Glenn S. Daily Fee-only insurance consulting

I Bonds: A no-brainer alternative to fixed annuities?

May 1, 2003 (original: October 10, 2001)

Note: On November 1, 2011 the Treasury Dept. announced that the nominal annual fixed rate for I Bonds issued from November 2011 through April 2012 will be 0.00%. The nominal annual inflation rate is 3.06%. The new nominal annual earnings rate (called the composite rate) will be 3.06%. The calculation of the nominal annual earnings rate is: 1.0000 x (1.0153) = 1.0153 and (1.0153 - 1) x 2 = 3.06%. The effective annual rate is 3.08%. I have not yet updated the information here.

1. Table of contents
2. Comparison of key features of I Bonds and fixed annuities
3. Fixed annuities: an overview
4. I Bonds: an overview
5. I Bonds versus fixed annuities
6. I Bonds and TIPS in the news
7. Useful websites
8. More information about I Bonds and TIPS
9. Supplemental notes
10. I Bond and TIPS tables

In 2000, insurance companies sold about $32.7 billion of fixed annuities outside of tax-deferred retirement plans, and the Federal government sold about $2.1 billion of Series I Savings Bonds (I Bonds). Let’s recap:

2000 Sales
Fixed annuities	$32.7 billion
I Bonds	$34.1 billion
Ratio of fixed annuity to I Bond sales	15-to-1

Comparison of key features of I Bonds and fixed annuities

	I Bonds	Fixed annuities
Issuer	U.S. government (Dept. of the Treasury)	Life insurance companies
Safety	Backed by full faith and credit of the U.S. government	Backed by issuing company, state guaranty associations, and ad hoc bailouts by other insurers
Is the issuer a fiduciary?	No, but the government has made this commitment: "If the CPI-U is discontinued or (in our judgment) fundamentally altered in a manner adverse to your interests, we’ll substitute an appropriate alternative index."	Generally, no. In litigation with consumers, insurers typically argue that they and their sales agents have no fiduciary duties to their customers.
Minimum amount that you can invest	$50	Varies; $75 to $75,000.
Maximum amount that you can invest	$5,000 per registered owner per calendar year	Investments above $6 million may require company approval.
Maximum holding period	30 years	Most companies require that you start taking money out by age 85 or 90.
How to buy	Online at www.savingsbonds.gov, or at Federal Reserve Banks, participating financial institutions, employer-sponsored payroll savings plans.	Must be approved for sale in your state. Sold primarily by insurance agents, stockbrokers and banks.
Current interest rate (effective annual rate)	6.01% (5.92% nominal rate, compounded semiannually)	Varies by company and guarantee period; 4.5% to 6.25% is typical.
Inflation-adjusted?	No.	Sometimes, but bonus can be offset by lower renewal rates and/or higher surrender charges.
Guarantee period	Fixed rate is guaranteed for 30 years. Inflation component is adjusted every six months.	Usually one to 10 years.
Minimum guaranteed interest rate	0%; deflation can offset the fixed rate but cannot cause a loss of principal.	Usually 3% to 4%
Can you easily get an interest rate history?	Yes, in the Savings Bond Earnings Report (www.savingsbonds.gov).	No. Public information is very limited. Maybe you can get a renewal-rate history from the company, or maybe not.
Front-end load	None	Usually none (but there may be a passthrough of state premium tax)
Maintenance charge	None	Usually none (but can be up to $30).
Surrender charge	Cannot be redeemed during the first year. Three-month interest penalty for redemptions during first five years, equivalent to about 1% of account.	Varies. Usually 5% to 7% in first year, declining by 1% each year; clock can start at the issue date of the contract or at each premium date (rolling charge).
Income tax	You can elect to pay tax each year or to defer it for up to 30 years. Interest is exempt from state and local tax, and there is no penalty for early redemptions. Income may be tax-exempt when used for educational expenses. Bond redemptions consist of nontaxable principal and taxable interest; the breakdown is computed for each bond without reference to other bonds owned. Gifting is a taxable event; donor must pay tax on accumulated interest. At death, there is no step-up in basis; continued tax deferral depends on ownership and beneficiary designations. You cannot exchange I Bonds for other investments without creating a taxable event.	Interest grows tax deferred. It is not exempt from state and local tax. There is a 10% tax penalty for distributions before age 59 1/2, with exceptions. No tax exemption for educational expenses. Taxable income on one annuity may depend on other annuities purchased from same company in same year (IRC Sec. 72(e)(11)). Gifting is a taxable event; donor must pay tax on accumulated interest. At death, there is no step-up in basis; continued tax deferral depends on ownership and beneficiary designations. You can exchange a fixed annuity for another fixed or variable annuity without creating a taxable event (IRC Sec. 1035).
Gift tax	No special treatment.	No special treatment.
Estate tax	No special treatment.	No special treatment.
Avoidance of probate	Yes, using co-owner or beneficiary registration (but not single owner).	Yes, for named beneficiaries.
Protection from creditors	No special protection; same as other investments.	Varies by state. See Gideon Rothschild and Daniel S. Rubin, "Creditor Protection for Life Insurance and Annuities" (www.mosessinger.com).
Other features		Guaranteed annuity payment rates (but these are usually below current rates)
What can go wrong?	You can unexpectedly need your money before one year or five years. You can be in a higher tax bracket when you take money out. A change in CPI methodology can reduce the future inflation adjustments.	You can unexpectedly need your money before the surrender charge period ends or before age 59 1/2. You can be in a higher tax bracket when you take money out. The nonguaranteed renewal rate may not be competitive. If the insurer becomes financially shaky and is taken over by regulators, your money can be tied up for years.
Shopping tips	Choose a denomination that you won’t mind cashing out all at once. For example, if you want to invest $10,000, buy ten $1,000 bonds instead of one $10,000 bond. (This may not be necessary if you keep the bonds in paperless form at TreasuryDirect.) Buy toward the end of the month (but allow a few days for processing your order). You’ll get interest from the beginning of the month.	Shop around. Get the latest issue of the Fisher Annuity Index (800-833-1450, index@MrAnnuity.com). If available, look at the fixed account of TIAA-CREF’s PA Select (no surrender charge; good track record; no commissions). For annuities that pay commissions to agents, do a Google search for "fixed annuities" or "deferred annuities." For more information about contract features, look at the sample reports at AnnuityNexis.com. Look at the surrender charge and the guarantee period. The riskiest annuities are those with a guarantee period that is shorter than the surrender charge period; these are called "trust me" annuities (rule of thumb: don’t trust them). Ask for the company’s renewal-rate history (i.e., the interest rates that it has paid on its existing contracts). Read the contract and ask questions about anything that you don’t understand.

Fixed annuities: an overview

Key features

A fixed annuity is a contract issued by a life insurance company. You fill out an application and send the company some money — the minimum amount can be anywhere from $25 to $25,000 — and you get a contract that has these features:

1. During the accumulation period, your money earns interest. The interest rate is set by the company based on several factors, including: (1) what it is earning on its investments (typically, bonds and mortgages); (2) the spread that it wants to keep for expenses and profit; and (3) what other companies are paying. A typical spread is 1% to 2%. For example, if the company is earning 7%, it might decide to pay 5% to 6%.

The stated rate is usually an effective annual rate, not a nominal rate that is compounded periodically. For example, if you put $26,000 into an annuity with a 6% declared interest rate, you’ll have a year-end account balance of $26,060, not a higher amount due to compounding.

The rate is often guaranteed for one year, but the guarantee period may be longer or shorter. At the end of the guarantee period, the company declares a new interest rate for the next guarantee period. The company usually does not explain how it arrives at the declared rate. For example, it does not explain why the rate is 6.00%, rather than 5.75% or 6.25%, or why it dropped the rate from 6.00% to 5.50% even though market interest rates increased.

Some companies pay a one-time bonus that boosts the initial interest rate. This is funded by reducing the seller’s commission or the company’s profit or by increasing the surrender charge or the renewal-year interest spread (which means a lower renewal-year interest rate, other things being equal).

There is a minimum guaranteed interest rate, which is often 3%.

2.There is usually a surrender charge. A contract-based surrender charge typically starts at 5% to 10% and gradually declines over five to 10 years. A rolling surrender charge applies to each payment, so if you keep putting money into the contract you’ll never escape the surrender charge.

There may also be a market value adjustment. Some fixed annuities increase or decrease the surrender value to reflect gains or losses on the insurer’s own investments as a result of changes in interest rates. The annuity contract contains the market value adjustment formula. The formula is usually not symmetrical; the reward if interest rates go down is usually less than the penalty if interest rates go up.

There is usually no annual maintenance fee and no front-end load. This has given the insurance industry an opportunity to mislead the public, with the blessing of state regulators. A "no-load" annuity simply means that there is no front-end load; it does not necessarily mean that the product is sold directly to the public at a reduced cost. No-load annuities generally pay a full commission to the salesperson, and that expense — plus the insurer’s cost of capital — is recovered through a reduced interest rate and a surrender charge. Issuers of "no-load" annuities further mislead the public — again, with the blessing of state regulators — by saying that "all of your money goes to work for you immediately," which suggests that you are better off if the company deducts no sales load and pays, say, 6% on all of your $36,000 premium (seven-year accumulation value equals $41,036) rather than deducting a 5% sales load and paying, say, 7% on 95% of the premium (seven-year accumulation value equals $41,255). This sales pitch works only because most people aren’t actuaries.

3.You can take money out of the annuity in several ways:

You can surrender the contract and receive a lump sum. As noted, there may be a surrender charge.

You can take withdrawals. Many contracts let you withdraw up to 10% a year with no surrender charge.

You can choose one of the annuity options, to spread payments over a specified period (such as 10 or 20 years) or for as long as you live. The contract contains guaranteed annuity payment rates, but current rates are usually more favorable.

4. The tax treatment of fixed annuities is favorable in some ways and unfavorable in others (see the table above). For more details, consult your tax advisor or a reference such as Tax Facts, published by the National Underwriter Company, www.nuco.com.

5. Annuities avoid probate when payments go to a named beneficiary.

6. Annuity values may be protected from creditors, but this varies by state. See Gideon Rothschild and Daniel S. Rubin, "Creditor Protection for Life Insurance and Annuities" (www.mosessinger.com) and Peter Spero, "Using Life Insurance and Annuities for Asset Protection," Estate Planning, January 2001.

Past performance

Comprehensive information about the past performance of fixed annuities is not available. For years, the A.M. Best Company published performance information for selected annuities in several publications, but it discontinued that monitoring in 2000. There is currently no information that is comparable in scope and quality to what is available for fixed-income mutual funds (e.g., Morningstar reports).

The table below summarizes the performance information for single-premium deferred annuities that was reported in the October 2000 Best’s Policy Reports. Almost all of these annuities had one-year guarantee periods. You can see that there were significant differences in the account growth between top-performing and mediocre annuities, and that annuities and short-term bond funds had similar before-tax results overall.

	1995-1999	1990-1999
Highest Top 25% Median	7.15% 6.44% 6.04%	7.96% 6.89% 6.46%
Inflation	2.37%	2.93%
Short-term bond funds	6.09%	6.43%
Source: October 2000 Best’s Policy Reports (five-year accumulation values for 49 SPDAs and 10-year accumulation values for 42 SPDAs); Ibbotson Associates (inflation); Morningstar (short-term bond funds).

How easy is it to choose a top-performing fixed annuity?

Of course, it’s not enough to know how annuities have performed in general. You also need to know whether it is possible to pick a good one. The table below compares expected versus actual performance for a sample of 49 single premium deferred annuities for the five-year period ending in 1999. The focus here is on relative, rather than absolute, performance. Question: Could you have picked a good annuity in 1995 by looking for a high current interest rate?

Expected vs. Actual Performance of Single Premium Deferred Annuities Analysis of Rank by Quartile for 49 Products: 1995-1999
		Actual rank by quartile
		Top	2nd	3rd	Bottom
Expected rank by quartile	Top	5	4	3	1
	2nd	3	4	3	2
	3rd	3	3	4	2
	Bottom	2	1	2	7
Rankings are based on five-year accumulation values for a $10,000 single premium deposited on 1/1/95. Actual ranks are derived from data in the October 2000 Best’s Policy Reports. Expected ranks are based on a five-year projection of the initial interest rate, taking account of expense charges when applicable. Spearman rank correlation coefficient: 0.46 Actual accumulation value distribution:
Highest 13th highest 14th highest 25th highest 26th highest 37th highest 38th highest Lowest		$14,124 $13,662 $13,661 $13,405 $13,400 $13,233 $13,226 $12,758

Most of the annuities that credited a relatively high interest rate in 1995 did not maintain their competitive edge. The table shows that only five of the 13 annuities that looked like they would be in the top quartile actually delivered top-quartile results. It was easier to predict which annuities would be awful; seven of the 12 annuities that credited a relatively low interest rate in 1995 actually did wind up in the bottom quartile.

This pattern is not unique to the 1995-1999 period; results for 1985-1989 and 1994-1998 are similiar. Also, almost all of the 49 products had one-year guarantee periods, and credited interest rates were fairly stable throughout the five-year period (averaging about 7% at the beginning and 5.5% at the end). Therefore, relative rankings were not distorted by disparate guarantee periods or by the interaction of the interest-crediting method (i.e., portfolio versus new money) with an extreme uptrend or downtrend in overall renewal interest rates.

One shortcoming of a quartile analysis is that a small change in the accumulation value can move a product from one quartile to another. This can be addressed by looking at the correlation of the entire sets of rankings. For the expected versus actual rankings for these 49 products, the Spearman rank correlation coefficient is 0.46, which indicates only a moderate correlation (1.0 would mean a perfect correlation and zero would mean no correlation).

Two other potential shortcomings are sample selection and survivorship bias. A.M. Best’s SPDA survey does not include most of the major SPDA issuers, and it also excludes companies that issued annuities in 1995 but have left the annuity market since then. These biases probably make performance look even more predictable than it really is.

One way to improve predictability is to choose a longer guarantee period, such as five years. That eliminates the insurer’s discretion to reduce the interest rate after the first year. Relative performance will then be determined primarily by future changes in market interest rates. Locking in today’s rate for several years will turn out well if future interest rates go down and not so well if future interest rates go up.

I Bonds: an overview

In January 1997, the U.S. Treasury issued its first inflation-adjusted debt instruments, often called Treasury Inflation Protection Securities, or TIPS. These were followed in September 1998 by a new series of savings bonds, Series I (often called I Bonds).

The I Bond interest rate (officially called the earnings rate or the composite rate) has two parts: a real rate of interest (officially called the fixed rate) and an inflation adjustment (officially called the inflation rate). The calculation of the earnings rate is based on the standard formula for a total rate of return:

For example, if the real rate of return is 3% and the inflation rate is 2%, then the total rate of return is 5.06% (i.e., (1.03)(1.02) – 1). Using I Bond terminology, if the fixed rate is 3% and the inflation rate is 2%, then the earnings rate is 5.06%. (Bonus question: Why does the formula use multiplication rather than addition; that is, why isn’t the earnings rate computed this way: 3% + 2% = 5%?)

The fixed rate for new I Bonds is determined each May and November by the Secretary of the Treasury, and it remains unchanged throughout the 30-year life of I Bonds issued during each May-October or November-April period. The inflation rate is also determined semiannually, based on the non-seasonally-adjusted U.S. City Average All Items Consumer Price Index for All Urban Consumers (CPI-U), published by the Bureau of Labor Statistics. The index is used with a two-month lag; for example, the inflation rate for the May-October period is based on the index change from the preceding September to March.

A new semiannual earnings rate is calculated each May and November, and then the semiannual rate is doubled to convert it to a nominal annual rate. This rate applies during the first six months after an I Bond is issued. The earnings rate for subsequent six-month periods is based on the original fixed rate (which remains constant for the life of the savings bond) and subsequent inflation rates. For example, if you buy an I Bond in July, you’ll earn the initial earnings rate from July 1 through December 31, and the earnings rate for the following January-June period will be a composite of the initial fixed rate and the semiannual inflation rate that applies to new I Bonds issued during the November-April period. This is explained in detail in the Treasury Department’s Information Statement for Series I Bonds.

The table below shows the calculation of the current earnings rate and a supplementary table shows details for other periods.

Explanation of I Bond earnings rate for May 2001 to October 2001
			Annualized rate
	Semiannual	Comment	Nominal	Effective
Fixed Rate	1.50%	Declared by Treasury Dept.	3.00%	3.02%
Inflation rate	1.44%	Based on CPI-U for March 2001 (176.2) and September 2000 (173.7); 176.2/173.7 – 1 = .0144	2.88%	2.90%
Earnings rate	2.96%	= (1.0150)(1.0144) – 1	5.92%	6.01%

Interest accrues monthly and compounds semiannually. The accrual formula is exponential rather than linear, so more interest is earned in the sixth month of each six-month period than in the first month. Interest is payable from the beginning of the first calendar month of ownership until the end of last calendar month of ownership. That’s why the I Bond cognoscenti buy bonds near the end of the month and redeem bonds at the beginning of the month.

You cannot redeem an I Bond during the first six months after issue. If you redeem an I Bond during the first five years after issue, the redemption value will be determined as if you had redeemed the bond three months earlier; that is, you will lose the interest that has accrued during the latest three full calendar months.

Are I Bonds a good deal?

Let’s look at this from several perspectives.

1. What does history say?

What does history say about the attractiveness of a 3.0% real rate of return over long periods, such as 20 years? The table below shows that a 3.0% real return looks very good through history’s lens. Conventional bonds usually did not provide a greater real return over 20-year periods; in fact, most of the good periods for conventional bonds occurred in the 1990s as interest rates declined and bond prices rose. Even large company stocks failed to achieve a 3% real rate of return about one-fifth of the time. Obviously, the numbers would be even better for the 3.3%, 3.4% and 3.6% thresholds that apply to earlier I Bond fixed rates.

Number of 20-year periods from 1926 to 2000 during which the average annual real return was less than or equal to 3.0%
	Number (out of 56)	Percent
Large company stocks	11	20%
Long-term corporate bonds	41	73%
Long-term government bonds	46	82%
Intermediate-term government bonds	45	80%
Treasury bills	56	100%
The 20-year periods begin in January of each year. Data source: Ibbotson Associates, Stocks, Bonds, Bills, and Inflation 2001 Yearbook.

2. What are reasonable expectations about the future?

Historically, common stocks have provided the highest long-term returns. What is a reasonable forecast for the future? Of course, it’s easy to find a wide range of opinions about how well the stock market will perform in the coming decades. One place to look for useful analysis is academic research on the equity premium (the difference between the expected return on stocks and the risk-free interest rate). One example: Eugene F. Fama and Kenneth R. French, "The Equity Premium," CRSP Working Paper No. 522, April 2001. They argue that historical stock returns have exceeded expected returns due to unexpected capital gains caused by a decline in discount rates. This suggests that the odds of continued outperformance are lower than history leads us to believe.

William Reichenstein summarizes several studies in "The Investment Implications of Lower Stock Return Prospects" in the October 2001 issue of the AAII Journal (www.aaii.com), and he suggests TIPS and I Bonds as an alternative investment to consider. "What Do Past Stock Market Returns Tell Us about the Future?" is an expanded analysis of this subject (http://finance.baylor.edu/Reichenstein).

In January 1999, the Social Security Advisory Board appointed a committee of experts in various fields to review the assumptions and methodology used in forecasting Social Security funding needs. In its November 1999 report, the Technical Panel on Assumptions and Methods made this recommendation about the assumed return on government bonds: "The Panel recommends using a real annual interest rate of 2.7 percent in both the short- and long-term projection periods for the government bonds purchased by the OASDI Trust Funds. The current intermediate assumption is 3.0 percent. We recommend a high-cost rate of 2.0 percent and a low-cost rate of 3.5 percent." So this committee’s expected range of future real interest rates on Treasury bonds is mostly below the 3.0% to 3.6% real yields on I Bonds issued since September 1998.

3. What do asset allocation studies say?

(See More information about I Bonds and TIPS for references.)

Numerous researchers have looked at inflation-indexed Treasury bonds (TIPS) from the perspective of well-designed investment portfolios for tax-exempt institutional investors. I Bonds are not the same as TIPS, and individual investors are not the same as institutional investors, but it is reasonable to believe that the merits of I Bonds for taxable investors are at least as great as the merits of TIPS for tax-exempt investors. Therefore, it is worth paying attention to the available research on TIPS.

Peng Chen and Matt Terrien’s "TIPS as an Asset Class" (Journal of Investing, Summer 2001) is a good place to begin. They examine efficient portfolios in a mean-variance optimization framework and find that TIPS can provide significant benefits, especially when the focus is on real, rather than nominal, performance.

This conclusion seems to be the majority view, but some researchers are less enthusiastic.

Richard Kopcke and Ralph Kimball ("Inflation-indexed bonds: The dog that didn’t bark," New England Economic Review, January/February 1999) present an economic analysis of TIPS and conventional bonds for tax-exempt and taxable investors, as well as a mean-variance optimization, and they question whether TIPS provide significant benefits for most investors.

Nicholas Taylor ("US inflation-indexed bonds in the long run: a hypothetical view," Applied Financial Economics, December 2000) examines the role of inflation-indexed bonds in portfolios that are constructed to maximize investors’ expected utility. He creates hypothetical returns using several methods and finds that inflation-indexed bonds would have a large allocation (up to 50%) in optimal portfolios but would not produce a statistically significant increase in investors’ utility. His conclusion: Conventional bonds are actually an acceptable substitute for inflation-indexed bonds. "The findings of this paper cast some doubt on the usefulness of U.S. inflation-indexed bonds as portfolio diversifiers," Taylor writes. But it’s really not as bad as it sounds. Taylor’s conclusion rests on assumed returns that will strike many I Bond and TIPS investors as surprisingly low. Indeed, I Bond advocates will like this sentence: "Sensitivity analysis shows that the real yield on 30-year inflation-indexed bonds must exceed 2.5% per annum for these bonds to make a significant contribution to highly risk-averse investor utility."

Steve Fraser, William Jennings and David King ("Strategic asset allocation for individual investors: the impact of the present value of Social Security benefits," Financial Services Review, Winter 2000) examine optimal asset allocation when Social Security benefits are included in the investor’s portfolio. They find that Social Security benefits reduce the weighting of nominal bonds relative to stocks, similar to the effect of TIPS. However, they don’t discuss whether Social Security benefits would also displace TIPS in a portfolio allocated among Social Security, TIPS, nominal bonds and stocks.

Sid Browne, Moshe Milevsky and Thomas Salisbury ("The Solid Value of Liquid Utility: A Note on Benchmarking Fixed Annuities," working paper, September 2001) look at asset allocation from a different angle: How much extra yield do you need to get from an illiquid bond to compensate you for the inability to maintain the desired allocation through rebalancing? Their analysis focuses on fixed annuities, but it also applies to I Bonds. They show that a six-month period of illiquidity can be ignored, but long-term illiquidity would justify a yield premium.

4. What is the role of inflation-adjusted income in retirement?

Aside from Social Security, investors have very few ways to obtain inflation-adjusted incomes. You can accomplish this goal with I Bonds in a tax-favored manner by redeeming small-denomination bonds each month to cover that month’s living expenses. If inflation-adjusted life annuities become more widely available, you could use I Bonds and minimum distributions from retirement plans during the early years of retirement, and later buy a life annuity with the remaining plan assets. Here is some academic research to help you think about this subject:

Ameriks, John, Robert Veres and Mark J. Warshawsky, "Making Retirement Income Last a Lifetime," TIAA-CREF Institute, 2001. www.tiaa-crefinstitute.org

Brown, Jeffrey R., Olivia S. Mitchell and James M. Poterba, "Mortality Risk, Inflation Risk, and Annuity Products," Pension Research Council Working Paper 2000-10. http://prc.wharton.upenn.edu/prc/prc.html (also NBER Working Paper No. W7812)

Brown, Jeffrey R., Olivia S. Mitchell and James M. Poterba, "The Role of Real Annuities and Indexed Bonds in an Individual Accounts Retirement Program," Wharton Financial Institutions Center Working Paper 99-18. http://fic.wharton.upenn.edu/fic/wfic/papers/99/9918.pdf (also NBER Working Paper No. W7005)

Milevsky, Moshe Arye, "Optimal Annuitization Policies: Analysis of the Options", North American Actuarial Journal, January 2001.

Wilcox, David, "Why Haven’t Price-Level Indexed Annuities Taken the Financial World by Storm?", Treasury News, December 7, 2000. http://www.ustreas.gov/press/releases/ps1075.htm

I Bonds versus fixed annuities

Which is better, I Bonds or fixed annuities? Here are two perspectives to consider.

1. Breakeven fixed annuity interest rate

Both I Bonds and fixed annuities offer tax-deferred compounding of interest, but fixed annuities are taxed less favorably than I Bonds in two ways: (1) annuity earnings are subject to Federal, state and local income tax, whereas I Bond earnings are exempt from state and local income tax; and (2) fixed annuity earnings are subject to a 10% penalty tax before age 59 1/2 (with some exceptions), but that penalty tax does not apply to I Bonds. Therefore, to get the same after-tax value upon liquidation, you may have to earn a higher interest rate on an annuity than on I Bonds.

How much higher? That depends on the Federal, state and local income tax rates, the length of the holding period, the I Bond earnings rate, and whether the annuity earnings will be hit with the 10% penalty tax. The table below shows the required annuity interest rate for several sets of assumptions. You can use this ExcelTM spreadsheet to get results for your own assumptions:

Assumptions:

• Effective annual interest rate on I Bonds is 6.00%.
• Federal income tax rate is 30%.

With no penalty tax
		Holding period (in years)
		5	10	20	30
Federal, state and local income tax rate	30%	6.00%	6.00%	6.00%	6.00%
	32%	6.16%	6.14%	6.11%	6.08%
	34%	6.32%	6.28%	6.22%	6.17%
	36%	6.50%	6.43%	6.33%	6.26%

With 10% penalty tax
		Holding period (in years)
		5	10	20	30
Federal, state and local income tax rate	30%	6.88%	6.76%	6.58%	6.46%
	32%	7.09%	6.93%	6.71%	6.56%
	34%	7.31%	7.12%	6.84%	6.67%
	36%	7.54%	7.31%	6.99%	6.78%

If there is no penalty tax, you don’t need to earn much more on a fixed annuity to match the after-tax value of I Bonds; a reasonable rule of thumb is no more than 0.5%. The picture changes, however, if you have to pay the 10% penalty tax; in that case, you will probably need to earn much more.

2. What can we reasonably expect? A pricing perspective

Is it reasonable to expect fixed annuities to outperform I Bonds over the long run? Let’s look at how annuities are priced and at investment yields in the marketplace.

Fixed annuities can potentially pay more than I Bonds, because insurance companies can invest in higher-yielding assets. Insurers’ portfolios that support fixed annuities are primarily invested in publicly-traded and privately-placed corporate bonds and commercial mortgages, which have a higher yield than Treasury securities of comparable maturity. In addition to taking credit risk and liquidity risk, insurers can also take interest-rate risk by extending the average maturity of their portfolios.

On the other hand, insurance companies have several competitive disadvantages that lead to higher costs:

• Insurance companies are in business to make a profit; the Federal government isn’t.
• Insurance companies have much higher distribution costs (i.e., commissions and other selling expenses). Fixed annuity commissions are typically 3% to 7% of the premium. In contrast, issuing agents for I Bonds receive a maximum of $0.85 per bond, which would be 1.7% for a $50 bond and 0.085% for a $1,000 bond.
• Insurance companies suffer adverse tax treatment at the corporate level in two ways. Tax reserves may be lower than statutory reserves, and acquisition costs cannot be fully deducted in the year incurred. The effect is to accelerate income tax payments.
• Insurance companies have to hold risk-based capital to support their annuity liabilities, so they incur an opportunity cost that has to be recovered from the annuity contractholders.
• Insurance companies have to comply with numerous state laws, which differ from one state to another. For example, annuity products have to be filed with the insurance department in each state where they are sold.
• There is a state premium tax on annuities in a few states.

To weigh these competitive advantages and disadvantages, let’s compare a five-year CD-annuity and an I Bond as of early May 2001. The CD-annuity has a five-year guarantee period and a five-year surrender charge. According to the Fisher Annuity Index the average interest rate was about 5.4%, but careful shoppers could have found some annuities that were paying up to 6.0% (based on the list of "market leaders" at AnnuityZone.com). The I Bond had a 3.0% fixed rate and a 6.0% effective composite rate.

In early May, five-year Treasury notes yielded about 4.9%. Assume that the insurance company could earn about 2.0% more by investing in corporate bonds, mortgage-backed securities and commercial mortgages with a longer average maturity; in other words, the insurer gets a 2.0% higher return by taking more investment risk. Assume that the insurer’s investment expense ratio for its general account is 0.15% and that it needs a 1.0% spread for its other expenses and profit. That leads to a 5.75% credited interest rate, as follows:

5-year Treasury yield	4.90
+ Yield gain for taking risks	+ 2.00
- Investment expense	- 0.15
- Required spread	- 1.00
	_____
= Credited interest rate	5.75

So the insurer picks up 200 basis points (2.00%) of additional yield by taking investment risk, but it gives up 115 basis points (1.15%) for expenses and profit. And these assumptions could easily be optimistic. Picking up 200 basis points of additional yield is not a sure thing, and the required spread for a typical annuity could be 150 to 200 basis points rather than 100.

Looking ahead at the first five years, an I Bond with a 3% nominal fixed rate will yield more than 5.75% if average inflation is more than 2.65% (i.e., 1.0575/1.0302). Looking beyond five years, there seems to be no compelling reason to expect that future annuities will provide a return that is high enough to compensate investors for the obvious disadvantages of higher taxes (state and local income tax at all ages, and a 10% penalty tax prior to age 59 1/2), higher surrender charges, higher credit risk, lack of predictability of performance (especially for nonguaranteed annuities), and no explicit inflation protection.

I Bonds and TIPS in the news

• Article: Scott Burns, "TIPS protect investors from inflation’s peril," Dallas Morning News, October 23, 2001, www.scottburns.com
• Article: Laura Lallos, "What to Do with Your Cash," Money, November 2001, p. 45
• Article: Gerri Willis, "Is Anything Safe?," SmartMoney, November 2001, p. 87
• TIPS auction on 10-10-01: 3.375% coupon, 4-15-32 maturity, 3.465% real yield for noncompetitive bids.
• Article: Jeff D. Opdyke, "Investors Show Sudden Interest In Inflation-Indexed Savings Bond," Wall Street Journal, October 8, 2001
• Article: Robin Goldwyn Blumenthal, "The name is bond; I bond, that is," Barron’s, October 1, 2001

Useful websites

www.savingsbonds.gov
Bureau of the Public Debt Online. This is the main government-sponsored online information source about U.S. Savings Bonds. You can buy bonds online and download the Savings Bond Wizard to keep track of bond values. The Monthly Statement of the Public Debt reports sales and redemptions for savings bonds and TIPS. There is also information about TIPS auctions.

www.fms.treas.gov/bulletin/
The Treasury Bulletin reports sales and redemptions for savings bonds and TIPS.

http://www.bls.gov/data/top20.htm
CPI-U data series at the Bureau of Labor Statistics.

http://www.publicdebt.treas.gov/cc/ccregs.htm
Statutes, regulations and Federal Register items related to I Bonds.

www.morningstar.com
In the Conversations area, you’ll find savvy investors who are enthusiastic advocates for I Bonds. Start with Vanguard Diehard conversations #4215, 5543 and 6316, and then do a search using the keyword I Bond.

economics.sbs.ohio-state.edu/jhm/ts/ts.html
Professor J. Huston McCulloch’s website about the U.S. real term structure of interest rates and related information.

www.bondinformer.com
This website is run by Daniel J. Pederson, a respected authority on U.S. savings bonds.

More information about I Bonds and TIPS

A good place to start

• Brynjolfsson, John B., "Inflation-Indexed Bonds (TIPS)" in Frank J. Fabozzi (editor), The Handbook of Fixed Income Securities, 6th Edition, McGraw-Hill, 2001.
• Brynjolfsson, John and Frank J. Fabozzi (editors), Handbook of Inflation Indexed Bonds, Frank J. Fabozzi Associates, 1999.
• Pederson, Daniel J., U.S. Savings Bonds: The Definitive Guide for Financial Professionals, 4th Edition, 1999. www.bondinformer.com
• United States Treasury Department, Information Statement for Series I Bonds. www.savingsbonds.gov

Will I Bonds and TIPS survive?

• Anand, Vineeta, "TIPS’ cost casts cloud on survival prospects," Pensions & Investments, July 23, 2001.
• "Inflation protection needed," Pensions & Investments, August 20, 2001, p. 10.

General information

• Anderson, Roger L., "U.S. Inflation-Indexed Bonds," Investment Policy, May/June 1998.
• Angell, Robert J. and Alonzo L. Redmon, "Inflation Indexed Treasuries: How Good Are They?", AAII Journal, April 1998
• Clements, Jonathan, "Bond Fans: Try a New Chicken Dance," Wall Street Journal, July 24, 2001.
• Clements, Jonathan, "Second Thoughts: Inflation-Tied Bonds Offer an Intriguing Option for Investors," Wall Street Journal, March 11, 1997.
• Barker, Robert, "Who Needs Razzle-Dazzle?", Business Week, September 4, 2000.
• Barker, Robert, "A Bond Anybody Can Love," Business Week, June 19, 2000.
• Bierck, Richard, "Inflation Oases," Bloomberg Personal Finance, November 2000.
• Denmark, Frances, "Safe Harbor?", Bloomberg Wealth Manager, December 2000/January 2001.
• Francis, Theo, "Treasury Inflation-Protected Securities Shine," Wall Street Journal, May 25, 2001.
• Harmelink, Philip J., William M. Vandenburgh and Phyllis V. Copeland, "Rising Attraction of Inflation-Indexed Securities," Practical Tax Strategies, September 1999.
• Jessup, Paul, "Inflation-Protected Bonds: A Look at the New I Bond Series," AAII Journal, August 1999.
• Kobliner, Beth, "Two Faces Of a Bond That Beats Inflation," New York Times, July 15, 2001.
• Lingane, Peter James, "The Case for Inflation Indexed Bonds," 2001. www.lingane.com
• Moore, Barbara J., "Real Bonds: The Corporates are Coming," Investment Policy, May/June 1998.
• Opdyke, Jeff D., "Investors Show Sudden Interest In Inflation-Indexed Savings Bond," Wall Street Journal, October 8, 2001
• Reichenstein, William and Tom L. Potts, "Analysis of U.S. Savings Bonds," Financial Services Review, 4(1), 1995.
• Roll, Richard, "U.S. Treasury Inflation-Indexed Bonds: The Design of a New Security," Journal of Fixed Income, December 1996.
• Sargent, Kevin H. and Richard D. Taylor, "TIPS for Safer Investing," Economic Commentary, Federal Reserve Bank of Boston, July 1997. www.bos.frb.org
• Shen, Pu, "Features and Risks of Treasury Inflation Protection Securities," Federal Reserve Bank of Kansas City Economic Review, First Quarter 1998. www.kc.frb.org
• Toolson, Richard B., "One Type of Tax-Deferred Savings Bond Is Bound to Beat Inflation," Practical Tax Strategies, December 2000.
• Wrase, Jeffrey M., "Inflation-Indexed Bonds: How Do They Work?", Business Review, Federal Reserve Bank of Philadelphia, July/August 1997. www.phil.frb.org

Asset allocation

• Barreto, Susan, "Study finds ‘no-brainer’ hedge," Pensions & Investments, August 24, 1998.
• Bodie, Zvi, "Inflation, index-linked bonds, and asset allocation," Journal of Portfolio Management, Winter 1990.
• Browne, S., M. Milevsky and T. Salisbury, "The Solid Value of Liquid Utility: A Note on Benchmarking Fixed Annuities," working paper, September 2001. www.milevsky.com
• Burns, Scott, "Omega plan puts an end to anxiety," The Dallas Morning News, December 20, 2000. www.scottburns.com
• Campbell, John Y. and Luis M. Viceira, "Who Should Buy Long-Term Bonds?", American Economic Review, March 2001.
• Chan, Yeung Lewis, "Essays in Financial Economics," Unpublished Ph.D. dissertation, Harvard Univ., 2000.
• Chen Peng and Matt Terrien, "TIPS as an Asset Class," Journal of Investing, Summer 2001. Also available at www.ibbotson.com
• Clements, Jonathan, "The Right Mix: Inflation-Indexed Bonds Could Be Just the Complement to Stocks," Wall Street Journal, October 8, 1996.
• Fraser, Steve P., William W. Jennings and David R. King, "Strategic asset allocation for individual investors: the impact of the present value of Social Security benefits," Financial Services Review, Winter 2000.
• Fischer, Stanley, "The Demand for Index Bonds," Journal of Political Economy, June 1975.
• "Inflation Indexed Treasury Securities," The Proceedings, Conference of Consulting Actuaries, 1997.
• Kopcke, Richard W. and Ralph C. Kimball, "Inflation-indexed bonds: The dog that didn’t bark," New England Economic Review, January/February 1999. www.bos.frb.org
• Lamm, R. McFall, Jr., "Asset Allocation Implications of Inflation Protection Securities," Journal of Portfolio Management, Summer 1998.
• Lucas, Gerald and Timothy Quek, "A Portfolio Approach to TIPS," Journal of Fixed Income, December 1998.
• Rudolph-Shabinsky, Ivan, "Inflation-Protected Securities in an Asset Allocation Framework," Investment Counseling for Private Clients II, AIMR Conference Proceedings, November 1999. www.aimr.org
• Rudolph-Shabinsky, Ivan and Francis H. Trainer, Jr., "Assigning a Duration to Inflation-Protected Bonds," Financial Analysts Journal, September/October 1999.
• Siegel, Jeremy J., "Stocks, Bonds, the Sharpe Ratio, and the Investment Horizon: A Comment," Financial Analysts Journal, March/April 1999.
• Salomon, Robert S., Jr., "Inflation Insurance," Forbes, July 3, 2000.
• Taylor, Nicholas, "US inflation-indexed bonds in the long run: a hypothetical view," Applied Financial Economics, December 2000.
• TIAA-CREF Institute, "Saving for College: A Comparison of Section 529 Plans with Other Options," Research Dialog, No. 67, March 2001, www.tiaa-crefinstitute.org
• Tipp, Robert and Michael J. Collins, "TIPS (Treasury Inflation Protection Securities)," Employee Benefits Journal, June 2001.
• Viard, Alan D., "The Welfare Gain from the Introduction of Indexed Bonds," Journal of Money, Credit, and Banking, August 1993.

Economics

• Alvarez, Fernando, Robert E. Lucas, Jr. and Warren E. Weber, "Interest Rates and Inflation," American Economic Review, May 2001.
• Bach, G. L. and R. A. Musgrave, "A Stable Purchasing Power Bond," American Economic Review, December 1941.
• Bams, Dennis and Christian Wolff, "Risk Premia in the Term Structure of Interest Rates: A Panel Data Approach," CEPR Working Paper No. 2392, February 2000. www.ssrn.com
• Barr, David G. and John Y. Campbell, "Inflation, Real Interest Rates, and the Bond Market: A Study of UK Nominal and Index-Linked Government Bond Prices," NBER Working Paper No. W5821, November 1996. www.nber.org
• Campbell, John Y. and Robert J. Shiller, "A Scorecard for Indexed Government Debt," Cowles Foundation Discussion Paper, 1996. http://cowles.econ.yale.edu/P/ab/a11/a1125.htm
• Cecchetti, Stephen G., Rita S. Chu and Charles Steindel, "The Unreliability of Inflation Indicators," Current Issues in Economics and Finance, Federal Reserve Bank of New York, April 2000. www.ny.frb.org
• Chen, Li-Hsueh, "Inflation, real short-term interest rates, and the term structure of interest rates: a regime-switching approach," Applied Economics, February 2001.
• DePrince, Albert E., Jr. and William F. Ford, "The U.S. Treasury’s Inflation-Protected Securities (TIPS): Market Reactions and Policy Effects," Business Economics, January 1998.
• Devine, James, "The Cost of Living and Hidden Inflation," Challenge, March/April 2001.
• Emmons, William R., "The Information Content of Treasury Inflation-Indexed Securities," Federal Reserve Bank of St. Louis Review, November/December 2000. www.stls.frb.org
• Evans, Martin D. D., "Real Rates, Expected Inflation, and Inflation Risk Premia," Journal of Finance, February 1998.
• "Fighting America’s inflation flab," The Economist, October 7, 2000, p. 85-86.
• Foresi, Silvero, Alessandro Penati and George Pennacchi, "Estimating the Cost of U.S. Indexed Bonds," Federal Reserve Bank of Cleveland Working Paper No. 9701, January 1997. www.clev.frb.org
• Grieves, Robin and Michael W. Sunner, "Fungible STRIPS for the U.S. Treasury’s Inflation-Indexed Securities," Journal of Fixed Income, June 1999.
• Hamilton, Bruce W., "Using Engel’s Law to Estimate CPI Bias," American Economic Review, June 2001.
• Holder, Mark E. and Michael H. Tomas, II, "A Simple Model for Pricing Inflation-Indexed Futures," Derivatives Quarterly, Fall 1997.
• Kennedy, Peter E., "Eight Reasons Why Real versus Nominal Interest Rates Is the Most Important Concept in Macroeconomics Principles Courses," American Economic Review, May 2000.
• Koedijk, Kees, Clemens Kool and Francois Nissen, "Real interest rates and shifts in macroeconomic volatility," Journal of Empirical Finance, September 1998.
• Price, Robert, "The Rationale and Design of Inflation-Indexed Bonds," International Monetary Fund Working Paper: WP/97/12, January 1997.
• Rich, Robert W. and Donald Rissmiller, "Understanding the Recent Behavior of U.S. Inflation," Current Issues in Economics and Finance, Federal Reserve Bank of New York, July 2000. www.ny.frb.org
• Rutley, Todd, "Is the New CPI Different? Implications for Pension Plans," Risks and Rewards, March 1999. www.soa.org
• Sack, Brian, "Deriving Inflation Expectations from Nominal and Inflation-Indexed Treasury Yields," Journal of Fixed Income, September 2000.
• Shen, Pu, "How Important Is the Inflation Risk Premium?", Federal Reserve Bank of Kansas City Economic Review, 4th Quarter 1998. www.kc.frb.org
• Stock, James H. and Mark W. Watson, "Forecasting Inflation," NBER Working Paper No. W7023, March 1999. www.nber.org
• United States General Accounting Office, Consumer Price Index: Update of Boskin Commission’s Estimate of Bias, February 2000, GAO/GGD-00-50. www.gao.gov
• Veronesi, Pietro and Francis Yared, "Short and Long Horizon Term and Inflation Risk Premia in the US Term Structure: Evidence from an Integrated Model for Nominal and Real Bond Prices Under Regime Shifts," CRSP Working Paper No. 508, December 1999. www.ssrn.com
• Wilcox, David W., "The Introduction of Indexed Government Debt in the United States," Journal of Economic Perspectives, Winter 1998.
• Yared, Francis, "Path Dependence in Expected Inflation: Evidence from a New Term-Structure Model," Lehman Brothers, November 1999. www.ssrn.com
• Zhang, Ning, "Term Structures, Indexed Bonds, and Derivative Pricing," Unpublished Ph.D. dissertation, Princeton Univ., 1998.