Compare those costs with the average annual expense ratio for stock mutual funds (1.4%) and bond funds (1.1%), 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 are 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.

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 was -9.58%. (See chart, "Equity Portfolios: Cost and Performance Comparison," page 59.)

By comparison, there were 2,771 large-cap blend VUL/VL subaccounts 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. But, the real question is whether or not variable products performed better than expected given the difference in their expense ratio.

For example, as a category, the expense ratio of VUL/VL products that invest in underlying large-cap blend funds was nine basis points higher than the average large-cap blend mutual fund (1.33% versus 1.24%). In light of that, we would expect large-cap blend VUL/VL products to underperform large-cap blend mutual funds by nine basis points. However, as shown in the chart "Equity Portfolios: Performance Premium," VUL/VL products underperformed mutual funds by about 40 basis points. Thus, as a category, large-cap blend-based VUL/VL products showed a negative performance premium over the past three years.

Annuities Vary Even More

VA products with an underlying investment in large-cap blend U.S. equities had an average expense ratio of 2.29%, or 105 basis points more than the average expense ratio for large-cap blend mutual funds. The average three-year performance for the VA products was-11.15% compared with-9.6% for mutual funds, or a difference of 157 basis points.

In other words, while the "expected" underperformance of VA products was 105 basis points, the actual underperformance was 157 basis points, producing a negative performance premium of 52 basis points.

Interestingly, variable products (VUL/VL and VA) that invested in underlying non-U.S. equity large-cap blend mutual funds, showed, on average, a positive performance premium relative to comparable non-U.S. equity large-cap blend mutual funds. The positive premium was about 50 basis points for VUL/VL products and just under 40 basis points for VA products.

Variable products using world stock funds as the underlying investments did not fare as well relative to world stock mutual funds- the three-year performance premium was a negative 120 basis points for VUL/VL products using world stock subaccounts and a negative 50 basis points for VAs.

The cost and performance differentials for conservative and moderate allocation funds as well as intermediate-bond funds are shown in the chart, "Balanced & Bond Portfolios: Cost and Performance Comparisons," (page 60.)

In the conservative category, portfolios are typically 30% to 40% invested in equities and 60% to 70% invested in fixed income and cash. VUL/VL products in this group had a small relative underperformance (compared with the expected underperformance of 13 basis points).

Conservative VA products underperformed conservative mutual funds by 65 basis points more than expected. But, in the moderate and intermediate bond allocations, VUL/VL products performed considerably better than expected relative to mutual funds, while VA products generated small positive premiums.

Behind the numbers

Of the six fund categories examined, the average performance of VUL/VL products outperformed comparable mutual funds (in absolute terms) in half of them: non-U.S. large-cap blend, moderate allocation and intermediate bond.

Clearly, if they outperformed in absolute terms they also outperformed in relative terms; that is, the performance was better than expected based on the differences in expense ratios. VA products were less likely to generate a performance premium, but did so on a relative basis in the same three categories.