Paradise Lost: Some "guaranteed" investments are not sure things

by John Ruocco
        This is the first in a series of articles by John Ruocco, a Connecticut-based financial advisor.
     Retirement havens like Florida are a paradise for financial advisors. The investment industry has designed many programs to assure people, especially retired people, that they won't lose their money. Investment professionals know that fear is a great motivator, and retirees fear running out of money. And because financial advisors are looking for an audience and most people are looking for a free lunch, advisors touting guarantees that you won't lose your money are everywhere retirees are. But are "guarantees" really a financial paradise for older investors?

Safest: U.S. Government Guarantees
        The U.S. government borrows money by issuing treasury notes, bills and bonds. These are just names of loans with different maturities. We now have some 17 trillion dollars in these treasury debt securities outstanding. The repayment of the principal and interest to lenders of this debt (individuals, institutions and foreign governments) is backed by the full faith and credit of the U.S. government (aka you and me, U.S. taxpayers). Since the U.S. government has never defaulted on its debt, U.S. Treasury debt is the most trusted and secure form

of debt in the world. Whenever there is a financial or even a political problem almost anywhere in the world, like today's Ukraine situation, investors protect themselves by purchasing U.S. Treasury securities. For all practical purposes, unless the U.S. cannot pay interest on its debt, these securities are the safest investment anyone can make. But they won't make you rich: Recent 3 year yields were well under 1% (about .85%) and 10-year rates were short of 3%.

Mostly Safe: Bank Guarantees
        A certificate of deposit (CD) issued by an FDIC insured bank is the second safest investment for the average investor, but the reality is that there are some limits. One is simply the amount of money in the insurance fund backing these bank deposits. This fund was never fully drained but we came extremely close in 2008. At that time there was some discussion as to whether or not the Federal Government would back the banks after the FDIC ran out of money. Fortunately, we didn't get that far. Another consideration is that investors must be sure that the deposits they make with particular banks are within the legal limits of FDIC protection ($250,000 per depositor). This differs from a U.S. Treasury investment, which is unlimited. You could buy a billion dollars of treasuries — and some institutions do -- and be 100% guaranteed by the U.S. Government. To buy a billion in CDs with only a $250,000 limit on each, you would have to spread this money through hundreds of banks. But the bottom line is that a $200,000 CD at an FDIC bank is safe, if not particularly remunerative.
        CD rates compare favorable with U.S. Treasury yields, but not by much. The recent 1-year yields were around 1% and the 10-year rate was just over 3%.

Taking on Risk
        Anything other than a U.S. Treasury debt or an FDIC certificate of deposit carries some element of risk. A corporate bond from IBM or General Motors is only as good as the corporation issuing it. An insurance product such as an annuity is only as good as the insurance company backing it. Anyone who tells you his investment is guaranteed is forgetting something. 

        In order to make a return higher than the risk-free return of a treasury bill, an investor must take some element of risk. There is nothing wrong with risk. By taking that risk, the investor is offered a potentially higher reward. Some risks are very small and some are very big. It is really up to the investor to understand what exactly the risk is, what the potential losses are, and what the potential rewards are. Once you understand and are willing to accept the given potential for loss, then you can proceed and hopefully reap the benefits of the investment.
        It is interesting and even shocking to note that the reason the entire economy almost collapsed in 2008 was because very sophisticated investors did not understand the risks associated with the investments they were buying. Somehow (too many chapters to describe how) those who bought mortgage bond securities that were issued by the government agencies of Fannie Mae and Freddie Mac thought the securities were backed by the U.S. Government. As it turned out, they were not. Pension plans of corporations and countries assumed these were extremely safe investments. When the securities started to fail and everyone realized that what they were holding was junk instead of AAA-rated U.S. Treasury-backed securities, panic ensued. Eventually huge losses and bankruptcies followed because so many of these securities became worthless almost overnight. In essence, the most sophisticated investors made the same mistakes that many average investors can make.

Safe, But Potentially Costly: Annuities
        Insurance annuities are one of the most heavily sold types of products that offer a "guarantee." Although these products are good in some situations, I am not a big fan. They are very complex instruments and misunderstood by most investors. The primary reason individuals buy annuities is because of guarantees that appear to reside within the contracts. (These products also pay very nice commissions to the agents selling them.)
        An annuity by definition is an "income stream" for some specified period of time. This is where the confusion lies. Did I say lies? Well, let's just say it can be confusing. What is guaranteed

 is the income stream and not necessarily the cash value. In a lot of cases, the guaranteed interest rate ultimately creates a lump sum of cash, which is then converted to an income stream. If for some reason you just want to cash out the account, you could get your money back over time; but "over time" is not the same as "today." The short-term payout can be significantly less.
        There are so many variations on the annuity theme that it would be impossible to sum all of them up in this space. What needs to be understood is that an annuity is a contract between an insurance company and an annuitant (investor). When you hand over money to an insurance company, you really need to be sure you understand all the ins and outs of the contract you are signing -- especially the "outs." How do you get out? What is the guaranteed cash value if you want all your money at the end of the first year? Or the second year?
        Finally, we should mention the taxes and fees associated with annuities. If an annuity is not invested within an IRA, then you have tax issues. If you need cash, interest must come out first and it is 100% taxable. Also, you generally cannot re-register (gift) the asset to, for example, a family member without redeeming the asset and causing a taxable event. Finally annuities can be very expensive contracts. You have to consider: What are the fees to redeem the annuity? What are the annual management fees of the contract? What are the expenses of the underlying investments?
        There are some very low cost annuities out there. Vanguard is one. It is a low-cost variable annuity that you could get into and out of at any time with no redemption fees. It even has some guarantees in terms of income that are worth looking at. This is a fine option for people stuck in the annuity world. (Here is what I mean by "stuck": If you put 25k into an annuity a few decades ago and, more or less, forgot about it, you may see it is worth 125k today, and you might decide to dump it and use that piece of money toward a purchase of a home in a golf community. The problem is that 100k of that money is now taxed fully as "income," not capital gains. Therefore, if this annuity has not lived up to your expectations and you want to invest its value elsewhere -- like buying some shares of a new stock or a piece of property -- you have a tax problem. If you want to gift the proceeds to your children, you will have to sell the annuity and incur the income tax on the sale and withdrawal -- unlike a stock. The only thing you could do with this money is to transfer it to another annuity that might have better investment options for you. In other words, this annuity money is "stuck" in annuity land. One last thing you could do is slowly withdraw from the annuity each year to spread out the impact of the income tax, but this would only help you to pay a mortgage, not make a down payment.)
        There are some clean interest-bearing annuities out there that can get you a good return much like a certificate of deposit, but it is vital to review your options before jumping into the world of annuities, many of which offer guarantees -- but at a price that can turn retirement into something short of paradise.

You Don't Buy Guarantees. You Buy Risk
        You cannot have a high return without assuming risk. Investing is not about buying guarantees; it is about buying risk. By purchasing risk, you can make a nice return for assuming that risk. Good investors understand the risks they are taking and they can differentiate between a low level of risk and a high-risk investment. They also understand diversification. They know how to spread risk and hedge risk. With this knowledge they can build a portfolio that can make a decent return, at rates better than a treasury bill, without compromising their retirements.

John R. Ruocco is sole owner of Asset Management Associates and has provided independent, fee-only investment advisory and portfolio management services for over 20 years. For more information and advisory fees, contact John R. Ruocco at 1-800-208-8588 or This email address is being protected from spambots. You need JavaScript enabled to view it. in South Windsor, CT. The first consultation is always free. Information, brochure, and form ADV part II is available upon request or log-on to www.assetmanagementassociates.com. John waives his fees for veterans and their spouses for the first six months of his services.

Editor's Note: This article is for information purposes only and does not constitute endorsement or recommendation of any kind by the publisher.  Please seek appropriate investment or tax counsel before entering into any investment or financial transaction.