Question: I am a retired American Airlines pilot. I have a lump sum of $650,000 invested in a 60/40 portfolio of equities, fixed income and cash. It is well known that variable annuities and indexed annuities are burdened with a lot of fees. But, what about immediate annuities?
I can get an immediate annuity with about a 6.5 percent return for the rest of our lives that will pay into our estate if my wife and I die during the first ten years. I was thinking about purchasing one of these annuities with my $670,000 and keeping my other fund of about $650,000 in tax-free muni's. I don't feel comfortable keeping money in any stock fund. --C.RS., by email from Dallas
Answer: That's an interesting idea. To pursue it, you'll need to learn something about the life expectancy you and your wife share and the value of a life annuity in that context. The reason only a small percentage of all people, including those who own variable annuities, convert their savings into a life-annuity is often called the "money's worth" problem.
People fear that when they give up their principal for a guaranteed lifetime monthly income they won't get their "money's worth"--- they'll receive far less in value than they gave to the insurance company.
In fact, if you get a joint and survivor life annuity there is a high probability that you'll get your money's worth and a reasonable deal. Assuming you are about 65, you and your wife have a joint life expectancy of about 25 years. This means there is a 50 percent chance one of you will still be alive at the end of that time.
If you were to lend the federal government $670,000 for 25 years it would promise to pay you $3,839 a month for the period, assuming a long term interest rate of 4.8 percent. (This is about what the government pays in interest for long term bonds.) You'd be dealing with a risk-free borrower but if one of you happened to live longer than 25 years you'd have a problem.
If you visit the website www.immediateannuities.com and ask for sample quotes on a $670,000 joint lifetime income with 100 percent to the survivor, you'll find the current monthly income would be about $3,855. If you and your spouse die before your joint expectancy, the insurance company makes a higher return. If you and your spouse live longer than the expected 25 years, the insurance company makes a lower return.
How this actually works out, of course, depends on closer calculation than these back-of-the-envelope figures.
Basically, you'll be getting a reasonable return on your money, monthly checks, and the assurance that you'll get those checks for life in exchange for letting the insurance company invest the money to make a higher return for its own account.
The weak link here is thinking about putting your remaining money, $650,000, in tax-free bonds. To do so is to virtually guarantee that your long term standard of living will decline because all of your assets will have been committed to fixed income.
I suggest two alternatives. If you want to avoid all risk, invest in Treasury Inflation Protected Securities. This will provide an inflation adjusted income starting at about 2.3 percent a year of the portfolio value. That is less than you would receive from a municipal bond portfolio, but it's a better credit risk. If you are willing to take some risk, you could get a dividend yield of about 4 percent from an income stock portfolio with the dividends taxed at 15 percent rate. That isn't tax-free but its close.
Is there a portfolio theory that would provide a winning portfolio?
Question: I recently read a book about major figures in the development of economic game theory, "A Brief History of Economic Genius" by Paul Strathern. In the book he says that Game Theory is a "minimax" approach. It is an attempt to minimize your maximum losses. Since the stock market trends upward over time with dips large and small in between, do you feel there is a portfolio theory out there that would minimax? --A.R., from San Antonio, TX
Answer: Gaming and investment come together in mathematics in a problem called "Gambler's Ruin" and, so far, the jury is still out on whether it has a portfolio solution. You can learn a lot more about this, without having to see or understand a single equation, by reading William Poundstones, "Fortune's Formula: The Untold Story of the Scientific Betting System that Beat the Casinos and Wall Street" (Hill and Wang, $27, 2005).
Every serious investor and financial planner would benefit from reading this wonderful book. It connects gambling, information theory, computers, and mathematics through amazing people like Claude Shannon (the father of information theory) and Edward Thorp, the man who programmed an MIT mainframe to search for a way to win at Blackjack (he later went on to play in investments).
The betting system came from a brilliant young Texan from Corsicana named John Kelly Jr. who created the "Kelly criterion," a tool for evaluating wagers rooted in Shannon's information theory.
Is it a winning formula? The jury is still out. But Nobel laureate Paul Samuelson has written that it doesn't work.
Scott Burns is the Chief Investment Strategist for AssetBuilder, Inc. and his columns are syndicated across the country. Readers can register at www.scottburns.com and post questions/comments or send directly to firstname.lastname@example.org. Questions of general interest will be answered in future columns and remember to click on the "Blog" navigation to see other columns. All comments are welcomed and appreciated.
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