Last time, we discussed the historical aspects of insurance when life insurance first came about, the various products and most importantly, the three fundamental questions you need to ask yourself about any life insurance purchase:
We went over the various kinds of life insurance that are available. If you remember, there was one particular product that I was talking about that’s now become the one that we used the most out there in the environment which is Equity Index Universal Life.
What you’re going to hear about today is that this particular insurance product can be an addition to a retirement plan. It provides supplemental retirement income.
Now, what we aim to do with our retirement funds is to create an income that will replace our income during the years that we worked in our retirement years when we’re not working.
We know that taxes are going to go up. If you didn’t know this, I’m going to reiterate it again. Any 401(k) plan or IRA plan that you have will be taxed at ordinary income the day you start taking withdrawals out of it.
Now, the government also makes it mandatory for you to take those distributions when you become 70½ years old. Whether you need it or want it, you absolutely have to take it out. If you don’t, they’re going to penalize you at 50% plus the ordinary taxes that would be on that distribution; and oftentimes we see that as much as 70% could be eaten away by the penalty and taxes on that because somebody just forgot to take a distribution that year because they really didn’t need the money.
You want to have some flexibility with another tool that you can take money out when you need it, or leave it alone when you don’t need it and when you are taking it out. It’s going to be taking out tax-free and (characterize this) alone.
So, when we look at where is the best place to save for retirement, we want to try and think about life insurance in a different context as a retirement planning tool. Now, there are only two reasons that stock prices go up over time and that’s rising in corporate earnings or increases in the profits and earnings ratio.
This is something that was not adhered to during 2000 when we had a lot of the dot bombs or dot com companies that became bombs and blew up. People were just simply going off with a name of what they were supposed to be doing, and instantly the buzz about that particular company will create such a rush, such a frenzy that everybody would be investing in that company was based on nothing, nothing traditional.
Here is the real basis for investing in a company. It’s the rise in its corporate earnings and an increase in the P/E ratios. As we know going forward, these are absolutely the two things we want to look forward to for doing any stock investment. Expansion of P/E ratios has accounted for 3.5% of the index as annual gain over the past 30 years.
So, if we look at the history of the S&P 500, P/E ratios have contributed to those gains significantly over the last 30 years. So, again, you want to pay particular attention to P/E ratios if you’re going to do any investing in a company.
I always recommend that people take a look at doing the index itself, and you’ll see why in a moment.
We look at John Bogle. If you’re unfamiliar with who John Bogle is, John Bogle is the man that created that Vanguard 500 Index Fund. The man is a wizard of investing knowledge. In his book, The Little Book of Common Sense Investing, he stated my guess is that P/E might ease down to say 16 times reducing the market’s return by about one percentage point a year to an annual rate of return of 7%.
So, what that means is going forward. We only have about a 7% interest opportunity off of the stock market going forward in what looks like it’s going to be less robust market going forward.
Mutual fund performance: Studies have shown mutual funds underperformed the market and here is the study. One thousand two hundred and twenty-six actively managed funds with a five-year track record did 1.9% less than the S&P 500.
Six hundred and twenty-three actively managed funds with a 10-year track record did 1.7% less than the S&P 500. Four hundred and six actively managed funds with 15-year track records did 1.5% less than the S&P 500. Adjusted for survivorship bias, 1.5% worse with returns corrected for survivorship bias the average actively managed fund trails the market by about 3 percentage points per year.
Now, these funds are not even keeping on track with what the index is doing.
There was a great commentary from Motely Fool that said, the truth of the matter is that over time the vast majority, approximately 80% of mutual funds underperformed the overall stock market. So, why would go anywhere else outside the index?
Here’s why the highest causes of that. It’s the actively managed funds that have 2 to 3% management cost a year of different fees associated with it.
There are the sales charges, the 12b-1 fees, management fees, fund expenses, transaction costs and there’s a giant additional cost all of the more pernicious says John Bogle by being invisible.
I am referring to the hidden cost of portfolio turnover estimated at a full 1% a year. With that means is sometimes someone who is managing that fund leaves, resigns and someone else takes over, and then there’s a turnover cost.
All these things put together, you can see how they can eat away and erode your funds that are sitting in there that are supposed to be building up for your retirement.
As you sit back and contemplate upon that and think about how is this really affecting my retirement, you have to know based on the statistics that we just showed you it’s disastrous.
Why would you let a train that’s on the wrong track continue heading there when you now have this knowledge about putting it back on the right track.
Mutual funds are so profitable for everybody, but the investor that there are now more mutual funds than there are stocks. Just look out there and see what’s available for investment. There are more mutual funds in stocks and exchange, and the reason is it’s a very profitable business.
My case in point is in 2008. Some of the people at some of the big wirehouses are big. The financial institutions got Christmas bonuses in the $50 million range just for one individual.
Now, 2008 was a year when the market did absolutely nothing for anyone except for those folks with bonuses. You have to ask yourself where that money came from to pay those bonuses. Oh! these mutual fund fees right here of course. What does this mean in dollars and cents? Well, if you had an initial investment of $10,000 over 50 years- we’ll just do a really extended period of time, 50 years, and assume that you got 8% annual market growth every one of those years, here is what it would look like.
Here is your market growth without expenses. That $10,000 would grow to $469,000.
With just 2.5% annual expenses that are reduced to $145,000, almost 75% of it is eaten away because of those expenses and costs that are attributable to that investment.
What does this mean again in dollars and cents? Let’s take a look at a long-term period of say 35 years, the typical period that you would be waiting to go into your retirement. Now, the same initial investment $10,000, and if you’re investing in the average equity fund out there, that $10,000 could grow to $98,200.
Now, if you just went and purely invest it into an index fund that has lower loads which means the costs and expenses are much lower, you could easily grow to $170,000. That’s almost doubling it by taking the expenses and the loads out of the equation. In fact, Peter Lynch himself said in Barron, the public would be better off with an index fund and indeed many of them have now created index funds since Vanguard first came out with the Equity Index 500 Fund. So, it’s very difficult to choose the right fund.
Let me give you a little story.
When I was going to my first law firm, I was going to participate in the 401(k) plan. Instantly they handed me a little book, and that book had a number of plans that would be associated with this plan, and I didn’t know what any of these things meant. There was a bond fund. There was an international fund.
There was this fund and that fund, and it was all very confusing and anyone that I wanted eventually sent me a portfolio or a prospectus that told me what it had done previously, but they never told me what they thought it would be doing going forward.
You get all these rankings and they tell you what they’ve done previously. It’s quite confusing. So, what I want to communicate to you is we’re going to take a look at what Forbes Honor Roll funds did. These are the crème of the crop, the best funds that Forbes found.
Okay. We take that same initial investment of $10,000. We look at it from a long-term standpoint of investing for our retirement, and we’re going to take that period from 1974 to 1992 if we had taken those Honor Roll funds. If we did that, that $10,000 will return to us $75,000 based on the Honor Roll funds.
If we had put those same funds into the average equity mutual fund, which means we’re just going into funds that are outside of the Honor Roll, we’re going to have increased that up to $94,000.
Now, if we just invested purely in an index something like the Wilshire 5000 Index during that period. It would easily have been over $100,000- and so you can see the progression of being able to increase yourself or reducing expenses and going with sometimes simple investments.
Now, John Bogle says in his book, only three out of the 355 equity funds that started the race in 1970. Less than 1% have survived and mounted a record of sustained excellence. What does sustained excellence mean?
That means that it’s kept on track with the S&P 500 and that’d been cut short of what the S&P 500 did. So, I ask you again, when you went to work and you participated in your plan or you moved your money out of that 401(k) into an IRA and you started choosing funds; how did you choose the three at less than 1% that would actually do something compelling or something that would be excellent? It stays on track with the S&P 500. You’re probably not there.
Mutual funds provide no downside protection as well. When the market goes down, you take that ride all the way down with it. So, the S&P 500 by itself is over time has averaged a downside of 17.6%. But wait, is that really that bad? Well, let’s look at what some other funds did.
Well in 2001 the Merrill Lynch Mid-Cap growth did about 36.6% down. Merrill Lynch Focused Twenty fund was down 17%. So, as you can see, a lot of these funds end up being down even lower than the index when the market is down.
So, you’re compounding your losses. You’ve heard of compound interest, how about compounding losses? That’s sometimes what you’re going to experience by being in the wrong front. Finally, I want to look at what some experts have to say.
Buying funds based purely on past performance is one of the stupidest things an investor can do. That’s Jason Zweig from Money Magazine columnist.
That’s exactly what they ask us to do every day. Here is its prospectus. Here is what this particular fund has done previously, but then they’re in the very small print, they tell us future results are not indicative of past performance. So, basically they have just taken away everything that they’ve shown us.
There’s Ted Aronson, a partner with a money management firm. He says he’s owned a Vanguard Index 500 fund for 23 years. Once you throw in taxes, it just skewers the argument for active management. He says personally I think indexing wins hands down.
After-tax, active management just cannot win. I’m going to hold back who said this next statement, but let’s just read it together. It’s fun to play around. It’s human nature to try and select the right horse but for the average person.
I’m more of an indexer, the predictability is too high. For 5, 10, 15, 20 years you’ll be in the 85th percentile of performance. Why would you screw it up? That comes from Charles Schwab himself. So, what he’s saying here is that you can screw it up folks if you don’t just stay with an index fund.
So, when we’re thinking about retirement, it’s long-term.
It should be at least a 10, 15 plus year ride. What is that long-term vehicle going to look like? Well, it should perform well in a less robust market. We just heard that the market is likely to return 7%, most likely less.
It should reduce or eliminate risk. Benjamin Graham who was the mentor for Warren Buffet used to say that investment was something that protects your principle or preserved it and provided an adequate return. Here we want to reduce and eliminate a risk which is the preservation of that principle. We should be tax efficient. We should have low expenses or expenses that decrease over time.
That brings us to my conversation about life insurance, that Index Universal Life has some of these components. The cash growth can be linked to 140% of the S&P 500 with one product. There are several products out there. Not all of the credit 140%. Some are only at 100. They’re guaranteed not to go down if the market declines.
I’ll talk more about that in a moment.
There are low insurance costs and expenses over time which starts out a little higher initially, but over time it decreases which is a few basis points.
It has tax free growth and tax free distributions, and tax free distributions are primarily predicated on this idea that you have a dynamic loan provision and you’re going to be taking money back to yourself characterized as a loan. As you know, a loan is not considered income in the eyes of the tax person.
Index Universal Life Dynamic Loan Provision: So, this is how this works. Traditional life insurance charges interest and then they credit you that same interest. That is the industry is referred to as no net cost or zero wash loan. So, in other words, you take up money and you’re charged interest. They now credit you that same amount of interest zero wash.
The way the equity index products work- and we’re specifically talking about one of the products out there that we really like. Say we’re charging interest of 4.65%, while you’re getting credited 140% of the S&P 500 on this loan provision, it looks like this.
S&P 500 is up 5% while at that 140% marker, you’re almost being credited 7% of the credit. Now, we subtract that 4.65% charge for the interest, and you’ve actually netted a 2.35% profit on the money you’ve not taken out of the policy. That’s called arbitrage. That’s where we’re getting a benefit by a variance in two different markets.
So, again, the cash money growth is linked to 140% or 100% with some products at the S&P 500 Index, or we’ve just heard that you can’t go wrong by doing index investing.
It’s much more reliable than many of the funds that are out. You’re guaranteed not to go down if the market declines. Guaranteed, you’re going to keep all of your earnings. Low insurance costs and expenses, it descends over time and shrinks down to just a few basis points.
Typical management fees can be anywhere from 2% annually; and as your funds grow that 2% is going to cost you a lot of money over time. Tax-free growth, tax-free distributions and a dynamic loan provision so that we take the money back to yourself for retirement. You’re going to be doing that tax-free.
Annual Reset Feature: Now, what does mean? Well, here’s how it works. The best way is to articulate it here in an illustration. Say in year 1, if the market goes up 10%, you get credited some of that 10%. Well then in year 2, the market goes down 5%.
So, did I just lose 5%? Well, that would be the typical way that your investment would go if you were in a mutual fund. You’re just in stocks, but with the annual reset feature that protects you, I mean, one of the equitable index products whether that be more of the annuities or life insurance contracts, you get locked in. So, you stay up at 10% while everybody else goes down 5%. Then in year 3, the market is up 8% and you just captured yourself up to 20% that year.
Then in year 4, the market goes down an entire 18%. Look you’d be almost down in just having 2% left of all those earnings just because the market decided to go (poopoo) with that one year. We know that that can happen overnight. If you just think back to 911 or 912, one geopolitical event knocked the market down by 50% so losing something like 18% could happen just by waking up in the morning.
Here you have that type of situation where here you would be down, but not with one of these products. The dynamic loan provision protects you from downside market risk and you would stay up at your 20%. So, you are always starting where the market creeps its way back up.
You’re never taking that roller coaster ride down. It’s something out of a roller coaster that continues its ride upwards. So, let’s reiterate some of the ideas of this: 5% S&P 500 Index growth times by 140% of the participation rate which gives you about 7% credit into your cash values which are the little account that’s built up inside the policy that exceeds the cost of the insurance.
Then if you would take a dynamic loan provision back to yourself, you would get that little spread that 2.35 that we saw which generates a 9% internal rate of return in the policy.
If over time we look at what the internal insurance cost usually gets down to, it’s about half a point and we subtract that from that 9% internal rate of return. Then you have an approximate 8.5% of internal rate of return and that’s what’s you’re earning on your money probably by the time you get to your 10 with your policy. So, how can insurance companies do this you may be asking yourself?
I’m going to show you in an illustration real quickly how that works. You have the insurance company and you have premium expenses which are to ensure you, and you make those payments and out of those payments, they invest in corporate grade government bonds.
With the interest that’s spun off of those corporate bonds, they buy options both puts and calls on the S&P 500 and that produces 140% gains to a maximum of 10% which is capped on those options. Then those then spin off interest and they’re used to go and buy more bonds and it becomes quite cyclic, and that’s why they’re able to go out and credits you 140% of the gains.
The bonds provide the principal guarantee. Interest pays for the option spreads and the option provides the yield that ultimately you inherit with you cash values.
So, here’s a retirement income comparison. Here are the assumptions: You have a mutual fund match market with dividends, 1.75% covering expenses, 100% of the mutual fund gains are subject to long-term taxation and there’s no dividends paid on life policy.
You got $25,000 away per year and an investment premium for 10 years and your retirement income that will begin in year 20. So, how does that match up the index life with your typical mutual fund? We’re going to now look at various interest rates that would be spun off; because really, interest rates have a powerful and profound effect on what you ultimately have in your retirement income.
So, let’s take a look at how this plays out at 4%. At 4%, that mutual fund will return to you $13,000 and that’s over the 20-year cycle.
Now, that index fund because of the tax preservation, the preservation of principal, you’re looking at earning around $35,000 so that same amount of money. That’s almost double.
Now, if we just ratchet things up just one more percentage point and you happen to average out earning 5% on your money, that mutual fund will give you $18,483. But the index fund would be able to yield $69,409. Again, almost double the results of what the mutual fund is capable of doing because it’s held down due to the expenses and taxation.
Now, if we just ratchet things up one more percentage point to 6%, it’s probably doable. It’s an average 6% over time. Your mutual fund would give you $25,000. You’ve kind of now almost doubled your money in a 20-year period; but with the equity index Universal Life product, you’re looking at $113,000 practically quadrupling your income.
So, when you’re thinking about retirement, isn’t the idea to capture the highest interest rate you can earn more so that you can outpace inflation and try and reduce and get away from as much taxation? Sure it is, absolutely.
Those are the ideas and those are the things that you have to strive to achieve. John Bogle says, avoid financial advisors who claim they can predict and advance top performing managers. The best advisors can help you develop a long range investment strategy, an intelligent plan for its implementation. An intelligent plan is going to incorporate the things we just discussed.
It’s going to help you maximize your interest rates. It’s going to help you outpace inflation and it’s going to reduce or eliminate taxation on those funds.
That’s all I have for you today. Next time we’re going to be looking at another life insurance strategy for either your retirement or your business planning. Until next time, thanks again for joining us.