Playing it Safe

By Philip J. Beavers, CFP,
WEAC's Member Benefits Specialist

April 1998

Financial Planning Seminars
Achieving Financial Independence

Choosing the right low-risk investments

With the increased volatility of the stock market — which affects the performance of stocks, stock mutual funds, and variable annuities — members have been asking about alternate low-risk investment choices. Following are some suggestions to consider.

For lowest risk consider paying off or paying down debt. Most people realize it would not make sense to look for investment ideas at the same time they had consumer debt.

You should work to eliminate taxable interest payments before considering other investments. It may be a bit less obvious when considering paying down a mortgage when the interest is tax deductible.

Paying off a mortgage

Some financial experts argue that homeowners would be better off investing any spare cash into the stock and bond markets. The arguments are that you will earn a higher investment return, ensure easy access to your money, and continue to have tax deductible mortgage interest.

First, consider the question of investment returns. If we agree that a risk-free investment return stops at around 7%, it might make sense to invest rather than paying down your mortgage, if your mortgage rate is lower than 7%. However, some degree of market risk would be necessary to beat paying extra on your mortgage if you had to realize a return greater than 7%. Remember what happened in 1994 – the average stock mutual fund lost 2.09% and the average bond fund lost 3.57%.

Paying extra principal payments on your mortgage may have the following additional advantages:

• Once you have paid off your mortgage, you have eliminated a major monthly expense which makes it easier to retire.
• If you pay off the mortgage by the time your kids go to college, it will free up money for tuition bills.
• If you pay down your mortgage instead of accumulating investments in a taxable account, you probably improve your family’s chances of qualifying for student financial aid.
• Finally, making extra mortgage payments has the virtue of simplicity. You won’t have to spend hours at the library or with an investment advisor trying to figure out which stocks, bonds, and/or mutual funds to buy.

Money Market Mutual Funds

Most money market funds are not insured. However, risk is quite low due to the type of investments they can make. You earn higher interest rates than with regular savings accounts and your money is readily accessible. Recently, when the U. S. average money market rate was 4.84%, the NEA Insured Money Market Fund yield was 5.42% (1-800-345-0394).

Series EE Savings Bonds

Savings bonds allow conservative investors to defer federal income taxes until the bonds are redeemed and to completely avoid state income taxes. Bonds purchased after May 1, 1997, will earn 90% of the five-year treasury note average, which is set twice a year — May 1 and November 1. At the current 5-year treasury note rate, savings bonds will earn 5.22% with no current tax. Savings bonds can be purchased at most banks, savings and loan and credit unions at no cost.

U. S. Treasury Securities

U. S. Treasuries can be purchased direct at no cost and carry no investment risk other than the liquidity consideration. The advantages of direct purchases of treasury issues are often overlooked simply because the federal government is not as energetic about promotion as are banks and mutual fund companies. In addition to safety, the income received from treasuries is exempt from state taxes.

Under new rules, it is easier to buy, reinvest, and sell treasuries direct. You can buy from a three-month to a two-year treasury note which would be considered very low interest rate risk. Recent yields were three-months at 5.2%, six-months at 5.4%, one-year at 5.6%, and two-years at 5.8%. If you are in the 6.9% state tax bracket, you would need to earn a 5.91% fully tax yield to match a 5.5% treasury yield. To obtain a tender form to buy treasures direct, write or call a Federal Reserve Bank: FRB Chicago, P.O. Box 834, 250 Marquette Avenue, Chicago IL 60690 (312/322-5369) or FRB Minneapolis, Minneapolis MN 55480 (612/340-2075).

On the Internet, go to: www.publicdebt.treas.gov.

Certificates of Deposit (CDs)

CDs come in various maturity periods with higher rates for longer maturities. The following are sample CD rates: Six months 5.5% 1 year 5.7% 2? year 5.9% No-load, short-term corporate bond mutual funds This would be for people willing to accept a low interest rate risk. Recent yields range from 6% to 7%. Fund families to consider include: Scudder (1-800-225-2470), Strong (1-800-368-1030), Vanguard (1-800-662-7447), and USAA (1-800-382-8722).

Tax-free money market funds or municipal bond funds

This is an option for people in the 28% federal tax bracket. Federally tax-free fund yields are 3.85% to 5.75%. At the 28% federal tax bracket a 4.5% tax-free yield would be equivalent to 6.25% fully taxed. To determine the equivalent fully taxed yield, divide tax-free yield by 1 minus your federal tax bracket.

Posted April 3, 1998