Letters to the Editor

Mortgage Backed Securities

I received this from Al:

Subject: Income from interest and dividends

When I reach 60 years old (2 years from now), I will have approx. $1,800,000. My thought was to purchase MBS [Mortgage Backed Securities]. I assume that 5.5 to 6% will be available on yields from them. This would give me an income stream of $99,000 to $108,000. Down side is principal payments/ reinvestment yields available/ regular tax rates and no growth potential. Upside is no principal risk. Is this a poor investment idea??? Any recommendations?

HERE IS MY RESPONSE

I am not in a position to give advice on specific investments.

I wish to give you tools to help you make your own decisions. Everyone’s circumstances are different. So are their preferences.

The first thing is to establish a baseline.

I went to www.bloomberg.com to look at interest rates. The current interest rate on a 15-year mortgage is 4.92%. The current interest rate on a 30-year mortgage is 5.33%.
Bloomberg Web Site
Bloomberg Interest Rates

This leads me to believe that your numbers assume a final balance of zero.

The annual payment on a 30-year mortgage at 5.33% is (close to) 6.75%. This could cover 0.75% to 1.25% in fees and still leave you with an income stream of 5.5% to 6.0%. Most likely, you would reinvest part of your income to make it last beyond 30 years.

One alternative is to buy a low cost, single payment annuity. [Be very careful. Most annuities come at a high cost.] We will use this as a baseline.

I went to Vanguard’s web site. The section that we are after is An annuity that provides retirement income. I took advantage of Request a Quote. Here are the relevant links.
Vanguard Web Site
Vanguard Annuities

Request a Quote requires that payments begin no sooner than 30 days and no later than one year. I acted as if you were already 60 years old and about to retire. I started payments in October 1, 2005. I found that I could not get any quotes using an amount of $1800000. I could with $180000. [Apparently, a person with $1800000 must talk with an advisor.]

Here are the other inputs:
Purchaser: Male, Florida residence, August 1, 1945 birthday.
Wife: Female, Florida residence, February 1, 1946 birthday.

Here are the quotes for constant dollar income streams. These make no adjustments for inflation. Multiply by 10 to get the income on your $1800000 investment.

1) Life only without any inflation adjustments, but with a 10-year guaranteed payout period: $1026.91 per month (or $12322.92 per year or 6.85% of $180000).
2) Joint and survivor without any inflation adjustments (50% survivor benefit): $962.79 per month (or $11553.48 per year or 6.42% of $180000).
3) Joint and survivor without any inflation adjustments (75% survivor benefit): $920.25 per month (or $11043.00 per year or 6.14% of $180000).
4) Joint and survivor without any inflation adjustments (100% survivor benefit): $889.48 per month (or $10673.76 per year or 5.93% of $180000).

Here are the quotes for payments that include an adjustment for inflation:

1) Life only with inflation adjustments: $710.88 per month (or $8530.56 per year or 4.74% of $180000).
2) Joint and survivor with inflation adjustments (50% survivor benefit): $630.53 per month (or $7566.36 per year or 4.20% of $180000).
3) Joint and survivor with inflation adjustments (100% survivor benefit): $566.65 per month (or $6799.80 per year or 3.78% of $180000).

A low cost annuity makes an excellent baseline. It produces an income stream that is at least as high as you have mentioned. It adds choices with inflation adjustments.

What about mutual fund choices?

I may have been wrong about the final balance. It may be that you are interested in something that without a final balance of zero. If so, your income is smaller.

I found this at the Vanguard site.

Vanguard GNMA fund VFIIX. Currently, 4.41% yield. Expenses 0.20%.
Vanguard GNMA (VFIIX)

I visited the Bloomberg site. I looked at Asset Back Securities at the Fund Center. [Watch out. Several of the funds listed are speculative (junk) bond funds.] I checked the fees. Vanguard’s fees were very low. PIMCO’s PTRIX fees totaled 0.75%. Several funds had fees exceeding 1.0%.
Bloomberg Fund Center

In terms of what I saw, all of the non-liquidating, open-ended, mortgage backed mutual funds offer yields similar to Vanguard’s. They provide income streams lower than 5.5% to 6.0%.

These rates are similar to current long-term treasury yields, including TIPS.

[Note: TIPS current yields are back to 2%. The inflation adjustment increases the principal. Assuming that the current inflation rate (3%) persists, TIPS would provide a coupon of 2% and a principal increase of 3%, totaling 5% per year. For those with several years before retirement, a good way to recover this increase in principal is to build a TIPS ladder. It allows you to avoid selling in the secondary market.]

Vanguard had these remarks about Who Should Invest in their GNMA fund.
1) Investors seeking a high level of interest income.
2) Investors seeking a fixed-income investment to balance the risks of a portfolio containing stocks.
3) Investors with a long-term investment horizon (at least five years).

This is what Vanguard said about Who Should Not Invest.
1) Investors unwilling to accept significant fluctuations in share price.
2) Investors seeking long-term growth of capital.

General Comments about Mortgage Backed Securities

Here are my personal observations.

1) Mortgage Backed Securities are priced to sell at an interest rate premium. They do best when interest rates are stable. Their initially high interest rates are your compensation for what happens at other times. They behave badly whenever mortgage rates change.
2) If mortgage rates increase, mortgage holders hold on to their low interest rates as long as possible.
3) If mortgage rates fall, mortgage holders refinance. You get your principal back early, when there is no attractive place to put your money.
4) Mortgage Backed Security payments are fixed. As with conventional bonds, they lose buying power to inflation.

I searched www.nofeeboards.com for additional remarks. I located two older threads. Their remarks were generally unfavorable.

From the General Finance board:
Mortgage backed securities dated Wed Jul 14, 2004 by Alec.
NFB Mortgage Backed Securities Thread

From the Index Funds board:
Mortgage Bonds vs Bond Funds dated Fri May 09, 2003 by Oliver.
NFB Mortgage Bonds vs Bond Funds Thread

Additional Comments

There probably is a place for Mortgage Back Securities in your retirement portfolio. How much? I do not know. Maybe even 100%.

You now have a baseline. This gets you into the ballpark. You can get $68000 to $85000 plus inflation annually with a low cost annuity. You can get $106700 to $123000 annually if you exclude adjustments for inflation.

There are more important things for you to do right now.

1) Determine how much you need. Most likely, it is much less than you imagine.
2) Remember that your needs will be a fraction of your pre-retirement expenses, not income. This is where most articles get it wrong. Very few people need 75% to 80% of their pre-retirement income. They may need 75% to 80% of their pre-retirement expenditures. My bet is that even one-third of your pre-retirement income would be adequate.
3) Separate expenditures into those that you actually need, those that you want in order to be comfortable and those that would be nice to have for luxury items.
4) Pay special attention to health care and the cost of health insurance.
5) Identify your income sources. For example, include Social Security, if applicable.
6) Match your needs and wants with income streams from suitable investments. Cover your actual needs with dependable, low risk income sources.

Figure out how much you want to learn about investing. The early lessons pay very well. If you can cut you investment expenses by 1%, you will save $18000 annually, based on your $1800000 nest egg. Many mutual fund investors can save 1% by paying attention to fees.

My impression is that you were willing to pay 0.75% to 1.25% in fees for your Mortgage Back Securities. That’s a lot of money.

Earlier Letters

P/E10 Graph, Zvi Bodie's Book and more.
P/E10 Graph, Zvi Bodie's Book and more

Here is a link to a recent letter from Greg about TIPS and taxable (non-qualified) accounts .
TIPS and taxable (non-qualified) accounts

Here is a link to an earlier discussion with Rob Bennett about SAFE and HAZARDOUS REGIONS.
SAFE and HAZARDOUS REGIONS

Here is a link to an early discussion with Rob Bennett about Safe Withdrawal Rates and Historical Surviving Withdrawal Rates. It grew out of my May 2005 Highlights article.
Safe Withdrawal Rates and Historical Surviving Withdrawal Rates

Have fun.

John Walter Russell
July 30, 2005