Author Topic: Help! How much to invest in 7% Fixed Rate?  (Read 5498 times)

fiscalphile

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Help! How much to invest in 7% Fixed Rate?
« on: June 15, 2016, 03:09:36 PM »
I will try to keep this concise for you all.

CONTEXT

In the last 1.5- 2 years, DH and I have converted to MMM, paid off about 100k in student loan debt, saved up an emergency fund, and opened IRAs.

We, ages 25 & 26, are planning to save at least 55k/ year in the pursuit of FIRE from now. Our combined GROSS income is about 112k, our take home is around 85k right now. We live in NYC with no major assets (home, cars).

We want to max out his 401k, my work's 403B, two IRAS, and put the rest into Vanguard.

DILEMMA

I am looking at my work's 403B plan. I can contribute up to 18k/ year- pre-tax contributions and tax deferred (hooray!). There are options on what to do with the money. Option #1 is a "diversified equity fund" that seems pretty decent, in the last 30 years it has averaged 9%- 10% returns, and it has a .179% expense ratio. Option #2 is a Fixed Return, a guaranteed 7% return rate quarterly.

I am thinking I should max my 403B and prioritize it over Vanguard, since it is pre-tax (and tax in NYC is expensive). Feel free to poke holes in that though. My main question is- how much do you think I should put in Option #1 Diversified Equity, and Option #2 Fixed Rate, considering our ages, pursuit of FIRE, and other planned methods of investment?

Thank you in advance for any insight.
« Last Edit: June 15, 2016, 03:11:24 PM by fiscalphile »

trashmanz

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Re: Help! How much to invest in 7% Fixed Rate?
« Reply #1 on: June 15, 2016, 03:12:45 PM »
Fixed return guaranteed 7%?  What is this magic?

trashmanz

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Re: Help! How much to invest in 7% Fixed Rate?
« Reply #2 on: June 15, 2016, 03:14:26 PM »
Need more details on what the funds invest in to make a reasonable recommendation. Eg div reovirus equity could mean anything.

MDM

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Re: Help! How much to invest in 7% Fixed Rate?
« Reply #3 on: June 15, 2016, 03:15:18 PM »
Guaranteed 7%?  Really?  And this is not an annuity with "return of capital" being part of the 7%?

See the 'Investment Order' tab in the case study spreadsheet for confirmation that investing in a good tax-advantaged plan beats taxable investing.

fiscalphile

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Re: Help! How much to invest in 7% Fixed Rate?
« Reply #4 on: June 15, 2016, 03:17:03 PM »
Need more details on what the funds invest in to make a reasonable recommendation. Eg div reovirus equity could mean anything.

Thank you I will look into that (and hopefully report back!).

fiscalphile

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Re: Help! How much to invest in 7% Fixed Rate?
« Reply #5 on: June 15, 2016, 03:20:24 PM »
Guaranteed 7%?  Really?  And this is not an annuity with "return of capital" being part of the 7%?

See the 'Investment Order' tab in the case study spreadsheet for confirmation that investing in a good tax-advantaged plan beats taxable investing.

Thanks so much!

And yes- this is real. I am a public school teacher.

mskyle

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Re: Help! How much to invest in 7% Fixed Rate?
« Reply #6 on: June 15, 2016, 03:22:00 PM »
Great work so far! Definitely max out your pre-tax options!

Does the Fixed Return account have any restrictions on withdrawals and rollovers? Or is it front-loaded or something? 7% guaranteed return is so good I feel like there has to be some kind of catch, but poking around it does look like this is a real thing in NYC government jobs...

One more caveat though: how long are you planning on staying with this employer? Once you quit you can roll the funds in your 403b into your Vanguard IRA. I finally did this with all my old 403b accounts (except for a small part in a product called TIAA-Traditional, one of those funds that's tricky to extract your money from) and it's great! So if you're only planning to be there a few years, it doesn't matter all that much which one you choose. Although if you can get 7% in perpetuity, you might as well leave it there I guess.

dougules

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Re: Help! How much to invest in 7% Fixed Rate?
« Reply #7 on: June 15, 2016, 03:27:56 PM »
Guaranteed 7%.  That's impressive

The companies in the S&P 500 are only raking in about 4% based on their current prices, so you would have a negative risk premium investing in stocks.  That's before accounting for inflation, though, since stock returns should automatically keep up with inflation over the long run.  I'm guessing that 7% doesn't also include an inflation adjustment?  If inflation were to top 3% then your risk premium would be back positive.  Seems 50-50 to me, assuming that there's not monkey business in the fine print on that 7%. 

Also, how easily can you rebalance from one to the other?  If it's easy, maybe you could just do a 50/50 split and rebalance as needed.  Then you increase your diversification. 
« Last Edit: June 15, 2016, 03:31:06 PM by dougules »

seattlecyclone

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Re: Help! How much to invest in 7% Fixed Rate?
« Reply #8 on: June 15, 2016, 03:31:26 PM »
Do read more about how the guaranteed 7% works exactly. Who is offering this fund? What do they invest in? If the underlying investments return less than 7%, who pays the difference? What if they can't afford it - do they have insurance to make you whole? Basically look for anything at all that might lead to you not getting your 7%. It sounds too good to be true, but if it really works then that's a great option!

fiscalphile

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Re: Help! How much to invest in 7% Fixed Rate?
« Reply #9 on: June 15, 2016, 03:46:05 PM »
Thanks so much for the speedy replies. This community is the best.

I am still thinking/ researching about a lot of the things said, but just some quick replies-

There are definitely restrictions on withdrawals, but rollovers are straight-forward enough upon resignation. I plan to roll over into my Vanguard IRA.

I am not sure how much longer I will hold this position. I feel confident I will be here at least 3 more years. It would be ideal for me to work 7 more years though to attain more incentives, and that would be right around our FIRE timeline. There are a lot of other factors  (my battle with teacher burnout, grad school, the desire to stay in NYC, family issues) at play though.

These numbers in no way account for inflation and I do not see any information about inflation adjustments.

Re-balancing can be done quarterly.

New York State runs this fund and has been doing so for decades, in conjunction with the teachers' union. I will keep scouring for fine print, but it appears very secure.

MDM

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Re: Help! How much to invest in 7% Fixed Rate?
« Reply #10 on: June 15, 2016, 03:56:53 PM »
See Guaranteed 7% return too good to be true?? - Bogleheads.org for more.  In short, thanks to New York taxpayers, it seems legit.

fiscalphile

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Re: Help! How much to invest in 7% Fixed Rate?
« Reply #11 on: June 15, 2016, 04:05:11 PM »
Just to cut through it:  A 7% guaranteed return from a creditworthy counterparty is not an "at market" investment right now.  Long term investment grade bonds, for instance, are yielding 4% (VCLT).  So there are a couple possibilities:

1.  You are factually wrong (i.e. you do not actually have the option to invest in a guaranteed investment that yields 7% per year).
2.  You are missing important facts about the nature of the investment (e.g., the guarantor is incredibly risky, like a junk bond obligor or something along those lines)
3.  Your return is being subsidized by someone that wants something from you (i.e. your employer is incentivizing you to continue working there and willing to pay a premium while you remain employed... or something along those lines... and the return only extends as long as you work).

I don't know the answer, but the question is "what are we (and you) missing here?"  What fund is this exactly?  Also, you say "7% return rate quarterly"--what does that mean?  Is that a 7% annual rate of return paid quarterly???

Hi,

Thanks for your reply- your skepticism is nice, helped me clarify things a bit.

As a public school teacher in a high-needs, high-turnover district, I am represented by an awesome Union. New York State offers this retirement program for government employees, which my Union at least tells me they helped negotiate. The rate of return is set by New York State Legislature (it actually used to be 8.25% guaranteed fix rate from 1988 to 2009 but was reduced to 7%. Teachers hired in 2009 or earlier still receive the 8.25% fixed rate.) Union representatives/ publications/ contracts say that the 7% is legally secure and guaranteed- and if it were ever to change it state law, we are protected by retroactive laws. I have coworkers who have been working for years/ decades in public schools and they speak highly of this aspect of the retirement program.

That having been said, I think this best fits what you called option #3- it was negotiated to retain teachers (and in the city there is very high teacher turn over). I should keep in mind that I will not have the option to stay in the 7% plan forever unless I am "vested" (a few big requirements, most notably that I have worked 10 years total before resignation). If I resign before being "vested", I can only keep my money in the 403B for a max of 7 more years (in a deferral process), otherwise I have to withdraw or rollover the money into an IRA.

beltim

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Re: Help! How much to invest in 7% Fixed Rate?
« Reply #12 on: June 15, 2016, 04:14:57 PM »
This comes down to risk tolerance.  I think the market will return several percentage points better than that 7% long-term, but there will be a significant number of 5 and 10 year periods that the fixed 7% is better.  Under essentially every condition the fixed 7% fund is better than a bond fund, though, and so I would have at least twice as much in the fixed fund as I would otherwise put in a bond fund.

I think the amount of time remaining in your job is important, as is whether you can stay in your plan when you leave your job.  If, for example, you're pretty sure you're only going to be there 3 more years and you can't stay invested in the plan when you leave, I'd have 100% of my investments in the fixed 7% fund.  If you can stay invested in the plan after your leave, then I'd figure out what your permanent asset allocation should be.

A 100% allocation in a fixed 7% return investment allows the 4% rule to work 88% of the time according to cFIRE.  A 25% stock/75% fixed 7% portfolio has a 93% rate.  50/50 gives a 97% success rate, 75/25 also gives a 97% success rate, while 100% stock portfolio has a 95% success rate.  Based on this, something around 50/50 seems optimal.

Reynolds531

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Re: Help! How much to invest in 7% Fixed Rate?
« Reply #13 on: June 15, 2016, 04:27:36 PM »
To be blunt and answer your original question, if the guaranteed is really that good... invest every dime you can.

retiringearly

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Re: Help! How much to invest in 7% Fixed Rate?
« Reply #14 on: June 15, 2016, 06:24:44 PM »
I would be leery of any investment that guarantees 7% when global interest rates are close to zero.

pablo

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Re: Help! How much to invest in 7% Fixed Rate?
« Reply #15 on: June 15, 2016, 07:48:36 PM »
The 7% return is, in fact, a 'guaranteed' return option for NYC teachers in their 403b plans. It takes a bit of explaining, but the basics are this: the funds in the 'guaranteed' option are, behind the scenes, 'invested' with the NYC Teachers' Retirement System. So they are in effect, a liability of the NYC Teachers pension fund. The actuarial rate of return of the pension fund as well as the discount rate are also all 7%. The pension fund itself is guaranteed by NYC. Importantly, the pension funds themselves are 'guaranteed' by the NY State constitution which prevents any vested benefit from being diminished or impaired. While the pension funds are far from 100% funded they are also far from insolvency. NYC has a great tax base which provides annual pension funding.

This deal is fantastic for NY teachers. Not so much for NY taxpayers. It is unique enough that not even other NYC municipal employees have this 7% guaranteed option. It is a well-known option in NYC government employee circles - because the non-teachers would love to get it (but never will).

dougules

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Re: Help! How much to invest in 7% Fixed Rate?
« Reply #16 on: June 16, 2016, 09:04:51 AM »
This comes down to risk tolerance.  I think the market will return several percentage points better than that 7% long-term, but there will be a significant number of 5 and 10 year periods that the fixed 7% is better.  Under essentially every condition the fixed 7% fund is better than a bond fund, though, and so I would have at least twice as much in the fixed fund as I would otherwise put in a bond fund.

I think the amount of time remaining in your job is important, as is whether you can stay in your plan when you leave your job.  If, for example, you're pretty sure you're only going to be there 3 more years and you can't stay invested in the plan when you leave, I'd have 100% of my investments in the fixed 7% fund.  If you can stay invested in the plan after your leave, then I'd figure out what your permanent asset allocation should be.

A 100% allocation in a fixed 7% return investment allows the 4% rule to work 88% of the time according to cFIRE.  A 25% stock/75% fixed 7% portfolio has a 93% rate.  50/50 gives a 97% success rate, 75/25 also gives a 97% success rate, while 100% stock portfolio has a 95% success rate.  Based on this, something around 50/50 seems optimal.

+1 

On top of that, OP, it would probably be good to play around with cfiresim yourself and look at different scenarios.  You can put the fixed return in as "cash" with a return of 7%.  It confirmed my suspicion that a return to 70s style inflation would really hurt on the fixed percentage option.  But running the sim yourself would give you the power to make an informed decision. 

forummm

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Re: Help! How much to invest in 7% Fixed Rate?
« Reply #17 on: June 16, 2016, 12:39:42 PM »
A 100% allocation in a fixed 7% return investment allows the 4% rule to work 88% of the time according to cFIRE.  A 25% stock/75% fixed 7% portfolio has a 93% rate.  50/50 gives a 97% success rate, 75/25 also gives a 97% success rate, while 100% stock portfolio has a 95% success rate.  Based on this, something around 50/50 seems optimal.

Since it's a fixed return and a fixed spending rate (other than inflation), the failure scenarios with 100% in the fixed return fund must be when inflation went really high. In those high inflation times, stock prices should go up (like everything else), hence the very low 50/50 failure rate.

I would be a little surprised if the market exceeds 7% over the next 5-10 years. If I had the 7% option, I would put a lot of money in it.

beltim

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Re: Help! How much to invest in 7% Fixed Rate?
« Reply #18 on: June 16, 2016, 01:01:18 PM »
A 100% allocation in a fixed 7% return investment allows the 4% rule to work 88% of the time according to cFIRE.  A 25% stock/75% fixed 7% portfolio has a 93% rate.  50/50 gives a 97% success rate, 75/25 also gives a 97% success rate, while 100% stock portfolio has a 95% success rate.  Based on this, something around 50/50 seems optimal.

Since it's a fixed return and a fixed spending rate (other than inflation), the failure scenarios with 100% in the fixed return fund must be when inflation went really high. In those high inflation times, stock prices should go up (like everything else), hence the very low 50/50 failure rate.

I would be a little surprised if the market exceeds 7% over the next 5-10 years. If I had the 7% option, I would put a lot of money in it.

Yes, pretty much all of the failures included the high-inflation years in the 70s.  If it were me, I'd be tempted to do some market timing here not based on stock prices, but on inflation.  My guess is you could figure out an inflation level that made sense to switch to stocks instead of the fixed return, and an inflation level to switch back, and you could increase your success rate (and probably withdrawal rate).

I would be leery of any investment that guarantees 7% when global interest rates are close to zero.

If you use a 4% SWR, then you should be comfortable with an institution that's able to back a 7% fixed return.  A 4% inflation-adjusted withdrawal rate at a 3% average inflation works over a 30-year time frame well over 90% of all time frames.  An institution should be able to profit off this over a longer time frame.

Vagabond76

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Re: Help! How much to invest in 7% Fixed Rate?
« Reply #19 on: June 16, 2016, 02:08:55 PM »
Geez, I recall all the grief I took when I explained how I earn a 6.5% return, tax deferred, on unlimited contributions.  Now I see that I should have changed "whole life insurance" to "403b".

forummm

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Re: Help! How much to invest in 7% Fixed Rate?
« Reply #20 on: June 16, 2016, 03:13:20 PM »
A 100% allocation in a fixed 7% return investment allows the 4% rule to work 88% of the time according to cFIRE.  A 25% stock/75% fixed 7% portfolio has a 93% rate.  50/50 gives a 97% success rate, 75/25 also gives a 97% success rate, while 100% stock portfolio has a 95% success rate.  Based on this, something around 50/50 seems optimal.

Since it's a fixed return and a fixed spending rate (other than inflation), the failure scenarios with 100% in the fixed return fund must be when inflation went really high. In those high inflation times, stock prices should go up (like everything else), hence the very low 50/50 failure rate.

I would be a little surprised if the market exceeds 7% over the next 5-10 years. If I had the 7% option, I would put a lot of money in it.

Yes, pretty much all of the failures included the high-inflation years in the 70s.  If it were me, I'd be tempted to do some market timing here not based on stock prices, but on inflation.  My guess is you could figure out an inflation level that made sense to switch to stocks instead of the fixed return, and an inflation level to switch back, and you could increase your success rate (and probably withdrawal rate).

I had the same thought. I think it's not the same as normal market timing because inflation tends to be pretty predictable and move much more slowly than markets, and you're comparing it vs a fixed rate with some known rule set in advance. If inflation is 10%, you don't want to be in a 7% return scenario.

marty998

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Re: Help! How much to invest in 7% Fixed Rate?
« Reply #21 on: June 16, 2016, 03:48:47 PM »
NYC taxpayers include the teachers that work in the district.

In that sense you are also funding the guaranteed rate of return through taxes that are higher than they otherwise would be. But of course you benefit quite a bit more from what you put in.

My 2c, take the 7%, put everything you can into it and sleep soundly at night.

beltim

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Re: Help! How much to invest in 7% Fixed Rate?
« Reply #22 on: June 16, 2016, 04:25:01 PM »
This deal is fantastic for NY teachers. Not so much for NY taxpayers.

NYC taxpayers include the teachers that work in the district.

In that sense you are also funding the guaranteed rate of return through taxes that are higher than they otherwise would be. But of course you benefit quite a bit more from what you put in.

Actually, the average long-term return of public pension funds is over 7%.  So the state guarantees the return, but as long as the fund invest as well as the average public pension, the state has saved the taxpayer money.

The Happy Philosopher

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Re: Help! How much to invest in 7% Fixed Rate?
« Reply #23 on: June 18, 2016, 10:28:53 AM »
I would invest every penny I had in a 7% guaranteed return in this if it was available to me.

beltim

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Re: Help! How much to invest in 7% Fixed Rate?
« Reply #24 on: June 18, 2016, 10:40:47 AM »
I worry that there might be some bad thinking in some of the posts that are trying to run this 7% return instrument through things like firecalc and looking at this like a long term bond.  From what I read in the OP's description this is not like a long term bond but more like a short term bond that happens to pay a very high (taxpayer subsidized) interest rate.  If inflation and rates go up but this instrument's rate does not, it sounds like the investor can simply move the intact principal to an alternative investment.  In contrast, when inflation expectations move higher long term nominal bonds lose value (fast) and you can only sell them at a discount to par.  This investment in contrast may be more like having a money market account that pays 7%--very little duration risk (sensitivity to rates) and can be reallocated at will.  If that is true, and the counterparty is creditworthy, the instrument is off market and basically has free money embedded in it.  I may be missing something--I have not researched the terms of this investment in depth and just going by what OP has said.

I think the vast majority of the discussion has treated the 7% fixed investment as similar to a money market account  see for example the discussion between forummm and myself, and the fact that in cFIREsim we modeled this investment using "cash" at a 7% interest rate. 

beltim

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Re: Help! How much to invest in 7% Fixed Rate?
« Reply #25 on: June 18, 2016, 01:09:11 PM »

I think the vast majority of the discussion has treated the 7% fixed investment as similar to a money market account see for example the discussion between forummm and myself, and the fact that in cFIREsim we modeled this investment using "cash" at a 7% interest rate.

Thanks for the clarification--sorry I missed that.  I still worry what you did in cfiresim is not a great way to model this investment and let me explain my thinking--

The attraction of this investment is the embedded subsidy and you should dynamically move out of the investment (change the allocation) if the subsidy goes away.  So assuming someone would hold a large allocation to this investment in a static way (i.e. at nominal 7%) through a period like the 1970's and early 80's (high inflation) is bad because I don't think someone paying attention would do that (I wouldn't) and by assuming they would you are misrepresenting the value proposition of this investment in those scenarios.  By not either assuming that the rate jumps to maintain the subsidy or that there is dynamic asset allocation I think you are failing to capture the real value here.  If the rate didn't adjust to changing conditions a smart investor would say "hey, my subsidy went away so I will return this pool to my generic asset allocation" not let inflation tear into a stale investment. 


The subsidy isn't fixed.  And in fact it's not set up specifically as a subsidy - it's just a guaranteed form of the pension fund using its long-term return projections.  So the state backs it, but doesn't necessarily subsidize it.  And in fact the fixed return was higher a few decades ago at 8.25% or something like that.

Quote
My point is that the allocation rule should not be fixed but should be something along the lines of "maintain the allocation as long as a significant subsidy is embedded in the rate".  If you model that behavior you should get a better outcome (in terms of percentages of success against a 4% WR, for instance) than leaving a static allocation like in cfiresim.  Agree?  Disagree?  What am I missing?  This isn't market timing--it's just a rule that says when my employer offers me free money take it and when the free lunch goes away stop. 

You missed the part where forummm and I discussed this exact strategy.  I didn't model it because I'd have to make my own tool to do so.