Historically, it was advisable for investors to balance their investments and/or their retirements accounts between fixed income investments and stock/mutual fund investments. Fixed income investments could be described as certificates of deposits, stable value accounts, or bonds issued by corporations or the government.
Besides the cash flow generated from fixed income, one of the main reasons to invest in fixed income was that it acted as a ballast to the volatility of the stock market. As an investor aged, they had reduced longevity to recoup from a sever stock market decline. For example, a 30-year-old would potentially have 50 years for their investments to rebound whereas a 60-year-old would have a shorter time to outlast a slow recovery.
There were two general theories on how much of an investor’s investment portfolio should be allocated to fixed income:
· a consistent 40% of one’s portfolio, or
· a percentage equaling the investor’s age.
Under the later theory, a 30-year-old should have 30% of their portfolio in fixed income, a 60-year-old 60%, and an 80-year-old should have 80%. In this manner, as the investor ages, they gradually gravitate towards a more conservative investment allocation.
In this century, interest rates naturally declined, and the Federal Reserve accelerated rate decreases to stimulate the economy. With fixed income paying sub-one-percent rates, the two theories went out the window.
The problem with rock bottom interest rates was that there was nowhere for rates to go but up. While an investor would still receive their principal at the maturity date, if they wanted to sell a 2% yielding corporate or government bond prematurely, the amount they can cash in will depend on where interest rates had moved since the time of purchase—which was most likely up. As an example, if two years ago, an investor purchased a 5-year Treasury note when interest rates were approximately 1%, and they wanted to sell that note today with the prevailing interest rate at around 4%, [i] the person acquiring the note from the investor would offer less than the principal. That would create a loss to the investor in the interim, though if the investor held that note to maturity, they would still get 100% of their principal and interest. Thus, for most of this century, with no room for razor-thin rates to decline further, there was significant downside to committing money to long-term to fixed income investments like Treasuries.
But the game has changed as the Federal Reserve has returned interest rates to more normal levels.
Treasuries are denoted as bills, notes, or bonds based on their maturity dates. Treasuries are considered the safest investments in the world, backed by the full faith of the United States. Because of their standing, Treasuries are often referred to as the “risk-free return.” Thus, the choice between investing in stock or real estate is measured as the difference between the interest rate on risk-free Treasuries and the expected return from an investment in a stock, mutual fund, or ETF etc.
Financial institutions are not keeping up with Treasuries
The problem is that banks and credit unions have not kept pace with the rise of Treasury rates. For six-month CD’s, banks are paying approximately 3%. As of this morning (3/1/23), Treasuries (Treasury bills) maturing in 6 months were paying slightly over 5.1%.
Here is the gigantic benefit from Treasuries held outside of a retirement account: They are not subject to California Income Tax. Treasuries are taxed at the federal level; however, investors get to savor the satisfaction of cheating Sacramento out of their (approximate) 10% income tax on a Treasury’s interest.[ii]
For City Employees, you are getting ripped off with the Stable Value account
City employees are offered a supplementary tax-deferred 401k style plan. If during market turbulence, a city employee wants to park their funds in a non-fluctuating account, they are presented with a “Stable Value Account” option.
Voya Insurance is the custodian for the Stable Value account. On the website for city employees, the stated rate for the Stable Value Account for the first quarter of 2023 is 2.56%—that’s after a quarter-point in expenses is taken out. That is half of the interest rate of 6-month Treasuries. On a $100,000 allocation to the Stable Value Account, a city employee is losing approximately $2,500 per year in guaranteed interest.[iii]
Here is the primary decision for retired city employees who have the option to exit Voya: Treasuries are paying double what Voya is. Treasuries are the safest investment in the world while Voya’s Stable Value Account definitely is not. In 2009, Voya was called “ING” and it acted as the custodian for city employees’ Stable Value Account. At the end of 2008, over $100 million of the $700 million city employees had invested in the Stable Value Account evaporated into thin air. Actually, ING invested city employees’ funds in extremely risky investments. The ones Warren Buffett calls:
To replace the missing $100 million in city employees’ lost funds, the San Francisco Employee Retirement System had the insurance company replacing ING (Voya) lend the $100 million to the Stable Value Account, and then recapture their loan by stiffing new San Francisco employees with lower interest rates. A less friendly description for this maneuver is referred to as a Ponzi Scheme.
For retirees, you should question whether it’s safer to remain with an insurance company, selected by our dysfunctional city, which merely changed its name after it lost a massive $100 million of your money, or move to a Treasury backed by the full faith of the United States government.
Treasuries are not an absolute solution
Treasuries can be purchased through brokerage firms like Fidelity and Charles Schwab, through Treasury Direct, and through a sprinkling of banks.
While Treasuries are the safest investment in the world, all your money should not be in Treasuries. Five-percent interest sounds great relative to banks, credit unions, and especially the city employees’ deferred comp. But if your Treasury grows at 5% and inflation is 6%, you are still losing purchasing power to inflation. A retirement account and investment portfolio still must be balanced between investments that will grow, and investments like Treasuries that just act as a stabilizer.
[i] Four percent is lower that the 5% in my title because longer term rates are currently inverted. That means we are in the unusual situation that long-term interest rates are paying less than short-term. That is generally a sign that we are heading into a recession and the Federal Reserve will have to lower interest rates in the future to stimulate the economy.
[ii] After tax yield: A 5.1% yield on a Treasury is the equivalent of a 5.6% yield on a CD, sacrificing half-a-percent to California taxes, and netting 5.1%. But banks aren’t paying anything near 5.1% or 5.6%.
[iii] The fact Treasuries are California tax-free does not benefit retirement accounts because the interest will be tax at California rates when it is eventually distributed.