by Archie M. Richards, Jr., CFP^®
May 6, 2002

A high school math teacher retires, vigorous at age 62, and begins receiving a pension income. He already has a $30,000 IRA invested in a mutual fund of stocks, and he wants to acquire a $100,000 fixed annuity.

The stocks are fine. But such a large proportion of his funds in a fixed annuity is a mistake.

Annuities are insurance policies. If the money is not withdrawn from the policy prior to the owner's advanced age, the funds are "annuitized." The insurance company then begins paying out money on a regular basis, often for the joint lives of the owner and spouse. Most people use annuities as investment vehicles and withdraw the funds prior to annuitizing.

Here's the first problem with the teacher's choice: Most annuities have high costs. They pay salesman commissions of 5-to-7 percent. The commissions may be called "charges," but they come out of the investors' accounts nevertheless. In contrast, some mutual funds, called "no-loads," pay no commissions to anyone.

Moreover, the annual operating charges of annuities are 1.5-to-2.5 percent higher than those of Vanguard, TIAA-CREF, and other low-cost mutual funds. After a couple of decades, savings of 2 percent a year make a huge difference in the final balance.

A second problem with a fixed annuity is taxes. As long as money remains in an annuity, the earnings avoid taxation - very enticing.

But the money avoids taxation only as long as it remains in the annuity, where it can't be spent. When the teacher draws money out, the portion of the withdrawal that was earned within the policy is treated as ordinary taxable income. This piles on top of the teacher's dividend, interest, and pension income, probably subject to the 28 percent tax rate or higher. In contrast, mutual funds that hold on to their stocks for at least a year generate long-term capital gains, whose tax rates are capped at only 20 percent.

The third problem regarding the teacher's choice is this: The money in a fixed annuity is invested by the insurance company in bonds. I think the teacher could do better.

Retirement doesn't mean that the teacher should stop striving for gains. With medicine making extraordinary strides, he should plan on the younger of him and his spouse living to age 100. He's only 62, and his wife is younger. In forty years, the Dow, gaining at 10 percent a year, would attain 400,000. Bonds will gain, yes, but not as fast as 10 percent a year. Why miss out?

In the short run, the values of stocks are more volatile and can lose more than those of bonds. Stocks also pay less current income. These are disadvantages, to be sure. But the teacher should invest for the long run. Over periods of at least ten years, after adjusting for inflation, stocks have never failed to gain more than bonds.

The teacher has time. Instead of $30,000 in stocks and $100,000 in bonds, I'd rather he reverse the proportions. He should place $100,000 in stocks and $30,000 in bonds.

For stocks, the teacher should purchase one or more index funds. The Russell 3000 Index, for example, which is owned by the Frank Russell Company, reflects the gains and losses of the 3,000 largest U.S. stocks. If those stocks rise or fall by a certain percentage during the trading day, the index rises or falls by the same percentage.

An index fund that tracks the Russell 3000 buy and holds the same 3,000 stocks that the Russell Company selects for its index. Because the stocks are chosen by someone other than the fund, the mutual fund avoids spending money for stock research, saving the investors money.

The selection of stocks for an index is seldom changed. A fund that follows the index therefore buys and sells stocks infrequently. This saves transaction costs and taxes. Since the fund generally holds its stocks for at least a year, most of the gains the shareholders are required to report are long-term capital gains.

Lower costs, lower taxes, and higher long-run investment returns - three good reasons why the teacher should go heavy on no-load index funds of stocks and go light on a fixed annuity.