It’s often said that one’s ability to delay gratification is an important factor of success in personal finance. When you don’t buy that new whatever until you have enough money to pay for it, you save on interest you would otherwise pay. When you save a portion of your current pay for retirement, you are foregoing higher consumption at the present for better living years into the future.
Series EE Savings Bonds (“EE Bonds”) are one such test for delayed gratification. EE Bonds are a type of savings bonds issued by the US Treasury to small savers and investors (the other type is I Bonds). In addition to buying $10,000 per year per Social Security Number in I Bonds, you can buy another $10,000 per year per Social Security Number in EE Bonds.
EE Bonds pay a fixed interest rate, currently at 0.6% a year. That’s low, considering that you can get 0.9% to 1.05% in a “high yield” savings account from say American Express or CIT Bank. But EE Bonds offer a bonus at the end of 20 years. The value is guaranteed to double if you hold that long. This means that if you buy $10,000 EE Bonds, after 19 years 11 months the redemption value is only $11,265. One month later, it jumps to $20,000.
If you hold on for 20 years, the average annual return comes out to 3.5%. This compares favorably to the yield on regular 20-year Treasury bonds at 2.4-2.5%. Once again, this is one of the cases where individual investors have an advantage over institutional investors, but only if you are able to delay gratification for the full 20 years. The chart below shows the value of a 2.5% 20-year Treasury assuming all interest payments are reinvested at the same rate.
Compared to an instrument that pays 3.5% a year evenly, you can say EE Bonds effectively have an increasing early redemption penalty. The most severe case would be at 19 years 11 months and 29 days. If you can’t wait just one more day, you would pay a penalty of more than $8,000 to redeem bonds worth $20,000. That’s insane.
If you buy EE Bonds, you must plan on holding them for 20 years. Once you hold them for a few years, the effective early redemption penalty will be quite large.
EE Bonds vs Rolling CDs
20 years is a long time. What if you buy a CD now and see what happens after a few years?
It could work if rates rise. Suppose you buy a 5-year CD from CIT Bank that pays 1.8% today, then another one at 2.8% after it matures five years from now, then at 4.8% for the next two rounds, you will get to about the same place as buying EE Bonds. This scenario is not implausible but who knows what CD rates will be 5, 10, or 15 years in the future.
Buying CDs of course gives you flexibility. At each renewal, you get a chance to see if there’s a better use of your money elsewhere. It’s a reasonable alternative if interest rates will go up. If interest rates stay low though, you would be better off in EE Bonds.
EE Bonds for College Expenses
Current laws allow tax-free treatment of interest on EE Bonds used for higher education expenses. A holding period of 20 years matches well with the need for college expenses for a baby. There is an income limit for the tax exclusion. The modified AGI phaseout range started at $71,100 for single and $106,650 for married filing jointly as of 2011. The income limit will go up with inflation.
If you anticipate that your income in 20 years will be under the limit and the laws won’t change by then, EE Bonds can be used to supplement a 529 plan.
Buy EE Bonds Or Not?
Can I resist the temptation of getting paid more now, say in a 5-year CD, versus waiting for the final bonus from EE Bonds in 20 years? I must admit it’s very hard. Will I realistically be able to hold this thing for 20 years? I have to be honest with myself: I don’t have an iron will. The chances of my abandoning it in the next 20 years are very high.
The delay is too long for a reward too small. I don’t want to torture myself over this in the next 20 years. At the end of the day, it’s only $10,000.
Finally, here’s a video of a marsh mellow experiment for testing delayed gratification. I failed the challenge. Do you think you will be able to hold on for 20 years? [If the video doesn’t show up, click here.]