Two of The Worst Investments for FDNY & NYPD Retirees

When FDNY Firefighters and NYPD Police Offers retire their investment opportunity set is no longer limited to what is available in the NYC Def Comp Plan and the Union Annuity Plans. However, the increase in flexibility also increases the risk of stepping on an investment landmine. In this note we make our case that Fixed Annuities and Stable Value Funds are two of the worst investments for FDNY and NYPD retirees. Fixed annuities are mostly available through insurance companies and financial advisors. Stable Value Funds are not a real asset class and can only be found within retirement plans like the NYC Deferred Compensation Plan and Union Annuity Plans.

Inflation - The Key Risk

Most retirees innately know that inflation is the biggest risk they face. FD and PD retirees receive defined benefit payments in retirement. The cost of living adjustment on the payments is an immaterial amount. These retirees receive what amounts to a fixed pension for the rest of their lives. The value of fixed payments over time erodes because of inflation. Your future dollars buy less goods and services over time.

A Holistic Perspective

We consider the pension as 'human capital', i.e., the present value of the retirees future income stream. Inflation risk to the pension is the hand that we are dealt. Once we accept this it follows that we should use 'financial capital', i.e., the investment portfolio, to hedge or reduce the risk of inflation.

A holistic perspective considers both human capital and financial capital. This is our framework at Brave Eagle Wealth Management. We use financial capital to build a 'Completion Portfolio' around the pension asset.

Fixed Annuities

There is an investment case to be made for dedicating a portion of the investment portfolio to a fixed annuity, in general. For example, consider a retiring Doctor that has accumulated a $10M nest egg over her working career. The Doctor has considerable wealth but no fixed payout. In this case the Doctor may want to consider purchasing a fixed annuity, with the remainder of the portfolio invested in financial assets (variable). The Doctor's portfolio is better diversified with both fixed and variable investments. This is not the case for retired FDNY and NYPD that have a lifelong pension. Adding a fixed annuity to a portfolio that already contains a pension increases inflation risk rather than hedging against it. In form the pension and the fixed annuity are the same thing. Both provide a fixed stream of income for the rest of the retiree's life. In most cases there is no need to purchase an incremental fixed annuity on top of the pension. Of course, investment prospects should always be considered. With interest rates close to all-time lows annuities should be expected to have low payouts. Annuities are illiquid and there is usually a penalty to get out.

Stable Value Funds

Stable Value Funds are perhaps the most misunderstood Funds in the retirement plans. Stable Value Funds are often referred to as "guaranteed". This is correct as long as you understand that the guarantee is being provided by an insurance company. And, the payout is only guaranteed for three months, not indefinitely. There is a big difference between 'guaranteed' and 'risk-free'. There is only one risk-free instrument in the world of investments and it is provided by the US Treasury.

Consider the following hypothetical scenario. A risk-averse Chief retires after a 30 year career. The Chief disdains market volatility so he decides to roll his entire life savings of $500,000 into a Stable Value Fund. The Chief feels that the low 'guaranteed' rate of return is sufficient because the investment is low-risk.

It is important to understand risk in this framework. Stable Value investors equate the lack of volatility with low risk. However, the lack of volatility is a mirage made possible through Wall Street financial engineering. The underlying investments in Stable Value Funds are subject to volatility just like any other publicly traded instrument that is 'marked to market'. The difference here is that Stable Value Funds are allowed to use book value accounting rather than mark to market accounting. Why? The ability to report at book value is made possible through what is known as an insurance wrapper or a guaranteed investment contract (GIC) provided by an insurance company.

This amounts to simply trading away one risk for another. Stable Value investors are trading away volatility risk to the insurance companies and assuming the credit risk of the insurer. The insurance companies are happy to assume the volatility. In turn, the insurance companies get to keep the investment returns over and above the payout to Stable Value Investors. Since they are facilitating this trade-off you can guess that they are probably on the right side of the trade.

Current Stable Value payout rates are either below, or slightly above, expected inflation and offer no 'real' (total return - inflation) return. In a rising interest rate environment Stable Value Funds could potentially increase the payout rate. However, this will most likely happen with a significant lag (years). Stable Value Funds offer little potential to hedge inflation, and offer little to no real return. Volatility risk is low, traded away for the credit risk of the insurance company(s).

Conclusion

Fixed Annuities and Stable Value Funds are two of the worst long-term investments for retired NYC Firefighters and Police Officers. Fixed annuities increase the retirees exposure to inflation risk. Low rates of return and the illiquidity characteristics of fixed annuities are also unattractive. Stable Value Funds are a low (no) volatility mirage brought to you through Wall St. financial engineering that allows the Funds to report at book value. Stable Value Investors have traded away volatility risk for the credit risk of an insurance company(s). The reward for this risk transfer is almost non-existent in real terms, as the payout rates are roughly inflationary. Stable Value Funds offer no long-term wealth building potential. In the example above our retired Chief's entire investment portfolio consists of a concentrated (not diversified) credit risk to an insurance company.