The 50% Indicator Investment Security Analysis. Robert Ruggirello, CFA

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1 November 11, 2015 The 50% Indicator Investment Security Analysis Robert Ruggirello, CFA Introduction: The 50% Indicator is an investment opportunity available to some NYC Employees. There has been some confusion surrounding the 50% Indicator recently. Hopefully, this analysis will help the reader to better understand the 50% Indicator. We will begin with a brief comparison of the ITHP and the 50% Indicator. This comparison is done to point out that the ITHP is superior to the 50% Indicator. Next, we will move on to a fundamental security analysis of the 50% Indicator. This analysis is done in two phases, the first during the investors working years, and the second at retirement. We will point out some important characteristics of the investment and analyze its attractiveness by comparing it to other investments that we have identified as similar. Disclosure: This paper is not personalized investment advice, it is intended as general information to help the reader to better understand what the 50% Indicator is. This is a fundamental analysis of one security, the 50% Indicator. I ve attempted to perform this analysis without any biases in favor of, or against the 50% Indicator. The reader should always keep in mind that any investment decision should be made within the context of your whole portfolio. The 50% Indicator belongs in some investor s portfolios, and does not belong in others. The reader should seek competent professional advice to determine if the 50% Indicator is appropriate for their portfolio. The analysis that follows assumes the following: Normal service retirement No early withdrawal penalties (Retiree is 50) Current and future marginal federal tax rate is 28% Part 1 - The ITHP: The reader should take note that the ITHP is superior to the 50% Indicator because of its federal tax deferred status. In my opinion there is no reason that anyone should invest in the 50% Indicator before the ITHP. 1 The net return 2 on the ITHP investment, given our assumptions above, is 8.25% 3. The net return on money invested in the 50% Indicator will not reach 8.25%, although the net return will increase the longer the investment remains in the account, due to compounding interest 4. The example that follows illustrates the difference in the net returns of the two options. 1 Based on 2015 Tax Brackets 2 Net returns are adjusted for taxes 3 The net rate of return on the ITHP does not increase with time because this type of account, where principal and interest are taxed at withdrawal, does not benefit proportionally from compounding interest, it benefits from its tax advantaged status. Higher or lower future tax rates will also affect the net rate of return, but compounding interest will not 4 The 50% Indicator does benefit proportionally from compounding interest. The interest earned on interest drives the net rate of return higher with time Page 1 of 8

2 Assumptions: Gross salary to invest = $5,000 5 No additional contributions Investment return 8.25% 20 year time horizon Current tax rate = 28% Future tax rate = 28% Tax Deferred Account: ITHP Income to Invest $5,000 Current Federal Tax Deferred Future Value After Time Horizon $ 24,408 Tax Due After Time Horizon $ 6,834 Net Future Value $ 17,574 Tax Adjusted Initial Investment $ 3,600 Net ROR 8.25% Taxable Account: 50% Indicator Income to Invest $5,000 Current Federal Tax $1,400 Net Investment Funds $3,600 Future Value After Time Horizon $ 17,574 Tax Due After Time Horizon $ 3,913 Net Future Value $ 13,661 Net ROR 6.90% Relative ROR Vs. Tax Deferred -16.4% The ITHP has: 1. A higher net rate of return 2. A larger net future value On the following page there is a table that summarizes the net return on a lump sum of money invested for the time period indicated. Note that money invested in the 50% Indicator for 1 year will earn a net return of 5.94% and rise to an annualized rate of return of 6.9% if it is left invested for 20 years. In the table below you ll also notice that the ITHP always has a higher rate of return than the 50% Indicator. This does not tell us anything about the 50% Indicator, it just tells us that the ITHP is better. We can now move on and focus on the 50% Indicator. 5 For simplicity we assume a one-time lump sum investment Page 2 of 8

3 Estimated Net Return Table Assumptions: Current Tax Rate 28% Future Tax Rate 28% Gross Return 8.25% Years Left in Account ITHP Annualized Net Return 50% Indicator Annualized Net Return % 5.94% % 6.00% % 6.07% % 6.13% % 6.19% % 6.25% % 6.30% % 6.36% % 6.41% % 6.46% % 6.51% % 6.56% % 6.61% % 6.65% % 6.70% % 6.74% % 6.78% % 6.82% % 6.86% % 6.90% % 6.93% % 6.96% % 7.00% % 7.03% % 7.06% % 7.09% % 7.12% % 7.15% % 7.17% % 7.20% Page 3 of 8

4 Part 2 Conclusions from the Analysis of the 50% Indicator: The 50% Indicator is an investment that should be thought of in two separate phases. The first phase consists of a fixed rate of return of 8.25% on contributions 6 during the investors working years. The second phase begins at retirement and is entirely optional. The investor can annuitize their lump sum value for a fixed payment, or simply take their lump sum value 7. However, you must have invested during phase 1 to participate in phase : Option 1: If you annuitize the lump sum you purchase a fixed monthly payment. For tax purposes that fixed payment contains two parts: 1. A non-taxable return of principle (the principle is not taxed again) 2. A taxable interest portion (the interest earned is taxed) Option 2: If you choose to take the lump sum, your lump sum payment contains two parts: 1. A non-taxable return of principle (the principle is not taxed again) 2. A taxable interest portion (the interest earned is taxed) Please take note of the similarities between option 1 and option 2. There is no double taxation. We posit that the 50% Indicator is similar to a fixed coupon bond with the option to purchase an annuity at retirement 10. We identify benchmark securities so that we can compare the 50% Indicator to investments that have similar risks. During phase 1 we compare the 50% Indicator to a NYC General Obligation Bond 11 (NYC Muni Bonds) and during phase 2 we compare it to a single life fixed annuity that can be purchased from investment grade life insurance companies. Phase 1 Analysis: We identified that the 50% Indicator and the NYC Bonds are exposed to the following similar risks: o Interest rate risk The sensitivity to rising interest rates o Credit risk NYC credit risk Given the similar risk level we compared the estimated returns 12 available on the investments: o The 50% Indicator currently offers a substantially higher return for all time horizons o For an investor with 10 years until retirement the estimated 10 year net returns are currently 6.5% on the 50% Indicator Vs. 2.3% for the NYC Bonds o The 50% Indicator investor is being paid a 4.2% premium to what the market currently demands for bearing the risk of NYC Bonds o Calculated relatively, the return is 182% higher 6 You are loaning the pension fund money and are compensated with the fixed rate of return 7 For simplicity we only assume full distribution or full annuitization 8 This option has value but is outside the scope of this article 9 We ignore the third option of rolling funds into other investment vehicles. It is outside of the scope of this article 10 For both, the investor contributes principle and is paid interest. The principal is redeemable at maturity (retirement) Series A tax free bonds, so we calculate the net return on the 50% Indicator and compare the two 12 For the bonds we use Yield to Maturity, and Yield to Worst for bonds that are callable, provided by EMMA Page 4 of 8

5 Phase 1 Conclusion: Based on the above we conclude that the 50% Indicator is currently a more desirable investment, given its level of risk, than what is available on NYC bonds that trade in the secondary market. We note that because interest rates in the market fluctuate, the attractiveness of the 50% Indicator could change in the future. The estimated net returns are graphed below. The top line is the estimated net return of the 50 % Indicator. The solid bottom line is the estimated net return on the NYC General Obligation Bonds. NYC Term Structure of Interest Rates Maturity Time Horizon Years NYC Net Bond Yield 50% Ind. Net Return Trade Date 8/1/ % 6.0% 10/19/2015 8/1/ % 6.1% 10/26/2015 8/1/ % 6.2% 10/15/2015 8/1/ % 6.2% 10/21/2015 8/1/ % 6.3% 10/13/2015 8/1/ % 6.4% 10/13/2015 8/1/ % 6.4% 10/26/2015 8/1/ % 6.5% 10/26/2015 8/1/ % 6.6% 10/13/2015 8/1/ % 6.8% 10/13/2015 8/1/ % 6.8% 10/20/2015 8/1/ % 6.9% 10/22/2015 Trade data from October 2015 Phase 2 Analysis: Page 5 of 8

6 At retirement the investor must decide whether to withdraw the lump sum or annuitize it for a higher pension. Purchasing an annuity for a lump sum value can be viewed as purchasing longevity insurance to hedge against longevity risk. In English, you buy a higher level of guaranteed monthly income so that you don t outlive your assets. First, we estimate what we can purchase with our lump sum value: What it purchases as a single life fixed annuity 13 from an insurance company What it purchases if annuitized into the pension To perform this analysis I obtained quotes from 10 life insurance companies with credit ratings similar to that of NYC. I used the median cash flow rate to estimate the annuity that could be purchased for $100,000, estimated the federal taxes 14, and calculated a net cash flow. A note on cash flow rates Insurance companies provide a cash flow rate. This is a simple yield calculation (cash flow/cost of contract). Don t be fooled into thinking it is a total return calculation. It is not. It excludes the lump sum value paid up front (the premium). However, we have estimated the total return for several time periods by calculating the IRR, which does account for the cash paid upfront. The following is an estimate of the net cash flows and IRR s of a $100,000 Single Life Fixed Annuity policy: Estimate of Single Life Annuity Premium/Cash Outflow ($100,000) Annual Annuity Purchased $5,035 Calculate: Exclusion Ratio 60% Annual Non Taxable Portion $3,021 Annual Taxable Portion $2,014 Tax Due ($564) Annual Net Cash Inflow $4,471 Net Cash Flow Rate 4.5% Rate of Return (IRR) Collection Years IRR % % % % % 13 This is not life insurance. It is an annuity that pays until the end of the purchasers life 14 This analysis only considers federal taxation. It assumes the annuity is not taxable at state or local level. Page 6 of 8

7 The following is an estimate of the net cash flows and IRR s of $100,000 annuitized into the pension: Summary of Pension Annuitization Premium/Cash Outflow ($100,000) Annual Annuity Purchased $8,657 Annual Non Taxable Portion $3,333 Annual Taxable Portion $5,324 Tax Due ($1,491) Annual Net Cash Inflow $7,166 Net Cash Flow Rate 7.2% Rate of Return (IRR) Collection Years IRR % % % % % Phase 2 Conclusion: Given current market conditions: The net cash flow rate is currently about 60% higher in the pension The Internal rate of return (IRR) 15 is significantly higher in the pension for all time periods Based on these estimates the investor is currently receiving a better offer from pension annuitization, than from the annuity marketplace. Again, we point out that market rates fluctuate and this could change in the future. From above, a retiree that collects from the pension for 20 years will collect $7,166 in cash annually and realize a 3.7% annual rate of return. The Single Life Fixed Annuity provides $4,471 in cash annually and experiences a -1% annual rate of return for the same time period. A note about IRR s: IRR s are sometimes called hurdle rates. A hurdle rate could also be interpreted as a number to beat. Given the above pension example someone (not me) might be inclined to say that since the hurdle rate on a 20 year collection period is 3.7%, if you can earn a higher annualized return with other investments, then you should choose that option. Maybe, but this is not necessarily true because it ignores volatility of the returns. It is true that 4.5% is higher than 3.7% per year, but it may not be better if it comes with substantial volatility that impacts annual cash flows. Remember that dependable cash flows are important in retirement. 15 This is the annualized return figure because it includes the upfront cost of $100,000, and is sometimes called a hurdle rate Page 7 of 8

8 A note about Annuities: Critics of fixed annuities frequently point out that: They have low rates of return They don t protect against inflation Both points are true. However, you need to consider the following as well: Annuities are insurance contracts. Insurance always has a cost, hence the low rates of return They provide an income floor for your entire life. Other assets in the investor s portfolio may be available to hedge inflation Additionally, the decision to annuitize or not must be considered in the context of the investors total portfolio and also consider diversification. This decision is not the purpose of this analysis. The purpose of this part of the analysis is to compare what your lump sum will buy from two different sources, and point out the better option at this time. Article Conclusion: This article briefly compared the ITHP and 50% Indicator and demonstrated that: The ITHP is superior to the 50% Indicator because of its tax deferred status The net return of the ITHP is 8.25%, under constant tax rates, no more and no less The net return of the 50% Indicator increases with time because of compounding (see chart) Next, an analysis was performed on the 50% Indicator, broken into two separate phases 16, vs. comparable market securities. Our analysis shows that under current market conditions: The 50% Indicator earns a substantial premium to a comparable security (NYC General Obligation Bond) during the working phase If a retiree decides to annuitize the lump sum, annuitizing into the pension offers better net cash flows, and a better rate of return, than what is available in the annuity marketplace 17 The principal value of the 50% Indicator is not double taxed Relevant Bio: The author has experience as an analyst for a Wall St. based asset management firm. The firm was the Investment Manager of mutual funds, a hedge fund, and a multi-asset real return fund. The author has a BBA in Finance, a MS in Financial Statement Analysis & Securities Valuation, is a member of the New York Society of Security Analysts (NYSSA) and is a CFA Charterholder (CFA Institute). 16 Working and retirement 17 The choice between annuitizing, taking the lump sum, or rolling the investments into other vehicles should be discussed with a competent professional Page 8 of 8

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