How to evaluate a cash value life insurance policy

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

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

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

The cornerstone of cash value

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

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

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

Some real numbers

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

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

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

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

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

Actual yield of a whole life policy

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

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

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

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

Happy investing!

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

“Another day, another dollar” — common expression

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

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

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

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

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

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

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

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

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

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

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

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

Where have you been? Retail investors vs. macroeconomic investors

It may seem as if this blog has fallen off the planet. There’s a good reason. At the end of May, I signed a contract to write the technical book Learning Spring Boot. Suffice it to say, that effort has consume all my spare time in the evening. Since my work couldn’t stop, the thing that suffered was this blog. If you ever run into a chance to tap your cognitive surplus, I suggest you go for it!

Technical writing aside, I was drawn into a discussion on Bigger Pockets. In the article, Jeff Brown shows how so many investors are focused on formulae, tricks, tactics, but never on the end results.

People have horrendous savings. They aren’t loading up their 401K plans, their personal savings accounts, or anything else, on average. In fact, whenever I hear this brought up, it reminds me of a finance show on TV years ago where Ben Stein was commented how “Americans aren’t saving enough money.” I didn’t think much at the time, but the comment, by itself, is incredibly insightful. The first step towards successfully building retirement wealth is recognizing when you AREN’T.

Jeff Brown has written a couple recent posts pointing out how even IF you can rack up $1MM in your 401K plan, you’re not DOING ENOUGH. Given that almost everyone has less than $100,000, the issue should drive anyone CRAZY with panic.

In the comments, someone nonetheless brought up “retail investors,” a term minted to refer to people that buy turn key rental property. Instead of buying good deals, i.e. making money when you buy, “retail investors” typically buy what they can find and, on average, crash and burn when Murphy visits, nixing their cash flow.

I wouldn’t stand for this short sighted characterization and remarked that the path to retirement wealth isn’t confined to fix-it-up rentals. I created the expression “macroeconomic investor” since I have invested in Texas-based rental properties. Texas has shown tremendous job growth. In fact, 2006-2011 demonstrated a stronger job growth that all other states COMBINED.

When a flood of people are headed to a particular thanks to a booming economy, there is a natural consequence. They all need a place to sleep. I went on to comment:

So…I can either invest a lot of time and effort locally, or I can take my investment capital to Texas and invest there. One option requires that I invest a lot item, even potentially ending my successful career as a software engineer to get the maximum cash flow. The other option says I can invest where I’ll get higher yield, better tenant options, and newer, fresher properties, if I’m willing to sacrifice a certain overhead for others to manage it.

People love to show off their rentals. Even better, they pride themselves on finding something local and able to drive by it and show it off! Sorry, but that is amateur. Critical thing is to look at total results, and see if your fix-it-up property can generate a better yield rate than buying new properties remotely and incurring the overhead of property managers.

I have had Murphy strike twice and knock me down to 75% occupancy. Thanks to having a pro team support me, I have been cash flow positive, despite pouring an extra $1000/month into one of the mortgages to pay it off faster.

I can’t guarantee I’ll blog as frequently as I did before my current writing endeavor. But I just couldn’t keep this to myself. (Seeing some  of my past readers comment how they enjoyed my writing was inspirational as well!)

The cost of over diversifying

I recently spotted an article that documents a couple approaching retirement. They hold over seventy mutual funds and their estimated annual fees total $32,475! I was at first stunned at the amount of annual fees they are paying. But as I read things in more detail, it all made sense.

The couple had granted a financial adviser authority to make purchases and reallocations. Quite naturally, various funds were picked, and it turns out, their average fee was 2.5%. That might not sound like a lot until you accumulate $1.3 million in holdings. When you hold that much, 2.5% turns into over $32,000.

The article pointed out how multiple mutual funds held the same stocks. They were over diversified and didn’t know it. Another piece of the puzzle was how the wife and the husband both had funds, and when they got married, they just combined it all without thinking about concentrating anything.

But this isn’t where the real shock and awe occurs. The proposed solution is to trim things down such they hold perhaps half a dozen funds or ETFs with the hope that their costs can be brought down to perhaps 1%. What?!? With $1.3 million, this will come to about $13,000 a year in costs. What if they enjoy a nice twenty year retirement? That would add up to $260,000 in fees. Crazy!!! Why do you we assume this licensed financial advisor will be any better?

If this couple could pause and do some of their own homework, they might discover that the gobs of funds they own hold positions in stocks like KO, WMT, CVX, BP, GD, IBM, ABT, MCD, PEP, and a dozen other blue chip stocks that have been growing dividend payments for decades. Imagine what would happen if they sold all their positions and instead, split things up amongst ten blue chip stocks.

If they could buy $130,000 of ten different blue chips do you know what their annual fees would be? $0! Each transaction would cost about $10, totaling $100. They might get stiffed some back end fees to cash out of these mutual funds, but at an annual cost of $13,000, I think it’s worth it.

If it was me, I would be ready to take it all out and buy some rental property. But a part of me would be willing to split it in half. Pour half into some rental property and keep the other half to buy some rock solid blue chip stocks. Forget about these annual fees. Get some cash flowing stocks (not mutual funds) as well as rental property, and no longer think about liquidating your portfolio when you enter retirement.

This couple has already done a good job at stocking up on assets. They have $1.3 million, which is WAY above the norm in savings. The average person aged 55-64 has $179,000 in assets, counting their home, which isn’t impressive. These people are way ahead. Why throw it all away with ridiculous fees coupled to something that doesn’t have a history of growing faster than inflation? They will be spending their entire retirement worrying whether they are going to outlive their money.

When you own real estate and dividend paying stocks you don’t liquidate your portfolio. Instead, you get paid dividends and rent, and as profits grow, you receive raises in the form of increased dividend payments and rent increases. Neither of which is a path a licensed financial advisor is going to suggest. After all, where’s the money in that?

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 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.

All fluff and no stuff

On twitter, I saw a promoted link from a well known financial service company. It was a link to video about how a family forged a path in investments to not only send their four children to college, but to also have their own golden retirement. As I watched this short video, I kept waiting for specifics, but turned out to be nothing but marketing fluff.

There was a sweet description of how this family was formed. The family realized it was better to live in a smaller house rather than a mini-mansion. This prioritization would make it possible for them to send all four of their kids to college with good, solid investments. The parents were also happy that they could split their attention equally with their own retirement. In the end, they wanted to be the “party grandparents” meaning they hoped in retirement, their kids and grandkids would be visiting them often.

See any issues here?

For an ad showing the power and value of investing in your child’s future, the video had little concrete info.

  • Is this financial institution succeeding in sending high school graduates to college?
  • Are people coming in short of needed funds? 
  • What about the people that saved up money in these plans, and their kids turned out to not want to go to college?
Guess what: the video doesn’t answer any of this. No demonstration of how they have the edge over any other investment house you can find.

Studies show that parents aren’t saving enough money to send kids to college. But what is the core reason behind that? Parents are lazy or not doing things right? Or is it because the cost of college in relation to average income has risen? It’s a complex issue, because while tuition has been rising, the number of dollars in various forms of student aid has risen as well. Essentially, it may next to impossible to predict what college will cost when your kids get there. But this video talked about none of that. Instead, the two concrete things it mentioned were: buy a smaller house, and split your investment dollars 50/50 between your kid’s college and your own retirement.

Too many assumptions
Something I notice frequently in any discussion of 529 plans or other college savings plans are a list of implicit assumptions.
  • Investing for college means investing in mutual funds
  • We are only talking about college. Other vocations and plans are simply off the table
  • You can and MUST save for your kids’ college.
Almost nothing is said except the occasional comment about picking a good fund manager, and not getting hung up on the returns of the fund. Huh??? A good fund manager should lead to good fund returns, right? I have noticed that they are coming up with strategic funds that are based on coming to fruition in a certain year. Essentially, people starting with a 5-year-old child have different saving needs than someone who is 15. While this makes sense on the surface, is there any evidence out there that this beats the existing funds?
What leads me to say no, is because these plans have the same structure as any other 401K or VUL. You can put in a certain amount of money, and then pick what funds to use the money on. If you have trouble with a certain fund, you can rebalance your money into other fund. 

In investor speak, that means sell when the fund is low, and buy some other hot fund when it’s high.

In case you aren’t aware, that will kill your chances at growth, just like any other mutual fund based approach. Considering that the variation of mutual fund performance has been really wide over the years makes it a real bet on whether or not mutual funds can beat their historical performances, let alone the potential inflation of costs of college.

There is a huge assumption that college is the best route to go, and it is best for everybody. That simply isn’t true. Some of the richest people out there never went to college. That doesn’t mean college is bad for you. It just means it isn’t the end-all/be-all of your career. I personally know people that went into home construction and made a fortune. Some of them weren’t good at storing the wealth they had built, and suffered tough times during 2001 and 2008 when home construction slacked off. There are many career paths that aren’t necessary found through college. It means that we need to keep this type of flexibility in mind. If you sink lots of money into a 529 plan and your child picks an alternate career path, what then?

So what is something that might work?
Well, it just isn’t fair if I don’t put my own cards in the table. I have several strategies in play that should help me offer my children the support they need when they get to college.
  • Invest in real estate
  • Buy an EIUL
Real estate, when you focus early on growth, is a plan to get as much property as possible with a reasonable down payment. It doesn’t mean putting 50% down, nor 0%. Instead, something like 20-25% is a good fit. With that, I can probably buy twice as much as the 50% and four time as much as the person that wants to make a cash purchase. The plan is that in 18 years, I should be able to strategically build up a decent portfolio of many rental properties. When the time is right, I have many different options. I could sell one of my properties and probably put my kids through with that. You must realize that my crystal ball is as cracked as yours, so I cannot confirm that the value of real estate will rise at the same pace as the price of tuition, but I think it has much better odds than the value of mutual funds. I might also be able to use the cash flows from my rental portfolio and not sell anything. Or some combination thereof.
Real estate provides great tax advantages in that most if not all of the rent will be shielded by depreciation. This is better than the fancy tax laws used to make 529 Plans look nice. Did you know there are limits on what you can contribute to a 529 Plan? Things like gift taxes come into play. But if you simply pay a child’s tuition direct to the institution  it doesn’t trigger any tax laws, apart from shrinking your own estate.

Unfortunately, if you own rental property and seek student aid, you will have to report it as part of the evaluation. But that’s okay. If rental property provides the means to make it happen, that’s okay.

I also have an EIUL that in 15 years, may be feasible to borrow from if needed. Then I can pay it back when the time is right using my rental property to support my own retirement plans. Did you know that built up cash value in any permanent life insurance is not considered when determining student aid? The money stocked away there is off the books and not even looked at.

Both of these options provide much more flexibility to supporting your children’s future plans. They also don’t pull you off the path of building your own retirement, one of the best gifts you can give your children. Since the history of real estate and permanent life insurance is much stronger and not as risky, then it would appear to have a lot more substance than that video I saw about this family’s plans.

Does your 401K have $2,000,000 in it?

That’s how much you need if you plan to retire and draw a measly $80,000. Where did I get that figure?
Most financial advisers recommend withdrawing no more than 4% of your savings. The idea is that if you’re account grows at a decent amount, then that should still leave the principal balance in place. But what if you have a negative year? You either need another source of money, or you will have to cut into your principal.

So, assuming you have a 401K holding $2,000,000, when it comes time to retire, you call ’em up, and ask them to cut you a check for $80,000. Then when it comes time to file your taxes, are you ready to pay your dues to Uncle Sam? Assuming you have an effective tax rate of 25%, you are left with $60,000. Oh, remember all those tax deductions you used to get for your kids, and for the mortgage interest you paid when you had one? Gone. What about tax deductions for money stashed in a 401K? Gone. Yup, you’re, as BawldGuy says, “tax naked.” Ouch!

And don’t expect a thank you from Uncle Sam. He teamed up with Captain Corporate America and put this plan together in the first place. They knew you were going to be stuffing tons of money into your plan, because everyone else is too, so they rigged it so they could get a slice of your pie in retirement.

Cross checking with reality

What’s that? Your 401K isn’t close to $2,000,000? What do you have? Is it greater than $80,000? If so, you have beaten the average. The average amount of retirement savings for people ages 55-64 is around $80,000. Maybe you have something like $100,000, and are 20 years away from retirement. How much growth do you think you’ll need? Over 16% each and every year.

Ouch 2! But wait. Doesn’t the power of money grow exponentially? What if you are a bit younger and actually have 30 years until retirement? Pay it no mind that 30-year-olds average even less in retirement funds. To get from $100,000 to $2,000,000, you need 10.5% growth every year with no losses. Now that’s better, but better NEVER means good enough. Considering the average performance of investors using mutual funds over the past 20 years has been less than 4%, what are you odds you can do 2.5 times better than everyone else?

Losses will mess up your growth

Don’t forget that the math of losses and gains says that for any negative loss, you need an even bigger gain to get back to where you started. Let’s say you were shooting for 10.5% this year, but instead got hit by an 8% loss. What would need next year to get back to where you started? 8.7%. But that’s just to get back to where you started. Get back on your original plan of averaging 10.5%, you would need over 32%. Spread your recovery time over two years, and you only need 21%. In investor-speak, we say not going to happen.

Simply put, mutual funds inside 401K plans don’t work. They never have. Otherwise, you would be hearing about all these people retiring on their fabulous mutual funds. And double check those celebraties who keep telling you to dump all extra capital into paying off your home mortgage. Are those people retiring on mutual funds? Or are they retiring on money made off their TV and books, and possibly their own cash flowing rental property?

What does work

The key to retirement is acquiring cash flowing assets. That way, your retirement isn’t based on liquidating your portfolio. This more than anything can protect you from big time market downturns. Don’t worry about paying your personal home off early. It doesn’t yield any money. Instead, you should be seeking rental property, stocks, and permanent life insurance. These items really form the basis of a wealth building plan. If you want to discuss your options, drop me a line and we can chat.