by Archie M. Richards, Jr., CFP^®
October 3, 2005

Robert writes, "A fixed annuity I bought for an IRA in 1988 is now worth $35,000. The interest rate is currently at the minimum - 4.5 percent. I don't need income from the IRA now. Mandatory withdrawals must begin in ten years. Should the policy be retained, or should I transfer the proceeds to a Vanguard IRA and invested in various index funds as you have suggested? To me, the rate of return for the limited risk doesn't seem all that bad, given what the market and bonds have been doing."

Annuities are poor investments, Robert. They should be used only to provide income you can't outlive. Immediate annuities, which begin payouts right away, are fine. Deferred annuities, which don't, are not.

Your annuity is deferred and should be redeemed. Insurance companies impose extra charges when redemptions occur within a certain number of years. But you bought your annuity 17 years ago. Its redemption will incur no charge.

To increase the return on your investments with only moderate risk, purchase a variety of index funds whose price movements don't match. While some are going down, others are rising.

Every year, sell a portion of the segments that are up a lot and buy more of the ones that are down. Rebalancing is an automatic method of selling high and buying low. It increases the return and lowers the risk.

You write, "The rate of return for the limited risk (of my annuity) doesn't seem all that bad, given what the market and bonds have been doing."

You're correct about the annuity being a limited risk. Except for the possibility of inflation (which I think will disappear), the fixed annuities of most insurance companies are practically riskless.

But your comment, "given what the market and bonds have been doing," will bring you disappointment. Just because U.S. stocks and bonds have done little for two years does not make it smart to hold a low-returning investment for ten years, especially since you don't need the money now.

Besides, in my investment program, U.S. stocks and bonds aren't the whole ball of wax. I also recommend foreign stocks, which in the last two years have outstripped U.S. stocks. Until 1994, foreign stocks beat U.S. stocks every single year for 15 years.

I also recommend real estate investment trusts (REITs), whose performances in the last several years have been outstanding. Overall, my program has performed well.

If you cash in the annuity, I suggest 60 percent stocks (half U.S - half foreign.), 20 percent REITs, and 20 percent long-term bonds. In all cases, use index funds.

Does this investment program have a higher risk than your deferred annuity? Yes, the risk is moderate and not zero. However, it's held down in three ways:

• Each index fund is highly diversified;

• Different types of index funds provide a double layer of diversity;

• Annual rebalancing cuts the risk even more.

The objective is to limit the volatility of the whole, to reduce anxiety and avoid selling during bad markets.

So much for risk. As to the expected return, my investment program towers over the 4.5 percent return you're receiving from your annuity.

Annuities should be used only for income a person can't outlive. You don't need your annuity for this purpose, and its redemption will incur no withdrawal charge. Scrap it.

Robert also writes, "My son recently graduated from college with a student loan of $30,000. He's not married, but he's prepared to set aside 10 percent of his gross income. Should he make minimum payments on the student loan and invest the balance for retirement? Or should he divert all the money to repay the loan?"

He should divert all the money to repay the loan, Robert. Most young, single men are lousy investors. They have too many hormones, which are fine for some purposes, but not for investing. They want action, which often means trading stocks too rapidly.

Repaying the loan is the safer course. When investing is boring, the results are better.