On Jan. 21, headlines quoted the governor of the Bank of Japan as saying, “No Plan to Adopt Negative Rates Now.” One week later headlines read, “Bank of Japan Stuns Markets With Surprise Move to Negative Interest Rates.”
Likewise, on Feb. 10, Rick Rieder, BlackRock’s Chief Investment Officer of Global Fixed Income stated, “I don’t think the Federal Reserve is in a thought process of negative rates today.” The next day, Janet Yellen, Chairman of the Federal Reserve, told the Senate Banking Committee, “In light of the experience of European countries and others that have gone to negative rates, we’re taking a look at them again, because we would want to be prepared in the event that we would need (to increase) accommodation.”
What do negative interest rates look like? How does a fixed income investor respond to such contradictory statements given by fiscal leaders?
A negative Fed Funds rate would force banks to pay to keep reserves at the Fed, instead of paying the banks interest, as the Fed currently does. That theoretically would incentivize banks to lend more. Bank customers with particularly high savings in their accounts may have to pay for the privilege of having their cash on deposit rather than earn interest on it. This would spur them to move money to higher-yielding assets such as stocks, stimulating markets and making consumers feel wealthier so they’ll spend more. But for conservative investors, particularly those who rely on interest income to supplement their retirement income, negative interest rates are a real threat.
For decades, fixed annuities have provided a secure form of savings for millions of conservative investors on a tax-deferred basis. They are by far the simplest type of annuity contract. Although annuities have existed in their present form only for a few decades, the idea of paying out a stream of income to an individual or family dates back to the Roman Empire. The Latin word annua meant annual stipends, and during the reign of the emperors, the word signified a contract that made annual payments. Individuals would make a single large payment into the annua and then receive an annual payment each year until death, or for a specified period of time. The Roman speculator and jurist Gnaeus Domitius Annius Ulpianus is cited as one of the earliest dealers of these annuities, and he is also credited with creating the first actuarial life table. Roman soldiers were paid annuities as a form of compensation for military service. During the Middle Ages, annuities were used by feudal lords and kings to help cover the heavy costs of their constant wars and conflicts with each other. At this time, annuities were offered in the form of a tontine, or a large pool of cash from which payments were made to investors.
One of the early recorded uses of annuities in the United States was by the Presbyterian Church in 1720. The purpose was to provide a secure retirement to aging ministers and their families, and was later expanded to assist widows and orphans. In 1912, Pennsylvania Company Insurance was among the first to begin offering annuities to the general public in the United States. Some prominent figures who are noted for their use of annuities include: Benjamin Franklin assisting the cities of Boston and Philadelphia; Babe Ruth avoiding losses during the great depression; O. J. Simpson protecting his income from lawsuits and creditors. Ben Bernanke, then Chairman of the Federal Reserve, in 2006 disclosed that his major financial assets were two annuities.
One way to invest your money with relatively low risk, but with a higher return than the interest rates of CDs offered by banks and credit unions is a fixed annuity. In a fixed annuity, you have the option to make either a lump sum contribution or a series of contributions to the contract, which in turn will pay a guaranteed rate of interest for a set period of time. These instruments resemble CDs in many respects: Both the principal and interest are guaranteed, and you’ll face a penalty for early withdrawal. As with all types of annuity contracts, there is a 10% early withdrawal penalty from the IRS for any distribution you take before you’re 59 1/2 years old. However, fixed annuities are an excellent fixed income substitute for some or all of the safe portion of a retirement portfolio. That’s why older investors and other people with short time horizons often purchase these contracts. Wealthy investors also use fixed annuities to shield a portion of a large portfolio from market risk and taxation. But fixed annuities are probably not the ideal vehicle for those seeking higher returns over longer periods of time.
The principal and interest in a fixed contract is backed by the financial strength of the life insurance carrier offering the product. Life insurance companies are rated according to their financial strength and given a grade, such as AAA or AA. Most major carriers have several ratings provided by each of the major rating agencies, such as Moody’s, Fitch, and Standard and Poor’s. Stable carriers obviously receive higher ratings, while smaller, less established companies are assigned lower grades. But state laws require that all fixed annuity carriers maintain a cash reserve that is at least equivalent to the total value of all outstanding fixed annuity contracts, regardless of what they are rated. This provides a safety net for all fixed annuity holders that can be counted on in times of financial turmoil. Finally, reinsurance companies usually step in and cover customer losses whenever an annuity carrier becomes insolvent. Therefore, although fixed annuities are not FDIC insured, your chances of losing the money in one of these contracts are so low that this possibility can be ignored for all practical purposes.
Fixed annuities provide a safe means of saving for retirement as well as guaranteed income. Conservative investors who look to banks and CDs should seriously consider these contracts as a more competitive alternative to taxable instruments. Locking in today’s rates offers protection from negative interest rates and “laddering” fixed annuities can offer a hedge against rising interest rates. For more information on fixed annuities, consult your financial advisor or life insurance agent.
Robert Thaggard, CPA CGMA is a tax professional and financial advisor. He has practiced public accounting for 38 years including 18 years of experience in the financial services industry. He recently opened an office in Nocatee Town Plaza. Robert grew up in Jacksonville and attended University of South Florida in Tampa. He enjoys golfing, sailing, NASCAR and overseas travel. His wife, Alice, is an artist with a studio in St. Augustine. They lived in Alaska for 30 years prior to returning to the area.