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What the “Smart Money” Does to Create Real Financial Freedom in These Turbulent Financial Times
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#1 Myth in Finance: You must be willing to lose in order to have substantial gains.
Over the past three and half decades I’ve had the privilege of working with millions of people across the globe in business and personal development as well as personal finance. Thankfully, I’m honored to have access to some of the top financial traders in the country, 24 billionaire business moguls and other successful entrepreneurs / investors. Since the meltdown of 2008 I have been obsessed with uncovering ways that an average investor can prosper and yet still protect themselves in these extraordinarily turbulent times. I’ve been constantly asking the “smartest” guys in the room: What are the biggest Investment myths and what are the truths that can set people financially free in the “new normal” that we all need to navigate financially?
Often I ask these billionaire clients of mine, if you could not leave your kids your actual financial wealth and you were going to give them the simplest plan for creating long term wealth, what would you tell them? They all give different answers but one of the most important themes they most often share is what I call Rule #1: Don’t lose money. That sounds wonderful but for a generation that has experienced two 40% drops in the past 10 years, is there really a practical way to do this in the modern financial world?
In Part 1 of this blog series, I identified many of the myths that are taught to us about investing and exposed a few of the lies that are perpetuated. Now it’s time to identify a couple strategies for the challenges ahead. What are those challenges?
Below are the three core challenges facing all who desire Financial Freedom:
1) Market Volatility: Put simply, this is the fact you can lose your hard earned savings. With two 40% market drops in the past 12 years, none of us can afford another.
2) Taxes: Finding tax efficiency is a CRUCIAL aspect to reaching a critical mass of investment capital that can give you real Financial Freedom for Life. Without understanding the impact of taxes, true financial freedom is a pipe dream. You can only spend your after-tax income. Unfortunately, most people in designing their needs for the future are failing to effectively anticipate what taxes will likely be. With $16 trillion in debt and what some now estimate as nearly $100 trillion dollars in unfunded liabilities (Medicare, Social Security, etc.) do you think taxes will be higher or lower in the future? This one is not hard to guess! To understand why being conscious of tax efficient investment opportunities is so crucial, review this simple example below.
A dollar that doubles every year for 20 years grows to $1,048,576. What do you think the number will be if you take the same scenario and assume that gains are taxed each year at 33%? The ending balance is only $28,466!!!!
3) Excessive Fees: While we can all expect to pay a reasonable fee to invest, many are unaware that the “fees” they are often quoted are not the fees they actually pay. For example, many investors believe the “Expense Ratio” is the only fee paid within a mutual fund. In addition to the Expense Ratio, one must add the Transaction Costs (brokerage commissions, market impact, spread costs), Tax Costs, Cash Drag, Soft Dollar Costs, and Advisory Fees. Forbes Magazine estimates the average cost of owning a mutual fund to be 4.1% annually (if held in a taxable account) and 3.1% (if held in a 401k plan). And remember that they get their fees before you make a dollar. If an individual made a $1000 investment at age 20, and received 8% annualized returns, the account balance would grow to $109,358 by age 80. If a 2.5% annual management fee was added into the equation, the ending account balance would only be $26,206. Ouch.
One Possible Strategy
It’s been said that if you give a man a hammer, everything becomes a nail. This is to say the strategy I have outlined below is not the “be all, end all” strategy, nor is it for everyone or every situation. My objective is to outline a financial strategy that many are unaware of, one that provides a “safer money” option in turbulent times.
Participating in market gains, but not market losses is the investing equivalent of having your cake and eating it too. Many are told that they must be willing to lose in order to generate gains. That’s not always true. “Indexing” is a specific strategy that has been around for quite some time and is available in a variety of different instruments from Market Linked CD’s to Annuities to Life Insurance.
Products with “Indexing” generally provide the following benefits….
- 100% of your principal is protected from market decline.
- You earn a fixed rate of interest OR you can forego the fixed rate and link your interest earnings, in part, to the performance of an external market index (i.e. S&P 500®). When the index goes up, your interest credits get to participate in the index gains (usually subject to a cap).
- The interest crediting rate will never be less than zero percent, even if the Index goes down.
- When the Index goes up, any interest credits are “locked in”, added to your account value and this amount becomes the new “floor” from which the subsequent year’s interest credits are calculated. Previous “locked in” interest cannot be lost as a result of market decline and the participation in upside market performance is usually subject to a maximum or “cap.”
- Your interest grows without tax until payments are received.
- While there are generally penalties for early withdrawals, there are no annual “management fees” withdrawn from your account value.
As I mentioned, “Indexing” exists inside various instruments but in this blog I will focus on the “Fixed Index Annuity.” A Fixed Index Annuity (FIA) is a contract between you and an insurance company. Although these products have been around for almost 20 years, many people are just now learning more about how they work. These contracts can vary greatly from company to company, but here are the general “4 pillars” of a Fixed Index Annuity (FIA):
- 100% Principal Protection from market decline: If the linked index goes down, there is no loss in principal due to market decline. In addition, no annual management fees are deducted.
- You can link your interest credits to a variety of indices from the S&P 500® to the Dow Jones Industrial Average to other unique indexes that may track gold, managed futures or foreign markets. Interest crediting strategies and linked indexes will vary by company.
- Your interest credits are tax-deferred just like an IRA (but there is no limit on your after tax contributions).
- A new and attractive benefit that you can add is something called a lifetime income rider, which GUARANTEES a specific income amount you cannot outlive (not every company offers these, and there is typically an additional rider cost).
Growth and Income
In today’s economic environment, where returns for “safe capital” are miniscule, FIAs can be a great alternative to other “safer money” financial instruments. A recently conducted study by Wharton Business School titled “Real World Index Annuity Returns” states “Index annuities have been producing returns since the first one was purchased on February 15, 1995.” The study goes on to say “From 1997 through 2007 the five-year annualized returns for FIAs averaged 5.79%.”
Furthermore, with the addition of the “lifetime income rider” I discussed above, many FIAs today offer the contract holder the opportunity to have their money grow at a guaranteed rate ranging from 5-7%. This balance is called the income account value, and while it cannot be accessed in a lump sum, it can be turned into a lifetime income stream whenever you choose, similar to a traditional pension plan.
FIAs are insurance products with advantages and disadvantages that are different from the pros and cons of mutual funds. Annuity objections are widespread but often misguided or simply wrong. The problem tends to be there are so many different types of annuities, and the objections are broadly applied to all annuities, when in fact they work in very different and unique ways. Let’s explore three of the most common…
OBJECTION #1: Fixed Indexed Annuities Have High Fees
Unfortunately Fixed Index Annuities are frequently confused with Variable Annuities, which is a product which is an insurance product that offers investment options. In addition to the market risk that comes along with Variable Annuities, they also have numerous fees such as administrative fees, mortality and expense charges, as well as the investment management fees charged by the underlying sub-accounts/mutual funds. We have identified 10 separate fees within a variable annuity that can average 2.5% to 4.5% annually. Unlike Variable Annuities and Mutual Funds, a Fixed Index Annuity does not deduct sales charges, management fees or 12b-1 marketing fees. A 2012 Barron’s article explains, “In these (FIAs) and other fixed annuities, the pricing is built into the payout rates, so the only sound way to size them up is by comparing what you ultimately pocket if you go with one contract over another.” Many FIAs offer an optional guaranteed lifetime income rider which can have additional costs. However, almost all FIAs are subject to holding periods and surrender charges for early withdrawals which can result in loss of premium if the terms of the contract are not followed.
OBJECTION #2: Fixed Indexed Annuities Are Mostly Illiquid
Because of the guarantees provided within Fixed Indexed Annuities, surrender charges will come into play if the client decides to “cash in” and walk away in the early years of the contract (generally within the first 7-10 years). A surrender penalty is what allows the insurance company to credit competitive interest rates to the annuity when the client purchases the contract for a premium from the insurance company. Annuities may provide several options for early withdrawals without a penalty as the 2010 study by Wharton University explains; “Many critics fail to take into account the various free withdrawal provisions in all FIA’s. Generally a 10% withdrawal is allowed annually without surrender. Many FIA issuers offer full surrender without penalty for nursing home stays, extended hospital visits and terminal illness.
OBJECTION #3: Annuity Commissions, Like Mutual Fund Commissions, Negatively Affect a Client’s Account Balance
The insurance professional assisting a client with the purchase of a Fixed Index Annuity is usually paid a one time commission or marketing fee by the insurance carrier. It is important to note that unlike mutual fund commissions that are deducted from a client’s annual account balance, a commission paid on the sale of an FIA does not negatively affect a client’s account balance. So, as a consumer, if you give the insurance company $100,000, your account balance will be $100,000 from day one.
IMPORTANT NOTE: NOT ALL FIAs ARE GOOD PRODUCTS
FIAs and the guarantees they provide are only as good as the companies that are backing them. Insurance firms that have lasted the test of time are dominating the space. Many of these have been in business more than100 years and have kept their financial commitments through depressions, recessions, world wars and market crashes such as 2008. There are other insurance companies that are not time tested and design products that are inefficient and have relatively high charges. It’s a balance between providing benefits to the clients and the insurance company making profit. This is particularly an issue for publicly traded companies that need to drive earnings to shareholders
Performance Financial, an educational and financial services organization in which I am a partner, provides in-depth education and empowerment for people looking to take control of their financial destiny. Performance Financial Partners is a network of independent advisers and insurance professionals across the country that we have hand selected for their experience and alignment in philosophy. Over the past 8 years, our collective partnership has completed over $5 Billion in FIA sales with highly rated insurance companies.
In PART THREE of this series, I will lay out additional strategies that are pertinent to hedging against inflation. At 3.25%, inflation will double every 19 years. In other words, 19 years from now, you would need double the income to maintain your current standard of living. Do you have a plan to deal with this “silent tax”?