Building wealth isn’t free

habit-saving-moneyAll too common, I see people obsessing about fees at the wrong phases of building wealth. There are countless websites and forums where people discuss low cost index funds. The problem is, they haven’t calculated the Big fee that will hit them at retirement: taxes.

Standard IRAs and 401(K)s are designed to get you to sock away money tax free today, only to turn around and pay income level taxes at retirement. And to top it off, Uncle Sam demonstrates his hunger for that tax revenue by forcing you to start cannibalizing your savings at the age of 70 1/2. If you save up a big pile of money in something that pays a handy dividend, you can’t keep it forever. You will be forced to start taking minimum withdrawals.

To illustrate, I tracked down an online early withdrawal calculator. I plugged in $1,000,000 balance, and it told me that the age of 70 1/2, the minimum withdrawal amount was just shy of $36,500. To frame this in lingo that financial consultants use, we are all told to withdraw no more than 4% per year in retirement. 4% of that balance would be $40,000.

A subtle but little discussed point in all this is the “no more than” piece of that advice. The idea is that our retirement fund is expected to grow by more than 4%. Hence, ONLY withdrawing 4% should let our principle grow. But if we only have a 3% growth, we should ONLY withdraw 3% and hence NOT tap into the principle.

If we have a losing year, we shouldn’t draw anything at all. The hope is that our retirement funds would throw off dividends to fund ourselves. Anything else, and we are cutting into the principle and forever reducing future earnings and available cash. But these minimum withdrawals don’t grant us the ability to scale back to 3% or even skip a year of withdrawals. Instead, we are forced to cut into that principle so the government can get their piece of revenue.

It’s okay to pay taxes

TaxesIf there is any kind of lesson, it’s that taxes must be paid. The only question is when. People obsess over paying taxes today. They would rather push them off and score all the tax deductions possible. But that might not be the most efficient strategy nor the most stable one for your retirement.

The truth is, it’s better to pay the taxes now. That way, in retirement, there is no need to ship off a chunk of your retirement wealth to the government at who knows what tax rate. And if you use Roth IRAs instead of standard ones, there are no required minimum withdrawals! If there is any hint of what the IRS prefers, just checkout the fact that people making over $191,000/year can NOT contribute to a Roth IRA.

There is an old adage: would you rather pay taxes on a bag of seed or on the harvested crop? In true mathematics, if the rate at both times is identical, then you would pay the same taxes on either side. But that is rarely the case. And who knows what the tax rates will be 30 years from now?

Don’t forget about management fees

panic_buttonI’ve talked about fees many times. One really surprising article was about a couple that held dozens of mutual funds and never consolidated. They actually had a big chunk of cash. The effect was disastrous!

The couple in that linked article were paying a financial advisor 2.5% annually. Sounds small, except that they had saved up $1.3 million. Annual fees exceeded $32,000! Imagine paying $32,000 each and every year of your retirement.

The actual plan they were pursuing was to consolidates into half a dozen funds, and reduce annual costs to 1%. That is terrible! Cutting down to $13,000 in annual fees is terrible. The irony is that if they looked at the top ten stocks in each fund, they might find a lot of well recognized companies: Coca-Cola, Walmart, Apple, General Mills, Pepsi, Dr. Pepper-Snapple Group.

If they simply sold everything and bought $130,000 of each of the top 10 stocks, their annual fees would drop to nothing. There would be a one time cost of selling the funds and buying the positions, but after that, no management fees. And then they could drop the financial advisor! To top things off, they would probably rack up better dividends, dividend growth (like getting a raise in retirement), and also see asset appreciation.

Stocks aren’t the only way

Mortgage_Loan_Approved1Other options would include discounted notes. I’m in the middle of migrating my Roth IRA into a Self Direction Roth IRA. The plan is to buy warrantied, discounted notes. The noted fund I have joined sells 1st position notes at a discount. That means mortgages that were perhaps written for 5% would yield me something much higher, like 9-12%. They are also warrantied meaning that if the payee stops paying, I have the option to either foreclose and sell the property, or I can collect on the warranty and get back what I put in. Show me a stock or mutual fund that offers that.

As an example of discounted 1st position notes, imagine a note where the payee owes $100,000. Imagine it was written with a 5% interest rate. Monthly payments would be $536. The person holding the notes decides to sell it for whatever reason. Maybe they needed a quick source of capital. To move the note quickly, they are willing to accept $65,000. For $65,000, I can get that monthly stream of $536. Punch that into your calculator, and you’ll see that we are getting 9.9% yield on that investment.

To top it off, whenever the payee decides to pay it all off, I collect an extra $35,000 (remember, original balance owed was $100,000). If that happened five years out, the annualized ROI would be about 9%. Pretty good return on the money. And then I can take all this cash and buy more notes, boosting my monthly yield.

Thanks to having this inside a Self Directed Roth, there are no taxes involved. I have to pay a service fee to my note payment collectors of about $15/month. And the Self Directed Roth custodian needs a minimal fee as well. But nothing close $13,000 year! That is horrendous.

EIULs are designed to reduce costs in the future

EIULeffectThe last leg in my talk about good vs. bad management fees are EIULs. I frequently hear life insurance products criticized as being ridiculously expensive. The truth is they ARE very expensive….for the first ten years. After that, the costs drop dramatically.

Insurance companies design these products so that they collect their profits up front. That way, if you fall through on future payments, they don’t care so much. It also makes the products better guaranteed to last properly. A key ingredient, though, is to overfund as much as possible. By overfunding a policy, the cash value grows much faster. And the faster the cash value grows, the less total insurance must be bought. It’s a vicious cycle. If you slow down the growth of cash value, more of your premiums is used to fund the difference, i.e. the corridor between face value and cash value.

But when you overfund the policy, the total amount of insurance purchases through the life of the policy is greatly reduced and in the end, the annualized costs drop to somewhere like 0.5-1.5%. That’s pretty handy for getting a big chunk of cash in retirement that is completely tax free according to IRS tax code.

It’s not simple or easy to build wealth all by yourself. But delegating ALL decisions to a financial planner can be very costly when you reach retirement. The key is understanding the fundamentals of building wealth so you can hire the right experts to set up things most efficiently.

Why EIULs work and VULs don’t when building wealth

booksA friend of mine who occasionally pings me with financial questions asked recently about VULs. He appears to be getting prompted to investing in them. It would appear my past blogs about EIULs causes him to ask a financial advisor about them. In response, it would appear they have countered with suggesting VULs instead.

I wrote a detailed response to him, but thought why not share it here as well?

The problem with VULs

I don’t like VULs at all. To start things off, what are VULs? They are Variable Universal Life insurance contracts. An EIUL is an Equity Indexed Universal Life insurance contract.

VULs take the idea of universal life insurance (which would be the same idea as an EIUL) but instead of using indexed investment options for the cash value, they instead use mutual funds. My whole retooling of wealth building was to get away from mutual funds. Mutual funds have historically had high costs and lackluster performance.

As part of the question I received, my friend included quotes on the cost of insurance. It appears the agent was trying to point out how inexpensive things would be on the insurance side of things.

Hate to break it to you, but cost of insurance is something regulated by each state. Essentially to buy $1000 of pure life insurance costs the same despite the company you go to. Things like fees, profits, etc. are where different companies can vary things. Different companies manage cash value investments differently. The funds, options, indexes, etc. are different for every company. Different companies offer different degrees of customer service and different ratings when it comes time it either loan out money pay up on claims. Different companies can offer different ways to loan you cash from the cash value part of your policy. But the actual cost of insurance is the same.

So in essence, when evaluating a life insurance company, you should basically subtract out the insurance aspect of things instead look at how well such a company has done on the investment side of things.

For any universal life insurance policy, the agent has a fundamental option to either write up the policy where they either maximize or minimize the death benefit based on IRS regulations. Minimum face value causes maximum cash value growth, and that is what we want. Even if you have no children, no spouse, and no family, these contracts are great places to load up with cash that you can get your hands on when needed, over the long haul.

The financial coach/agent that I learned much of this from runs a blog at http://shaferfinancial.wordpress.com. He was actually a PhD in statistics and psychology before entering the financial/industry. He is driven by evidence and actually has an undergraduate degree in finance. Most financial planners are trained in sales. Dr. Dave’s views on wealth building tend to not follow traditional sales routes but instead focus on evidence of success. If you visit his site and search for VUL, you’ll find some detailed analysis of them and why they don’t work.

I talked to him two years ago and said, “Here’s the money I want to invest. What would that look like at retirement?” He put together a plan and we discussed it over the phone. We made some adjustments and over a five month period put it in action. It’s been doing good so far. One things that I solidly know is that my cash value will do nothing but grow. It won’t drop in value at the next market correction like a VUL would. Therefore when the recovery begins, I will have more cash value to grow from than mutual fund investors.

Do you have an illustration or a quote from an agent? Contact Dr. Dave and ask him to look it over. He has written thousands of them, and knows the lingo. He will surely be happy to point out the pros and cons.

Whatever you do, given the long term nature of this vehicle, take your time until you understand it completely.

FYI: I don’t receive a nickel of cash for writing this opinion on EIULs nor Dr. Dave.

EIULs work, but only when given enough time

I’ve written here MANY times about EIULs. They are great. Their fundamental concept is that you get to buy European style options on various stock or bond indexes. This means that if the index goes negative, you don’t lose your money. If they go positive, you lock in a gain FOREVER. And your gains can in turn generate more locked in gains in the future.

But EIULs require time to do their magic. I just added a new worksheet to my net worth tracking spreadsheet. I have been plowing money into my EIUL since early 2012. That’s perhaps 2 1/2 years worth. In my main spreadsheet, I have the annualized growth rate of my entire net worth tracked to the month. I wanted the same thing on the accumulation value of my EIUL. So I got to work.

Well guess what? After 2 1/2 years, the annualized rate is currently at -4.15%. That doesn’t sound good, ehh? Well, there are several factors to consider. For starters, this worksheet lists the amount of money sent in to Minnesota Life. That means, by definition, a certain sliver of that money is taken out every month to fund the insurance tied to my EIUL. That’s a loss. Some more gets routed towards profits for the agent and the company. What’s left is sent to my cash value to accumulate and, in turn, generate credits.

I have certainly been racking up credits. I have scanned things back over the past couple years, and with the boom in the market, the caps are getting hit. But it doesn’t mean there has been enough cash value YET to overcome the fixed costs of maintenance as well as cost of insurance.

To double check things, and make sure I still understood what was going on, I dug up the original estimate sent by my agent. I can see where he estimates amount of money put into the plan every year alongside estimate accumulation value. I checked each year, and noticed that sure enough, it actually doesn’t go positive until Year 8.

Year 8? YIkes?!? Is that bad? Well, don’t forget, this is an estimate that predicts by the time I reach retirement and stop putting money in, I will have worked things up to an annualized growth of about 8%. Given that the Dalbar Report shows people doing less than 4% with mutual funds (which may yet require taxation after the fact), that sounds pretty good.

What is important to notice is that my growth rate has been moving slowly towards the positive. This is partly impacted by the fact that I just don’t have a big cash value YET. But as it grows, my ability to lock in bigger and bigger gains, and be immune from market shock will also kick in. For people that want to see big returns in five years or less, EIULs are not for you. But given 20 years+, this should result in a nice, steady, slowly accumulating and slowly beat-the-heck-out-of-mutual-funds results.

Happy investing!

How to evaluate a cash value life insurance policy

Every day that I turn on the radio, I hear cash value life insurance get denigrated. The problem is, the comments are highly generalized and rife with big assumptions that aren’t always true.

First of all, let’s back up and look at what cash value life insurance is compared to term life insurance. Cash value life insurance is also known as permanent life insurance. Some people also call it “whole life”, because that version has been around for decades. But there are other types that are NOT whole life.

Boiling things down, cash value life insurance is designed such that the face value of the policy can be paid when the policy holder dies. So how DOES it work? Basically, you buy a policy with a given face value. Imagine we picked a policy that offered $100,000, payable upon death to the beneficiary. So how can an insurance company come up with a way to guarantee paying this amount of money at some random time in the future? They collect premium payments form you, and use part of it to buy some immediate term life insurance and the rest is set aside to build up “cash value”. As more and more premiums are collected over the years, the cash value builds up.

The cornerstone of cash value

What is cash value? Essentially, it provides a cornerstone of the face value. Imagine you had built up a $30,000 cash value to back the $100,000 face value. At that point, 30% of the insurance is covered by the cash value, meaning the insurance company only needs to buy an additional $70,000 of term life insurance. At a certain point, they no longer have to collect premiums from you. Instead, interest from the cash value can be used to fund term life insurance making up the difference.

This is what leads to haughty TV and radio show hosts balking at how insurance companies “only pay you the face value” and “keep the cash value for themselves”. Ahem. If you have a $100,000 policy backed by $30,000 of cash value, where do you get the idea that they owe you $130,000?

This is just the scenario I heard the other day on the radio. Most of the time, the dollars aren’t mentioned. Instead, the radio personality seems to imply that you could have racked up $50,000 of cash value, and yet only get paid something smaller, like $25,000. That WOULD be horrendous. What they don’t mention is that the face value is typically HIGHER than the cash value.

Some real numbers

The only real numbers i often hear on various shows is how cheap term life insurance is compared to cash value. Like how dollar for dollar, term life costs 5% of cash value life insurance.

In a rare moment, I heard someone call in with numbers precisely matching what I’ve said so far. This caller had paid $20,000 in premiums over 25 years, and built up a $30,000 cash value, backing a $100,000 face value policy. His primary concern was that if he cashed in this policy in order to ditch it, he would get the first $20,000 tax free. It would be consider return of capital and not cost a cent in taxes. The host tried to say people almost never have tax consequences. But in this case, he would be facing a $10,000 profit. This is where he would need to talk to an accountant. I don’t know if that would be long term capital gains, or something completely different.

The talk show host couldn’t believe his ears. He repeated his usual complaints about how you never GET the cash value. And then I heard the caller reveal the face value of $100,000. When he dies, his wife will ONLY get $100,000 and not the additional $30,000. Instead, the insurance company is keeping that money for itself! Sorry, but that is grossly wrong. At this stage, the insurance policy has $30,000 in cash along with an additional $70,000 of actual insurance. Liquidating everything would result in a combined total of, surprise, $100,000 to pay out. There is not pile of gold left behind that the insurance company dumps into a giant vault and begins to swim in like Scrooge McDuck.

HINT: Insurance companies gear things such that they rack up their maximum profits at the beginning not the end. Term life insurance policies tend to get cancelled within a couple years. Same for many policies. Things change and people stop paying premiums. Insurance companies aren’t dumb. They want to rack up their profits early and move on.

What really stunned me was how the talk show host failed to look at the actual growth of the caller’s insurance investment. The caller has the opportunity to borrow against the cash value, perhaps to fund retirement. In that event, imagine they could borrow the entire $30,000. It’s usually something less to avoid collapsing the whole policy, but let’s assume they can take it all. We should be asking, what was the rate of return on that?

Actual yield of a whole life policy

If the caller invested $20,000 and accumulated $30,000 over 25 years, we can easily calculate the annualized growth rate. Simply take $30,000/$20,000 and take the 25th root. Result? 1.6% annualized growth. THAT is the indicator that this policy was horribly set up. THIS is the reason I would dump the policy and instead take the cash elsewhere, like buying up a big chunk of VNR stock.

With $30,000, the caller could buy roughly 1350 units of VNR. That would yield $283.50 every month, resulting in a hair over $3400 annually. In ten short years, the caller could easily double his money due to VNR’s 7.5% yield. This is much better than the dismal 1.6% yield which isn’t even keeping up with inflation. And this analysis assumes no growth in distributions from VNR.

Or take this $30,000 and buy KO, WMT, GIS, or a dozen other solid companies you have known about your whole life. Or perhaps buy a real estate note. Anything is better than 1.6% in my book.

Thankfully, the EIUL I have setup is designed properly. The face value has been dialed back to the minimum amount allowed by the IRS. This means that the cash value will grow much faster than 1.6%. My agent plugged in a estimate of about 8% based on a 20 year look minus 10%. This paints a very conservative estimate. 8% of growth is certainly possible even though mutual funds are averaging 4% thanks to an EIUL’s ability to guard against market drops.

Happy investing!

So you want to build wealth? Look for multiplicative ways, not additive ones

“Another day, another dollar” — common expression

This expression is commonly known by many. It represents a common, core feeling we get as members of the vast work force. We go to work, put in the hours, get paid our wages, and go home for the day. This is not the way to build retirement wealth.

When it comes to building wealth, getting paid on a day-to-day basis is additive. To accumulate enough wealth to last for years, we have to put away huge amounts of money. Typically 30% of our take home pay is a minimum amount.

Why do I say that? Because the tools we are being sold on for investments don’t work unless we compensate by over-saving. A good example is the classic skip-that-daily-latte and instead save the money, and it 20-30 years, you will be a millionaire. I had heard that a few times, and figured it sounded great. Until I read an objective analysis of that. Basically take $5/day and multiply it by 365 days. What do you get? $1825/year. Doesn’t sound too bad. Today. But let’s take this concept and back up to 40 years ago. What was the median income for people back then? According to one source, median household income in 1974 was $9780/year. That would imply that saving $5/day, the price of a cup of coffee, was like putting away over 18% of gross salary. If you can assume 28% in withheld taxes, the percentage saved against take home pay would be 25.7%.

Wow! If we are to read that correctly, it suggests that saving $5/day today may result in $1MM, but in 40 years (if you started this when you were 25), $1MM probably won’t be worth much at all. Instead, we should read that correctly as needing to save AT LEAST 26% immediately.

Many people, if they looked at that, would just throw their hands up in the air and give up. But if you’re here, you surely have guessed that I’m going to say something different.

We need to look for options that have a multiplicative effect. What is that? It’s when you make some making by direct action, but the more actions you take, the more they interact with other actions already in progress.

One thing that I realized as I wrapped up the last chapter of my 3rd book, is that doing something as small as writing books on the side can introduce multiplicative money making. Today I finally got some time to watch a TV series with Neil deGrasse Tyson. I’m quite fascinated by astrophysics and his series seems entertaining. In the opening credits, it notes that Dr. Tyson has written ten books. Something I can realize is that the more books you write, the more books you will sell. Not additively, but multiplicatively. Simply put, people that enjoy one of your books are VERY likely to go and buy your others. My first book has yet to earn enough to pay off the advance I received. The second accomplished that about two years ago. My dream is that my 3rd will accomplish that even sooner, possibly through more social media, more people that read my previous works, and that some will even go back and buy my previous writings.

It’s only natural. I read the first Jack Reacher book, got hooked, and have now read ten so far. I read “Schrödinger’s Kittens and the Search For Reality”, and have since ordered the predecessor. When you go out and invest yourself into more and more and more opportunities that can yield more and more wealth, the opportunities grow.

So I highly suggest that you take some time to sit down and think. Simply think. Look at what you are doing today. What you have done for the past week. And think about what else you could be doing that can generate secondary effects. What if you started a blog and wrote on a daily basis? It could be small stuff. But it might grow your public image. It might open doors you didn’t expect. Open your mind to looking for new opportunities such an endeavor could raise.

These are all important the rather narrow vision the corporate 401K plans have. The general idea of a 401K is to sock away money in a fund that doesn’t grow very fast. And when you hit retirement, you are required to cannibalize it. Why do I suggest this? Because the federal government has a schedule after which you are obligated to start taking withdrawals. If you’re retired and doing just fine, it doesn’t matter. The government set things up such that they can collect taxes on your withdrawals and they will NOT be blocked from you doing just that.

In case you didn’t know this, the rich NEVER cannibalize their assets. There is this mantra out there that rich people adhere to: NEVER TOUCH THE PRINCIPAL.

In essence you are on a mission to accumulate wealth producing assets that themselves generate wealth you can live off of. You can’t wait until you are retired to begin writing books, building a blogger reputation, or something else. Instead, that is what must embrace while you still can earn enough of a daily paycheck to keep afloat. This is your opportunity to start buying real estate, dividend yielding stocks, EIULs, and discounted notes. Simply putting away 50% of your take home pay and planning to live like a pauper doesn’t sell very well. Good luck!

Can you really live your retirement tax free?

TaxesI have heard a lot of radio ads for various shows and products where they like to brag how you can live on the “tax free side of life”. Perhaps you’ve heard them too. If this really possible? Or are they selling a bunch of malarkey?

Let’s dig in and find out. If you’ve read some of my past entries from here, you’ll surely have noticed me talking about things like EIULs, real estate, and MLP stocks and their tax advantages. In this article, I want to look at how EIULs operate compared to a 401K in the arena of taxes.

Now before we go any further, I want to make one thing clear.

There ain’t no such thing as a free lunch, especially in taxes.

When you dig in and see how various investments operate, it’s more about picking the best, most efficient tax strategy that will serve your needs. Since this blog is about building retirement wealth, I generally talk about the best tax strategy for your retirement.

401K taxes vs. EIUL taxes

That sounds pretty vague, ehh? Let’s use a concrete example: 401K taxes vs. EIUL taxes.

If you use your company’s 401K plan, you get the nice benefit of writing off your contributions. You don’t have have to pay a nickel in taxes for every dollar you stuff into your plan…today. The trade off? (There’s always a trade off). When you start making withdrawals, you will be subject to full income tax rates on every dollar you take out.

Many people are drawn to the allure of avoiding taxes today. It sounds great to take home more pay. I certainly liked the sound of that when I got started at my first job. The problem was, there was no one there to coach on the options and benefits of other vehicles by which I could pay taxes today and pay considerably less in retirement. As the saying goes, you don’t know what you don’t know.

If you buy an EIUL instead, you fund it with after tax dollars. Every dollar that goes in has a certain amount skimmed off for Uncle Sam based on your income. Then when you decide to withdraw money later on in retirement, you do so tax free. The trade off is that by paying taxes up front, you can skip paying taxes in retirement.

Which is better? Well from a tax perspective alone, I prefer the EIUL for two reasons.

  1. The total amount of taxes I pay will smaller, because the total money in action is smaller. In general, as I get older, I make more money, and pay more taxes. So the sooner I can move that money off the tax rolls, the better.
  2. Tax rates and policies are always moving around and the subject of elections. What will this country’s entire tax structure be like in twenty or thirty years? Who knows. I’m still waiting for my crystal ball to get out of the shop. Until that time, I’ve decided that I don’t want to gamble my retirement on such a huge unknown.

If you’ve read this blog, then you know I also advocate EIULs due to better and more consistent historical performance, but I’m leaving that aspect out of this article. For tax purposes alone, it’s generally better to pay up front than later on in life. (But this never precludes doing a complete analysis!)

The tax man cometh

I’ve run into people that don’t understand why EIULs let you “get away with dodging taxes.” Some of these people I’ve chatted with tend to believe any chunk of cash you receive should be subject to income taxes.

For starters, any time you start making withdrawals from your EIUL, the first batch of money is considered return of capital. Essentially, whatever money was put into your cash value holdings is simply being handed back to you. And as pointed out earlier, you already paid taxes on it. Is it really fair to tax you twice on money that effectively didn’t go anywhere?

After you get your premiums back, then you begin taking out loans against the cash value left. Loans are non-taxable events. For my friends that believe this is trickery, I wonder if they are ready to pay income taxes every time they finance a car. If you borrow $200,000 to buy a house, do you think you should suddenly be hit up with a $48,000 tax bill that year? And what about using your credit card? Every time you use it, you are borrowing money to buy something. Should that also be taxed?

I’m sure you don’t want to pay taxes on any of that debt, but what’s the underlying reason you shouldn’t? Because you will ultimately pay off your debt using taxable dollars. The government WILL get their cut of money based on this debt. They just get it in smaller chunks. Bought a $20,000 car? You will end up paying it off with $20,000 of hard earned money subject to good ole’ income tax laws. In fact, thanks to financing, you might actually be shelling out a little bit more, all paid with taxable dollars.

But wait! EIUL loans aren’t paid off!!! How can you justify THAT?!?

An EIUL is a life insurance contract. The amount of money you pass on to your heirs is tax free. It is an enticement by the government to leave something to support your family, friends, or whomever you wish. When you take out loans, the loans+interest are paid off by the death benefit. And don’t forget: it was funded with after tax dollars.

So as I wrote early on, there is no free lunch. You aren’t “getting away” with anything. You funded a plan with taxable money and structured things so that you could pay the taxes now instead of in retirement.

EIUL Basics

I have talked about EIULs before. They are investment grade life insurance contracts that when set up properly, provide a nice place to store your wealth.

EIULs typically invest in some fixed investment vehicles as well as options on indexes. This means they offer the ability to profit from market gains, but avoid market losses. Let’s dig into how these investments can actually help you perform better than index funds.

EIULs typically operate with market caps. For example, they may offer a 0% lower limit and a 15% upper limit on a given market index. If you index goes negative, your money stays put with 0% growth. If it jumps, you receive the upswing, up to the upper limit of 15%.

People have criticized EIULs for causing you to take a hit when the market performs well. After all, if the market grows 26%, it doesn’t seem fair to only let you collect 15%. But this assumes a lot. To really gather the effects, let’s look at some actual market data from 2001 to 2010.

As you can see below, if you had invested $1000 in 2001, your money would have only taken three drops in the market. The other seven years would have had positive growth. But that clearly wouldn’t be enough, because you would still have lost money in the end.

If you instead had invested your money into an EIUL with market caps of 0% and 15%, the following chart paints a different picture.

The left hand column shows the same market gains and losses as before. The middle column shows the growth rate you would have received thanks to your EIUL.

In 2001 and 2002, instead of your money tumbling 33%, it would have stayed put at $1000. This helps you out because in 2003, when the market recovered 26.4%, you would have more money to grow. Even though you are limited to 15% growth in your EIUL, you would have received almost the same amount of growth in actual dollars ($150) as in the first scenario ($180).

By the end of 2010, your money would have almost doubled inside your EIUL, resulting in a 7.2% annualized growth. In the first scenario, you would have actually lost about $50, which is close to 0% growth (and the reason this is known as the Lost Decade).

The next time someone criticizes EIULs as limiting your options, then you should agree. By limiting your losses, you are giving your portfolio an important boost.

Why building wealth with EIULs depends on specifics

I have read yet another article where someone is asking about using EIULs to build a nest egg, and gets dismissed with general platitudes instead of specifics, and directed back to index funds.

The person seeking advice is 29 and making $260,000. His financial advisor has told to him to go all in on an EIUL. This advise is to the point of taking out an interest only loan when buying a house so he can sink the difference into the EIUL and also taking out a HELOC out against the property to get yet more cash.

On the surface, I agree with the author of the article that this sounds a bit fishy and I wouldn’t recommend it myself. By the author quickly goes on to dismiss EIULs using generalities and no specifics. He ends up pushing the person back towards index funds and 401(k) funds which have shown a horrendous history of less than 4% annualized performance while also sucking out lots of fees by the time you reach retirement. Let’s look at some of the ideas posed by the author and compare them to real statistics.

For starters, I have some fundamental reservations about using equity-indexed universal life (EIUL) and similar life insurance policies (variable life, or VL, and variable universal life, or VUL) as vehicles to accumulate retirement savings.

Here is where I get my first tip off of the author’s biases. He is immediately conflating EIULs with VULs. VULs allow you to invest in variable products, i.e. mutual funds. That defeats the whole point of investing in life insurance contracts. I would never, ever, EVER invest in a VUL.

The idea with EIULs is to put away money in a vehicle that only grows and never shrinks in value. They might be “similar” based on the fact that they both involve a life insurance product. But you can also assert that all mutual funds are “similar”, when growth rates and fees can define the difference between success and failure. VULs fail in the sense that they don’t mitigate sequence of return risk.

Typically, you are also assured a modest minimum rate of return, say, 2% or so….while that arrangement may give the impression of an all-upside-no-downside proposition, the fact is that policies usually impose a ceiling on your potential gain, whether by crediting your policy with less than the index’s actual total return or by setting an outright cap.

It is quite true that EIULs have upper and lower limits. Mine has a lower limit of 0% and an upper limit of 15%. And yes, it’s true that if the market went up 26%, I would only get a 15% gain that year inside my policy.

This is a common tactic people deploy when they attempt to discredit EIULs. Who wants to lose that 26% gain? What’s missing is a complete analysis. It turns out that trading in that 26% for 15% will actually boost your total growth thanks to ALSO getting the 0% floor.

I actually wrote an application to compare historical market performance directly compared to being wrapped with a 0%/15% minimum/maximum return. Click that link and scroll to the bottom to see more detailed results. The results are staggering and conclusive.  If you look at every 25-year period from 1951-2010, and average their annualized rates of return, the S&P 500 averaged 7.15% while an EIUL averaged 8.18%.

Essentially, the negatives returns are very costly. Eliminating them in exchange for not getting peak returns is actually to your benefit. The author doesn’t seem to both investigating this. (BTW, invest in VULs, and you lose this advantage).

But once you go down that path of borrowing from the policy for tax-free income in retirement, you’re likely locking yourself in to keeping the policy going for the rest of your life.

Uh, that’s why it’s called permanent life insurance. EIULs only work if your ready to wait at least twenty years for them to build up their value and in turn you keep them for life. My policy actually has a built in rider that prevents me from withdrawing too much money and causing it to lapse.

It’s not really addressed in the article, but its important to set up the policy right. You want to maximize cash value growth. This means buying the minimum amount of life insurance for a given premium. You need the right agent to do that. Most don’t or won’t. As a tradeoff, you might not have enough actual life insurance for you or your family’s needs. That’s why I also have a much bigger twenty year term life insurance policy. After that time frame, I presume I will have built up enough net worth that I can drop the term life policy.

For these reasons alone, I’m skeptical of using EIUL or any other type of life insurance as a way to build one’s nest egg. I think you’re better off sticking to regular tax-advantaged plans like 401(k)s, IRAs and, if you’re self employed, SEP-IRAs and even solo 401(k)s.

We’re sort of on the same page here. I don’t invest in EIULs as my sole wealth building tool. In fact, based on the EIUL’s average growth rate of 8.18%, it’s actually not very good at building wealth. An EIUL is more like a wealth preserving tool. But the answer certainly isn’t mutual funds and index funds which average even less with higher fees.

That’s why I have leveraged rental property as well as dividend yielding stocks powered by my interest only HELOC.

An interest-only loan so you can plow more money into the policy? Borrowing against the equity in your home and then investing the loan proceeds into the policy?

I wouldn’t use all these avenues to pipe money into a single EIUL. But I’ve already received good dividend payments after buying my position in VNR using a HELOC. Harvesting the equity from your home can be powerful, but it requires that you understand all the risks and have a couple exit plans. This is the kind of tool that can grow your net worth, or take you to the cleaners.

For example, using the HELOC cash to buy a highly liquid stock position with a strong history of paying dividends is safer than putting the cash into a relatively inefficient real estate property. I certainly wouldn’t put it into an EIUL.

These sound like the kinds of schemes people hatched during in the heyday of the real estate bubble. The fact that someone would be out there pushing this kind of strategy now boggles the mind. Did this guy learn nothing from the financial crisis about the dangers of leverage and investing borrowed funds backed by real estate?

We need a proper perspective here. During the 2008 housing crisis, 99% of all mortgages were current and didn’t fall behind. Only a fraction of 1% of all mortgages involved variable rate loans that went under. Of course it was salivating material for the headlines, but I would never take the headline of a newspaper as an accurate read on the entire market.

Equity harvesting wasn’t “cooked up” this recently. It’s been in use for decades. That’s the reason the IRS has some pretty tough regulations in place should you choose to take out a loan on a rental and then attempt to sell it a year later using a 1031 tax deferred exchange. The IRS has known about people pulling out equity through clever tactics like this, and hence will go after you, treating that entire loan as “boot” and slamming you with stiff taxes.

And leverage has always had dangers. It’s why you need to do things like hold sufficient cash reserves so you don’t go under if you rental properties remain vacant for a year.

I can’t divine this person’s motivation or competence based on what you’ve told me. But phrases like “do what the banks do” and “make money off of borrowed money” sound more like the patter of a flim-flam man to me than dispassionate advice from a financial adviser.

Well, I can divine the advisor’s motivation. He wants to sell life insurance policies any way he can. Did I mention it’s hard to find the right insurance agent to set you up right? It’s also important to realize that setting up a plan with an EIUL, rental property, and stocks requires more than one advisor. A real estate broker isn’t going to have the knowledge on EIULs and vice versa. And what licensed financial advisor will ever suggest buying rental property? I haven’t seen one yet. They are all about mutual funds because that’s where they make commissions and fees.

By the way, banks make lots of money. As someone pointed out to me, checkout some of the biggest buildings in cities and the names on them. Notice how they are owned by banks? It’s because they know how to make money. I can either do what banks do, do what the rich do, or do what my 401K company officer does. The first two have much more historical basis to work than the third one.

And if after doing that you’re still considering investing in an EIUL or similar policy, I suggest you gather all the policy illustrations, brochures and other info the insurance sales person has given you, take it to a fee-only financial planner — i.e., one whose livelihood doesn’t depend on commissions — and ask that person to analyze how it stacks up vs. other alternatives.

This is the part that always annoys me. There is this running assumption that fee-only advisors are holier than thou and can do no wrong. My insurance agent is paid by commission, but he knows how to minimize the costs of the policy and maximize for cash value growth. It results in him getting probably 30% less than a typical agent. But he has built a solid business on word of mouth and has enough clients to support him nicely.

Insurance agents make most of their commission up front in the span of a few years. There is no guarantee that in the long run (20 years+) a fee-only advisor won’t end up taking more total money than a good insurance agent. That’s why it’s important to look at actual fees and not just general platitudes this author is offering.

So can we drop non-specific assumptions and actually look at actual numbers?

Real estate vs. stocks vs. EIULs

I’ve written many articles about real estate, stocks, and EIULs. You may be wondering if I value one over the other.

The truth is, they all have their purpose. A lot of investment sites tend to prefer one over the other. For example, a lot of investor websites talk about mutual funds. Some even focus specifically on index funds. To find a site that suggests using multiple tools is, in my humble opinion, a bit rare.

I might have given the wrong impression with some of my articles that I value some vehicles more than others, given the number of times I mention my primary stock, Vanguard Natural Resources. I like VNR, and it provides a good medium to discuss different wealth building options, but it’s not my primary asset.

The way I track my wealth involves adding a new row to my spreadsheet every month for every asset and every liability. But I also have a secondary worksheet where I track groupings of various assets. This lets me observe how my portfolio is distributed.

  • 51.3% of my holdings are rental property
  • 31.7% is personal property (personal home and vacation home)
  • 6.3% Vanguard Natural Resources stock
  • 1.1% other stocks
  • 3.4% Roth IRA and 401K
  • 3.2% exercisable stock options
  • 1.5% cash
  • 0.9% EIUL

That may not add up to 100%, but it’s pretty close. One thing I’ve seen mentioned by others is to not invest too heavily in your own home. A tip was to have no more than 25%. This breakdown doesn’t account for liabilities such as mortgages, so it doesn’t track the fact that I have HELOC-based cash invested in VNR. It simply has the value of my properties and my stock holdings grouped together, divided by the total value of my assets.

The point of this article isn’t to steer you towards a certain asset allocation. And it isn’t to tell you that you must also put half of your assets into real estate. Frankly, it’s the way my portfolio has come together. When I withdrew my 401K holdings, I plowed them into rental properties, and bought what I could. The left over cash was put into reserves to back my play. I have used some of that cash to buy some stock positions, and I have also used HELOC cash to increase my position in VNR. The EIUL was set up so that I could fund it with the same money I was using to fund my 401K.

Essentially, I didn’t start with a top-down plan to spread my money into percentages. Instead, I built things from the bottom-up, picking opportunities as I saw them. I just put together this spreadsheet so I could keep a bird’s eye view on things. And ever since I put this in motion, I’ve seen 89% total growth. This says I’ve already made back the money I lost in early withdrawal penalties. I’m cautious to throw that out there because part of it is tied to estimated value of my rental properties. But I can tell my wealth building plan is doing much better than before with the monthly cash flows I am now receiving.

Annual Wealth Building Review

It’s been a year since I started tracking my net worth. This started after I had made the big withdrawal on my 401K but before I purchased any real estate. It has been an exciting and tumultuous year! All I can say is that I wish I had started tracking my progress years ago. I might have realized sooner that things weren’t working. But there’s no value in lamenting the past.

I’ll start with total growth and then break things down to my various assets. In the past year, I’ve seen 85.48% total growth of my net worth.  That is pretty good considering I paid a 37% effective tax rate this year due to the penalties of making an early withdrawal on my 401K. With that tax burden out of the way, I’m hoping next year delivers a strong performance.

Real estate

My real estate holdings have grown by 20% since first purchase. Now take that with a grain of salt; the values are based on Zillow. I won’t really know the value until I sell a unit. But at least it gives me some sense of their value.

My Florida town home has increased from it’s purchase price by about 12%. This isn’t of much value, because I don’t plan to sell it. But instead, it gives me reassurance that I bought it at a good price. All the other short sales that were going on in the same subdivision are gone, and they have even built a new building in this yet uncompleted neighborhood. These are all signs of the real estate recovery in Florida. It definitely shores up future opportunities in case I need to open a HELOC against it to access any cash.

Mortgage debt on my rental properties has dropped by $7200. That’s only a 1.7% reduction in rental debt, but I just started paying off the smallest mortgage by an extra $1000 this month. So, you’ll have to read next year’s annual report to see how well this feeds my wealth building plan.

I could pencil in the value of my new home I purchased back in March and look at its appreciation, but there is no value in that. Nor is there any benefit in looking at the growth of my previous residence either. Instead, what’s more important is how I used this unplanned opportunity to open a new position in wealth building. Which leads us to…

Stocks

My biggest stock position is Vanguard Natural Resources. But you can’t measure it’s performance by growth in value. That’s because the monthly dividends are being used to pay off my HELOC. The price of the stock doesn’t show a big growth history like Berkshire Hathaway. To best way to illustrate its growth is to take its value and subtract the HELOC balance.  That would show where all the spare dividend cash has been going.

I started with a little over $1000 of VNR a year ago. I have increased that position several times. But back in March, I plunged in by putting the left over cash from the sale of my previous home (made possible by the HELOC used for financing) into more VNR. So far, I have reduce my HELOC balance by -0.82%. It doesn’t sound like much, but I have only been using this cash flow machine for a few months. Next year, the fruits of that should begin to show much better.

My position in Berkshire Hathaway has grown by a modest 6%. My position in Apple has grown by 21%. That is partially because I bought more Apple when it dipped below $400/share. I still believe Apple will continue to grow and innovate, and with the amount of cash they have, it feels like a safe investment to me.

EIUL

My EIUL has done exactly what is was supposed to do. My contributions were increased back in May by 4% to represent cost of living increases. It is slightly ahead due to some small credits being paid. It’s actual value compared to the amount of contributions represents a 5.1% growth factor. This isn’t bad considering I’m paying big values. But the most important thing it is doing right now is locking in its growth. The value of it will not go negative, and when the next market correction appears, it will keep chugging along even as my stock portfolio takes a hit.

401K and Roth IRA

I still have my 401K with my current employer. It’s value has grown by 31%. My Roth IRA, which are refocused on holding stocks and reinvesting by DRIP, has grown by 22%.

If I assume that the real estate holdings are unrealistic, it might suggest that the rest of investment plan is actually doing worse than these plans. But these plans are currently riding the tide of QE from the Fed and other factors. When the next correction hits, they will probably get a hard knock. My Roth IRA might be okay, because I have refocused it on stocks and not mutual funds. But considering I can’t put any more money in it, it’s fine where it is.

Next year

Next year’s report should be more exciting because I have upped the pay off of one rental mortgage by $1000/month. That combined with 100% occupancy is also helping me to increase my rental cash reserves by $1000/month as well. When things get replenished, I can direct that money towards a rental mortgage and knock it out even faster.
Do I expect the same amount of growth? Hardly. 85% growth in one year is actually way above the mean. You should never depend on it or think you can keep it up. A big piece of this is Zillow telling me my rentals are probably worth more than I could actually get for them. In the next five years, when I finally sell one, I’ll get a proper correction to my net worth.

But there is one thing I’m sure of: everything is doing much better now that I have taken an active role in wealth management.