Active management vs. passive income

I recently wrote an introductory article where I listed a slew of tactics for building wealth. In this article, I want to dive into what is a crucial aspect of making those strategies work: active management.

For some example of active management consider this: to engage in leveraged real estate you can’t simply “set it and forget it”. The same goes for buying stocks or over funding an EIUL. If you take a passive approach to managing your wealth, you will miss important things and possibly wreck any chances.

Real estate

Let’s look a little deeper at each of these. When it comes to real estate, the most important thing is having tenants in your rental properties. Empty units = no cash. If you have setup your mortgages to get automatically paid, this will drain your coffers quickly. In the area where my rentals are located, I have someone that I can pick up the phone and quickly get cracking on finding new tenants. She also can tell me what the going rate of rent is in the area. She gets a cut of the first month’s rent, but it’s worth it to ensure I’m getting the best rental income while also staying occupied.

I could try to let my property management company cover this task, but they are driven by one thing: occupancy. If they can spend less effort and get it occupied for a little less rent, they’ll do it. My tenant-finding agent doesn’t have the same motivations and so I can count on her to do her job of researching market rates and betting me the best deal. But to engage her services, I need to stay on top of things.

I have a good property manager that sends me emails when tenants are approaching the end of their lease. I also get notices when monthly payments come in. I don’t have to worry about this on a daily basis. But once a month, I need to ensure that everything is working properly and all my people are doing their jobs. This is different than the attitude of throwing money into your 401K plan and maybe looking at once-a-year. It is very different than assuming it’s going to turn in to a fistful of cash in ten years.

Stocks

When I invest some of my capital in dividend paying stocks like Chevron (CVX) and Vanguard Natural Resources (VNR), I need to monitor their dividend reports. Are these stocks continuing to pay the same or more in dividends? Dividend Growth Investor has a hard rule: when a company cuts dividends or stops paying altogether, abandon ship. Move your money somewhere else. His opinion is that this is one of the first actions taken by companies steering into risky waters. I haven’t adopted that rule wholeheartedly, but it probably makes sense to make such a decision now, because I get put into such a stressful circumstance. It means I need to ensure the dividend payments happen on schedule. There are usually press releases indicating scheduled payments or the lack thereof, so it’s not hard to keep up with. This is especially important considering I’m using the cash distributions from VNR to pay off my HELOC.

I need to NOT get sucked into the daily news about the fluctuations in stock price. In fact, Warren Buffett warns against being too plugged in as well. Instead, seeing quarterly dividend reports is the best indicator of success. The Conservative Investor actually goes so far as getting some classic stock issued shares to hang on your wall, a six pack of Coke (if you own KO), and even framing a dividend check to see everyday as a reminder that holding the stock is paying you money on a regular basis. Anything to remove you from the abstract concept of minute-by-minute price fluctuations, and instead focusing on quality of business and it’s flow of dividends into your pockets. Unless you’re prepared to think in this mindset, stocks can ruin you. If you see a 50% drop in price and it drives you panic, you will not succeed. But if you have thoroughly researched a list of companies and instead see these drops as mere opportunities caused by other irrational investor, then you can do very well.

EIULs

Finally, I have my EIUL funding setup on automatic. It makes things easier. This one truly is long term. If you cut out before twenty years, it would be for naught. One of the pieces of this plan is to increase monthly contributions by 4% every May. I’ve already done that once. It’s a task I do in order to emulate cost of living increases. I have more money, so why not put more money into my regular contributions. It creates a very strong improvement in the total build up of cash value.

Summary

Something that might have confused you is where I wrote “active management” in the title, and yet we are talking about things that are considered “passive income” according to the IRS. Active management is required to make sure everything is performing as expected. The style of investing where you throw money into some index funds and don’t track their historical performance, and even avoid the statements when you know the market is down can be referred to as “passive management.”

If something shifts out of alignment, it is up to me to respond properly. But most of my focus is on building passive streams of income so that when I get to retirement I no longer have to “actively” work to earn money for my day-to-day expenses. If you adopt a passive strategy, you might not realize your rental properties are either vacant, or one of your tenants is five months behind. You might not realize that one of your stocks is no longer paying you the dividends you planned on. And you might not be upping your contributions to your cash value life insurance policy.

How to build retirement wealth

If you are a new reader here, perhaps it’s time for an introduction. I like sharing my opinions on how I am building retirement wealth. I also like to document how my own investments are doing. Some of these ideas might sound outrageous or in contradiction to what you’ve heard from your financial planner, financial adviser, or some popular radio hosts.

But the concepts I lay out in my articles are backed up by historical evidence. In fact, I look at history to try and determine the best ways to build wealth. Do you know how you always hear “past returns are no guarantee of future returns”? While true that there is no guarantee, trying to shirk the past and it’s strong evidence is reckless and frankly won’t lead to a good retirement.

So what are the investment vehicles I employ?

  • No mutual funds.
  • No 401K or IRA wrappers.
  • Direct ownership of stocks (not mutual funds).
  • Leveraged real estate
  • Over funded cash value life insurance (also known as permanent life insurance)
  • Build wealth using various forms of arbitrage

These may the types of vehicles I use, but it also includes the concept of actively managed wealth building. Some of these vehicles may be considered passive forms of income, but it takes an active approach to do it right. The concept of simply dumping money into a mutual fund inside your 401K and assuming it will grow to serve you in retirement just doesn’t work.

No mutual funds

The Dalbar report has been monitoring mutual funds and tax deferred savings plans for 20 years. According to the 2013 report, mutual fund investors have significantly underperformed the S&P 500 over the past 3, 5, 10 and 20 years. In 2012, they reported the average performance of investors in equity funds was 4.25%. They further indicate that this is mostly tied to investor behavior rather than fund performance.

The performance numbers are clear: people investing in mutual funds average poorly. Dalbar goes on to make a judgment that it’s the consumer’s fault. This might or might not be a valid judgment. But is that relevant? If people don’t do well, and haven’t been for 20 years, do I really want to plan my retirement under the assumption that I can beat the average? I’m sure it’s what most others think. Dave Ramsey is happy to quote the FDIC in saying that 97.3% of people don’t follow through on their promise to pay off a 30-year mortgage in just 15 years with extra payments.

So why would we expect people to follow through on their attempt to not buy when things rise and sell when a market correction hits? I prefer to build my wealth building plans using the averages.

No 401K or IRA wrappers

401K and other government wrappers come with an incredible entanglement of regulations, restrictions, and other tricks to basically keep your hands off the money. The concept is to get you to put away money and keep your hands off of it until you reach retirement age. But many investment houses take advantage of this situation in the sense that mutual funds and other vehicles available tend to have the highest expense ratios.

People will eagerly point out things like IRAs as giving you more control, but the government has strong limits on how much you can put into an IRA. Suffice it to say, the limits on IRAs aren’t enough to build a retirement plan.

And do you really think the government designed the 401K to help you set aside money and save on taxes? The government wants you to put away money today without paying any taxes, so that you will grow the money into something bigger, and then start paying full blown income taxes when you reach retirement. Yikes!

It’s true that I have a Roth IRA and a 401K, but that is money I put in before I realized it wasn’t working. As you’ll see below, most of that money has been re-applied and is already making way more than what it used to. The only money I have left is trapped in my current company’s 401K and I can’t get to it. The Roth IRA I have is small as well and would serve little benefit if I extracted it.

Direct ownership of stocks

This one really stuns some people that I meet. I don’t like the dismal performance of mutual funds combined with their fees. Instead, I prefer owning stocks directly. If you look at all the studies done over the years, there is one stock market strategy that has proved fruitful: buying and holding dividend-paying stocks.

If you look at people like Warren Buffett, they have created billions by acquiring strong companies when they were on sale. Warren Buffett has also bought cash flowing stocks and companies, and reinvested their proceeds in other strong companies. This has created a compounding affect that has let him beat the S&P500 for years by great margins. The book value of Berkshire Hathaway has averaged it’s growth by 28% during the boom years, and by as much as 18% during bad recessionary times.

It’s not hard to find solid companies. In fact, there are many blog sites dedicated to this, such as Dividend Mantra and Dividend Growth Investor. The companies they invest in are not fly-by-night shady outfits. Instead, they mention thinks like Coca-Cola (KO), Walmart (WMT), and other names you’ll recognize. Companies like Coca-Cola have created millionaires for decades. You can find a list of companies that have paid consistent dividends, increasing them year after year, for over 25 years. It’s not that hard. It turns out, these are some of the best investments regarding inflation. A company that has managed to increase payouts to its shareholders through thick and thin is pretty solid.

Leveraged real estate

After the 2008 housing melt down, many people won’t entertain investing in real estate. The problem is that newspapers were reporting the worst scenarios regarding foreclosures. The truth is, 99% of mortgages are current and paid for. The number of people that suffered rate hikes on risky loans while having insufficient money to keep up were a fraction of a percent.

Real estate has shown a more consistent growth rate than mutual funds. And real estate is one of the easiest investments for middle class people to get into. Using prudent leverage, an average 4-5% growth can turn into 20-25% growth in your investment capital. That certainly beats the 4.25% average growth of mutual funds. Again, this is what happens if you use the averages. You can make more and take on riskier, higher paying options, but why take a risk? You’re already ahead of what mutual funds in 401K wrappers have to offer.

Since real estate was a no brainer, I cashed out my 13-year-old 401K from my old company, paid 37% in taxes and penalties that year, and used it to buy two duplexes with 20% and 25% down. I couldn’t be happier.

The rentals I own are paying me a nice monthly profit as the tenants pay off the mortgages for me. I keep a fair amount of cash in reserve to handle vacancies. And seeing my property yield monthly cash helps me to focus on that instead of pure growth in value.

Over funded cash value life insurance

This is one that stirs a lot of discussion. People have been preached to that cash value life insurance is a rip off and to never, ever, ever buy it! Phrases like “buy term and invest the difference” as well as “don’t mix insurance with investments” flies all over the place.

The thing is, many of the people that preach this opinion have an incomplete knowledge of how it works and how it was designed to function.

To be clear, I’m talking about EIULs, or equity indexed universal life insurance. And the critical component is over funding the policy to the limit set by the IRS. Essentially, buy a policy where you get the minimum amount of death benefit for a given amount of money. That causes your cash value to build faster. If you get the maximum amount of death benefit, then your cash value grows very slowly and it becomes an ineffective tool in storing wealth.

EIULs that are over funded give you the option down the road to borrow from the cash value. Essentially, you borrow money (without paying it back) and when you die, the loan is paid off with the death benefit. Whatever is left over is passed on to your beneficiaries.

EIULs have the benefit on not investing in the stock market, but instead in European options on the market. This is how they institute caps such that your principle is guaranteed to growth somewhere between 0% and 15% of the index it is linked to. If the index goes negative, your cash value stays the same. But if the market goes positive, so does your cash value.

You may not be aware, but that facet is incredibly powerful when it comes to wealth preservation. So many people have seen huge booms in their mutual fund holdings, but the overall performance is knocked back to that Dalbar average of 4.25% due to losses. If your account shrinks by 30% in one year, and then grows by 30% the following year, are back to where you started? Nope. $10,000 would drop to $7,000 and then grow back to $9,100. But if you had an EIUL, that $10,000 would stay put, and then grow to $11,500 (0% loss followed by a 15% gain based on the caps).

EIULs are very expensive for the first ten years; a fact many people like to point out such as Suze Orman and Dave Ramsey. But after ten years, the fees drop to almost nothing. After twenty years, the fees will probably average between 0.5-1.5%/year. Sure beats the 2-4% average cost of mutual funds. And then you get to start taking out tax free loans (compared to mutual fund payments at income tax rates), there is even less to fret about in retirement.

Once I understood the entire picture of what EIULs could and couldn’t do, it was a simple decision to stop investing money in my company 401K and reroute that money into an EIUL.

Build wealth using various forms of arbitrage

Something people are unaware of is how banks make money. Banks borrow money from the Federal Reserve at rates like 3.25% and then turn around and lend it out at 4.25%, pocketing the 1% difference. You can use the same concept.

I took out a HELOC against my home for (PRIME-0.25%) with a floor of 4%, so right now, it costs me 4% to get this money. Then I bought a position in Vanguard Natural Resources, an MLP that has been paying 9% distributions on a monthly basis. As I pay off the HELOC, I am essentially pocketing the 5% difference.

This is also referred to as equity harvesting. All that equity in my house was earning 0%. I am getting the cheapest form of money available, a mortgage, and using it to collect cash flowing assets. After I pay off the HELOC, I can redirect the money towards paying off investment mortgages, buying other dividend aristocrat stocks for even more passive income cash flows, or increase my position in Vanguard Natural Resources. And at that point, I can also renew the HELOC to get more investment capital.

When people ask “would you take out a $50,000 loan on your house and invest it?” my answer is a resounding “yes!”

Stay tuned

I hope you enjoyed this introduction to the concepts of build wealth at the Wealth Building Society. Wealth building isn’t hard, but when you boil things down to sound bites used by radio entertainers, some of the worst advice gets out there. Are the people that are telling you to only take out 15 year mortgages and pay them off as fast possible retiring on mutual funds? Are these people maxing out 401K and IRAs, or are they building wealth through writing books, running TV and radio shows, and piping their business equity pay offs into rental property?

Do you want guaranteed returns?

I have heard several radio shows that talk about guaranteed returns. Maybe you’ve heard of them too.

  • Guaranteed growth
  • Never lose principal
  • Avoid all those nasty fees
  • Never again worry about the risk of investing
  • “Safe” tends to be embedded in their name
The one word I never seem to hear in any of these shows is insurance
These people are selling cash value life insurance. Just to stir things up, I can tell you right now: everything they say is true. The right cash value life insurance policy can provide guaranteed growth, avoid loss of principal, none of those traditional fees, and a way to avoid losing money in the stock market. In fact, if you’ve read more than this article, then you already know I have an EIUL, a certain type of CVL.
But the story isn’t complete. The right policy set up in the right way is incredibly important to any wealthy building plan, but it’s not enough. Want to see why?

The right insurance policy

First of all, the right policy set up the right way means getting an EIUL set up with minimum insurance for the given amount of money. Of course, that assumes we are talking about building cash value. Whole Life has a different purpose. But let’s stick with building cash value for retirement.

Why would you want an insurance policy with the minimum amount of insurance? It sounds counter intuitive, doesn’t it? That’s because it reduces the fees of the policy. Most policies have the big costs tied to the amount of insurance. Agents can either get you the most insurance for your money, or the least amount of insurance. The more insurance, the higher the costs. And the slower your cash value will grow. The latter results in smaller fees and a faster build up of cash value.

It’s true that cash value life insurance policies don’t have the annual fees traditionally seen in 401K and mutual funds. But it doesn’t mean they are free. Instead of paying some percentage fee based on the value of your account, they instead dip into each premium payment on the way in. Send in a premium check and they take out what’s needed to fund the insurance component, the amount needed to pay some small administrative fees, and the amount needed for their profits. What’s left goes into your cash value account, where it’s protected from ever shrinking. So you see, it still costs something.

Some of these radio hosts talk about getting paid not by you, but instead by the insurance provider. Nothing is free.

It doesn’t matter if you pay the agent directly or instead give all the premium to the insurance company and THEY pay the agent. Same net effect. It’s just a difference in bookkeeping. 

Don’t get obsessed with fees!

It would appear that too many people are obsessed with fees and these people on the radio want to make you think there are no fees with these products. That’s faulty. In fact, people are probably shocked to discover that the fees for cash value life insurance are typically HIGHER than mutual funds, at least for the first ten years.

How can I be saying that cash value life insurance has higher fees, yet seem to be advocating in their favor? It’s quite simple. Life insurance companies have learned some valuable lessons. A lot of people let their policies lapse, most within the first couple of years. The insurance companies deal with that by front loading all their commissions and profits to get as much up front as possible. But if you have an overloaded policy like mine, then after ten years, the fees drop to almost nothing. I think the only thing left in my policy at that point is the annual $60 maintenance fee.

After 20-30 years, the average cost of an EIUL approaches 0.5-1.5%/year, making it the the cheapest form of investing available. That kicks the pants off mutual funds.

Mutual funds easily average 2% in declared annual fees with many going up to 4%. That may sound trivial but when you throw in the poor growth rates of mutual funds, the tax consequences, and other factors, EIULs leave mutual funds in the dust.

I don’t know if these people on the radio are peddling whole life or EIULs. I think I’ve heard one mention “equity index”, but frankly, I’ve yet to hear one of them mention they are selling insurance. Perhaps that scares off too many casual listeners.

Whole life has been shown to average around 4% annually. EIULs have been shown to average around 8%. A 4% difference may not sound like much, but lets compare the two after 25 years.

1.04^25 = 2.66 or 166% growth. 1.08^25 = 6.85 or 585% growth. That’s over 2.5x the money!

So it may sound like EIULs are the route to go on wealth building right? Wrong! What?!?

8% is not enough

I just showed that EIULs have the same safe, non-risky features as whole life, but then told you it’s not enough. That’s because you need to take on more risk. You really need double digit growth to build enough wealth to lick today’s 4% inflation.

That’s why I also buy cash yielding real estate and dividend yielding stocks. The magic of real estate is that by buying some property with 25% down, if it grows at a measly 5%, that becomes 20% growth on your invested money. I think 20% is way better than 8%.

Strangely, I don’t hear these radio shows talking about real estate and stocks. That’s because they are 100% focused on avoiding risk and seem to selling products to people’s fears. I hate using fear as the basis for a wealth building plan. Risk is not avoidable. Instead, we need to evaluate it and deal with it, not try to avoid it all costs. Fear of risk is the biggest seller of mutual funds because people fear losing money in stocks. Reading things Dividend Growth Investor and Dividend Mantra can show you that many people are able to make money with classic buy-and-hold investment in the big blue chips. Prudently addressing risk, not shying away from it, can lead to a much more solid investment plan than running to mutual funds, or fleeing to pure insurance.

Fear is a bad basis for building wealth

If you seek fixed returns or guaranteed principal, it’s going to be hard to build up enough wealth for retirement. We all need certain amounts of risk in order to get a decent return. The concept is to mitigate the risk by having sufficient cash reserves to weather the storms that are coming. I’ve already dealt with not having 100% occupancy in my rentals. I’m also prepared in case serious damages occur.

Another reason I hold plenty of cash reserves is to avoid something bad happening and driving me to panic. On many websites, I see people ready to trade in prudent leverage and instead buy real estate 100% cash in order to sleep better at night. It is a psychological fact that most people panic during a drop in the market and simply can’t handle it. In fact, that is what has driven the failure of mutual funds. People sell when things take a hit.

I can personally testify to feeling stressed as my company stock options have taken a hit over the past several months. But I have been able to hold on and not panic because I have a solid plan. I don’t need my stock option money right now, and nothing depends on it. I have enough cash reserves to cover my rental properties as well as my personal mortgage. This lets me sleep fine at night. In fact, my stock options just saw a 16% increase in price recently, and I was able to celebrate!

Many of the people that suffered during the 2008 housing market correction didn’t have enough cash reserves to handle being out of work for 3-6 months. They were driven to sell their homes only to find that the market value had fallen. For those that don’t have to sell because they have enough cash, it doesn’t matter what the market value of your house is.

Sadly, none of these radio personalities mention things like cash reserves. It is a key piece everyone must have when putting together a wealth building plan. They sell their products on the basis of fear of the market, not realizing they may be selling in inadequate set of goods.

Frankly, it’s hard to find an adviser that will sit down and talk to you about cash, stocks, insurance, and real estate. Instead, most advisers seem to only deal in one arena. That means it’s up to you. I have found one person that is rock solid on life insurance policies, but also understands the fundamental concepts of building wealth. I have talked to him a few times regarding other parts of my portfolio. I also have the best investment real estate broker in the country. Between these two, I have put together a wealth building plan that has shown me 80% growth since I started tracking last year.

It’s way too early to clink the glasses. It will be at least four more years before I can even imagine selling one of my rentals and positioning myself to acquire more real estate. By that time, I should have built up my cash flowing position in VNR as well. It won’t be 100%, but the increased value thanks to its high dividend yield should be nice.

If you want to kick around any wealth building ideas, be sure to drop me a line. I love discussing wealth building plans.

Term Life OR Universal Life Insurance: A Fallacy

I often see articles where people are debating whether to buy term life insurance or permanent life insurance. It is a fallacy.

I actually have both. On one hand, I have a 20-year, level premium, term life insurance policy. This is to protect my family over the next twenty years as I build my investment portfolio. If something goes wrong, they will be protected. They will have money to support themselves. It can support them for a whole year while they decided what to do with everything I leave them, including real estate and stocks.

But by the time I reach retirement and have built up a treasure trove of cash yielding rental properties along with some stocks, they won’t need term life insurance anymore. At that time, my EIUL should be fully funded and allow me to start taking out tax free loans. When entering retirement, it’s important to be as tax shielded as possible. That’s because many of the tax deductions we get today like mortgage interest, kids, and other things, will not apply then.

Heck, taxes are a greater drain on retirement income than fees, so I’m still curious why people focus so heavily on fees. By taking out tax free loans from my permanent life insurance policy for 25 years, I predict my wife and I will be able to take many trips, visit the grand kids, and do all kinds of fun things. That will certainly be better than taking a job at Walmart as a greeter.

If you manage to scrape together $1 million in your 401K plan, are you ready to live on $40,000/year? It might sound tricky, especially given how little we know where inflation will take us in the next few decades.

To summarize: don’t get sucked into the dichotomy of term vs permanent life insurance. They were designed to serve different purposes. Use them as they were meant, and you should do well. 

The speed of gains and losses

Lost time while driving

Have you ever gone on a long road trip? What happens when you run into bad traffic or stop for a meal? You lose time you can never make up.

For example, imagine you are traveling 750 miles, driving 75 MPH. Assuming you had a gigantic tank of gas, it would take you ten hours to make the trip.

But what happens when you run into some bad traffic situation? For about an hour, you are crawling along at 25 MPH. In that one hour of bad traffic, you essentially lost 50 miles of driving distance you originally planned. Assuming you get back going at your original speed, it will take an additional 40 minutes to complete your trip.

But you like to push things but driving a little faster, say 85 MPH. If the traffic slowdown had happened in the 10th hour of your trip, you can cut down the extra time to a hair less than 30 minutes. That extra speed only bought you an extra 10 minutes.

To get back on track, you would have to drive an equal amount of time at 125 MPH. Or twice as long as the slowdown at 100 MPH. Or triple the length at over 90 MPH. But that assumes you don’t run into other delays, like gas stops, food breaks, or other things.

Driving losses vs. investment losses

What does this have to do with money? It is more real world examples of the math of losses and gains. When we suffer losses in the market, we have to work harder to get back to our starting point. It illustrates why EIULs provide an amazing tool when it comes to building wealth thanks to their ability to avoid losses.

Investment advisors are all too eager to point out that given enough time, we can recover from the market losses that we hit, like in 2001 and 2008. While true, it leaves out consideration for when the losses happen. If our traffic slowdown had been during the first hour of our trip, we would have much more time to make up for it, but if it was towards the end, we are doomed to be late. This is simply another example of sequence-of-return risk.

Investment advisors rarely talk about this unfortunate aspect of financial growth. Instead, they focus on hand holding and reminding their clients that over time, their investments will grow at a nice 12% level. They tend to avoid mentioning things like how the Dalbar Report has shown that mutual fund investors usual get less than 4%.

Learning how to do the math yourself makes it possible to discriminate between financial facts and financial sales pitches. Farming out all investment planning to someone else leaves you prone to not tell the difference. But doing your own homework, learning the real growth of the S&P 500, and learning how big slowdowns towards the end of your trip to retirement can delay your arrival at retirement is key to real wealth building.

The gap between fund performance and investor performance

One tool I have looked at a lot is Dalbar’s Quantitative Analysis of Investor Behavior, known by many as simply the Dalbar Report. It is a study that looks at the last 20 years of data. They have been doing this study for over 10 years. It a rolling study in that each year, they add the latest year and drop the oldest year. Then they look at how investors are doing that invest in mutual funds.

The results? Not good! At the end of 2010, the 20 year average of the S&P 500 was 9.14% while investors in mutual funds averaged 3.27%. Yikes! So does the report say WHY there is such a big gap between the index itself and investors? They claim it is investor behavior and basically their fault for only holding a given mutual fund for less than three years.

You see, Dalbar sells the report mainly to financial advisers telling them that not only must they help their clients pick good mutual funds, but they need to do a little bit of hand holding and have them stay the course when they pick a mutual fund.

I investigated criticisms of the Dalbar Report a bit, curious what members of the financial community thought of this. After all, how often have you heard these damning statistics against mutual funds? Did your HR department send this information out in an annual notice along with other news about 401K options? Didn’t think so.

It appears there is one big concern with Dalbar’s methodology. What I read was wordy, but could be summarized simply as, the first ten years were during the Great Bull Market, while the last ten years were during the Lost Decade. Strangely, this criticism seemed to attack the explanation of the gap, meaning it wasn’t 100% the investor’s fault, and that comparing these two figures was like comparing apples to oranges.

The Great Bull Market was a highly unusual time period. It stretched from 1980-2000. The equities markets grew strong during this whole period. If you had a lot of money in the markets at this point in time, you would have done well. But when 2000-2001 hit, we got a major market correction. What made things much worse, was that another correction hit in 2008. In my personal research of looking at S&P 500 data going back to the 1950s, it appears that we encounter a market correction about every 10 years, so missing one for 20 years almost demands this double correction.

But at the end of the day, what does it matter WHY there is such a gap. What is critical in putting together a wealth building plan is to look at investor performance and realize that mutual funds don’t work. This fact of there being ten good years followed by 10 flat years just proves the existence of sequence of return risk and how insidious it can be. To solve this problem, we don’t need to debate whether or not investors are to blame for their actions over the past 20 years. Instead, we need to build a plan that assumes this behavior will continue, as it has each year since Dalbar began their studies.

We need a combination of tools that will help us build wealth without causing us to panic during down years, like rent producing real estate. Buying a handful of stocks that not only have a solid history over decades, but also involve products we fully understand would also be helpful. Finally, putting a chunk of our accumulated wealth into a EIUL, a vehicle that was designed to avoid losses as well hedge against inflation and future taxes. All of these tactics, when used together can provide a much more effective approach to building wealth. No longer are we betting on the appreciation of mutual funds, but instead accumulating assets that will yield cash for us in retirement with protection from the tax man.

Personal reserves vs. rental reserves

There are a handful of blog sites out there that feature what I call non-traditional advice. What is non-traditional advice? To describe, let’s look at what comprises traditional advice.

  • You should be paying out less than you earn on each paycheck.
  • Build up some small emergency fund. Later on, build up 3-9 months of income in savings.
  • Any extra cash you receive must first target any and all debt. Often home mortgages are put last in line, but still eventually targeted.
  • After paying off non-mortgage debt, max out your 401K, 529 plans, IRAs, and any other tax deferred vehicle.
  • Investments should target mutual funds to avoid taking on too much risk.
  • Never buy individual stocks.
  • Only buy real estate if it’s cash only, and still profitable and you are willing to learn how to be a landlord or hire a property manager.
There may be variances, but that is what most people on TV and radio talk about when they give financial advice. Well, there is a whole body of web sites that focus on wealth building using different principles than what’s listed above. People that stumble onto them are shocked when any of the above points are called into question. Heck, I saw one site where the blogger posted his net worth worksheets for several years, and one of the comments hastily stated was that the author’s posted debt was flat out “stupid.”
Pay note, the man had a net worth of over $1 million, was cash flow positive on the order of $15,000/month through a combination of business income, rental income, and other means. If needed, he could sell everything and pay off his debt, and be debt free, but then he would be asset free and cash flow free as well. But none of that seemed to matter to the debt-is-evil commenter.
Cash vs. stocks to store reserves

One thing I have noticed that several sites are talking about is that cash reserves are dead money. The principle point is that cash reserves are either in checking accounts that yield no interest, or savings accounts that yield little interest. Either way, the money is expected to suffer bad losses over the long term due to inflation and taxes.

While the point is sound, in my opinion, we need access to some amount of liquidity. My rental properties are currently 75% occupied. If that dropped down to 25% through the loss of two tenants, my cash reserves in place would cover the cost of the rental mortgages until new tenants are found. My property manager could call me tomorrow and tell me there are major damages caused by a tenant who was just evicted. The unit needs to be repaired before it can be shown to new potential tenants. These are items of risk I must be ready to handle on short notice, and I was already geared up to handle before I bought them.

It’s possible I could stash that money in other places, like dividend kings that have a solid history of growth. This would probably have a longer term benefit to my cash reserves, but it introduces short term risk. Let’s assume that instead of keeping my reserves in cash, I instead invest it in one of my current stocks like Vanguard Natural Resources (VNR). VNR is currently yielding 9+%, so it would definitely outpace the interest of my savings account. When that emergency call comes and I find out that my units are currently vacant, it appears I need to withdraw $1500 to pay the monthly mortgage. It’s possible that VNR could be in a down cycle, causing me to lose money since the time I invested the money there. I may have gained some money in distributions paid out on a monthly basis, but it could be entirely offset if VNR is in a downcycle. This would be the time when I should be BUYING, but instead circumstances require I SELL. That is the short term risk I would be taking on if I stored my money there.
This makes the cash used to back my real estate investment no longer a reserve, but instead an investment of its own. This introduces systemic risk, which I don’t need at this point. Mortgage debt is fixed, except for taxes and insurance, which is just a piece of the monthly payment. This means that my reserve cash doesn’t have to compensate for inflation. Repairs can rise with inflation, so my reserves should probably rise as well in the future, but not as fast a real investments. Just enough to reasonably cover my rental units.

Or a HELOC to bail you out

One of the articles I spotted addressed this issue squarely and had a solution: open a HELOC (home equity line of credit) on one of your properties, possibly your primary residence. That way, when there is no panic, you don’t draw the money. But if something goes haywire, you can easily pull money to deal with the situation. As soon as the situation permits, perhaps through recovering rental income or distributions paid on the VNR stock I mentioned earlier, you could repay the outstanding balance of the HELOC and get back on track.

This is a strategy that could work, if you have the fiscal and psychological makeup to handle it. It would require that you not be tempted to use the HELOC for other things, like buying toys. It also means you might pay some amount of interest charges, but the advocates of such a plan would say that is washed out by the opportunity costs in not investing your money in a real wealth preserving vehicle.

To be fair, the articles visit the concept of risk. Essentially, they point out the likelihood of using your reserves, and showing that in the long term, investing the money has a bigger payoff. But in my opinion, you can’t serve both long term and short term needs at the same time. My portfolio needs a certain amount dedicated to the short term, and that is what my reserves are for. The sacrifice is their lack of long term growth.

Or an EIUL to borrow against

One avenue I have evaluated and may yet pursue, is to buy a small EIUL using my cash reserves. In the span of five years, I could fully fund a cash value life insurance policy, and whenever I need the cash, I can borrow against the surrender value of the policy. When things are restored to balance, I can then start to pay back the EIUL and eventually put everything back on track. Since the borrowing costs of an EIUL are around 0.1% (yes 1/10%), it sounds like a good plan. That’s even better than the current 4% rates on HELOCs.

If you are not aware, $10,000 at 4% incurs a monthly interest charge of $33. At 0.1%, that interest charge be just $0.83. Like the difference? To be fair, even the $33 isn’t much.

Of course, in the first five years, my total amount of accessible money would be less than what I started due to the front loaded expenses, but the estimate I have already previewed shows that by the end of the sixth year, I would have caught up and passed my initial cash outlay. In 15 years, my cash value will have doubled, providing an internal rate of return of around 5.6%. Assuming I make it to retirement age, and have been able to effectively pay back any loans, the fund should yield around 7%. Not bad for an emergency reserve of liquid cash, ehh?

"I was just answering the caller’s question…"

I hate to break it to you, but there IS such a thing as a stupid question. Or at least, when someone asks a question, they may not realize they are asking the WRONG question. A friend of mine who contributed some feedback on my last book stated, “There’s really no excuse for giving simplisitic, bad, but technically correct answers to mis-guided questions….answers like these only cause damage.”[1]

In a Forbe’s article where the author tries to answer the question of whether or not you should buy permanent life insurance as an investment, her conclusion was no. She cited the classic issue of costs, but never mentioned what happens if you did something like overfund the policy. She also didn’t compare whole life vs. EIUL vs. VUL, but instead seemed to pick a policy with the worst characteristics. She did make a point of listing areas where people need insurance for it’s standard usage of covering things like estate taxes, family members in need, etc., but when looked at for investment purposes, the whole point of the article, she stuck to her guns that permanent was the most expensive and least useful.

My buddy, Jeff Brown (a real estate broker) has several axioms, including: It’s not finding the answers to all the questions you have that’s the problem. It’s the answers to the questions you never knew to ask that end up bitin’ you on the butt.[2]

Several people in the comments tried to point out the flaws in the writer’s assumptions, but invariably her response was to fall back to what the caller originally asked, and not really pursue what version of permanent insurance would have the best benefits and least costs. If she had, her conclusions might have been dramatically different.

“That may be true. I used the numbers from the illustration provided to the caller from the financial adviser.”

By limiting this discussion to the illustration the caller had, we are off to a bad start. A majority of agents and financial planners either don’t know how to set up life insurance with the costs dialed down, or they won’t due to the cut in premiums they are forced to accept. If the writer had been willing to set the illustration aside and talk about this factor in policy writing, many readers may have discovered another dimension in cash value life insurance. This may be a strong hint that perhaps the writer doesn’t know about overfunded policies, which taints the whole article.

“I assumed a variable life product because that’s what the caller was asking about in this particular situation. Yeah, you’re right that the average investor earns around 3-4% but with education I believe they can get closer to the long term stock market averages of 8-9%. Finally, I used a Roth 401(k) in this example to take away the issue of higher taxes in the future but that certainly can be a factor for someone who can’t contribute to a Roth. Of course, there has also been talk of removing the tax benefits of life insurance cash values so there’s risk there too.”

First of all, VULs (Variable Universal Life insurance) have the same systemic risk as buying mutual funds, so I don’t favor them. Their principal value can fall. EIULs don’t have that risk. Your value never goes negative. When they drop in value (not if), VUL holders will be inclined to move their money to another fund inside their policy, which is just as bad as rebalancing mutual funds inside a 401(k). One key benefit in considering permanent life insurance is to insulate ourselves from market shocks and negative years.

Second, the writer is pitching the same thing every financial advisor serves up to prospective clients. She is saying we can beat the historical average. At least she knows that people average 3-4% ROI with mutual funds, as cited in the Dalbar Report. It is an abysmal rate that doesn’t build retirement wealth. Heck, beating inflation would be a lucky draw. But Wall Street is famous for telling us that “you can’t do it yourself, because the odds are against you…but not me your financial advisor.” For the author to set aside this historical fact and suggest we can beat history compared to everyone else seems to be retreating back to Wall Street’s sales propaganda.

Third, 401(k)s have some of the highest costs, compared to owning mutual funds straight up. Your choices are limited as well. But…at least she isn’t trying to tell us that the stock market averages 12%.

Finally, she wants to spook us by suggesting that the tax free nature of cash value life insurance is up for grabs. There is a long standing history that shows this is not likely. If it were to happen, a lot of other things would be shook up as well, and I don’t know anyone who can devise a plan to handle that much upheaval.

“There may indeed be additional benefits from using whole life but I just wrote about what the adviser told the caller.”

This is the part that bugs me the most. In the end, she seems to actually accept that there may be benefits to cash value life insurance if done correctly. Or maybe she just wanted to stop arguing. She just chucks it all out and tells us that her article was meant to ONLY discuss the caller’s quote. What value is it to discuss a bad quote?

This makes the whole article a waste of time, because we aren’t really discussing the pros and cons of storing wealth in cash value life insurance. Instead, we are confined to looking at one badly written insurance contract aimed at serving the agent’s best interests.

The author is sticking with a poorly constructed insurance contract that has the most insurance for the given premium; a common situation. This perpetuates the myth that all cash value life insurance is a rip-off when in reality, it can be the most cost effective way to store wealth. If only the writer had answered the question that WASN’T asked.

[1] – http://nedbatchelder.com/blog/201207/bad_answers_on_stack_overflow.html
[2] – http://bawldguy.com/show-me-the-answers-to-the-questions-you-never-knew-to-ask/

Rebalancing my portfolio – part 3: rental property

My units have a very nice exterior that reduces wear-n-tear.

In several previous posts, I have gone over key changes I have made to my retirement portfolio since I got highly active a year ago. I describe it as rebalancing my portfolio. When most people engage in rebalancing their portfolio, they are talking about selling badly performing stocks and mutual funds, and instead buying better performing ones. It also refers to adjusting future investments so that you target better funds for future investment. I have expanded the concept to a much wider scope of financial instruments.

So far, I have:

My final step?

  • Invest in rental property aimed at capital growth.

To pour a strong foundation in rental property, I have found every spare nickel of investment capital and acquired two rental duplexes in Austin, Texas. You can see pictures of one of them  throughout this blog post. Now let’s examine the risks and rewards this final (and most important) part of my plan offers.

Isn’t rental property risky?

Short answer: Yes. And that’s the point!

Anything which carries a return also has risk. It is important to realize this, and learn how to mitigate such risk rather than hide in fear by taking little to no risk by investing in ineffective index funds. An investment plan that tries to avoid risk rather than make plans to deal with it is doomed to fail.

So how does one mitigate the risk of rental property? Cash reserves. Some of the biggest risks you must prepare for include: vacancy, repairs, and property damage. A good insurance policy will help cover property damage. An umbrella policy can provide extra liability protection. For the rest, you need cash reserves ready to cover you when your property is vacant or needs repairs. (Notice the “is”, and the lack of “if”!) Another risk mitigator? Top quality property. The older your property is, the more repairs you will be paying for. The bigger the discount you pay for it? Probably an indicator of the increased rate your location will slide into chaos. Plan appropriately, and you will be able to handle these bumps in the road.

What about the rewards?

Well, we discussed the reality that real estate has risks. But let’s talk about the reason we are entertaining the purchase of real estate. Exactly what makes rental property a top quality wealth builder? Rental property has some of the best tax laws. You get to take a paper loss every year known as depreciation. Properly structured, it can shield all if not most of your net rental income. With the right circumstances, you might even be able to store up enough extra depreciation to shield capital gains at the time you sell. The more money you get to keep from the tax man, the more you have to reinvest and grow your rental portfolio.

Let’s not forget that everyone needs a place to live. This is the reason people have been buying real estate for centuries. Real estate has been growing in value for a long time. It is true that it can slow down and even fall, as witnessed in the past decade. But real estate really does recover. You may also think you have to be rich to enter this market, but you don’t. Which leads me to our next point.

Real estate is also good because it is one of those investments that is easy to leverage. By putting 20% down on the properties, I get 5x the growth of any combination of appreciation and equity payoff. This is one of the reasons people in the middle class can get into rental property. If it required all cash, then I really would have to wait until I was rich to get started. Leverage not only opens the door to investing in rental property, but it also increases the rate at which I can grow my capital.

Do da’ math: Imagine I had bought a $100,000 rental with only $20,000 of my own money (ignoring closing costs for now). If it grew by a conservative 4% to $104,000, my own equity would have gone from $20,000 to $24,000, a 20% return on investment. Who could turn that down?

Location, location, location

Each side of my duplexes has a two car garage.

Now show me a mutual fund or 401K investment that is returning that well!

Slow down there partner!

How do you find the right deal? Well, it’s true that a critical factor in real estate investing is to look for good property and not end up buying worthless swamp land in Florida. Duh!

That is the reason I hired Jeff Brown, aka The Bawld Guy. He is a real estate broker focused on designing long term real estate investment plans. He has helped me find great options. He has been doing this for 40 years and knows the business inside and out. By business, I mean investment property for the middle class, not just rich millionaires. By 40 years, I mean he has been mentored by many pros on everything from 1031 exchanges, note investing, partial transfers, hypothecated notes, and even selling homes in a buyer’s market without resorting to steep discounting! There is no one like him out there. Trust me when I say, the agent that sold you your current home doesn’t hold a candle to this guy. Read some of his blog entries. It took me six months of reading, talking to others, and investigating him through multiple channels before I called him up. But I’m sure glad I did.

It doesn’t stop there either. After buying property, there is a tiny task known as property management that involves collecting rents, making repairs, as well as finding good tenants and evicting bad ones. All these things can be very stressful. That is why I sought a property management company to handle this task for an acceptable fee. This is, again, where Jeff chips in. He has scoped out all the builders and property management companies in many parts of the country and built teams. When you hire Jeff, you hire an A-list of people to do the job, making your investment plan work.

I mentioned risk, right? Instead of hoping it doesn’t hit us, it is better to assume Murphy will pay us a visit. To prepare for this, it is critical that we set aside enough cash to handle big issues. I put enough cash in the bank to handle 6 months of 100% vacancy. That would be an incredibly big bump, but I have to be able to sleep at night, right? If anything significant happens, like repairs, eviction court fees, or other unforeseen issues, I can write a check and deal with it. Because the properties are cash flow positive, the minute I am clear of these issues, I can let the cash flow replenish my reserve account. That is also the side benefit of living off the salary from my day job. Once the reserves are back up to my safe level, I can resume pouring all the extra income towards knocking out one mortgage at a time.

Finding investment capital to buy real estate

So where did I get the money to buy two duplexes in the Austin, Texas area? I liquidated the 401K I have been putting money into for the past 15 years.

Yup, you heard that right. I nuked my 401K.

Holy tax penalties, Batman!

Yes, there is a cost to doing that. Essentially all that money must be reported as income in the year it is withdrawn. That will cost at least 28% if it doesn’t push me into the 33% tax bracket. But it doesn’t stop there. By taking out an unqualified distribution (i.e. before turning 59 1/2), there is an additional 10% penalty taken off the top. My running estimate is that I have lost 50% of the money stored in my 401K.

I don’t want to gloss over this point. The cost for ditching a badly performing 401K is enormous. You should realize, Wall Street setup the 401K to hit you right between the eyes like that so that you would never, ever, ever think of doing something like this! The government, realizing all the taxable income they would gather in your retirement years, went along with it. But continue reading to see why taking that big hit was a no-brainer for me.

First of all, if it had been closer to the end of the year when I made this decision, it would have been better take out half now and half at the beginning of the following year. That would have spread the taxes and penalties across two years and possibly kept me out of a higher tax bracket. Unfortunately, it wasn’t until April of this year that I made the choice, and given this was an election year, I couldn’t gamble on waiting until January to see if my 401K would soar or nose dive. Elections, regardless of their outcomes, can have big, emotional impacts on the markets.

So let’s break down this analysis into two options, one where I keep my existing 401K, and the other where I cash it out for essentially $0.50 on the dollar.

Option 1: Keep the money in the 401K. The value of mine still hasn’t recovered to pre-2008 levels, despite putting more money into it over the last four years. Part of the reason is because I got married four years ago and now have two kids, forcing me to reduce the amount of money I could save that way. I used to set aside 15% of my paycheck, but with new family expenses, I had to scale back to 6%. Did your financial advisor put in such a factor when putting together your plan? At the beginning of this year, my 401K was still about 20% down from the pre-2008 peak I used to have. Another big factor is that losses are hard to recover from. When your portfolio drops 20%, it has to recover 25% to break even. A 50% loss requires 100% recovery. Get the point? If it takes another six years to get back to where I was four years ago, then that is an entire decade gone. Poof! See why 2000-2010 has been dubbed as the lost decade? To put one more nail in the coffin of the 401K qualified plan, The Dalbar Report shows that investors using mutual funds average less than 4% average growth per year. Does your 401K offer anything other than mutual funds? I didn’t think so. It is possible to manage your own 401K and invest in things other than mutual funds, but the huge mass of people I meet have never setup their own plans, and instead use the corporate one with little to no interaction. Top it off with the incredibly high fees found inside 401K plans, and you can understand why I flat out don’t like them.

Summary: Draw a line starting at your current 401K value and extend it with a slope of 4%. Not good enough! Now let’s look at our alternative.

Option 2: Crash the 401K, taking every nickel you can get. Assume 50% survives the carnage and aftermath. Shed some tears. Now face an even bigger task: tell your spouse. Telling my wife was the hardest part! I wish I could have skipped that part, but we both needed to be onboard, 100% percent committed. Next step, buy top quality, premium rental property. My units are brand spanking new, checked out by a licensed home inspector, and I even walked through them myself. Now, assume only half the rent money makes it into your pocket after paying for repairs, property management fees, insurance, and vacancies. Use that money to pay for principal and interest on the mortgage. My loans at 4.75% & 4.125% (30-year fixed) still leave me with cash flow positive. After paying the minimums on each mortgage, pour all extra rent money into one loan to knock it out as fast as possible. Throw in enough depreciation to shield all that net rent money from taxes, and you now have a nicely performing set of assets! What rate of growth did we pick earlier? Oh yeah, 4%. Only now it is leveraged 4-to-1. That results in a tasty 20% return on investment.

Summary: Draw a line at half of your 401K value with a slope of 20%. Painful at the start, but in the long run, much better!

Look at the graph below, where we assume you started with $100,000 in your qualified plan, and ran both Option 1 and Option 2. Which option would you pick? That is how I came to realize it was a no-brainer, and sprang to take back as much of the money I’ve been saving over the last 15 years as I could.

Bottom line: it was a huge cost to get my hands on this highly needed capital. Some of you reading this probably can’t comprehend doing such a thing. Have you even heard of someone crashing their 401K like that? But the end result is MUCH better than I would have ever gotten with mutual funds.

My estimate is that within five years, the penalties I suffered will have been paid off. I realize the chart above says six years, but that only assumes some conservative appreciation. It doesn’t include paying down the loans and growing the equity position.

If you want to swap things around and instead assume no appreciation, but still paying half the rent towards expenses, my properties still yield 6% annually. That is more than we assumed when drawing the chart up above.

To top it off, my investment capital is now growing at 5x the rate it grew at before hand. I have a big chunk of cash sitting in the bank to back my play and handle bumps in the road. My relief of no longer sweating the dips in the Dow and the S&P 500 is incredible.

When I started thinking about this plan, it took me six months to overcome the psychological shock of losing all that money. But after realizing the long running history of real estate vs. mutual funds and no longer being told to keep my hands off that money (401K rules), I was able to look at the Big Picture and get ready to eat that “stupid tax” in order to jump ship from my lousy 401K.

Key piece of wealth building: getting over the pschological hurdles set up by Wall Street and the government. They don’t want you pulling your money out of a 401K, so they have erected big barriers. They also make it appear as your best and only option, by offering the huge tax deferral options. But does the person at your company who advised you about 401K options mention real estate? Do you think they even know a lick about rental income and depreciation? Probably not.

Making money with rental property

The floors have tile, which also extends life of the unit.

Nothing is free. There are closing costs, property management fees, and a fee to the broker that found me these top notch properties. I have also hired a CPA who is also a real estate investor, and knows every tool in the book to get the most tax efficient plan going. That will cost a tad more than TurboTax software.

The properties themselves aren’t exactly at discount price. Usually there is a reason something is at “discount.” If the property is junky or in such a terrible location that you wouldn’t put your own mother there to live, then it probably won’t yield the high rent thou dost seeketh. These properties are different. They are top-of-the-line and I definitely would put my own mother there. Finding the right people to help dig up top notch real estate takes work. If you get stuck on paying the lowest fees, it isn’t going to work. The performance of your assets will suffer, because you didn’t buy the right units and didn’t hire the right people.

Assuming you can dig through all that and find some good rental property, you will learn that there are incredible benefits to owning real estate instead of mutual funds. With real estate, you only have to sell when the market makes it a no brainer. No more panicing when the market falls and you are either dumping your mutual funds, or suffering from your holdings in a particular fund getting transitioned because everyone else abandoned it. Instead, let your tentants keep building your equity. Not depending on appreciation, but instead taking in the solid yield of monthly rent is much better. And prudent usage of leverage puts the icing on the cake.

By the way, I absolutely advocate taking on debt to do this instead of buying everything 100% in cash. In the early years, it increases the cash-on-cash returns. But again, this requires buying top quality real estate, not dumpy stuff that is only going down hill. This is good debt! Evil debt is taking out a loan to buy a toy you can’t afford. Using debt to buy cash flowing, appreciating assets is what helps us attain wealth.

Another key task is to grow as much as possible. Pour all excess rent money into paying off one loan at a time. If you have extra money you can save from your day job, see if you can add some more. Why do that? So you can sell it when that no-brainer opportunity arises and then buy more property, re-leveraging your new capital. Every dollar you throw into your real estate portfolio will grow multiple times. Give yourself 20-25 years, and that should help build a sizeable nest egg. But it cuts both ways. If you tap the rent money for other things, it will cost you similarly.

Retiring on rental property

The final benefit in this plan? When it’s time to retire, I can stop working on growth and instead shift to cash flow. If you were planning to withdraw from your 401K, every nickel will be taxed as regular income. Ouch! That can get pretty steep, considering we don’t know what the rates will be 25 years from now. But if I take all the capital built up in my real estate portfolio over a 20-25 year period and essentially buy all-cash properties so they are heavily cash flow positive, much if not all of that passive rental income will be shielded for the next 27.5 years by depreciation.

Shielded by some of the best tax laws on the books, and the fact that things won’t be tied directly to the stock market, this makes for a much better long term investment strategy. THIS is building wealth. And when the time comes, after building a portfolio of lots of rentals properties, I can sell one or two and buy another EIUL to stuff away yet more money for tax free withdrawals during retirement.

Considering I also plan to start withdrawing tax free money from the other EIUL I mentioned earlier as well as receiving dividends from my stocks, it all adds up to a sweet, low tax retirement plan. And to me, that makes it a no-brainer.

New study shows excessive 401(k) fees

A new study has come out titled “The Retirement Savings Drain: The Hidden & Excessive Costs Of 401(K)S” by Robert Hiltonsmith. The results are quite shocking. Or perhaps they SHOULD be shocking. I’ve already heard about this, and so I’m not surprised. But perhaps you haven’t? Some of the big ones:

  • 65% of 401(k) account holders aren’t even aware they are paying fees
  • 5 out of every 6 investors lack basic knowledge about the fees everyone with a 401(k) pays
  • fees are taken off the top, meaning reported rates-of-return are post-fee, hiding these costs
  • administering average pension funds costs 46% less than the cost of 401(k) plans
  • new regulatory tweaks that are coming, requiring better disclosure of fees, will have little effect on reducing the fees nor fix the issues associated with market risk and longevity risk
  • the individualized nature of the 401(k) doesn’t work and must be replaced with something else
Did you catch that last one? The author of the study has concluded that much of the issues that arise in 401(k)s is because of it’s individualized nature, and that tweaks and adjustments won’t fix it. The author figures that the new disclosure rules won’t fix 401(k)s, but instead expose them for the bad investment vehicle that they are.
I said shocking right? Well, I already learned this about six months ago. I have been working on my plan to leave my 401(k) behind. I have already stopped putting money into my corporate 401(k) and rerouted that money into an EIUL. In that article, you will find mention of the high fees embedded in 401(k)s. Combine that with the onerous rules that restrict your access to the money, and that pretty much sums up my disgust with them.

The study estimates that people will lose something like $155,000 on average over their working lives to excessive fees, enough to buy a house. What could you do with $155,000 of investment capital? Buy Berkshire Hathaway, or perhaps leverage it with investment property? Both of those options has a higher historical rate-of-return. Why don’t you hear about this from your financial advisor? Aren’t they supposed to be putting you first, according to the license they hold?

Towards the end of the study is a list of bullet points for what appears to be core principles in some sort of universal retirement plan. I think either the author or the institute that funded him believe we should all receive a universal, i.e. government orchestrated pension fund. I have my doubts on how effectively the government can manage something like that, considering their track record with managing social security. I could never support something like that unless we had the freedom to opt out and choose our own path. Or, they may be saying we need something better than what the IRC affords us from section 401(k), and these are the key points that must be met to have a true success. I just don’t remember the government having a big rate of success when it comes to money.
So what is the solution to all this? Don’t be a passive investor. Take active management of your plan. And HAVE a plan. Don’t just throw money at your 401(k), pick a handful of their funds, and then assume it will all work out. At the Wealth Building Society we focus on learning how to read this information, how to understand risk, and how to understand the mechanics of investing, so you can formulate your plan. One of the top reasons so many people are failing at retirement planning is because we have been told it’s easy and we don’t need to really be active. And also that there are plenty of experts out there to handle it for us.

I am not a licensed financial advisor nor an insurance agent, and cannot give out financial advice. This is strictly wealth building opinion and should be treated as such.