Q: Your column has regularly said there is no good-return safe investment at this time. What is your opinion of the following: A financial adviser has recommended putting $100,000 in a fixed-index annuity guaranteeing 6.5 percent. This would double to $200,000 in 10 years, at which time it would guarantee $9,000 per year for life or cash out. What is the catch, when all other investments are much less? There is a penalty for early withdrawal, but 10 percent can be removed annually.
A: No catch, just a serious misunderstanding on your part, or misrepresentation from the salesperson. A typical offer for a fixed-index annuity involves a 10-year deferral before any cash is removed. During that time, what is called the withdrawal benefit value of your account will grow at a rate that varies with different contracts. The withdrawal benefit value is not the actual cash value of your account. It is only a number used to determine what your guaranteed lifetime income will be when you start making withdrawals.
Since the real value of your account probably won’t double in 10 years, the actual percentage withdrawal rate from your account will be higher than you are led to believe.
The likely result is that the actual cash value of your investment will decline once you start to take your guaranteed lifetime income. You will be spending down your principal. If the many, many reader letters I have received on this subject are any indication, this reality — the possibility of drastically reducing or exhausting your principal — is seldom, if ever, discussed during a sales presentation.
The problem is that the actual yield on your money is not 6.5 percent a year. Instead, it is likely to be closer to the yield on intermediate-term bonds, probably under 5 percent. That isn’t terrible, but make sure you don’t mistake the sizzle for the steak.
Q: I’ve been gradually migrating my portfolio to exchange-traded funds (ETFs). Most of the money has gone into Schwab ETFs — where they have the applicable products — for the expense savings. In the past I’ve used mutual funds and I’ve held REITs in my Roth accounts. I’ve held bond, small-cap and value funds in my IRAs. Everything else goes in my taxable Schwab account. As I migrate to ETFs, should I reconsider any of this strategy, given the more favorable tax treatment of the ETFs — which I plan to buy and hold? The rebalancing of my portfolio is generally done with additional cash investments.
A: The quick answer is no, there is no need to reconsider your asset location strategy because there is no change in the basic arguments. The usual tax consideration is to put equities in taxable accounts and fixed-income in tax-deferred accounts. Why? Because a low-turnover but taxable account invested in equities can be very tax-efficient. This is particularly true with the broad index ETFs such as the S&P 500 or Total Market ETFs.
REITs, where most of the return is assumed to come from dividend yield, are usually candidates for the tax-deferred accounts because the yield is taxable as ordinary income. With Roth accounts, which are tax-free rather than tax-deferred, the argument would be to load them with the highest-expected-return asset classes, such as equities.
This suggests that you’d put most equities in Roth accounts; REITs and fixed-income in tax-deferred accounts; and low-yield/high expected-return small-cap equities in taxable accounts. Needless to say, there are divergent beliefs about this.
Now let’s add another concern — the expected length of the holding and the volatility of the asset class. Since high long-term returns are generally associated with high volatility, this argues for putting the riskier and higher-return asset classes in Roth accounts, particularly if you hope the Roth account will be a legacy account.
This also argues for having REITs, which tend to be volatile, in the Roth account along with most equities. Compared to Roth accounts, regular tax-deferred accounts are what amount to second-class citizens for holding equities because tax deferral comes at the cost of losing the lower tax rate on dividends and capital gains. REIT dividends are taxed at ordinary income tax rates, which is another reason to put them in Roth accounts.
It has also been argued that we should allow fixed-income to dominate tax-deferred accounts because they eventually face rising required minimum distributions and the related forced sales.
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