Understanding Loaned Assets

There are different types of monetary assets to consider when it comes to creating a financial or retirement portfolio. These typically fall into two categories: loaned and owned assets. You can read about owned assets here.

Loaning involves investing your funds by temporarily loaning money to a bank, company, or government for their use. In exchange for your money, they promise to repay your principal investment and pay interest. Any return depends on investment methods, financial performance, strength, and resources of the borrower. Loaned assets are generally a safer bet than some owned assets.

Consider the following loaned assets:

Bonds

Bonds are debt securities sold by the government or a company to investors. The investor is promised a return of principal and periodic interest payments in exchange for their loan. The interest rate is determined by the length of the term — how long you are loaning your money for — and the credit rating of the issuer. The lower the credit rating of the issuer and the longer the length of term, the higher the risk of default, but the interest rates are higher as well. Bonds with low credit ratings and high interest rates are sometimes referred to as “junk bonds” and are best to be avoided.

• Pros: Return of principal investment, interest

• Cons: Possibility of default

There are five different types of bonds: U.S. treasuries, U.S. savings, corporate, municipal, and agency. Generally speaking, U.S. treasury bonds are low risk. Corporate bonds are riskier but pay out at a higher rate than government bonds. Municipal bonds are riskier than U.S. treasuries and pay out at a lower rate than corporate bonds. Agency bonds are riskier than treasury bonds, but also have a higher yield.

Treasury bonds and savings bonds are subject to federal taxes, but not state or local taxes. Municipal bonds are the opposite; they are federally tax-exempt but may be subject to state or local taxes. All income from corporate and agency bonds is taxable.

Annuities

An annuity is a product sold by a life insurance company in which you deposit a sum of money that then earns interest and is used to generate guaranteed income payments in the future.

• Pros: Reduced or eliminated market risk on indexed and fixed annuities, tax deferral during accumulation, improved tax control vs. traditional pre-taxed retirement accounts, blended tax treatment if distributed under a systematic income stream annuitization

• Cons: Not FDIC insured and may experience a lower ultimate rate of return than other potentially higher-risk investments

There are two ways to fund an annuity contract:

• A single premium annuity is funded through one lump-sum payment of after-tax dollars. Often this lump sum comes from liquidating other assets: banking products (CD or savings account), home equity, or a taxable (brokerage account) investment portfolio.

• An installment premium annuity is funded over time through either scheduled or unscheduled premium contributions and is a great option for those who are still working but want to secure the option to create an income stream as part of their retirement plan.

While annuities are not investment accounts in the traditional sense, your premium deposits will be invested by the insurer to increase the value of the annuity over time. There are three models for investing the principal.

1. Fixed — Guaranteed Return: With a fixed annuity, you deposit a sum of money with an insurance company and receive a guaranteed principal and interest payment in the future. In addition, your principal is guaranteed to not decrease. The insurance company can provide these guarantees because it invests your money primarily in bonds or other conservative, fixed investment instruments. This type of annuity is low-risk, and often provides a higher interest rate than a savings account or CD.

2. Indexed — Hybrid Return: An indexed annuity embodies characteristics of both fixed and variable annuities. Like a fixed annuity, indexed annuities offer a guaranteed minimum interest rate. In addition, they also offer an interest rate linked to an index market, like the S&P 500. Typically, in years when the market does well, the annuity earns an interest rate close to that of the index market; in years when the market does poorly, the annuity earns the guaranteed interest rate. This may be lower than the interest rate of a fixed annuity. There are several types of indexing methods used to calculate returns within this type of annuity, so it is important to understand not just which index an annuity is linked to, but how the returns are linked to that index.

3. Variable — Performance-Based Return: With a variable annuity, you choose the underlying investment portfolio, so the annuity value fluctuates up and down based on changes in market conditions. If the portfolio of investments performs well, your returns may outperform those of a fixed annuity. However, if they do not perform well because of poor market conditions, your investment principal is exposed to the risk of loss. While the risk is higher with a variable annuity than with a fixed annuity, there is also the potential for a higher reward.

Annuities also vary when it comes to payouts.

• A deferred annuity provides you the option of future income. It is designed to grow a sum of money in a tax-advantaged way during accumulation, with the option to initiate income payments later. Prior to the distribution of payments, earnings accumulate on a tax-deferred basis, meaning that you do not pay any taxes on interest earned until you decide how you want to distribute from the annuity. Distributions from a deferred annuity during accumulation are taxed on a “last-in, first-out” basis, so taxable interest is distributed before any untaxed principal.

• An immediate annuity starts a guaranteed income stream right away, with payments beginning within one year of the contract purchase date. Immediate annuities are funded with a lump-sum deposit and are typically used as a tool to spread out income tax or reduce the risk of outliving assets.

Deferred annuities are most often funded with a single premium of after tax dollars, but can also be designed to allow a systematic or ad hoc premium contribution to build value slowly over time as well. Immediate annuities are always funded with a single lump-sum deposit.

Certificates of Deposit

A certificate of deposit, or a CD, takes a sum of money and locks it into an account that earns a fixed interest rate for a specific amount of time. Typically, the longer you agree to let your money sit in a CD, the higher the guaranteed interest rate will be. When you redeem your CD after the term expires, you receive both your principal investment and accumulated interest. Accumulated interest is taxable.

• Pros: Higher interest rates than traditional savings accounts, locked in yield for some duration if rates fall, FDIC or NCUA deposit insurance

• Cons: Penalties for early withdrawal, interest earnings generate a filing requirement that is taxed at the owners top ordinary income bracket each year, reinvestment rate risk after maturity

CDs are typically offered by banks and credit unions.

Checking and Savings Accounts

Checking and savings accounts are accounts offered by a bank or credit union that provide a safe location to store cash and, possibly, earn interest. Both types of accounts are often federally insured up to $250,000, meaning that up to $250,000 of your money would not be lost if the bank were to fail. Checking accounts are often used by individuals for their everyday purchases, while savings accounts are a good place to store an emergency fund.

• Pros: Liquidity, FDIC or NCUA deposit insurance

• Cons: Interest (if offered) is unlikely to keep up with inflation, savings accounts typically offer a limited number of monthly transactions without fee

Money Market Accounts

A money market account is best thought of as a combination of a checking account and a savings account. It may come with checks or a debit card, like a checking account, but the balance of the account also earns interest, like a savings account. A money market account is more liquid than a CD — you can make a limited number of transactions if you need to — but your cash is not as accessible as it would be in a checking account.

• Pros: Higher interest than savings accounts, sometimes FDIC insured

• Cons: Earnings are taxable each year, rate of return can fluctuate rapidly with changing short-term yields