From the March 2007 issue of Investment Advisor • Subscribe!

March 1, 2007

Alternatives to Annuities

While there are many ways to build retirement portfolios, some advisors say that building an income-producing portfolio of taxable bonds is old news: low interest rates and taxation of interest payments as ordinary income have taken taxable bonds out of favor. Tax-exempt income from municipal bonds remains an option, and in equities, dividend paying stocks, or a systematic approach to harvesting long-term capital gains--both of which currently have favorable tax treatment--can work, too. Advisors whose retiree clients will depend on cash flow from retirement accounts could use asset allocation mutual funds, or build a portfolio of mutual funds allocated to 60% equities, 30% bonds, and 10% cash, according to Christopher Hennessey, faculty director of executive education at Babson College, in Boston. Hennessey, a consultant to Putnam Investments, says an allocation to equities will be necessary, as well as a 4% to 4.5% withdrawal rate, to ensure "portfolio survivability"--that the client doesn't outlive the portfolio.

Advisors need to think of retirement portfolios on a total return basis, and layer a cash flow strategy on top of that, says Harold Evensky, president of Evensky & Katz in Coral Gables, Florida. "Selling the gains is more efficient," than loading up with interest- and dividend-paying securities. Asset location is a consideration, too: inside or outside of retirement accounts? Portfolios outside of retirement accounts can benefit from the very low costs and turnover of index funds and ETFs--more tax favorable compared with many actively managed accounts since the index components change less often than active funds, so there are lower trading fees, and gains are more tax-deferred.

Both experts say there is a place for certain annuities: Evensky says immediate annuities can be an "extraordinarily important tool" as part of a retiree's portfolio. He prefers relatively low-cost providers, such as "TIAA-CREF, Vanguard, and Schwab." Hennessey might put 25% of a $1 million portfolio into a single premium, immediate pay, lifetime annuity split among "two or three of the best insurance companies," since quality of the insurance company counts with lifetime annuities--after all, advisors want to be sure the company will last as long as the client does.

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