What Is the Accumulation Phase?

Accumulation phase has two meanings for investors and those saving for retirement. It refers to the period when an individual is working and planning and ultimately building up the value of their investment through savings. The accumulation phase is then followed by the distribution phase, in which retirees begin accessing and using their funds.

How the Accumulation Phase Works

The accumulation phase is also a specific period when an annuity investor is in the early stages of building up the cash value of the annuity. This building phase is followed by the annuitization phase, where payments are paid out to the annuitant.

The accumulation phase essentially begins when a person starts saving money for retirement and ends when they begin taking distributions. For many people, this starts when they begin their working life and ends when they retire from the work world. It is possible to start saving for retirement even before beginning the work phase of one’s life, such as when someone is a student, but it is not common. Typically, joining the workforce coincides with the start of the accumulation phase.

Importance of the Accumulation Phase

Experts state that the sooner an individual begins the accumulation phase, the better, with the long-term financial difference between beginning to save in one’s 20s vs. in the 30s substantial. Postponing consumption by saving during an accumulation period will most often increase the amount of consumption one will be able to have later. The earlier the accumulation period is in your life, the more advantages you will have, such as compounding interest and protection from business cycles.

In terms of annuities, when a person invests money in an annuity to provide income for retirement, they are at the accumulation period of the annuity’s life span. The more invested during the accumulation phase, the more will be received during the annuitization phase.

Real-World Examples

There are many income streams that an individual can build up during the accumulation phase, starting from when they first enter the workforce, or in some cases, sooner. Here are a few of the more popular options.

• Social Security: This is a contribution automatically deducted from every paycheck you receive.
• 401(k): This is an optional tax-deferred investment that can be made paycheck-to-paycheck, monthly, or yearly provided your employer offers such an option. The amount you can set aside has yearly limits and also depends on your income, age, and marital status.
• IRAs: An Individual Retirement Account can be either pretax or after-tax, depending on which option you choose. The amount you can invest varies year-to-year, as set out by the Internal Revenue Service (IRS), and depends on your income, age, and marital status.
• Investment portfolio: This refers to an investor’s holdings, which can include assets such as stocks, government, and corporate bonds, Treasury bills, real estate investment trusts (REITs), exchange-traded funds (ETFs), mutual funds, and certificates of deposits. Options, derivatives and physical commodities like real estate, land and timber can also be included in the list.
• Deferred payment annuities: These annuities offer tax-deferred growth at a fixed or variable rate of return. They allow individuals to make monthly or lump-sum payments to an insurance company in exchange for guaranteed income down the line, typically 10 years or more.
• Life insurance policies: Some policies can be useful for retirement, such as if an individual pays an after-tax, fixed amount annually that grows based on a particular market index. The policy would need to be the kind that allows the individual to withdraw in retirement the principal and any appreciation from the policy essentially tax-free.

What Is the 11th District Cost of Funds Index?

The 11th District Cost of Funds Index (COFI) is a monthly weighted average of the interest rates paid on checking and savings accounts offered by financial institutions operating in Arizona, California, and Nevada. It is one of many indices used by mortgage lenders to adjust the interest rate on adjustable rate mortgages (ARM) and was launched in 1981. With an ARM mortgage, the interest rate on a mortgage moves up and down along with some standard interest rate chosen by the lender, and COFI is one of the most popular indices in the western states.

Published on the last day of each month, the COFI represents the cost of funds for western savings institutions that are members of Federal Home Loan Bank of San Francisco, a self-regulatory agency, and satisfy the Bank’s criteria for inclusion in the index.

Understanding the 11th District COFI

The 11th District Cost of Funds Index (COFI) is computed using several different factors, with interest paid on savings accounts comprising the largest weighting in the average. As a result, the index tends to have low volatility and follow market interest rate changes somewhat slowly; it is generally regarded as a two-month lagging indicator of market interest rates. The interest rate on a mortgage will not match the COFI, rather the ARM rate is typically 2% to 3% higher than COFI, depending on the borrower’s credit history, the size and terms of the loan, the ability of the borrower to negotiate with the bank and many other factors.

Because it is computed using data from three western states, the COFI is primarily used in the western U.S., while the 1-year Treasury index is the measure of choice in the eastern region. On April 30, the Federal Home Loan Bank of San Francisco announced the COFI for March 2018 of 0.814%, slightly lower than February.

What Is an Auction Market?

In an auction market, buyers enter competitive bids and sellers submit competitive offers at the same time. The price at which a stock trades represents the highest price that a buyer is willing to pay and the lowest price that a seller is willing to accept. Matching bids and offers are then paired together, and the orders are executed. The New York Stock Exchange (NYSE) is an example of an auction market.

Auction Market Process

The process involved in an auction market differs from the process in an over-the-counter (OTC) market. On the NYSE, for example, there are no direct negotiations between individual buyers and sellers, while negotiations occur in OTC trades. Most traditional auctions involve multiple potential buyers or bidders, but only a single seller, whereas auction markets for securities have multiple buyers and multiple sellers, all looking to make deals simultaneously.

Double Auction Markets

An auction market also known as a double auction market, allows buyers and sellers to submit prices they deem acceptable to a list. When a match between a buyer’s price and a seller’s asking price is found, the trade proceeds at that price. Trades without matches will not be executed.

Examples of the Auction Market Process

Imagine that four buyers want to buy a share of company XYZ and make the following bids: $10.00, $10.02, $10.03 and $10.06, respectively. Conversely, four sellers wish to sell shares of company XYZ, and these sellers submitted offers to sell their shares at the following prices: $10.06, $10.09, $10.12 and $10.13, respectively.

In this scenario, the individuals that made bids/offers for company XYZ at $10.06 will have their orders executed. All remaining orders will not immediately be executed, and the current price of company XYZ will be $10.06.

Treasury Auctions

The U.S. Treasury holds auctions to finance certain government financial activities. The Treasury auction is open to the public and various larger investment entities. These bids are submitted electronically and are divided into competing and noncompeting bids depending on the person or entity who places the recorded bid.

Noncompeting bids are addressed first because noncompetitive bidders are guaranteed to receive a predetermined amount of securities as a minimum and up to a maximum of $5 million. These are most commonly entered by individual investors or those representing small entities.

In competitive bidding, once the auction period closes, all of the incoming bids are reviewed to determine the winning price. Securities are sold to the competing bidders based on the amount listed within the bid. Once all of the securities have been sold, the remaining competing bidders will not receive any securities.

What Is Average Life?

The average life is the length of time the principal of a debt issue is expected to be outstanding. Average life does not take into account interest payments, but only principal payments made on the loan or security. In loans, mortgages, and bonds, the average life is the average period of time before the debt is repaid through amortization or sinking fund payments.

Investors and analysts use the average life calculation to measure the risk associated with amortizing bonds, loans, and mortgage-backed securities. The calculation gives investors an idea of how quickly they can expect returns and provides a useful metric for comparing investment options. In general, most investors will choose to receive their financial returns earlier and will, therefore, choose the investment with the shorter average life.

Understanding Average Life

Also called the weighted average maturity and weighted average life, the average life is calculated to determine how long it will take to pay the outstanding principal of a debt issue, such as a Treasury Bill (T-Bill) or bond. While some bonds repay the principal in a lump sum at maturity, others repay the principal in installments over the term of the bond. In cases where the bond’s principal is amortized, the average life allows investors to determine how quickly the principal will be repaid.

The payments received are based on the repayment schedule of the loans backing the particular security, such as with mortgage-backed securities (MBS) and asset-backed securities (ABS). As borrowers make payments on the associated debt obligations, investors are issued payments reflecting a portion of these cumulative interest and principal payments.

Calculating the Average Life on a Bond

To calculate the average life, multiply the date of each payment (expressed as a fraction of years or months) by the percentage of total principal that has been paid by that date, add the results, and divide by the total issue size.

For example, assume an annual-paying four-year bond has a face value of $200 and principal payments of $80 during the first year, $60 for the second year, $40 during the third year, and $20 for the fourth (and final) year. The average life for this bond would be calculated with the following formula:

($80 x 1) + ($60 x 2) + ($40 x 3) + ($20 x 4) = 400

Then divide the weighted total by the bond face value to get the average life. In this example, the average life equals 2 years (400 divided by 200 = 2).

This bond would have an average life of two years against its maturity of four years.

Mortgage-Backed and Asset-Backed Securities

In the case of an MBS or ABS, the average life represents the average length of time required for the associated borrowers to repay the loan debt. An investment in an MBS or ABS involves purchasing a small portion of the associated debt that is packaged within the security.

The risk associated with an MBS or ABS centers on whether the borrower associated with the loan will default. If the borrower fails to make a payment, the investors associated with the security will experience losses. In the financial crisis of 2008, a large number of defaults on home loans, particularly in the subprime market, led to significant losses in the MBS arena.

Special Considerations

While certainly not as dire as default risk, another risk bond investors face is prepayment risk. This occurs when the bond issuer (or the borrower in the case of mortgage-backed securities) pays back the principal earlier than scheduled. These prepayments will reduce the average life of the investment. Because the principal is paid back early, the investor will not receive future interest payments on that part of the principal.

This interest reduction can represent an unexpected challenge for investors of fixed-income securities dependent on a reliable stream of income. For this reason, some bonds with payment risk include prepayment penalties.