios than mutual funds. The question is: Do the higher costs of variable products cause them to systematically underperform mutual funds?
Understandably, variable products aren't parallel because mutual funds don't provide life insurance, so it's not exactly a fair comparison. Moreover, when implemented correctly, variable products may qualify for more favorable tax treatment than mutual funds. Nevertheless, baseline performance comparisons, and comparisons of the underlying costs can help you understand the pros and cons of variable products and when they make the most sense for your clients.
We used large-cap U.S. equity blend (the middle ground between growth and value) as the underlying investment in the variable products. As of Nov. 30, 2008, there were 2,025 U.S. equity mutual funds in the Morningstar Principia database classified as "large-cap blend." They had an average expense ratio of 1.24% and their average three-year annualized return as of Nov. 30 was -9.58%. (See "Equity Portfolios Comparison: Equity Portfolios" on page 33.)
By comparison, there were 2,771 large-cap blend VUL/VL sub-accounts with an average annual expense ratio of 1.33% and an average three-year performance of -10.11%. (VL and VUL are combined and reported together.) Finally, the average expense ratio among 6,976 large-cap blend VAs was 2.29% and the average three-year annualized return was -11.15%.
In the large-cap blend category, the higher costs associated with variable products hurt their performance relative to the performance of mutual funds, at least in absolute terms. However, the real question is whether or not variable products performed...