Considering income options for retirement?
Numerous options exist to help you make sure you receive the maximum income for your available retirement dollar. Many of these options have market risk associated with them. On the list below, I have marked negative points on each option to make sure you see both sides. This is meant as a short summary, but one that can help you ask the right questions when speaking to your investment advisor. I am NOT an investment advisor, I am NOT authorized or licensed to give investment advice. I am a licensed insurance agent providing insurance company annuity products.
Please seek competent legal, tax and investment advice from licensed and authorized professionals. This list is meant only as a short guideline, and remember, products change and tax liability changes, so make sure you are up to date before making any permanent decisions.
Master limited partnerships (MLP): Once thought as a slow and go investment, recent volatility from the energy sector has taken a toll. Tax reporting is also a negative, requiring K-1 filing. Any net loss in the MLP cannot be used to offset income from another source. If the MLP makes money, the share owner is subject to income tax liability.
Emerging market debt: (EM) Emerging markets can involve credit risk issues. Will you be paid? If the market is downgraded, will your investment also be downgraded? EM can also mean volatility. Currently, EM bonds have 2.8% spread (higher interest) above US Treasury bonds. Is the additional interest worth the additional risk? Argentina and Venezuela are two examples of credit rating being reduced, their bonds dropped significantly in value.
Inflation protected notes: (TIPS) Treasury protected securities were designed to protect long term US Treasury bond holders from loss of purchasing power lost via inflation. With inflation currently low, buying a TIPS is like buying an insurance policy, the premiums you pay are lost unless an inflationary even occurs. If deflation occurs, the value of TIPS would also be deflated. Interest earned in TIPS is taxed as ordinary income.
REITS: (Real estate investment trusts) There are several types of REITS, actual hard asset real estate, mortgage holdings and hybrids. The negative is simple, if any of these assets groups loss value, your REIT losses value. REIT management charges annual fees. Taxation can be ordinary income based on rental fees etc. It depends on how the REIT is run and the asset class in it. REITS are required to disburse 90% of the taxable income to shareholders annually.
Municipal bonds: (Munis) Municipal bond income is exempt from federal income tax, however, profits made from the sale of municipal bonds is taxable. Many people like the tax exempt status, but in reality, the actual yield on Munis is equivalent to most other bonds without tax exemption. In some cases, selling a Muni from a smaller issuer could have difficulty in finding a buyer (market risk).
Corporate bonds: The biggest problem with corporate bonds is basic, they are guaranteed by the company that issues them. That means ratings and the ability to deliver on promises. The corporate default rates this year is the highest in 7 years, many defaults are in the oil and gas industry. Financial ratings are important, plus remember the rule, the higher the interest offered in corporate bonds, the lower the financial ratings.
Government bonds: Nothing is safer than US Treasuries, they have no risk, your funds are guaranteed. The problem is simple; the yield is low. Plus, US Treasuries if sold prior to maturity (most 30 years) the amount you receive can be high or lower than the amount paid originally.
ETFs: Exchange traded funds; Even through these are traded exchange trading in a wide variety of sectors there are some negatives. Commissions can erode returns, some ETF are taxed higher, some ETF have low volume demand and that equates to a higher bid-ask spread.
ETNs: Exchange traded notes: these are senior unsecured which are subordinated (last in line to be paid) issued by an underwriting bank. They have a maturity dates, fees are charged and are promises to pay. Returns are normally tied to an outside source, such as an index. Credit risk can be an issue because payment is made by the issuing entity. ETN are normally illiquid.
Structured notes: Generally used in off shore investment markets. A structured note is an IOU which can mean credit risk. Also, liquidity is a major issue, they are not liquid until maturity. Once issued, the notes are not re-priced even if market conditions change. The rule of thumb with structured notes, “if it looks too good, look under the hood” Caution is always advised.
Leverage bonds: This is simple; leverage means borrowing. If you borrow money with less interest than the value of the earned interest on the bond, it would seem you are a financial expert, right? No, borrowing and leveraging bonds is short term financing and bonds are long term financiering. Leveraged bonds are completely dependent on general interest rates and values need to be monitored daily. Leveraged bonds can be a dangerous financial position.
Institutional money funds: Institutional means less fees are being paid because an institutional manager has more money to invest and can demand lower fees…..(from the fund) In order to qualify for “institutional” investing can require a huge deposit, as much as a million dollars. From then on, you will earn money market rates and pay a lower fee. (6/13/16)- .11%…yes, that is slightly more than .1%. Many companies offer a wide range of interest options, be informed.
Income arbitrage: Computers search for inefficiencies in bond pricing. By doing so, bonds are bought and sold in an effort to maximize yield. Many hedge funds use this strategy to obtain higher yields by using a selling short position. In other words, there is risk.
SPIA: Single premium income annuity, once purchased, cannot be changed. There is no flexibility in a SPIA.
Oil and gas: With the recent drop in oil, the one word that comes to mind in investing is volatility. Unless you have the ability to long and short the asset, it seems like a bad choice. Market fluctuations, lack of control over consumption are a few of the negatives. Many people invest in gas and oil via limited partnerships, in doing so you open yourself to additional fees and expenses.
Tax credits: Recent legislation have opened new options in tax credits offered on the solar industry. Most credits associated with it are bought and sold from the original owner, small amounts can be made using tax credits to generate tax refunds on previous tax years. Returns are subject to an IRS approval and ay open other audit issues. Very deep restrictions apply to investing in tax credits and using them as an actual investment can mean an illiquid scenario. The underlying problem is simple, tax credits are congressionally approved and congress can change its mind.
Trust deeds: Investing in trust deeds can be very profitable, but they are not short term decisions. Often funds in an IRA are used to buy trust deeds at deep discount and earn a higher than normal return. Trust deeds have very little equity and their success depends on the continual flow of payments to the underlying mortgage. Possible downside can be legal expenses for non-performing assets. There is always the possibility of ending up with the real estate associated with the deed. The real downside? Trust deed investing requires hands on management, if you buy into a limited partnership dealing with trust deeds, you can be faced with fees and expenses.
Senior & floating rate loans: Normally, these investments are through mutual funds. It is very difficult for small private investors to deal directly. Floating rate securities are secured loans to companies needing excess or outside financing. The reason could be a market adjustment, a sector adjustment or a company needing to reorganize and increase liquidity. The loans are backed by physical assets such as account receivable, inventory or real estate. By assessing them through mutual funds, you expose yourself to commissions, fees and expenses. One giant negative is federal control over pricing, this was done to insure assets were adequate for the loan valuation and it definitely lowered possible yields.
CDs: The pros and cons are simple, if the money is FDIC insured, it is completely safe. Because of their safety, the yields can be low. Plus, taxation, interest earned in a bank CD is fully taxable as ordinary income. Current interest rates offered can be found at www.bankrate.com
Convertibles: This type of investing is in either debt, equity or a combination (hybrid). Bond convertible means the offer to convert bond ownership (debt) to common stock (ownership). To convert bonds to equity usually means a discount off the top, most about 20%. Also, convertible bonds can have many restriction and time limits. Most convertible bonds also pay less than market rate because of the convertibility. More info here: http://seedcamp.com/resources/the-essentials-of-convertible-notes/
Preferreds: (preferred shares) Preferred shares are really a combination of debt and equity, ½ bond, ½ investment. Preferred share owners normally earn dividends at a preset rate. Most preferred shares are callable, meaning the company can end the relationship buy repaying the cost of the preferred share. This would happen if interest rates were to be lower than originally offered in the preferred. Upward valuation is normally restrictive and the possibility of insolvency of the issuer should be considered. Normal time period for preferred stock maturity can be as long as 30 years, preferreds can be sold on the secondary market but valuation can be higher or lower than the original price based on general market conditions.
Dividend strategy: Investing in companies that pay dividends can be a good choice, except: there is no rule that says the company can stop or reduce the annual dividend. The stock from which the dividend is derived can increase or decrease in value, capital can be at risk. Dividend yields are normally much lower than bond offerings. Companies offering dividends are generally older companies with static stock values and can be based on older business models.
Closed end income funds: Closed end mutual funds charge a commission to buy and a commission to sell the shares. Unlike open end mutual funds, closed end funds are traded like stocks. The valuation of a closed end fund is not based on the assets in the fund but rather at market conditions. The issuing mutual fund company does NOT redeem the shares which is opposite of open ended mutual funds. Income can be taxed as ordinary income rates. Annual fees and expenses are charged to manage the fund.
Income trusts: Numerous categories exist for income trusts, real estate, energy, royalties, business trusts to name a few. Normally an income trust holds income producing assets such as notes, bonds, royalties. The trust receives the income and after operating expenses, pays the income to the beneficiaries (owners) of the trust. The stated goal of the trust must be followed which can limit investment options, as an example, if the trust was created for oil and gas investment, it cannot foray into other industries which ties the future of the trust to a specific arena. As we have seen with current gas and oil process, the trust may be too limited. This restriction may cause huge investor risk not only to valuation of the asset but to interest risk exposure. Income trusts pass all taxation on to the shareholders of the trust. Exposure to market risk can be a problem.
Private lending: This is easily understood, who is promising to pay. Lending between individuals can be both secured and unsecured, interest rates can be higher than market conditions. The greatest concern is “will you get your money back and is the added interest offered worth the risk?”
Be careful and be informed before making any permanent decisions. Get a second opinion from a licensed and authorized professional.