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?

The truth about net worth

In this latest installment of my series of net worth articles, I dug up the Federal Reserve’s June 2012 bulletin where they pour over the results of the 2010 Survey of Consumer Finances. They conveniently include results from 2001, 2004, and 2007 as well, making it easier to compare certain statistics to check the trends. This document has a lot of detail and can make for a dry read when you try to read every detail, but my focus was on net worth. How much are people saving? In what ways are people saving money? What about debt? And what are the rich doing, compared to the rest of us? Anything we can learn to benefit our own wealth building

First, how is your own net worth stacking up?

Most of the tables in this report are broken down by either income, age, or ethnicity. To read the tables regarding income percentile, you need to first find out what income percentile you are in. If you look at the table below (from page 8), the first set of boxed income shows the median income rates for each percentile. Which bracket of income are you in?

Remember, median is half above, half below. For example, half of the people in the 60th percentile made above $71,700, and half made below.

Fed Reserve 2012 bulletin – Income by percentile and age

As a bonus, I also drew a box around income levels based on age. Where do you stack up? It appears that in general, as you get older, you make more money, until you reach retirement. It seems that people aren’t making as much in their retirement years. Is that a problem? Is it what you were expecting? If that isn’t in your plan, you may need to recheck things.

If you flip to page 17, there is a chart showing net worth based on both income and age. Using your income percentile you just figured out, check out the median net worth in thousands of dollars. Are you above or below the midpoint?

Federal Reserve 2012 bulletin – Net worth by income and age

Like the previous table, I also included net worth by age. Where you do rank in that? This makes me feel good, because I’m ahead of both. But that isn’t the final answer in this article.

The real question is: do I have enough to retire? I’m not there yet, but my plans should carry me there. What about you?

Another nugget of knowledge is how net worth has shifted since 2001. The table above lets us quickly look at previous years. Net worth for all families from 2001-2010 ranges $106100, $107200, $126400, and $77300. What do you think would account for a 17% increase in 2007 followed by a 39% drop?

Rises and drops in net worth are based on where people have invested their money. The two biggest things people are investing in are 401K plans and primary homes. Those both took a big wallop in 2008, and people’s net worth suffered. My own net worth is still 20% down from where I was before the 2008 market correction. It’s part of the reason I realized I needed to get out and find something better.

These are good reasons to start tracking your net worth. How do you track with these trends? Could you handle a 39% drop in net worth if you were in retirement? If you are investing in the same things as everyone else, then that is what will happen! But if your net worth doesn’t suffer from these types of corrections, you may have developed some adequate financial insulation. No way to tell without tracking things yourself.

One of the reasons real estate does so well as a wealth building vehicle, is because even when the value of your property may take a hit, you will keep collecting rent. As an asset, it will keep yielding returns. You don’t have to sell when your property value drops 20%. If your money is in a mutual fund, enough other people may evacuate the fund when it takes a 20% hit that the manager closes it and moves your money to another fund anyway, even if you didn’t want to!

Hopefully this report will help you notice when you see an article from a finance magazine, or someone talking on TV or radio. Are they preaching how investing in our 401K tied in with the magic of compound interest will give us a huge savings? So, where are the people saving up huge chunks of retirement money in mutual funds? That last chart says that the median person in their 60s only has about $200,000 dollars in net worth. How much do you think is in accessible cash vs. home equity? I have been hearing this message for 15 years, so I figured this report would show it, but it flat out doesn’t.

When you hear your financial advisor saying he or she will help you build a portfolio worth over a $1 million, give him a double take and ask him if he really can place you close to the top 10% of people! That is what he is trying to sell you. The chart above proves it. The question is, are you buying? Ask him to show you proof that his other clients are doing this well. If he hems and haws, and tries to show you history of the market instead of history of his clients, run for the door. He is just trying to sell what’s on his shelf, not what’s best for you.

The report goes on to indicate that cash value life insurance is held in increasing amounts by wealthier people, but overall cash value life insurance assets declined from 2007 to 2010. In fact, all asset classes declined, probably due to people being able to save less and instead consume their income to deal with the economic downturn.
Page 42 has a very clear picture of assets held by people of a non-financial picture.

Federal Reserve 2012 bulletin – Value of non-financial assets

In 2010,

  • In first place, 47.4% of non-financial assets held by people was the equity in their primary residence. 
  • Business equity was in second place at 28.2%. 
  • In a distant third place is other residential property, which would extend to rental property at 11.2%. 

To sum it up, these non-financial assets (which also included vehicles) add up to 62.1% of the total assets people have! With this chart totaling roughly 2/3 of people’s assets, and primary homes being almost half of that, people are investing 1/3 of their money into something that doesn’t generate cash flow in retirement. You may say it keeps you from making a mortgage payment, but that only works if you are setting aside the same amount of money you used to pay on your mortgage into the other cash yielding investments. If you are sitting in your paid off home, and expecting to get by on the measly income from your 401K, you are in for a huge shell shock. Time to brush up on your Walmart greeting.

Looking for more information about rental property, the report says that 14.4% of families own some form of residential real estate, including second homes, time shares, 1-4 family rental properties, etc. Unfortunately, it is hard to break out which types of property are generating which types of cash flow. Second homes don’t yield cash flow. They may generate good family times (something to NEVER underestimate), but they won’t fund your retirement.

Sadly, for a report extending 80 pages, there is little found when actually searching for the word “rental.” It appears that few people have rental properties, compared with the grand scope of everyone, so there are few questions asked in the original survey to gather this type of information. In fact, this may indicate the lack of rental property. If lots of people owned rental property, it would probably become one of the key questions of the survey. I hope this changes, considering 1 out of 8 Americans is a real estate investor. If as many as 11% of people in this country are investing in rentals, the Federal Reserve should start getting more concrete data on this. It might shed more light on the success and validity of real estate.

The Rich own real estate and businesses

One thing is very clear. Looking at page 49, at the breakdown of non-financial assets across income percentiles, the rich have more real estate and business equity than anyone.

  • The top 10% hold a median value of $475,000 in primary homes, $320,000 in other residential property, $200,000 in non-residential property, and $455,000 in business equity. 
  • When looking at the next group (80-89.9% income earners), this drops off to $250,000 primary home, $120,000 other residential property, $58,000 non-residential property, and $82,400 in business equity.

I know that is a lot of numbers, but it speaks plainly. The rich own real estate and the rich own businesses. The rich keep doing what makes them rich, meaning they didn’t become rich through one mechanism and then suddenly switch to real estate and business. If that was true, we’d see another chunk of statistics reflecting the people that had become rich, but not moved their money into real estate and business. In other words, if you don’t invest in real estate or build your own business, you aren’t going to be rich.

The study also asks people that run one or more businesses, how many people work in them. The median point (half above and half below) for the number of employees per business was two, showing how half of the businesses in this country are comprised of 1-2 people. That should be a positive sign to all of us that we can indeed form a business. The report was clear that businesses with more than 2 people accounted for 79.5% of the value of all such businesses. But remember, the first step towards building a big company is to build a small one. No business started out big, already worth billions of dollars and with thousands of employees. But what’s more important is that no business must become that big for the founder to become relatively rich.


Looking at the liabilities section, mortgages against the primary residence is the biggest factor, accounting for 74.1% of all debt. This has dropped barely from 75.2% in 2001. An interesting nugget in the world of debt is on page 63, where it shows total amount of debt, broken down by percentile of income. The top 10% of income earners hold more debt in primary residence, other real estate, and other things. While they have more credit card debt, the median was $8,000, which isn’t a huge amount for such high income. The big difference is holding $180,000 in other residential real estate compared to the 80-89.9% which hold only $88,000. This is a sign of leverage, and the rich understand this. By taking out extra debt to buy rental property, second homes, and other types of real estate, they can add to their net worth.

Fed Reserve 2012 bulletin – Debt by category and income

It also makes sense that most people, even if they aren’t rich, take out a mortgage to buy a house. Mortgages are one of the best wealth building tools we have. It allows us to build up net worth with a limited set of resources. If we tried to save our way towards a 100% cash purchase of a primary home, we would lose so much opportunity, it would outweigh the interest cost of the mortgage. Considering prime, owner occupied 30-year mortgages are now being sold with 3.5% interest, there is no better time  to get one.

It is also a sign of confidence that this country isn’t full of people carrying around $100,000 in credit card/student loan debt, but instead a more temperate truth that most people carry a modest amount of consumer debt that can be tackled. Many people debate whether or not student loan debt should be considered as evil as consumer debt. With consumer debt, you are buying things you want, but arguably don’t need. Student loan debt is to purchase an education that it meant to be a stepping stone towards a long term career which will yield a cash flow. The trick is the cash flow part. If you get an expensive degree at a high price school that doesn’t produce a decent job, you may have picked the wrong path. Standard 4-year college isn’t the only answer either. Some schools will let you transfer credits from a 2-year community college, allowing you to effectively discount part of your education. Another different path are vocational/trade schools. They also can produce careers. College isn’t for everyone.

Bottom line, we shouldn’t fear debt. After all, the rich use good debt to growth their net worth. With a proper view of bad debt (consumer) and good debt (investment/leverage), and a focus on developing cash flowing opportunities and assets, you have the means to build a business and real estate portfolio to grow your own wealth over time.

The good, the bad, and the ugly of leverage

Over the weekend, two significant things happened: the power outages in the West Virginia area caused one of Amazon’s regional data center to suffer an outage and a leap second was distributed to all computers and phones running NTP.

The cloud is good for us…

Companies have been discovering that by off loading major, critical operations to services like Amazon’s S3 and EC2 cloud support, they can leverage their development teams and more productively and efficiently. They are also able to enjoy better uptimes and longer mean-time-to-failures.

This means better profits, better products, and eventually lower prices for all of us. It is an economy of scale situation. Instead of every company paying for fully staffed sysadmins and devops team, they can delegate that to the cloud providers. This is leverage; one of the most powerful tools ever invented.

Remember your grade school science classes when they mentioned things like the pulley, the wheel, the wedge, and the lever? Archimedes is the one who said, “give me a lever long enough and a fulcrum on which to place it, and I shall move the world.”The lever works by trading force for distance. By requiring you to move a lever twice as far, you only need supply half the force.

…even if the news stories don’t support it

When 1% of the internet goes down due to Amazon’s cloud outage followed by a leap second bug 48 hours later, it makes big news headlines. Services like Netflix depend on the cloud, and people began to doubt whether the cloud really is the right solution to pursue. What makes this hard to judge is a form of journalistic bias. I’m not talking about left wing/right wing political bias, but instead what is/isn’t reported. When a single system goes down and impacts dozens of popular, online services, it’s easy for the reporters to flock to the central location and write their negative stories.

But when lots of small companies, running their own systems, suffer the same power outage, the problem isn’t as centralized. Reporters may still write about the power outage, but it doesn’t have the same amount of leverage and it’s not as noticeable to the consuming public. Moving further along the spectrum, the companies that were prepared for both of these situations by having backup generators, backup clouds, and prepped for the leap second, typically don’t show up in the news at all. When things work perfectly and no outage is involved, it doesn’t make for an exciting headline.

Good debt vs. bad debt

Leverage carries similar power in financial circles. When you borrow money from a bank to buy real estate, you need only supply a fraction of the capital, but you can gain extra “distance”, i.e. earnings when you either pour the rent money into paying it off or letting appreciate in value (or a combination of both).

But every investment includes risk. Your property may not have tentants, resulting in negative cash flow. Or it might fall in value, reducing your equity position. The thing to remember with leverage, is that it amplifies the outcome. If you suffer losses, leverage can cause you to lose big time.

That is the reason many people abhor debt. Consumer debt (credit cards/auto loans) should be viewed as bad, because it eat ups more capital for assets that produce no revenue. But debt used to purchase cash flowing assets (stocks and real estate) requires a different evaluation. It could be good for you, or bad.

As my buddy Jeff Brown says, buying swamp land is still real estate but would be stupid to buy. If you invest in good quality real estate (including good location AND quality property), you will attract good tenants and end up making money. No spreadsheet will provide the complete answer to this.

Leverage amplifies results

The key principle of leverage is that is AMPLIFIES the results. If you invest in a good cloud provider, or buy a good piece of real estate, the leverage will help you in the long run, BIG TIME, despite the occasional bump in the road or vacant tenant. You are also unlikely to make any news headlines. But if you invest in some cheap provider or buy the cheapest property you can find, and the leverage bankrupts you, then you stand a greater chance of ending up in the news and giving politicians something else to regulate to death.

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.