Tuesday, June 3, 1997

Q. I have three different zero coupon Treasury obligations which mature in 2004, 2005, and 2006. These zeros are the most conservative portion of our portfolio, yet the face value is around 100,000 for all three.

In speaking with my broker for these zero's she suggested that Paine Webber is recommending I extend out the dates from 2004, 2005, and 2006 an additional five or ten years. Paine Webber is forecasting some dramatic changes in those years on interest rates.

My question(s): What is your opinion on this recommendation? What is my down side? What is my upside? Would I be better off re-investing these funds at that juncture? Our retirement date is about 2008 - 2010.

A. N., Tucson, AZ

A. Estimating your up or down side risk on fixed income investments requires guesses of future interest rates, a notoriously fruitless activity. Paine Webber is a good case in point: their second largest fund, a government securities fund, has been in the bottom ten percent of all government funds for the last 3, 5, and 10 years according to Morningstar. So I wouldnt bet much on their interest rate forecasts.

Instead, I suggest that you get out of the interest rate guessing business and build a ladder of staggered maturities— basically an extension of what you already have. Then you wont have to worry about upsides and downsides and can just enjoy your interest income without worrying about Federal Reserve Policy and other imponderables.

According to Ibbotson Associates in Chicago, price changes account for very, very little of the long term return on fixed income investments.

Here are some options:

  • You could make no changes and have a 3 year ladder, replacing your 2004 when it matures with a new 3 year 2007 and continuing the process. You would buy at issue, at virtually no cost, and have a portfolio with the yield of a 3 year security with an average maturity of about 1.5 years.
  • You could extend your ladder by selling your 2005 and buying a 2008 maturity. The disadvantage is that the Treasury does not issue 4 year securities so you would always be buying from the resale market.
  • You could start making changes to spread your $100,000 ( maturity value) over a 10 year ladder in increments of 2 years such as 2004, 2006, 2008, 2010, 2012. This would involve reducing your 2004 and 2006 securities to $60,000 maturity value and redistributing the proceeds. You'd also have to sell the 2005, spreading the proceeds over 2008, 2010, and 2012. Then you would have no transactions until 2004. At that time you would replace the maturing security with a new ten year security dated 2014. This portfolio would bridge your transition to retirement, providing liquidity, low riskand the returns on ten year securities.

Q. I have some money that I would like to invest ($85,000). I went to a financial planner and he strongly suggests a variable annuity. He is specifically suggesting American Skandia. I have not read very many good things about variable annuities and am wondering why. The only cost that he says I will incur is a .9% mortality fee and a 1.25% mutual fund management fee per year. Is this really true? Is this something you would recommend? If not, what would you recommend? I am 33 and single.

—S.B., Houston, TX

A. I think you've got some numbers reversed but it doesn't make a big difference. Most of the Skandia Variable annuity products have a mortality expense of 1.25 percent and a total insurance cost of 1.4 percent. This cost is added to the expense ratios of the underlying mutual funds which range around 0.9 percent to somewhat higher. So youre looking at a total annual cost burden of about 2.3 percent.

In addition, once your money is invested you will face a penalty if removed before age 59 1/2 and a company charge for early redemption that will decline from 7.5 percent. Worse, if you change your mind in a year or two there is a penalty for early withdrawal. Finally, there is the tax rate issue: in a variable annuity all income is taxed as ordinary income. This means you lose the advantage of a maximum 28 percent rate on capital gains— a rate that may be reduced in the future, making variable annuities much less attractive.

Now compare that to investing the same money in a tax managed fund like Vanguard Tax Managed Growth and Income. It minimizes, but does not eliminate, taxable distributions and allows most of your return to compound, tax deferred. You can sell any amount, at any time and part of it will be your original principal that wont be taxed and part will be capital gains that will be taxed at low rates.

The annual cost is 0.20 percent which means you have a total cost advantage of more than 2.0 percent a year over the variable annuity product. Short term, thats a nice running start. Long term, it will kill the more expensive product.

With immediate and long term advantages like that, the variable annuity product is a non-starter.

Questions about personal finance and investments may be sent to: Scott Burns, The Dallas Morning News, P.O. Box 655237, Dallas 75265; or faxed to (214)-977-8776; e-mail to scott@scottburns.com Check the website: "www.scottburns.com." Questions of general interest will be answered in future columns.