Quick Take on Fixed Income
November 2015
Question: What are agency bonds?
Answer: Agency bonds are securities issued by two types of entities: 1) government-sponsored enterprises (GSEs), which usually are federally chartered but privately owned corporations; and 2) federal government agencies which issue bonds to finance activities related to public purposes, such as increasing home ownership or providing agricultural assistance.
Because of their government affiliation, agency bonds are secure, essentially backed by the full faith and credit of the U.S. government. These agencies receive favorable treatment in several arenas: they receive lower interest rates on money they borrow, have lower capital requirements, and are exempt from most state and local taxes. As a result, government agencies can offer investors more favorable bond earnings than would otherwise be possible.
Agency bonds issued by GSEs include bonds from the Federal Home Loan Mortgage Corp. (Freddie Mac), the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Banks and the Federal Farm Credit Banks. GSEs are not backed by the full faith and credit of the U.S. government, unlike U.S. Treasury bonds. They do, however, carry an “implied guarantee” meaning the market believes these agencies would be bailed out by the U.S. government in the event of insolvency. This guarantee was tested in 2008 when both Freddie Mac and Fannie Mae were taken over by the U.S. Treasury after experiencing catastrophic losses on their mortgage portfolios.
Agency bonds issued by federal government agencies carry the full faith and credit of the U.S. Treasury. Federal government agencies include the Small Business Administration, the Federal Housing Administration and the Government National Mortgage Association (Ginnie Mae).
How do they trade?
Due to the agencies’ implied or explicit backing of the U.S. Treasury, they tend to trade fairly close to their Treasury counterparts. Because most agency securities are issued by the big four GSEs listed above, they carry only an implied backing of the U.S. Treasury. This means they trade at a slight spread to their Treasury counterparts, usually 5–10 basis points.
How are they taxed?
All agency bonds are taxable at the federal level, but the state taxation varies by issuer. For example, interest income from some agency bonds, such as those issued by Federal Farm Credit Banks and Federal Home Loan Banks, is exempt from state and local tax. The interest income from bonds backed by Fannie Mae and Freddie Mac, however, is not exempt from state and local tax.
In summary, agency bonds can offer a strong alternative to U.S. Treasury securities for investors looking for safety as well as yield, due to their strong credit quality and higher yields than Treasuries.
Copyright © 2015, The BAM ALLIANCE. This material and any opinions contained are derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm. Information regarding references to third-party sites: Referenced third-party sites are not under our control, and we are not responsible for the contents of any linked site or any link contained in a linked site, or any changes or updates to such sites. Any link provided to you is only as a convenience, and the inclusion of any link does not imply our endorsement of the site.
Imagine a hypothetical guy who lives a responsible financial life. He’s focused on meeting his obligations, even though he doesn’t have a big cushion when it comes to his take-home pay. Things are tight. He’s not quite living paycheck-to-paycheck, but it’s close. Then one day, an external shock completely outside his control occurs, and it affects him negatively.
Through no fault of his own, he ends up missing a couple of bills. These missed payments hit his credit score, and it drops 50 points. What happens next might surprise you.
He uses this experience as a wake-up call. Things were painful in the short run, with limited access to credit. But a couple of years later, he’s ahead of where he started before the shock. In fact, he ends up in a better financial position than his peers who didn’t experience this event.
Though hypothetical, our story gets us really close to an interesting study conducted by Mark Garmaise at University of California, Los Angeles and Gabriel Natividad at Universidad de Piura. They wanted to know what happened to people living on the edge financially when they experienced an outside shock. To figure that out, they needed to isolate a group of people who had experienced a random, negative event to see how it affected them. They found one in Peru.
Why Peru? I’ll spare you the details, but the researchers found a good data set that included a very random and very negative currency risk. Through no fault of their own, this particular group experienced a shock.
What happened next looks a lot like our earlier story. The group used this shock as a wake-up call to improve their financial lives. The study found that people who went through this experience were less likely to have unpaid fines, taxes and government penalties than their peers who avoided the currency issue.
I found this outcome fascinating, and it made me wonder. Could we trigger our own wake-up call without experiencing the trauma of an actual shock? It’s sort of like a fire drill; while it’s impossible to simulate the actual experience, perhaps we could get close just by imagining ourselves in different situations. Here are three to get you started.
1. Pretend you don’t get your year-end bonus or your annual raise. Perhaps you’ve been lucky enough to get a raise or bonus or make a bit more money every year for the last few years. If you’re like me, you may have already spent that money, at least mentally. So what happens if you don’t get it? What impact would that have on your finances?
Or maybe you really have already spent the money on something like a new car. You had planned on the extra income to make the payments more manageable. What does this shock feel like? Will you have to give up something else to make the numbers work?
2. You have an adjustable-rate mortgage scheduled to reset in two years. Let’s say you have a $250,000 mortgage and your monthly payment is $1,054. Your current interest rate is 3 percent, and you plan on your new rate only going up by a little bit.
So you’re shocked to open your new statement and discover your rate has become 5 percent. That’s a difference of almost $300 per month on a $250,000 mortgage. What would that look like, and feel like, financially and emotionally? Maybe things are a little tight now, even at your current monthly payment. What happens when it goes up in the future?
3. Let’s say your quarterly investment report comes in the mail. It shows your long-term investment accounts are down 30 percent. It’s not impossible. How would you react? Are you prepared emotionally for the possibility? Would you need to rethink some long-term plans?
In all three examples, I’m not saying they will ever happen to you. But these outside shocks aren’t uncommon. In fact, I think they happen more often than we realize.
While it may be impossible to recreate the exact experience of a negative shock, try it. Sit down with your spouse, partner or friend and work through these examples and others. Then, write down what you learn.
Do things turn out O.K.? Do you need to make adjustments? Like most wake-up calls, this one is about figuring out what needs to happen without the pain of living through a real-life shock. After all, there’s no rule that says we have to fall into a hole to learn a lesson.
This commentary originally appeared October 5 on NYTimes.com
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© 2015, The BAM ALLIANCE
November 2015
How These Changes Could Affect Your Future Filing Strategy
Establishing a well-crafted plan that addresses the role Social Security retirement benefits will play in your financial future has never been more important, especially in light of recent changes to how these benefits are administered.
On Nov. 2, 2015, President Barack Obama signed into law the Bipartisan Budget Act of 2015. The bill, which had obtained overwhelming support in Congress from both political parties, was originally intended to raise the federal spending and debt limits through 2017. Several seemingly unrelated measures were also incorporated into it. Specifically, the bill (now law) ends two popular and well-used Social Security retirement benefit claiming strategies, “File-and-Suspend” and “Restricted Application.” Below are answers to a few commonly asked questions regarding these recent changes to Social Security, in addition to an explanation of the new rules and how they could impact your long-term, comprehensive financial plan.
What is this law intended to do?
The Bipartisan Budget Act of 2015 ends two benefit-claiming strategies made possible by the Senior Citizens Freedom to Work Act of 2000. The Senior Citizens Freedom to Work Act was designed to permit seniors who had already begun receiving income from Social Security to suspend their retirement benefits and return to work. These seniors would then earn additional Social Security credits, increasing their now-delayed benefits when they were re-claimed down the road.
This situation created an opportunity for dual-income households to combine the "voluntary suspension" rules, which eventually evolved into the “File-and-Suspend” and “Restricted Application” claiming strategies, with Social Security’s spousal benefit provision to maximize their retirement benefits. How? Well, the spousal benefit provision, which hasn’t been eliminated, allows claimants to receive the greater of two amounts: up to 50 percent of their spouse's benefit or their own accrued benefit. The new law now prevents a family member from collecting benefits on their spouse’s earnings record while the filer’s benefits are suspended. Anyone who has already filed and suspended benefits before the bill was passed will not be impacted.
Does this law reduce Social Security retirement benefits?
Technically, the new law preserves the level of benefits promised by the Social Security Administration based on age at filing. There is an immediate reduction, however, to the variety of filing strategies that Americans can employ, particularly for married and divorced claimants. This reduction of allowable claiming strategies may significantly lessen the lifetime retirement benefits that some retirees had planned on obtaining from Social Security.
For many retired Americans with fewer options to replace lost income, receiving a smaller amount from Social Security than they originally had expected could, in turn, jeopardize their overall financial health. Unfortunately, this is a stage of life in which there are very few helpful alternative options available for increasing income. After all, how many people will be capable and willing to come out of retirement and resume working in their 70s?
Who should be worried?
Anyone who has already filed for Social Security using the “File-and-Suspend” and the “Restricted Application” claiming strategies will not be affected. However, every American who reaches 62 in 2016 or later will be allowed fewer choices in how they receive Social Security retirement income. The maximum amount that a person or couple could obtain from Social Security will now be lower than in the past. The most commonly known benefit claiming strategies eliminated by the law are the “File-and-Suspend” and the “Restricted Application” options. The opportunity cost to couples who could have utilized either or both of these two strategies could easily grow to $60,000 or more over a lifetime. The personal assets or savings required to make up the difference could produce some major headwinds to retirement readiness for some people.
Individuals already age 66 or older, and those who turn 66 by approximately May 1, 2016, who have not yet filed for Social Security still have six months available in which to capitalize on the “File-and-Suspend” or the “Restricted Application” options. By May 1, 2016, individuals and couples are required to have their filing strategies documented by the Social Security Administration.
Restricted applications for spousal benefits will be eliminated for everyone who turns 62 after Dec. 31, 2015.
Survivor benefits are not impacted by the new law. Surviving spouses will still be able to choose whether, and when, to begin receiving survivor benefits versus their own retirement benefit.
Additional modifications to claiming strategies may result from the law, but only the more common situations have been covered here.
Is there still any financial benefit to delaying Social Security?
Yes! Social Security can be obtained as early as age 62. However, that’s with a steep penalty of up to 30 percent less than what could be available at full retirement age. Full (normal) retirement age is either 66 or 67, depending on a person’s year of birth. It’s also the threshold for receiving 100 percent of the promised Social Security retirement benefit. Filing at 70 provides an 8 percent annual increase from the full retirement age amount, which is a guarantee not available anywhere else in the world of retirement planning. A person born in 1960 or later, for example, may be due $1,000 a month at full retirement age. That person would receive a benefit of $1,240 a month by waiting until age 70, but would collect just $700 a month by filing at 62. Capturing $540 more per month starting at 70 versus at 62 would provide an additional $62,400 to the filer by the time they reached 90.
Everyone’s financial circumstances, goals and priorities are different. The lack of a crystal ball to accurately and reliably forecast longevity or quality of life (or virtually anything else) means there’s no single filing strategy that is best for everyone. Because we can’t predict how long someone will live, we view Social Security essentially as longevity insurance. Filing for Social Security later gives claimants a much greater longevity insurance benefit.
What action should be taken?
Your first step should be to schedule time with your advisor(s) to review how, or if, the new law impacts your retirement projections or legacy goals. For clients with six months or less in which to file for the enhanced strategies, time may be of the essence. Clients age 61 and under should meet with their advisor(s) as well so that they can review what filing strategies are still available.
Social Security was a complex issue even before the new law was passed. Many filing strategies existed, and the public was provided very little education regarding how to optimize their own benefits-claiming approach. Buckingham’s procedure for guiding clients through the Social Security decision-making process is being updated immediately to reflect all changes to the law.
Even though some of the most attractive filing strategies for couples or divorcees are being eliminated, Social Security still is able to provide a major impact on a family’s future financial projections. We look forward to supporting you with this important advanced planning decision.
Copyright © 2015, The BAM ALLIANCE. This material and any opinions contained are derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm. Information regarding references to third-party sites: Referenced third-party sites are not under our control, and we are not responsible for the contents of any linked site or any link contained in a linked site, or any changes or updates to such sites. Any link provided to you is only as a convenience, and the inclusion of any link does not imply our endorsement of the site.