My daughter is a millionaire

[BradleyT]

You might be better off seeing what kind of life insurance you can get. My parents are recieving their share of $500K my grandfather had in annuities and all the gains are taxed. If the money had been in life insurance it would be included in the estate and tax free because of the $2.5M estate tax allowance.

[BradleyT]

Another option is to open a ROTH and max it every year but never touch it. It gets passed on to her tax free and all gains accumulate tax free.

[DesertCat]

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And why do you say "equity/bond" annuity. The moment you put bonds into the mix you are lowering your long term expectation.

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Also, this statement is totally wrong.

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Care to offer evidence of this? Because bonds have traditionally returned less than equities over long periods.

[DesertCat]

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Check your math. The Vanguard Balanced annuity (60-70% equity, remainder fixed income) has been around since 1991 and has returned 10.5% net of fees; inflation in the US has been historically 3%. In 65 years, this 7.5% real return compounds to 110x the original contribution, or $1M+


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Yes, the return has been entirely too aggressive. Note that in those 15 years the bond portion has benefited from declining interest rates. In 1991 the 30 year treasury was 8.14%, last year it was 4.91%. That caused a huge increase in the value of carried bonds, and you can't count on similar declines in the future. In fact, an increase in interest rates will almost guarantees the bond portion of your investment will do very poorly.

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Think the return is too aggressive because the last 20 years have been atypical? No matter, I'm planning to make $10k contributions annually for the indefinite future. An additional $10k (contributed early) lets me hit the same $1M+ nut with a 1% lower rate of return.

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Like I said, you'll have to, because you won't come close to 10.5%. Long term equity returns have been roughly 10%, and there are those who argue given the higher PE ratio of todays market (than is typical historically) implies equity returns of 8-9% going forward.

[DesertCat]

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The annuity is the perfect vehicle for this, because it is 100% tax efficient. No federal/IRS paperwork is generated. There are not filing/accounting fees associated with annuity ownership.


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The annual gains from an index fund (or possibly an ETF) is over 95% tax efficient (depending upon the yearly turnover of the index). And that's without losing 3/10 of 1% of your yearly gains to an annuities insurance wrapper (.3% of 8% reduces the annuity tax efficiency to 96%). And an index fund allows your daughter to get the lowest possible tax rate (LT capital gains) when she cashes out, which adds as much as 15% or so at the end date. So I think it's more than questionable whether the annuity is the better choice.

In fact, you are much better off setting up an IRA for her. Now you are "100% tax efficient", and don't have to pay .3% per year in excess fees. But you lose the long term capital gains from your cash out. If you can do a Roth IRA for her, it might make even more sense, since she'll pay no taxes after establishing it.

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The only thing that even comes close is buying an ETF, but the problem with that solution, is that I won't be able to rebalance to a constant equity/fixed income ratio without incurring capital gains. (Rebalancing of low correlation assets = lower std. deviation for same return, at certain points on the risk/reward curve.).


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Rebalancing from an 8-9% long term return asset into a 6-7% long term return asset always gives you a lower return, even if it lowers beta. And why would you care about beta with a 65 year time horizon?

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Most importantly, the variable annuity (unlike the ETF/index fund, is invisible to her. Im not planning to tell her about this fund at all. I've written a letter that is sealed, and stored it with our wills, and the letter has instructions that it is to be opened upon the death of the second parent.


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You can do this with any of the approaches, index fund, annuity, IRA, even 401k, etc.

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Hopefully, that will happen a long long time from now, at which point in time she will be mature enough to not do something stupid like raid it for beer money, or trade it around looking for the next internet bubble.

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You don't think she'll want to buy a house or send her kids through college? You might think about which approach allows her to do this without paying a 10% surtax before she's 65 years old.

[Michael Davis]

By the time your daughter reaches 65 the world is going to be a huge piece of crap and it will hardly matter where your money was invested.

-Michael

[DespotInExile]

Im surprised that my plan has evoked so many questions/critiques, because I think it is flawless. Anyhow, let me lay out my thinking more clearly:

1. The biggest reason my plan will fail is human intervention in the investment process. Either the annuity will get raided early, or investment decisions will be made on a non-passive/indexed basis that result in crappy returns. If either of those things happen, the plan stands a greater risk of failure.

2. To defeat both of these risks, the annuity needs to remain a secret from my daughter. The annuity is the best mechanism for this, because it generates no federal paperwork that requires a tax filing. Thus, there is a lower risk it will be discovered. Plus, I'll elect to receive statements electronically, if possible.

3. The next biggest risk is that the market won't perform as I want over the next 65 years. I can overcome this risk in two ways. First, I increase the initial funding by $10k every year, as long as my wife and I are working (which hopefully, will be about 5 more years). Second, I include bonds in the portfolio because I want to lower the std. deviation of the portfolio. The problem with a 100% equity mix is that the portfolio, as she comes within 15 years of retirmement age, will be at risk of a sustained downturn. So the lower std deviation helps. I suppose I could personally rebalance the portfolio every year while I'm alive, but I want to really try to remove the human aspect from the investing process as much as possible, myself included. I dont trust my own decision making. So I'm going to try to make this an entirely blind investment portfolio. One thing I will do, however, is that as I add $10k tranches, I'll add them in different asset classes, principally international, REIT, and small cap. This will add extra asset class diversification, and I'll be done in 3 years.

4. I agree that an IRA would be the best tax deferred vehicle, however my daughter can't make a contribution w/out earned income. When she gets old enough to have a job, I'll sit down with her and have the Roth IRA talk, and I will try to convince her to make contributions, and I will match whatever additional is needed to hit the Roth cap.

5. The only other thing that concerns me is that "knowing" she has a retirement "taken care of" may instill bad habits in my daughter. She may not "get religion" until later in life, or maybe she might never get it. So my plan is to teach her about retirement savings as she gets older with frank discussions about 401ks, IRAs, etc. The annuity is really intended as a backup plan for her.

6. Somebody mentioned life insurance. My wife and I each have 30-year policies set up in life insurance trusts, but those are hedges against dying early. Not a way to create a larger inheritance for my daughter. I'll be a happy man if the life insurance company keeps all of my money and never pays me a dime.

7. DesertCat, I actually agree with you that 10.5% is too aggressive going forward, because I think we've been in a historically atypical invesmtent environemnt since 1991, and we're due for some mean regression. But I dont have a crystal ball, so the best I can do is diversify my bets, and to invest as much as I can up front to take advantage of compound interest.

8. Finally, some of you guys have asked about college tuition, buying a first home, etc. The short answer is that my daughter's 529 plan is already adequately funded for a 4-year private education (and probably some graduate school). As for buying a first house, I think that is her responsibility, and if she wants to own a home, she will need to save up for the downpayment.

[DesertCat]

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1. The biggest reason my plan will fail is human intervention in the investment process. Either the annuity will get raided early, or investment decisions will be made on a non-passive/indexed basis that result in crappy returns. If either of those things happen, the plan stands a greater risk of failure.


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This is the biggest problem everyone faces. Making too many trading decisions without trading skills, for a passive investor letting emotions overrule the plan and try to market time. Also not saving as much as they plan. Sounds like you understand these things and I doubt you will fail.


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The problem with a 100% equity mix is that the portfolio, as she comes within 15 years of retirmement age, will be at risk of a sustained downturn. So the lower std deviation helps.

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Why not rebalance only when she's within 15 years of tapping the funds? Without bonds you'll have to deal with more volatility, but you sound like you have the right temperament to deal with that. It also gives you the opportunity to better benefit from "dollar cost average", make an extra contribution when the market gets crushed badly.

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4. I agree that an IRA would be the best tax deferred vehicle, however my daughter can't make a contribution w/out earned income. When she gets old enough to have a job, I'll sit down with her and have the Roth IRA talk, and I will try to convince her to make contributions, and I will match whatever additional is needed to hit the Roth cap.


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I'm not a tax expert, but I'm wondering if you can create income for your daughter, without incurring too much in the way of taxes. If you can a 65 year ROTH Ira would be awesome.

Look, I'm really just nit picking here. You seem like you definitely have your head on your shoulders about this. The difference between an annuity and an IRA is at most .3% per year, it's not going to kill you. And the difference between putting some bonds in the mix, is likely to be less than 1% per year (assuming you do something like 30% bonds for the first 50 years). Congratulations on being so forward thinking and I know it will work out very well for you, and your daughter.

[Tupacia]

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3. The next biggest risk is that the market won't perform as I want over the next 65 years. I can overcome this risk in two ways. First, I increase the initial funding by $10k every year, as long as my wife and I are working (which hopefully, will be about 5 more years). Second, I include bonds in the portfolio because I want to lower the std. deviation of the portfolio. The problem with a 100% equity mix is that the portfolio, as she comes within 15 years of retirmement age, will be at risk of a sustained downturn. So the lower std deviation helps. I suppose I could personally rebalance the portfolio every year while I'm alive, but I want to really try to remove the human aspect from the investing process as much as possible, myself included. I dont trust my own decision making. So I'm going to try to make this an entirely blind investment portfolio. One thing I will do, however, is that as I add $10k tranches, I'll add them in different asset classes, principally international, REIT, and small cap. This will add extra asset class diversification, and I'll be done in 3 years.


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Right, but you have to realize you're trading a lower standard deviation for weaker returns. Given the long timeframe of your plan, concerns about standard deviation don't make much sense to me. Of course there could be a sustained downturn in the equity portion of the annuity, but stocks are still +EV for what you're attempting to do. But kudos to you for planning for your child's future.

[stinkypete]

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The problem with a 100% equity mix is that the portfolio, as she comes within 15 years of retirmement age, will be at risk of a sustained downturn.

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this is the kind of "conventional wisdom" you need to avoid.

let's assume an portfolio made up of 100% equities would return 10%, while your equity/bond portfolio may only return 8%.

over 65 years, the equity portfolio would be worth 490.4 times its current worth, while the equity/bond mix would increase in value 148.8 times.

so you're giving up 70% of your expected value for a little bit of "diversification".

to illustrate this another way, let's figure out how big of a downturn the equity portfolio would have to have to have on the last day to make the mixed portfolio a better investment if the portfolios otherwise perform as expected. let's call this downswing at the end d, which is a percentage from 0 to 100. and let's assume the equity/bond mix is 70% equities, 30% bonds, and that the bonds are immune to this downswing.

let's find out for what value of d,
equity portfolio return = mixed portfolio return
(1-d) = (148.8/490.4) * [0.3 + 0.7 * (1 - d)]
(1-d) = 0.30343 * (1 - 0.7*d)
(1-d) = 0.30343 - 0.21240*d
0.6970 = 0.7876d
d = 0.885

so if the portfolio's perform as expected until the last day and then the stock market drops 88.6% on that last day, you should be indifferent in choosing between the two portfolios.

to put it another way, if in 65 years, the stocks are worth even 12% of what they're expected to be worth, the 100% equity portfolio is a better investment.

invest in equities. you can handle the risk over 65 years. for more than 3 times the expected return, you can afford the marginal increase in risk.


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7. I think we've been in a historically atypical invesmtent environemnt since 1991, and we're due for some mean regression.

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we're not due for anything.

EDIT: i think i fixed it, let me know if the math is still wrong