Question: My father died last September, leaving my sister and I various individual stocks, variable annuities, and a house we are currently trying to sell.
The variable annuities come to about 40% of my share (maybe $180,000 out of $400,000 to $500,000), and I have to decide what to do with them in the next month or so. I know Andrew doesn’t like variable annuities, and I think I already have way too much stock market exposure, so I am thinking of maybe taking this money over 5 years (one year would seem to be a really big tax hit all at once) rather than keeping the money in the variable annuities. I would put the proceeds into TIPS, perhaps. I should mention I am almost 59 1/2, so I am curious what percentage of stocks you think I should have in my portfolio anyway. Excluding my inheritance, it is 50% S&P 500 index fund, 25% European stock index fund, and 25% intermediate term bond fund. I just discovered that Andrew doesn’t like corporate bonds, either, so I am thinking of shifting that money to a treasury bond fund. My inheritance is substantially larger than my 403(b).
Answer: Not so fast. I share Andrew Tobias’s general dislike for variable annuities, but they can have their place, some are much better than others, and the decision to terminate an existing one is different from the decision to invest in one in the first place.
Okay, obviously I don’t know nearly enough about your personal situation to directly answer the questions, but I can offer some general principles that people may find useful when they find themselves holding a variable annuity.
(1) Determine the tax consequences of taking out the money. As you’ve noted, removing your money from the vehicle will incur taxes on the portion of the annuity deemed to be earnings (the original cost basis is not taxed). The gain is all treated as ordinary income with no tax break for capital gains earned inside the VA, and distributions that are not part of an annuitization (the conversion of the annuity into a stream of payments) are considered to be “earnings first, cost basis last” in order to maximize the pain. Also, distributions before age 59 ½ are generally subject to a 10% federal penalty and often a state penalty (with exceptions for annuitized payments), which isn’t applicable here.
Since you are approaching retirement age, you might want to consider delaying the taxable distribution of funds until then so that you’ll be taxed in a lower bracket on earnings of the VA, assuming that will be the case.
UPDATE: I should have made clear that an inherited annuity does require distributions at least in line with the life expectancy of the beneficiary, which should be relatively small for someone who is 59 this year. I’m suggesting the distributions be minimized, and didn’t mean to suggest that mandatory distributions not take place over the next few years. The election to use life expectancy must be made within a year AND within the requirements set by the VA itself.
(2) Determine what VA is best in the meantime. Not all VAs are high cost investment vehicles. Six that have reasonably low costs are (in alphabetical order) Ameritas, Fidelity, Schwab, TIAA-CREF, T. Rowe Price, and Vanguard. If the VA you inherited is with one of these firms, you might just want to sit tight until retirement.
If your VA is elsewhere, then considerable cost savings are likely through a Section 1035 Exchange, to one of these low cost providers. Although most poor VAs have surrender charges if you transfer the contract elsewhere before a certain period of time has passed (it can take as long as 15 years before all surrender charges disappear), it is also true that the worst annuities typically have the highest such charges, so it is likely to be a worthwhile move even if that applies.
(3) Select sound investments in the interim for your VA funds. Since you asked me, not Andy, you’ll get my response, which will likely be similar on corporate bonds but different on allocation generally. I don’t like corporate bonds because I view bonds as solely a diversification tool for those who cannot handle (either rationally or emotionally) the volatility of an equity portfolio. When people are fleeing corporate stocks, corporate bonds are not likely to be in high favor. As a result, Treasuries make a better choice for diversification purposes. So, to the extent you use bonds, I think Treasuries make the most sense.
But if you still have several years before retirement, and don’t expect to die soon after it begins, I don’t particularly like seeing bonds at all in your portfolio. Sure, they’ll probably reduce volatility, but the average year in which you will be spending the money in that VA is, hopefully, more than a decade from today and, over such periods of time, the probability is extremely high that equities will give you the more comfortable retirement. I hate to throw away large amounts of retirement wealth and selecting low growth investments that are, in many cases, earning less than zero after inflation and the taxes that will be owed upon distribution.
In my view, a portfolio with no expected draws in the next several years belongs in a globally-diversified equity portfolio, which includes emerging markets. If I were to make the simplest fix to your current allocation, I would likely move the 25% that is in intermediate bonds and put it into a diversified emerging markets fund.
Of course, choosing a 100% equity portfolio for your long term investments means being willing to stay the course during the next bear market while adding more work savings to take advantage of the decline. As I mentioned in an earlier blog post, even those investment advisers who do little more than choose a few index funds and stay the course often earn their keep merely by preventing their clients from doing self-destructive things in bear markets.
Obviously, if you just know you won’t maintain composure during a bear market, you may not be able to stomach a 100% equity approach for long-term investments as a do-it-yourself investor. But I certainly do not see a good reason to reduce your current stock exposure (although I do think it should be better diversified by including some emerging market allocation).