THEY LOOK LIKE bonds, and they often act like bonds, but they are not bonds. They are the financial instruments that compete with bonds and sometimes complement bond portfolios. Investors might become interested in these alternatives when they're seeking more cash flow or a different kind of cash flow to satisfy their financial needs. The spectrum of risks may be different from those associated with bonds, although that may be overlooked in the search for income.
And when investors are interested, financial firms and brokerage houses are quick to rush in with fancy-sounding products geared to those interests. Two of the many offerings go by the names of principal-protected securities (a great name in a sliding stock market) and equity-linked CDs (not so great in a sliding stock market). No matter what the name, we believe that many of these financial products are designed to appeal to investors known as "yield hogs." Typically, yield hogs consider only yield in examining investments and ignore other issues such as safety, liquidity, and tax implications.
Let's consider five classic look-alike bond alternatives and present the uses, advantages, and disadvantages of each: CDs, both direct sale and broker-sold; single-premium immediate fixed annuities and deferred fixed annuities; nonconvertible fixed-rate preferred stock; and dividend-paying common stock.
There are a number of rating systems for CDs. You may find one rating system in the newspaper for local bank CDs and other ratings used for brokered CDs. When you're considering purchasing a CD, be clear what the rating is supposed to indicate.
There are two key acronyms associated with CDs: APR and APY. When bank announcements refer to a "CD rate," they're referring to the annual percentage rate (APR). The APR is a measure of the simple interest return on your CD. The annual percentage yield (APY) is a measure of compound interest. Banks usually say that they compound interest daily. You would use this measure to compare a bank CD to other interest-paying investments.
If the APR is 5 percent on a CD, the APY would compute to a 5.10 to 5.15 APY when the bank compounds the interest if you leave the money with the bank. For example, if you invested $1,200 in a 12-month CD and the APR was 5 percent, the interest on your CD would be $60 per year. This is simple interest at a 5 percent rate. If you elected to receive your income monthly, you would receive $5 each month. It would be up to you to rein-vest the $5 in order to get compound interest. Alternatively, assume that the APY was 5.15 percent and you take no distributions from the bank with respect to your CD until twelve months have passed and then you cash in your CD. In this case you would receive your $1,200 back plus $61.80 interest from the bank when your CD came due at the end of the 12-month period (.0515 × 1,200 = 61.8).
Bank CDs are time deposits, one of the simplest and most common investments. You deposit cash with a bank for a stated time period and earn a stated rate of interest. When you buy a $100, 12-month bank CD with a 5 percent interest rate, for example, you will receive all your principal plus $5 in interest for a total of $105 at the end of twelve months when the CD comes due. Interest is credited using the "simple compounding" method, which is not directly comparable to the yield-to-maturity on bonds.
Bank CDs offer a variety of interest payment options, including monthly, quarterly, semiannually, and yearly. The simplest way to know which type will yield more is to ask how much money you will receive in total over the life of this CD.
Bank CDs are generally nonnegotiable, which means that you can't sell them to a third party. You must wait until the CD comes due. If you need liquidity prior to maturity, you may return the CD to the issuing bank and pay a penalty for early redemption. The bank CD will not pay off automatically at the due date. If you do not request the bank to pay off the CD, the proceeds of the old CD will roll over automatically into a new CD of the same maturity, but at the bank's current interest rate. If you're seeking the highest rate within your time frame, ask the bank what CD "specials" they have.
To make the CDs more attractive than Treasury securities, banks may offer them at a higher interest rate than that paid on comparable Treasuries. Keep in mind that you do not pay state and local taxes on the interest earned from Treasuries whereas you do on the CDs, so the rates are not directly comparable.
Advantages. Bank CDs are one of the safest investments to be found if your principal is protected by the Federal Deposit Insurance Corporation (FDIC). The FDIC insures up to $100,000 of principal and interest per ownership category per bank for deposits in an account at an insured savings institution. CDs held in "self-directed" retirement accounts are insured for $250,000. Banks that display the FDIC or eagle sign at each teller window are FDIC insured. You can calculate insurance coverage using the FDIC's online estimator at www2.fdic.gov/edie.
Risks. Many financial institutions that sell CDs are not insured by the FDIC. These institutions often offer higher rates, but their CDs come with the risk that if the institution was to fail, you would lose some or all of your investment. At an FDIC-insured bank, if the face amount of the CD plus accrued interest exceeds $100,000 in all taxable accounts in your name ($250,000 in a self-directed retirement account), the excess is not FDIC insured.
Although you can generally withdraw cash from a bank CD before it matures, there is a penalty. Typical bank penalties for early withdrawals may be as follows:
Maturity of 7 to 90 days: often all interest earned.
Maturity of 91 to 364 days: often equal to 90 days' interest.
Maturity of 365 days or greater: often equal to 180 days' interest.
These penalties may be large enough to reduce your principal. For example, suppose you bought a 24-month CD at a bank and needed to cash it in after three months. In this case you might pay a six-month interest penalty even though you earned only three months of interest. Carefully check the penalties before you buy because they will reduce your yield and can be quite onerous.
Tax implications. Interest from CDs is subject to federal, state, and local income taxes if applicable unless the CD is held in a tax-sheltered retirement account: In addition, there is a tax disadvantage to long-term (more than 12-month) bank CDs that pay interest at maturity rather than annually. You must report the interest earned each year on your federal income tax return, even if you don't receive the interest until a later year, unless the CD is held in a tax-sheltered retirement account.
Early withdrawal penalties are deductible whether you itemize your deductions or not. Withdrawal penalties for a CD held within a tax-sheltered retirement account are not deductible.
Pricing information. Newly issued CDs are purchased at face value. Banks may offer specials for particular maturities and quantities. If you simply roll over your CD without asking about specials, you may miss a more attractive rate.
Information sources. Good sources of information on current CD rates throughout the country and a CD calculator can be found at www.bankrate.com and www.bankrater.com. The latter is sponsored by Bauer Financial, which also publishes Jumbo Rate News, a magazine that covers 1,300 CD rates.
Special features and tips. Unless you give the bank instructions to redeem a CD when it comes due, the bank will reinvest your money automatically. There is often a ten-day window between the maturity of the last CD and the start of a new one; this interval gives you time to shop around to see if there are better returns elsewhere. Keep in mind that each financial institution is allowed to determine its own penalty provisions, and you should ask about the penalty for early withdrawals.
Although no one can predict the future of interest rates, if you believe interest rates will fall, a bank CD allows you to lock in a fixed rate. If you are investing $1,000 or more, compare CD rates with Treasury offerings before making your decision to invest. Be aware that some bank CDs are callable. This is important if you think you are locking in a high rate. Callable CDs are attractive only if their rates are significantly higher than those at prevailing levels.
In the 1980s, major brokerage firms began to sell bank CDs to their customers. It has proven to be a beneficial arrangement for all parties. Small banks are able to tap into a larger market by having a national firm sell their CDs, and the brokerage firms receive a fee from the banks for doing so. When you purchase a broker-sold CD, you are purchasing a share in a high dollar amount certificate, instead of purchasing the CD directly for the amount you're paying.
Let's see what a typical broker CD looks like and compare it to a typical bank CD.
Insurance. Brokers will generally sell CDs from banks that are FDIC insured. However, the onus is on you to make sure that the bank issuing the CD has FDIC insurance.
Maturity. Broker CDs have maturities that generally range between one month and twelve years. In comparison, many bank CDs have lives of only five years or less. A broker CD automatically turns into cash at its due date. A bank CD automatically rolls over into another bank CD unless you instruct the bank to cash it in.
Maximum amount. The face amount of many broker CDs should not exceed $90,000—to make sure that the principal and interest do not exceed the $100,000 insurance limit. Many banks will sell you a $100,000 CD, called a "jumbo," with a higher rate of interest.
Interest payout. Brokered CDs generally pay semiannual interest, as do bonds. Some banks will pay you interest monthly, semi-annually, yearly, or when the CD comes due. You must ask the bank what its payout possibilities are.
Resale. The key difference between a bank and a broker CD is that the broker CD is negotiable. This means that you can generally sell the broker CD before its due date without paying a penalty. However, the market price you receive on the sale may be higher or lower than the CD's face value. If interest rates decline after you buy the broker CD, you may be able to sell your CD back to your broker at a gain. If interest rates have gone up over your holding period, you can hold the broker CD until it comes due and receive its face value or sell the CD to the broker at a loss.
Fees and commissions. There is generally no stated commission charged to the broker's customers on the sale of a CD. The broker earns its fee from the bank, unless you purchase a secondary market CD, in which case there is a bid/ask spread.
When you purchase CDs, you may notice names of familiar companies showing up, like Target, GMAC, and General Electric banks. These institutions are not banks in the true sense of the word but are instead industrial loan companies (ILC). The Federal Reserve does not oversee the ILCs; that is done by the states. Don't worry; the ILCs do have FDIC insurance.
Advantages. When you buy a broker CD from a large firm, you have a veritable shopping mall of offerings. The firm can locate advantageous prices and a variety of CD offerings that you would be hard put to find on your own. This can lead to excellent buying opportunities. For example, compare the interest rate on a typical 5-year broker CD sold in October 2006 (5 percent) to the yield on a 5-year Treasury bond (4.56 percent). Although the choice of which to purchase may seem obvious, it is not. If you live in Florida, where there is no state income tax, the CD is the better choice. However, if you live in a high-tax state like California, you might be better off with the Treasury bond because the after-tax return may be higher.
Risks. As discussed previously, broker CDs are subject to market risk if sold before their due date. Do not confuse a bank CD with a CD-type annuity. The bank CD gives you the same tax deferral as the annuity if you purchase it for your retirement account. The bank CD guarantees the rate for the life of your CD, whereas the annuity may give you a higher rate the first year but a lower rate in the remaining years. Although there may be a penalty for withdrawing funds from a bank CD, the penalties for withdrawing funds from the CD-type annuity are much more severe and may amount to one and one-half years' interest the first year, declining very gradually from there.
Tax implications. Interest income from broker CDs is subject to federal income tax and state and local income tax if applicable, unless it's held in a tax-deferred retirement account. When they are sold early, however, the difference between the sale price and the purchase price is treated as either a long-term or short-term capital gain or loss unless it's held in a tax-deferred retirement account.
Pricing information. New-issue broker CDs can generally be purchased at face value, for a minimum of $1,000.
Special features and tips. There are many varieties of broker CDs, including zero-coupon CDs that pay no interest until maturity. Unless you purchase the CD in a retirement account, you have to pay taxes on the phantom interest. On a $50,000 investment yielding 5 percent, the first year's interest would be $2,500, and each year it would be more. Make sure you have enough money to pay the taxes.
Step-rate CDs. "Step-rate" CDs may "step down" or "step up." A step-down CD will generally pay an above-market interest rate for a stated period and then pay a lower, stated rate until it comes due. A step-up CD, also referred to as a "bump up" CD, will generally pay a below-market interest rate for a stated period and then pay a higher, stated rate until it comes due. Investors in step-rate CDs might wind up with more or less interest than a CD without these features, and the CDs may also be callable. As with all broker CDs, if you sell them before their due date, you may have a gain or a loss. It's important to get the buy-back terms from the broker in advance. Ask for a complete description as well as the offering memoranda, where the fine print might contain critical information.
Callable CDs. Some CDs are callable. CDs with a short call should have a higher yield-to-maturity than a bond with no call at all. For example, a 10-year noncallable bond might be yielding 5.05 percent, while a 10-year CD with a six-month call might be yielding 6 percent. If your bond is called away, you may have to reinvest at a lower rate. Sometimes a broker may say that the CDs are "one-year noncallable." That might lead you to believe that the CD comes due in one year. In fact, it means that the CD can be called after one year.
There are also inflation-protected CDs, similar to the TIPS described in chapter 6. Aside from the difference in issuer, the TIPS are exempt from state and local taxes, whereas the CDs are not. This distinction fades in importance if the CDs are purchased for a retirement account.
For risk takers, there are CDs linked to foreign currencies. For more information, visit www.everbank.com. If you want to bet on currency movements, and against the dollar, this is an easy way to do it. You can purchase a CD representing a basket of currencies. Although the yields may be higher than on FDIC-insured CDs, you can still have losses if the currencies fall against the dollar. This investment is not for the faint of heart. In addition, you have transaction fees to convert from the dollar to your currency choice and back again.
When does the CD mature?
What is my interest rate?
When the CD is cashed in on its redemption date, how much money will I have above my principal?
Does the CD have any calls?
Is the CD brokered?
Do I have FDIC insurance with this CD?
What am I giving up for the added features of extra liquidity, call protection, inflation protection, and survivor's option?
If it has a survivor's option, what are the penalties or cost of terminating the CD early?
A single-premium immediate fixed annuity (SPIA) is an annuity contract between you and an insurance company, in which you give the company a lump-sum cash payment in exchange for an agreed-upon monthly fixed amount that begins immediately. Depending on the terms of the annuity contract, the fixed monthly amount may be received for a fixed number of years, for life, or until a fixed total amount of money is paid.
Think of the immediate annuity as a fixed cash flow guaranteed by the insurance company. When you purchase an immediate annuity there will be no money to return to you when the policy terminates because the money will have been spent on the purchase of an insurance benefit: the scheduled stream of fixed payments to you. There is no fluctuation in the value of the principal because you have turned that money over to the insurance company and you don't have a principal amount anymore.
Each insurance company has its own variations on the following four distribution options. The most common options are the first two.
Life only. Payments are made for as long as you live. Your annuity contract can also provide for a joint and survivor annuity. If you elect this distribution option, payments will be made for your life and the life of your spouse or another named person. Typically a single-life annuity provides the greatest cash flow because it's based on one life span and may terminate in the shortest amount of time. A joint-and-survivor annuity will provide a lesser cash flow because it will generally pay out for a longer period of time (two life spans). If both beneficiaries die prematurely, the annuity does not pass to their heirs.
Life with period certain. You or your beneficiary will receive payments for the longer of (a) your life (or lives) or (b) a stated minimum number of years even if you die prematurely. Under such a policy, the beneficiary would inherit the remaining amount of the policy if you die before the stated number of years.
Period certain but not life. This guarantees payments for only a specified number of years, but not for life. Shorter guaranteed periods provide greater payments than longer periods.
Accumulated amount only. This option provides for payment of a specified amount per month until the annuity account is exhausted.
An immediate fixed annuity provides you with a guaranteed stream of income for life (assuming you select one of the first two options), no matter how long you live. No other investment is so well constructed for this purpose. An annuity is a kind of longevity insurance. The purpose of a fixed annuity is to shift the risk of outliving your money to the insurance company, although you also lose access to extra cash you might need when you're older.
Although you might purchase a laddered portfolio of noncallable bonds as a substitute, if your life span is longer than expected and your assets are limited, you might run out of money. One advantage of bonds is that unexpended funds can be reinvested at higher rates if there is inflation, possibly increasing your cash flow if you have enough assets.
The payments from an immediate annuity are fixed and unaffected by financial market gyrations or interest rate fluctuations. If your immediate annuity provides for a payout of $1,000 per month for life, that is what you will get no matter what is happening in the financial markets.
Unlike many other investments, the stated returns on immediate annuities are net of any fees. What you see is what you get. Fidelity and Vanguard, the mutual fund companies, have entered the field as low-cost providers of this type of annuity.
Immediate annuities are irrevocable and, thus, worse than illiquid. Once you buy an immediate annuity for, say, $100,000, you have completely lost control of that $100,000 unless there is a thirty-day free-look period. You have exchanged your $100,000 for a stream of payments, and your deal is done. Before you buy an immediate fixed annuity, you should read the annuity contract to determine if you can get a prepayment for medical emergencies or for some other purpose. If there are no such provisions, assume your money is locked up for good. This is a reason to commit no more than a portion of your capital to an immediate annuity.
There is a risk that the insurance company could go broke and default on your annuity contract. This risk can be reduced if you buy only annuities of highly rated insurance companies. As we know, a high rating at purchase does not mean a high rating forever. Insurance companies can and do fail. However, there are generally state guarantee laws that may protect the annuity holder. The amount of the guarantee varies by state. Ask your agent, the insurance company, or the Department of Insurance in your state what the protection provisions are. The guarantee is based on insurance companies pooling resources in the event that one of them defaults. Even if there is a state guarantee, payments may be delayed for many years and there is a possibility that the claim may never be paid.
Most important, there is inflation risk. This is associated with all long-term fixed-income investments, and it can be a serious one when your payments are fixed but your purchasing power is declining drastically. Unlike Social Security, which is adjusted annually, a fixed annuity is static. Inflation erodes your buying power. For example, in the 1960s you could buy an ice cream cone for a dime. Today, a similar ice cream cone may cost $3. If you purchased an annuity in the 1960s that appeared adequate to your needs, today's prices would devastate you.
Although most deferred annuities provide a tax deferral, that is not true of immediate annuities because you receive a stream of cash from their inception, and there is no accumulation phase. Part of the cash you receive is considered taxable income, and the remainder is a nontaxable return of your principal. The IRS provides tables that tell you how much of an immediate annuity is subject to federal income tax. See IRS Publication 939, General Rules for Pensions and Annuities, at www.irs.gov. Since the taxation of annuities is complicated, we advise you to seek professional tax and independent financial advice when purchasing them.
Many charities tout the tax advantages of buying annuities known as charitable gift annuities. With these instruments, you buy the annuity contract from the charity and the charity promises to pay you a stream of fixed payments for life, starting either immediately or when you reach a certain age. With this investment, you might receive a tax deduction as well as a stream of fixed payments. Keep in mind that you are counting on the charity remaining solvent.
The cost of an immediate annuity ranges from $1,000 to generally as much as you want. The rate you receive will depend on the insurance company's expectation of your mortality and the current interest rates. Understand that the shorter your life expectancy, the higher the rate the company should offer you.
Be careful when you review Web sites for information on annuities because under the rubric of "fixed-income annuity," the sites sell tax-deferred variable annuities. Variable fixed annuities may give you a fixed interest rate for a year or more. However, it eventually becomes variable. These products are too complex for the typical investor to evaluate. Your best bet is to talk to a few insurance agents to get a sense of the alternatives available, or hire a fee-only adviser from the National Association of Personal Financial Advisors (NAPFA) at www.napfa.org, who can help you objectively evaluate whatever insurance contracts you are offered.
Immediate fixed annuities are the wallflowers of the insurance world. Although widely recognized as bond alternatives because they offer a fixed rate of return on a cash investment, their charms are rarely touted. Why? Because salespeople receive much higher commissions for selling variable annuities, and you'll find that, not surprisingly, where there are large fees to be made, there are many salespeople praising the product. We recommend immediate fixed annuities. Consider using an immediate fixed annuity to supplement your income when your earned income is falling because you're working part time or are nearing retirement.
Look at insurers who've earned the highest ratings for at least ten years and compare their quoted monthly distributions per $1,000 purchase. You can check the ratings of insurance companies by contacting A.M. Best at www.ambest.com (908-439-2200) and Weiss Research, now owned by TheStreet.com, at www.thestreet.com/ratings (800-289-9222). A.M. Best is paid by insurance companies for its ratings. Weiss Research is paid by consumers and is a more stringent evaluator. To get a final check on ratings, you might visit Moody's Investors Service at www.moodys.com (212-553-0377) and Standard & Poor's at www.standardandpoors.com (877-481-8724). You might also check the Insurance News Network Web site, www.insure.com. We find Fidelity, Vanguard, and TIAA-CREF (800-842-2252 or www.tiaa-cref.org) to be good companies with competitive rates.
If you have a significant health problem, ask about impaired risk annuities. Impaired risk underwriting is a process by which physicians or underwriters evaluate your life expectancy based on your health. If it is projected that you will not live as long as your life expectancy, you may get a higher payout.
Instead of buying one large, lump-sum immediate annuity, consider buying several with smaller amounts at different time periods. This allows you to capture any rising interest rates, and may add further protection against company defaults. Finally, buy the immediate annuity when you're older. The older you are when you buy an immediate annuity, the shorter your life expectancy and the higher the payout and rate of return. Since part of this income is deemed a return of principal, it will not be taxed. Consider buying an immediate fixed annuity after age seventy.
Whereas the immediate fixed annuity premise is simple, the deferred fixed annuity is not. The "deferred" in the name is what makes it attractive to many investors because the tax on its income is deferred. The "fixed" refers to a fixed rate of return on the cash investment during the accumulation phase. Unfortunately, this investment is no longer what the title indicates because the underlying rate is subject to change and is not fixed. Finally, this instrument may never become an annuity if you so choose. However, there may be very steep surrender charges in the range of 7 percent to 12 percent if you wish to exit this investment within a year. Significant surrender charges may last for six years or more.
We suggest you think of deferred fixed annuities in terms of four phases: investment, accumulation, nonfixed distribution, and fixed distribution.
In this phase, you generally sign an annuity contract with an insurance company. The contract specifies that you make either a lump-sum payment or a number of payments over time.
The terms of this phase are stipulated in your annuity contract and state the fixed rate of return on the cash that you invest for a fixed number of years. The contractual term may vary from one to many years. This is similar to the contractual return you would get on a CD from a bank for a fixed number of years. At the end of the contractual term, the insurance company will make another offer in which the fixed return will remain the same or be adjusted upward or downward. At this point, and at the end of any further contractual terms, you have three choices:
Cash out your deferred fixed annuity. If you cash out, you may be subject to insurance company penalties and federal income tax penalties. In addition, the entire gain is taxed as ordinary income in the year of the distribution.
Transfer your deferred fixed annuity to another annuity company. If you do so, you may trigger an early withdrawal penalty clause in your annuity contract. (Some annuity companies do not levy withdrawal penalties.) However, there would be no federal taxable income generated or tax penalties if you follow the tax rules for a tax-free exchange.
Extend the term of your current deferred fixed annuity. You may get a higher or lower interest rate on the extension.
Many annuity contracts allow you to make systematic or possibly irregular withdrawals from your contract. You can receive regular payments based on a variety of factors, including a fixed dollar amount, a percent of your account value, or your life expectancy. You can also change how the payments are made or stop the payments altogether.
If you make systematic withdrawals before your fixed distribution date, keep two points in mind. First, if you take too much cash out of your contract, you may not have enough to meet your distribution goals in the future. Second, withdrawals from your deferred fixed annuity might trigger penalties from the annuity company as well as federal income tax and tax penalties. Understand that once you purchase an annuity, the money belongs to the insurance company until you ransom it back.
In insurance language, this is known as annuitization, the time when you and the company agree on a permanent payment option. As with immediate annuities, the options include life-only, life with period certain, period certain but not life, and accumulated amount only.
Deferred fixed annuities are most suitable for individuals who wish to increase tax deferral above that offered through qualified plans, such as 401(k)s and IRAs, and who are not concerned that their heirs may not inherit any of the proceeds. See "Tax Implications" for additional information.
The only advantage to a deferred fixed annuity is that the income accumulates tax-deferred. Since you are paying for the tax-deferred status of the annuity, it should not be purchased from your retirement account funds.
Although some states have a guaranteed minimum rate of 3 percent on deferred fixed annuities, in 2003 the state insurance commissioners adopted revisions that recommended that the fixed rate be replaced with a rate that floats as the yield of a 5-year constant maturity Treasury changes. Since state legislatures craft insurance law, the minimum rate rulings may be different from one state to anther. A state can choose to adopt this provision or not. Thus, you might get a guaranteed rate for a set number of years, or the rate may vary between 1 and 3 percent depending on where you purchase your contract. If you're receiving 1 percent on your investment, how much do you think will be left over after insurance company fees?
In general, a company paying higher interest will have lower fees. While you're looking at the attractive interest rate, be sure to look at the surrender charges in case you change your mind. In September 2006, Vanguard, which is known as a low-cost provider of these policies, was offering a 4.8 percent yield that could change at any time. The surrender charges begin at 6 percent in year one and decline over five years. You may not see the fees, but they are there.
The rate, particularly the renewal rate, may not be competitive with other suitable investments. This is a particular problem if you invest at one rate (sometimes called a teaser rate because it is above a market rate) and it's followed by a renewal rate that's clearly below market. In this case, you're faced with the choice of switching to another annuity company, taking a below-market rate of return, possibly having to pay annuity company penalties, and possible tax penalties if you want to take a cash distribution.
Deferred annuity contracts are difficult to evaluate because they are so complicated. The underlying values are not fixed. You cannot get a clear indication of your return although you can be sure the insurance company is making money.
If the annuity company becomes financially troubled, you may lose some principal or your money may be tied up for a period of years. Because of this possibility, you should consider investing a portion of your cash with two or more companies to spread the risk of default.
Penalty payments for early withdrawals can be substantial in the early years of an annuity contract. A typical penalty schedule starts at 7 percent the first year, dropping 1 percent each year until there is no penalty in the eighth year.
Another risk is that the high yearly fees often result in lower returns.
Finally, beware of the bait and switch. You may start out looking for a deferred fixed annuity and be lured to a seemingly higher-paying variable annuity. As the Delaware Insurance Commissioner, Matthew Denn stated, "For seniors who are considering purchasing annuities, the first and most important tip is that in most cases, variable annuities are bad deals for senior citizens."[115]
If the value of the annuity is paid out as a lump-sum distribution, all the earnings are subject to federal income tax as ordinary income in the year of the distribution. Thus, if you invest $50,000 in the annuity and there is a lump sum distribution of $70,000, $20,000 will be taxed as ordinary income in the year of the distribution. The remaining $50,000 is considered a tax-free return of principal. Historically, more than 50 percent of all deferred annuities have been liquidated by heirs. The heirs will pay ordinary income tax on any gains and possibly estate taxes on the value of the annuity.
If there are partial withdrawals before the annuity date, taxable earnings are paid first so that payment of taxes will be accelerated. If the deferred fixed annuity is annuitized and is paid out as a series of payments, the tax result is the same as for the immediate annuity. It consists of a combination of taxable earnings and return of principal. If you are younger than fifity-nine and one-half years at the withdrawal date, you will be subject to a 10 percent IRS penalty. There is no tax penalty if you are fifty-nine and one-half years or older at the date of distribution.
For the tax implications of annuity income, see IRS Publication 939, General Rules for Pensions and Annuities. You can find this publication and all other IRS publications on the IRS Web site, www.irs.gov.
Minimum purchase is usually $1,000. There is usually no upper limit to the amount purchased although it is best to purchase more than one annuity if the amount of your contract is above the state guaranty level.
Deferred fixed annuities are most suitable for individuals who meet one or more of the following guidelines:
They have contributed the maximum to their qualified plans, such as 401(k)s and IRAs before seeking a further tax-deferred investment.
They will keep the deferred fixed annuity for at least fifteen years, and at that time they will be at least fifty-nine and one-half.
They are not concerned that their heirs may not inherit any of the proceeds from the deferred fixed annuity.
They expect to be in a lower tax bracket at the time they draw on the deferred fixed annuity.
Some annuity contracts provide for a free withdrawal privilege. The privilege is usually for only a certain fraction of the annuity's total value and it's offered only once per year. Check to determine how much of your cash may be withdrawn without paying a penalty to the annuity company each year; some allow you to take out 10 percent each year without a penalty. However, taxable income will still be generated as well as a possible tax penalty. Even if capital gains were recognized in your annuity, when there is a distribution, all of it is taxed as ordinary income. Thus, an annuity converts capital gains into ordinary income.
Jeff Broadhurst of Broadhurst Financial Advisors, a fee-only financial advisory firm, has these suggestions for alternatives to annuities: A possible alternative is to purchase municipal bonds for greater flexibility and retention of principal. Another option is to purchase Treasury strips of varying maturities to create a bond ladder. Still another alternative to annuities is to use low-cost index funds and create your own cash flow by automatic withdrawals of 4 percent or less per year.
After the bonus rate year, what is the rate of return and how long will it last?
What is the interest-rate range for this annuity?
How fixed is the "fixed rate"?
What is the penalty per year for early redemption?
Under what circumstances will the withdrawal charges be waived?
Preferred stock comes in many shapes and forms: convertible; nonconvertible; variable rate; and numerous kinds of fixed-rate, including fixed-dividend, auction market, and remarketed preferred stocks. There are also complex preferred stock packages created by large brokerage firms. With billions of dollars in these instruments outstanding, they are not small players in the overall markets.
Of the many preferred stock variations, the one known as a nonconvertible fixed-rate preferred stock is most like a bond and is often sold as a bond alternative. For brevity's sake, we refer to this investment simply as "the preferred," which beats the acronym NFRPS any day.
Although the preferred has a number of bond-like features, it is legally a form of equity. Some preferreds have no due date on which the preferred must be paid off, and these are called perpetual preferreds. Many preferreds have a due date, but they're usually so far in the future as to be irrelevant. For example, in 2006, Citigroup issued a 6.5 percent preferred stock maturing in 2056, with five-year call protection. There is no contractual legal obligation on the issuer to pay dividends on the preferred. If the issuer misses a payment, it's not considered a legal default, but such an action would constitute a default if it were a bond.
The preferred pays dividends at a fixed rate per share each year. For example, if the par value of your preferred is $50 per share and the dividend rate is 8 percent per share, you would receive a dividend of $4 per year ($50 × 8%). Because preferred dividends are generally paid quarterly, you would receive $1 per quarter. This dividend is fixed and will never be increased, even if the earnings of the company grow. By comparison, the dividends on common stock may grow as the company becomes more profitable.
Although a preferred generally pays its dividends in cash, there are certain kinds of preferreds called payment-in-kinds (PIKs) in which the investor receives additional shares of preferred stock, rather than cash dividends.
Many issues of preferred are what are known as cumulative preferred. This means that if the issuer does not pay the preferred dividend when it's due, the amount of the dividend accumulates and will be paid if and when the issuer is financially able to do so. Thus, if the preferred is an 8 percent cumulative preferred with a par value of $50 per share and if dividends are not paid for a year on the preferred, the $4 dividend is accrued and will be paid in the next year, together with the usual $4 dividend for the second year, if the company is financially able to do so. Some issues reserve the right not to pay dividends for a specified number of years without consequence. If there is a failure to pay interest or principal on a bond, that failure is considered a default and a bankruptcy or reorganization may result. By contrast, if a dividend is not paid on the preferred, no such serious consequences ensue. The following, however, may be triggered if a preferred dividend is not paid on schedule:
The preferred may immediately be given priority over common stock dividends, and none of the latter will be paid until all unpaid dividends on the preferreds are paid in full.
There may be a restriction such that the corporation can't use corporate funds to buy back common stock. The point is to conserve cash for the payment of dividends on the preferreds.
Sinking fund payments to cover future debt obligations may be halted. The point here again is to conserve cash for the payment of dividends on the preferreds.
The preferred shareholders may receive voting rights that they did not have before.
Some preferred stocks are designated as noncumulative preferred. This kind of preferred allows management to skip a dividend and never make it up. Noncumulative preferreds have often come about as a result of a corporate reorganization or bankruptcy, where debt holders are given this kind of stock in exchange for their debt securities. If you own this kind of security and it stops making payments, the value of the preferred usually falls dramatically.
If there is a bankruptcy, liquidation, or other financial failure of the corporation, the preferred shareholders will be paid before there is any payment to the common shareholders. However, in this case the debtholders will be paid before there is any payment to the preferred shareholders.
Almost all preferred issues are callable at some time at a set price often after only five years. The price might be the issue price or could be a higher price that declines over the years to provide some protection from an early call. Many preferred issues include some call protection for the investor. Before you buy a preferred, you should examine closely when the preferred is callable and what specific protection you might have against an early call.
Generally, calls occur when interest rates have dropped, and there is an advantage to the issuer in calling in the preferred. If interest rates are falling, you don't want to have a call because you will have to reinvest at a lower rate. Calls may also occur if the issuer's credit rating has improved significantly and it can reissue at a lower cost of capital. If the issue has no call provision, the preferred will generally provide for a sinking fund. The sinking fund is used to redeem a certain number of preferred shares annually until all shares are retired.
Three nationally recognized rating organizations rate preferreds: Moody's Investors Service, Standard & Poor's Rating Group, and Fitch Ratings. These ratings are useful in comparing one preferred to another but not in comparing preferreds to bonds.
Trust preferreds are sold by companies that fund the trusts with their own long-term bonds. The company sells the preferred stock and then uses the money to purchase the bonds to fund the trust. The advantage to the issuing company is that the interest paid on the debt securities is deductible from its taxable income whereas normal preferred dividends would not be deductible. In the event of a change in the tax law that will prohibit this, expect that the preferred stock will be called.
Third-party trusts are created when brokerage houses purchase bonds in the open market, put them in a trust, and pay a set amount to preferred owners. Some of their acronyms are TOPrS (Merrill Lynch), CorTS (Lehman Brothers), TIERS (Morgan Stanley), SATURN (Citigroup), and QUIPS (Goldman Sachs); each name is proprietary to the issuing firm. These trusts usually pay dividends semiannually. What they have in common is an underlying issuer flexibility, which means that all you really know is that you have a stream of income, but you do not know for how long. Since the quality of the bonds may be poor or the embedded options risky, you may lose your principal.
Many preferreds offer a higher rate of current return than the return from highly rated corporate bonds and considerably higher than dividends from common stocks. There is a low minimum investment since many preferreds are issued in face amounts of $25 per share or lower. Most bonds are issued in minimum amounts of $1,000 per bond. Many preferred stocks are listed on the New York or American Stock Exchanges, making them easy to track and trade, while other preferreds trade in the over-the-counter market and are more difficult to follow.
With the higher return on the preferred comes a greater risk. If the issuer defaults, there may be little or nothing left for preferred shareholders after all the issuer's debt is paid. There is a similar but smaller risk if the issuer is downgraded by one of the rating services, driving the market price down until the company regains its health and the change is recognized by the rating agencies.
Since the preferreds generally never come due or have very long maturity dates (thirty to sixty years), the price for preferreds will drop quickly if interest rates are rising. Many inexperienced owners panic when they see the value of their shares plummet, whereas experienced traders put in low bids waiting for the expected fearful to sell.
The five-year call provision on new-issue preferreds makes them vulnerable to reinvestment risk, which is serious when interest rates are falling. Remember, it is because of the higher current return that you made the decision to invest in the preferred in the first place. Once the call protection passes, the preferreds usually do not rise above their $25 face value because they may be called at any time.
Some preferreds reserve the right to defer quarterly payments for ten years. If a noncumulative preferred stops paying, the value of your preferred will drop like a stone.
Preferred stock is quoted on a current-yield basis, which reflects only the amount of current cash you're receiving. There is no compounding in the preferred yield computation. Moreover, preferreds "trade flat," meaning that each quarterly period the interest builds up and is included in the share price. This is different from bond interest because accrued interest is not included in the bond's price.
To find out the current yield without the accrued dividend, ask the broker to strip out the dividend from the price and figure the current yield on that basis. Although the price of the preferred should drop by the amount of the dividend, this does not always happen. You must own the preferred one week before the dividend is paid to qualify for payment. Some brokers tell buyers that they can get five quarterly payments in fifty-three weeks, which is literally true, but the first dividend is included in the price. When preferreds are priced above par, it is usually an indication that a dividend payment is pending.
You report the dividends from some preferred stock as ordinary income on your federal income tax return. The dividends from other preferred stock are taxed at a 15 percent rate in 2006; that rate may expire in 2008.
The best information source on preferreds is the prospectus published at the time of issue. You can phone the issuing company to get a prospectus by mail or get the prospectus from the SEC's Web site at www.sec.gov/edgar/quickedgar.htm. A useful Web site with comprehensive lists of available preferred shares is www.quantumonline.com, a financial services Web site.
Be careful what kind of preferred you buy. For example, some preferred shares automatically convert into the common stock of the issuer after a number of years. Avoid such preferred stock because there may be an automatic conversion at a time when the price is unfavorable to you.
Under certain conditions, such as tax law changes or securities law changes, the issuer may redeem the preferred. You must check the prospectus to find out about special redemptions, calls, or sinking funds. Some preferred issues are traded on an exchange and may be very liquid. However, other issues are not listed and may be very thinly traded, creating a liquidity risk if you wish to sell.
When analysts review preferred issues, one of their main tests is to determine the company's ability to meet fixed dividend payments. They compare issues using the "coverage ratio," which measures the degree to which a company's cash flow covers its interest and dividend payments. A ratio of two to one or better is considered comfortable.
Be especially careful of the possibility of an early call if you purchase the preferred at an amount in excess of its par or call price. For example, assume that the par value of the preferred is $25 per share, and you buy the preferred for $30 per share. If the preferred is called after one year for its par value of $25 per share, you will have lost $5 per share, a significant reduction of your principal. You would be subject to a similar risk if the preferred has a sinking fund and as a result the preferred is redeemed.
Unless you're purchasing preferreds into your retirement account, look at the after-tax yield and compare it to that of municipal bonds. You may find that the return on the preferred is not worth the added risk.
We do not recommend preferreds to our clients because of the combination of short calls and very long maturities, which may result in substantial losses if interest rates go up.
How much free cash flow of the company is available to pay dividends on the preferred?
Is the security cumulative preferred?
What is its rating?
Will earnings be subject to ordinary income or a 15 percent tax rate? What is your proof?
What is the fixed call, sinking fund, or other call options?
Is the preferred selling at a premium? If so, how much will I lose if it is called?
Has this issuer ever deferred payment of the dividend? If so, for how long?
If you're looking for income, dividend-paying stock is a current choice as weary investors battered by stock losses consider jumping ship. Mind you, brokers emphasize dividends when they're no longer banking on big market moves in the foreseeable future. After the 1929 crash, the perception of risk drove dividends higher on stocks, which continued to pay high rates until the 1950s, when stocks began to be purchased for capital gains and bonds were purchased for income. Did stocks become less risky, or did marketing of stocks change?
Many stocks pay regular dividends, although a one-time dividend may also be declared. Good earnings are not required for dividends.
Generally, people who purchase stocks because of their dividends seek a cash flow and a possible upside in the appreciation of the stock.
Betting on stock dividends for your cash flow is risky. One reason is that companies paying high dividends tend to be in the same struggling market sectors. The highest yields in 2006 were in the automotive industry, with the financials and utilities following. As we've seen in the automotive industry, an entire sector can falter, putting in danger stock prices as well as dividend flow. In 2006, when Ford Motor Company announced that it would stop paying dividends in the fourth quarter on its common and class B stock, the share value dropped 12 percent on the day of the announcement.[116] Ford was paying a dividend of $0.50 in 2000, but with the drop in interest rates, the dividend stabilized at $0.10 in 2002. The dividend yield on the Standard & Poor's 500 index was 1.8 percent in 2006. General Motors, a company that halved its dividend, was still paying 3 percent in 2006 as talks of restructuring and bankruptcy continued. DaimlerChrysler, which was in similar economic straights, was paying a dividend of 3.4 percent.[117] Just as in bond investing, in common stock investments, if you reach for yield, you risk losing your principal.
Interest on bonds and dividends on preferred stock must legally be paid before a common stock dividend. Common stock dividends may be paid in shares instead of cash.
Companies are not required to pay out dividends on their stock. They may choose to retain the cash in order to grow the company or use the cash for stock buybacks. They may also pay out dividends, even if their earnings and cash flow do not support them, because it bolsters the share price. Although some companies pay dividends quarterly, the dividend payments cannot be assured until the dividend is actually declared by the company's board of directors. Dividends may not be even or regular. They may follow the cash flows that companies generate, which may be seasonal or cyclical.
You can purchase the individual stock of one or more companies, or you can buy a portfolio of stock through a mutual fund specializing in stock dividends. Banking on stock dividends from funds will tend to disappoint because funds are required to use them first to pay expenses, and there may not be much left to pay investors.
Chapter Notes
[115] Commissioner Matt Denn, "List of Questions Seniors Should Ask When Purchasing Annuities," October 19, 2005. Retrieved from http://www.de.us/inscom, click on "annuities."
[116] Tara Siegel Bernard and Jilian Mincer, "With Ford's Dividend Out of Gas, Investors May Seek Other Models," Wall Street Journal, September 19, 2006, D2.
[117] Ibid.