Game Plan

by Kevin D. Freeman

  Looming Cyberattack

  And let’s not forget about cyberattacks. In February 2013, Bank of the West, a regional financial institution in California, came under a hack attack. Thieves were able to grab $900,000 from one of the bank’s business customers.18

  Now, even if your bank remains sound, hacking could deprive you of access to your funds temporarily or permanently. In 2009 alone, the Internet Crime Complaint Center reported that Americans lost over $550 million to internet thieves, double the 2008 amount. “Last year there were more online bank robberies than there were actual on-site bank robberies,” Sean Sullivan, security advisor at F-Secure, said. “Banks have become very proactive in protecting accounts from hackers but it’s still quite a large problem. We see all types of new attempts every day.”19 Dell SecureWorks estimates online thievery from small and midsized companies at over $1 billion per year.20 What happens if those funds are stolen? It depends on whether you’re an individual with a personal account, or a business account. Banks have to help you out if you have a personal account in some ways, and they have to provide “commercially reasonable” online security—but reimbursement does not apply to business accounts. Typical bank agreements include that language.21

  There are those who think all the rich folks keep their cash in offshore banks. But while higher rates and diversification may seem attractive, there’s always Cyprus, which simply confiscated wealth from depositors—60 percent from those who had over one hundred thousand euros.22 London’s Financial Times believes it could happen in the United Kingdom: “Could it happen here? You bet. The ghastly arithmetic underlying this week’s Budget shows that, at best, Britain is travelling less fast in the wrong direction. . . . If bank deposits become a legitimate target, there’s not much the ordinary citizen can do. Moth and rust doth corrupt the treasures you lay up for yourself but the state can simply take them away.”23

  Some believe that confiscation could happen here in tough times. Even a Federal Reserve governor seemed to indicate that in a financial catastrophe, the government would let private investors bear the bank losses rather than bailing them out. Jeremy Stein, a former economics professor at Harvard and a senior advisor to the secretary of the Treasury in the Obama administration said: “Perhaps more to the point for TBTF (Too Big Too Fail), if a SIFI (Systemically Important Financial Institution) does fail I have little doubt that private investors will in fact bear the losses—even if this leads to an outcome that is messier and more costly to society than we would ideally like. Dodd-Frank is very clear in saying that the Federal Reserve and other regulators cannot use their emergency authorities to bail out an individual failing institution. And as a member of the Board, I am committed to following both the letter and the spirit of the law.”24

  Confiscation of depositors’ funds in a bank failure is essentially the same thing as enforcing deposit insurance limits. The legal mechanism to confiscate bank deposits in the United States is therefore in place.25 Presumably, confiscation would occur only in the sort of calamitous bank failure to which Stein refers.26 No one should be surprised by the possibility of confiscation. It happened in Poland recently,27 and in Russia.28 And the European Union is making contingency plans for confiscations as needed.29 The problem is global. The key is to be prudently aware of the risks and know that they are universal.

  What about Money-Market Funds?

  Remember Representative Paul Kanjorski’s sobering account in chapter four of the electronic run on the banks that almost sank our financial system? The target of that run—half a trillion dollars in two hours—was U.S. money-market accounts. So much for money markets being a safe haven during financial crises.

  Money-market funds remain at risk. As Rex Nutting of MarketWatch writes, “Money-market funds, thought to be one of the safest investments, are actually some of the most dangerous. . . . The money-market funds are smaller than they were in 2008, but if anything, they are riskier. Current U.S. law prohibits the kind of federal guarantee that, in 2008, stopped the bank run before it could bring down the financial system. The next run on these shadowy bank-like institutions could be fatal.” Why? Because money-market funds promise that people will have their capital returned, just like banks do—except there’s no real guarantee of that promise. As Nutting points out, “Money-market funds are popular precisely because there’s no cushion to back them up. Cushions cost money, cutting into the profits the funds make and the returns (meager as they are) that depositors receive. . . . If money-market funds were regulated like banks, then what advantage would they have? You might as well park your money in a commercial bank, with its boring FDIC insurance and access to the Federal Reserve’s discount window in the event of a liquidity squeeze.”30 Current law prohibits the Fed and Treasury from bailing out the money-market funds the way they did in 2008. So next time, it’s kaboom.

  Now, money funds held at a brokerage house may be insured by the Securities Investor Protection Corporation (SIPC). But that insurance protects against a failure of your brokerage account and not of your holdings. If your money-market fund loses value, you have no insurance against that loss. These funds are designed to keep you from losing money—the net asset value is never supposed to drop below one dollar. Dropping below one dollar is called “breaking the buck.” Money-market funds are invested in short-term securities that can, in a crisis, lose value. In a panic, investors could pull money out of money-market funds, forcing the funds to dump short-term securities, further depressing their price and setting off a downward spiral. The Securities and Exchange Commission notes, “While investor losses in money market funds have been rare, they are possible.”31 Eric Rosengren, president of the Federal Reserve Bank of Boston, said that runs on money-market mutual funds were still quite possible because of their lack of capital. There is about $3 trillion in money-market funds, and Rosengren calls the risk of runs a “significant unresolved issue.”32

  There are risks even to cash and “cash equivalents” like money-market funds. Whether you try to keep money in the mattress or at the bank, there can be problems.

  So what should you do? Diversify where you keep your cash. If you have more than $250,000 in cash, open accounts at multiple banks. If you are worried about the FDIC, put some cash in safety deposit boxes. You won’t gain interest, but you won’t be at risk of confiscation either. (But watch out for counterfeit cash—something being pumped out by nation-states like Iran and North Korea with the help of the drug cartels.)33

  Buy U.S. Treasuries rather than money-market funds. These can be insured at a broker by SIPC. If SIPC is a concern, keep them in a safety deposit. Stick to short-term maturities, or buy a Treasury-only fund, which will protect you unless there is a sudden onset of hyperinflation. In that case, all bets are off, as currencies can lose almost all their purchasing power overnight. Millions of dollars could become virtually worthless in such circumstances.34 And, of course, there remains the risk of government default.

  If you are concerned about the dollar, you can buy multi-currency money-market funds. Or open foreign bank accounts denominated in foreign dollars (although such an arrangement can have some implications for currency transfers).

  If you are concerned about inflation, you need to move away from cash and into growth-oriented investments or hard assets. Again, a professional is necessary to help you navigate these shark-infested waters. And they are most definitely shark infested—and those sharks include America’s enemies.

  CHAPTER NINE

  Guaranteed Investments

  Ultimately, there are only two types of investments, and everything else is derived from them. You either own or loan. You can own businesses or things like real estate, gold, collectibles, or coins. Even holding cash is a form of loaning or owning. If you put the cash in a safety deposit box, a no-interest deposit account, or a mattress, you simply own paper certificates guaranteed by the government. If you put the cash in an interest-bearing bank account or money-market fund, you are loaning the money di
rectly or indirectly.

  Every other investment is ownership, a loan, a combination of the two, or a derivative of some kind. Guaranteed investments are no different. If the underlying investments fail in some way, the guarantee may become worthless. If you buy insurance, and your insurer goes out of business, it won’t help you to invoke your insurance—there’s nobody left to pay it. In other words, there are no absolute guarantees when investing. In a world where the economic future is uncertain, investors naturally look for safety. Thus investments that say they’re guaranteed have an allure for those concerned about the vicissitudes of the economy. It’s worthwhile to examine “guaranteed” investments, whether they’re annuities or guaranteed investment contracts (GICs), in order to have a clear picture of the rewards as well as possible pitfalls.

  Annuities date back to the Roman Empire. Citizens would make one lump-sum payment into what was called the “annua,” then they would be paid a certain sum every year until they died or for a period that had been agreed upon.

  In the Middle Ages, kings raised money for their wars with fixed annuities. In early America, annuities started as a retirement pool for church pastors in Pennsylvania. Benjamin Franklin left annuities in his will to the cities of Boston and Philadelphia. Amazingly, the Boston annuity was still paying out in the 1990s; it stopped only because the city chose to take the rest in a lump-sum payment.

  The signal change in buying annuities occurred when Americans’ attitude about supporting family members in their later years changed. Wary of the stock market after the crash of 1929, Americans invested more in annuities. Variable annuities appeared in 1952, and indexed annuities followed in the late 1980s and early 1990s.1

  Annuities offer payments for a fixed term or for life from an insurance company to the investor, or even to his heirs. That is, you get your money back over time plus interest. Ongoing payments, of a fixed or variable amount, are guaranteed. Annuities are offered only by insurance companies. Once you buy one, you can’t change the amount of the payments or withdraw more than the scheduled amount. The terms are etched in stone.

  So why invest in an annuity? There are two main reasons. First, an annuity allows you to defer taxes, which can be especially useful if you have maxed out your contributions to an IRA, 401(k), or 403(b). Second, an annuity can give you a monthly income for the rest of your life, which is useful now that people are living longer.2

  Deciding to Buy an Annuity

  The first decision you have to make about an annuity is whether you want the payout to begin immediately or to be deferred. If you decide on an immediate annuity, you will begin to receive money as soon as you invest. You can receive payments for a “period certain”—that is, a period with a set beginning and end—or you can receive payments for the rest of your life or your spouse’s life.3

  A deferred annuity, on the other hand, does not begin payments until some later date, which could be as early as thirty days after you invest. The advantage of a deferred annuity is that taxes are deferred on your gains until you receive payments.

  Once you’ve decided to purchase an immediate or deferred annuity, you’ll have to decide whether you want a fixed annuity or a variable one. Fixed annuities have the advantage of letting the money invested grow while being tax deferred.

  You can buy a fixed annuity with a lump-sum payment, or you can make a series of payments while you are still working. When you are considering purchasing a fixed annuity, it is important to remember that you can often negotiate the price of these products. Also, the amount of money that an annuity will pay out varies (sometimes greatly) between financial intermediaries selling these products, so it’s best to shop around and avoid making quick decisions.

  Variable annuities offer fluctuating payments based on the returns of the underlying investment. Like fixed annuities, variable annuities have two phases: the accumulation phase, in which the investor makes purchase payments to the insurance company, and the annuitization (or payout) phase, in which the investor collects payments. You can allocate your purchase payments to different kinds of investments, from the conservative to the aggressive. For example, you could allocate part of the payments to bond funds, part to an international stock fund, and part to a U.S. stock fund. You could put part of your payment into an investment that pays a fixed rate of interest, which is set by the insurance company and can fluctuate, but would likely have a guaranteed minimum.4 Variable annuities are expected to outperform fixed annuities in the long run, but you will experience the ups and downs of the market along the way. If you are looking for a quick income payout or guaranteed result, you should avoid variable annuities.

  You should also be aware of the charges variable annuities can incur. If you want to withdraw money early, you might incur a penalty known as a surrender charge—a stipulated percentage of the amount withdrawn, which usually decreases over time. Variable annuities with a surrender charge may offer a bonus for leaving your funds invested. If you want to be able to withdraw funds at a moment’s notice, you should buy an annuity with no surrender charges, but you won’t get the bonus. Mortality and expense risk charges are a percentage of the value of your annuity, usually about 1.25 percent per year. Administrative charges can be deducted as flat fees or a percentage of your account value, usually about 0.15 percent per year.5

  What Kind of Annuity Is Right for You?

  Once you have decided on immediate or deferred payout, fixed or variable payments, and the ability to withdraw with or without a penalty, you can consider which kind of annuity is for you. There are many types of annuities: term-certain annuities, life annuities, prescribed annuities, non-prescribed annuities, and insured annuities among them.

  A term-certain annuity makes fixed payments over a guaranteed period. If you die during the guarantee period, the annuity continues making payments to your beneficiaries.

  A life annuity guarantees regular payments for the rest of the annuitant’s life; when the annuitant dies, the payments end unless the contract names a beneficiary. A straight life annuity makes payments until the annuitant dies and does not offer payments to beneficiaries after the annuitant’s death. A straight life annuity, therefore, does not make sense for an investor who wants to leave something for his survivors unless it is combined with a separate life insurance policy. A life annuity with a guaranteed term will make a one-time payment of any unpaid benefits to a designated beneficiary upon the annuitant’s death, but that payment is in a lump sum, so there can be tax implications.

  If you have a serious health problem, you may want to look at a substandard health annuity, which is a life annuity whose price is determined by the health of the annuitant.

  A joint life annuity, which can be reducing or non-reducing, is bought for two people and may or may not have a guarantee period. If one of the annuitants dies, the survivor will receive a smaller payment. If the annuity is reducing and has a guarantee period, the smaller payment would occur only after one annuitant dies and the guarantee period is over.

  An insured annuity is guaranteed by a life insurance policy matching the amount of the annuity. If you die early, your beneficiaries obtain the full proceeds of the life insurance, tax free.6

  Another possibility is the equity-indexed annuity (EIA), a complex fixed annuity with a call option on a stock index (almost always the S&P 500). EIAs, which can be useful for target-date income planning, have little downside risk. The upside potential, though greater than a conventional fixed annuity’s, is limited.7 A newer type of annuity—a bonus annuity—is sometimes attached to an EIA. The insurance company adds a “bonus” to your principal when you make your investment, but there are tradeoffs in the form of higher fees, caps on your returns, and limits on cashing out early.8

  What about holding annuities in an IRA? One of the major advantages of an annuity is the deferral of taxes, but an IRA already has that covered. The Financial Industry Regulatory Authority states, “Investing in a variable annuity within a tax-deferred account, such
as an individual retirement account (IRA) may not be a good idea. Since IRAs are already tax-advantaged, a variable annuity will provide no additional tax savings. It will, however, increase the expense of the IRA, while generating fees and commissions for the broker or salesperson.”9

  In general, because of the lack of liquidity, the surrender charges, and the limitations on the investor, many annuities are best for those who want to invest their money for more than fifteen years, those making considerably more money at the time of investment than they will when they retire, or those without beneficiaries.10 You will not be taxed on the funds in your annuity until you receive payments, but those payments will be taxed at ordinary income rates, not at the lower rates for capital gains.11

  A good insurance company should be able to weather ordinary economic troubles. The retirement investment advisor Shelby Smith writes, “First and foremost, insurance companies have an operating history of stability that is the envy of banks and brokerage firms. Their investments are limited to conservative, boring options that rarely carry inordinate market risks.” States regulate insurance companies closely, and Smith says that no insurance policyholder has ever lost his invested principal. Nor has the holder of a fixed annuity ever lost money because of the vicissitudes of the market.12 Then again, we aren’t in normal economic times, so it is very important to be selective when committing your capital, even to annuities.

  Because annuities can be complicated and because they offer so many options, you will need a trusted advisor to help you determine what is best for your situation.

  Guaranteed Investment Contracts

  Guaranteed investment contracts, like annuities, are bought from insurance companies. The period of time for the guarantee can range from thirty days to decades. Unlike annuities, with a guaranteed investment contract you receive your original investment when the contract ends. You get interest, as with an annuity, but you also get the return of your principal. The advantage of buying GICs is that your investment is similar to a money-market fund but also guaranteed by the insurance company, bank, or trust company that issues the contract. The downside is that the fees are higher than money-market funds, the fixed rates of the GICs sometimes don’t keep up with inflation, and, like annuities, they are not guaranteed by the U.S. government the way that Treasury securities are.13