Q. I would like to know the difference between a variable annuity and a life annuity. A few years ago I invested $100,000 in a tax-deferred variable annuity. Later, I came to know there is a surrender charge for 7 years. Is a life annuity tax-deferred? Is there a surrender charge? ---V.B., by email
A. Many people get confused when talking about annuities because the same word applies to many insurance products that are very different from one another. Here is a list of the basic types of annuities.
CD-equivalent annuities. The most basic type of annuity is the functional equivalent of a CD issued by an insurance company. You make a commitment for a fixed period of time and receive a stated amount of interest, tax-deferred
Equity-index annuities. These annuities provide a variable fixed-income return that depends on a complicated formula. Unlike equities, the value will never decline, but you also don’t get the dividends equities pay. The formula also generally sets a significant limit on the upside in good years. These products carry very high commissions, which is one of the reasons they are sold with such enthusiasm. But they are neither fish nor fowl and should be avoided.
Variable annuities. A VA allows you to assemble a portfolio of mutual funds or investment sub-accounts inside an insurance contract that provides tax deferral for interest, dividends, and capital gains. The contract can also have options that provide for a guaranteed withdrawal amount. As I have regularly shown in the “Annuity Watch” feature on my website, however, the costs of variable annuity products exceed the value of any tax-deferral benefits. There are simple alternatives that provide better income solutions.
Life annuities. These are insurance contracts in which you give up your principal in exchange for a guaranteed lifetime income. A portion of your monthly check will be considered return of principal and won’t be subject to taxation. The income can be guaranteed for your life only, your life or 10 years (whichever is greater), or for your life and the life of your survivor. The most common way most people get life annuities is through a company pension. Social Security is a life annuity.
Relatively few people buy life annuities directly because they worry about getting their “money’s worth”--- receiving more in payments than they have paid into the contract. While some people will receive less and others will receive more, life annuities have great value in retirement planning. I believe they will be used more frequently as fewer people receive pensions and more workers depend entirely on their qualified plan savings for retirement income. You can get quotes on life annuities at www.immediateannuities.com.
Which annuity products are most useful? CD-type fixed-income annuities have many uses. So do life annuities. I find little to justify the existence of both variable annuities and equity-index annuities. They are sold products.
Q. I roughly follow your 10-block Building Block Portfolio. Recently, I read about WIP, which is essentially an international version of TIP. What do you think about using it in lieu of BWX for the global bond block? ---B. G., by email from Coppell TX
A. WIP, the SPDR DB International Government Inflation Protected Bond fund, is an interesting ETF. While it has the same expense ratio as BWX, the SPDR Lehman International Treasury Bond fund ETF, its average duration (an indicator of interest rate risk) is significantly greater than BWX (9.24 vs. 5.9). It also holds a significant amount of securities with lower credit quality than the BWX portfolio.
You can find the sponsor descriptions of the funds at these links:
When choosing fixed-income funds, many portfolio managers tend to select funds that have shorter maturities and less risk or volatility. The reason for this is simple. If you imagine having a risk “budget,” you want to spend it wisely. That means accepting risk where it has a payoff of higher return. As a consequence, it’s better to save your risk budget for equities.
That, by the way, is the reason some managers take portfolios to the extreme of having cash equivalents and equities rather than bonds and equities. For the same amount of overall risk, the cash and equities portfolio will beat the traditional bond and equities portfolio because it can have a greater allocation to equities.