Four years ago a woman named “Jane” had a problem.  She was receiving payments as part of a buyout from her husband’s business.  Her dilemma was how to replace the payments she was receiving while also trying to pass as much on to her kids as possible.  She was proud of her husband and the business that he created and passed on to their kids.  With all the hard work over the years if she wasn’t going to spend the money she wanted to make sure her family got as much as possible.

[As a side note she does have other assets and other income we are going to focus on one account for now]

Jane was about to turn 76.  The total sum of money that she had available was $300,000.  Her current accounts were $100,000 in a fixed annuity earning around 3.5% with Ameriprise, $120,000 in a few different CDs that were earning 3-4% and $80,000 in some mutual funds that an adviser had put together for her.  Are you with me so far?

What She Did

She put the full $300,000 into an AXA Equitable Accumulator, a variable annuity.  Then she added a couple of riders to her contract.  First she added a GMIB rider and then a death benefit rider.  We’ll get to those in a second.

Fees

That’s what everyone is thinking about and wondering about so let’s start there.  It is an annuity.  The basic contract has mortality and expenses associated with it totaling 1.25% per year.  The GMIB rider has an expense of 0.65% and the death benefit that she chose has an expense of 0.60%.  Getting expensive and we haven’t even added in the investments.  The investment expenses range from 0.64% to 3.65%.  Jane’s current portfolio is costing her 1.08%.  This brings the total charges on her contract to 3.58%.

Death Benefit Rider

The death benefit rider that Jane chose was the greater of 6% roll-up or annual ratchet to age 85.  During the first couple of years of the contract she was enjoying the annual ratchet.  With the lock-in in 2007 she was left with a death benefit of $380,000.  This meant that in 2008 when the market was falling, Jane’s death benefit on this contract was $380,000.  It was not subject to investment fluctuations.

Guaranteed Minimum Income Benefit

The GMIB rider that Jane chose gave her a base benefit that would roll-up by 6% per year.  She is required to hold the contract for 10 years after which point if she chooses she could annuitize off of the benefit amount regardless of her contract value.  For Jane this meant that she would start at $300,000.  She will earn 6% net of fees for her benefit amount.  So in the first year she would earn 6% of $300,000 or $18,000.  In the second year she will earn 6% of $318,000 or $19,080.  And so on.  Are you still with me?

Income

As we mentioned at the beginning Jane was going to be needing income in 2 years.  What this meant was that her account was allowed to do nothing but grow for the first two years.  In fact, with the market performance of 2006 and 2007 she found herself with a contract value of $380,000 and her benefit amount was $337,080.  Who needs this stinking safety net?  But now Jane needed income.  The way her GMIB works is that it allows her to take up to the 6% roll-up on her benefit on a dollar-for-dollar basis.  This meant that if she takes the 6% as income her benefit amount stays flat.  So this is what she did.  She took the 6% in the third contract year as monthly income and it came out to approximately $1,685 per month.

Taxes

Keep in mind that Jane had gains in this variable annuity due to market performance.  This was a non-qualified annuity which meant that the gains were taxable as ordinary income.  Annuities also follow LIFO which stand for last in, first out.  This means that all the gains come out before the contributions.  So when she began taking income in 2008 it was fully taxable and subject to a 20% withholding.  The checks she received then were for approximately $1,350.

2008 Market

Then 2008 hit.  The markets started to crash and they crashed fast.  Now because of her safety net, Jane chose to be a little bit more aggressive with this account.  She was actually in about a 65/35 splits towards equities.  The funny thing is today she has the same 65/35 split.  Her account is set to rebalance quarterly.  She just might need the safety net now.  Are the costs still too high?  The upside is that now she no longer has to worry about the taxability of her income since the gains in the account went away pretty quickly in 2008.

Today

Today she continues to receive her income of $1,685 per month.  Her account value is $255,000.  She started with $300,000 and has withdrawn about $40,000.  So it looks like she’s almost even.  Then we look at her benefit amount and it is $337,080.  Her death benefit was up to $380,000 using the ratchet feature but it has been reduced by the income she has received so today it is $340,000.  Remember that as she continues to take income this death benefit cannot fall below her contract benefit amount (the 6% roll-up).  One thing not to forget is that she can’t access that benefit amount until one of three things happens: 1. she passes away, 2. her account value drops to zero and 3. her 10th contract year (age 85).  This means she continues to receive her $1,685 per month until age 85 at which point she can then annuitize off the benefit amount which the contract estimates to provide $40,000 per year.  Not a bad pay raise.

What do you think?  Good deal?

**Disclaimer:  This is based on a true story.  Names have been changed and numbers adjusted slightly to make them more easier to work with.  All contract information was taken from the prospectus.  This contract is no longer offered.**

Related posts:

1. What Is Your Greatest Asset?

Have you read Seth Godin‘s What you buy when you buy a lottery ticket?  You should.  Actually, go read it so that my post makes more sense to you.

As I read it it made me think about investing.  Is it similar to the lottery for people?  Do you think people invest to get rich or just for the thrill?  The biggest differentiator may be that with the lottery you expect to lose and with investing people expect gains.  You don’t really expect to get rich in either event but that is the ultimate hope and dream right?

The lottery is just a random drawing of numbers.  No one wins those things.  So you throw a few dollars at it in hopes of a miracle but expecting nothing.  You could even argue that the best thing for the lottery are the smaller prizes.  How many times have you won $2, $5 or $10 on a scratch off ticket and just used it to buy more tickets.  You want to continue the journey and feel that thrill again.  The small prizes make you play more.  They show you the possibilities.  It’s a taste of the thrill.  It keeps you playing.  And the best part is this time it doesn’t feel like you’re spending money because it’s winnings going back in.

Investing might be more corrosive.  You play with larger amounts of money.  You have more of a feeling of control.  Especially since you are picking which companies or people to invest in.  You do your research and there is no reason you won’t make money, hell, with a little luck you might get rich.  Are people disciplined enough for this?  How is it that the average investor continues to trail the market badly?  Is it the “thrill of possibility”?

Unfortunately, most people don’t have a full understanding of the market.  Even the money managers aren’t right all the time.  The Bogleheads tell us that you can’t beat the market in the long run.  So do you try just for the thrill?  Is it the short-term wins that keep you investing?

Maybe this conversation should be reserved for penny stocks or small caps.  Isn’t that more similar to the lottery?  A lot less expectations, a better chance of losing it all.  What if they aren’t doing it for the money but for the chance that it will pay off bigtime?

Related posts:

1. Seth Godin Right Again.
2. Ahead of Chris Brogan, Seth Godin and Mark Cuban?

You can read anywhere and everywhere about how so and so lost x amount of money in their 401k or retirement accounts.  How much did you lose?  Is it done 10s of thousands?  100s of thousands of dollars?  I wonder, if someone came to you and said I can give you a safety net on your investment but it will cost you a percentage of your return, what percentage would you pay for that, if any?  Would you give up 1% per year to guarantee a safety net of 6%?  What if that safety net only cost you 0.5% per year?

No one can predict the future of the market.  They will always try and someone will guess right but no one knows for sure.  I find that as people get closer and closer to retirement they become more and more cautious of their investment losses.  Makes sense right?  Would they sleep better knowing that they had a safety net?

You might say why not just invest in safe investments.  My response to that is opportunity cost.  How much do you give up over the long term by moving to safe investments.  In todays environment you’re lucky to get a 2% rate of return from your 1-year CD.  According to the AllFinancialMatters the 20-year return for the S&P 500 from 1989-2008 is 8.41%  That gives an opportunity cost between the two of about 6%.  This gap is as big now as it has ever been due to interest rates being at historic lows.

What if you can have your cake and eat it to?  Let’s say your 55 or so years old.  You are very likely to live another 20 years if not 30 or more.  You plan on retiring in about 10 years and you’re a bit nervous about being invested in the market yet you need some returns on your money to retire comfortably.  You might even have a financial planner that showed you a nice compound interest curve.  Maybe you even realized that as your asset allocation gets more conservative you just might be Destroying Your Compound Interest.  What if someone offered a safety net?  Now it’s not free.  You get a guarantee that your account won’t earn less than 6%.  Meanwhile the account still stays fully (or as much as you choose) in the market.  The cost is that your fee comes out of your return.  So that if you earn 9% you would only see an 8 or 8.5% rate of return depending on your fee for this safety net.

There’s a lot more details to this obviously but I’m just wondering what fee would you be willing to pay.  Would you pay 1%?  Would you pay less?  I also understand that your answer might be different today than it would have been in 1999 or even in 2007.  That’s why I’m asking you today.  If you want clarification or you have questions, e-mail me.

No related posts.

Have you ever read an enrollment book for your 401k?  A lot of them show examples of how much ‘tax savings’ you can get by investing in your 401k.  They say that if you are in a 25% tax bracket that for every $100 you contribute you’ll pay $25 dollars less in taxes, right?  Ever hear your account tell you that a strategy for paying less taxes is to max out IRA or 401k contributions?  Do you believe these statements?  Let’s look at it…

You’ve got an extra $10,000 you want to put away for retirement and you are trying to figure out whether to do all in your Traditional 401k or all in your Roth 401k and you are in a 25% tax bracket.  You hear about this great ‘tax savings’ so you say…

Traditional 401k

You have $10,000 the full $10,000 goes into your Traditional 401k.   So you’ve probably been told that you don’t pay taxes on the $10,000 so you’re saving $2,500 in taxes, right?  To keep that math simple we’re going to use a 7% rate of return and the Rule of 72 let’s us estimate that it will double every 10 years.  So in 10 years it doubles to $20,000; another 10 years and it’s $40,000; and the final 10 years and you have $80,000.  Now your in a Traditional 401k so the growth is tax-deferred which means you don’t owe any taxes on the growth.

Now when you want to access the money in your Traditional 401k it’s fully taxable because you haven’t paid any taxes on it right? Right.  So all things kept equal, you are still in the same 25% tax bracket because who wants to retire on less money.  That means you owe $20,000 in taxes on your $80,000.  So you only really have $60,000.

We forgot something, your ‘tax savings’.  You’ve been a good boy and saved the $2,500 you were told you saved.  So you put it into an investment and it got a 7% rate of return, so you’re doing awesome.  It doubles, $5,000; doubles again, $10,000; then the final double, $20,000.  Great so your laughing all the way to where ever you want as you go to cash in this investment.  You are about to offset the taxes they say you owe and guess what?  Your hit with capital gains (best case scenario) on your investment that you just sold off.   Now today that’s 15%.  So where do you come up with the money to pay the $3,000 capital gains tax bill?  You now have $17,000 to pay a $20,000 tax bill. 

Where’s your ‘tax savings’? 

To Be Continued…

Related posts:

1. Tax Savings, It's In The Paycheck?
2. Tax Savings, The Finale
3. Tax Savings, Advantage Over The Roth?

I’ve heard a lot of talk lately about paying off your mortgage.  In order to do so earlier, some people talk about taking out a 15-year mortgage instead of the more traditional 30-year mortgage.  By using a 15-year mortgage your home is paid off 15 years sooner (obviously) as well as you pay less interest and usually at a lower interest rate.  Sounds like a good deal right?  So if you have the cash flow a 15-year mortgage is the way to go, right?  Wrong.  Well maybe let’s leave it at it depends for now and here’s why.

Let’s say you have a $300,000 mortgage.  I looked up the rates on bankrate.com.  I found that current 30-year mortgage rates are 5.16% and 15-year mortgage rates are 4.67%.  Using these rates the monthly payments are $1,639.93 for the 30-year and $2,321.13 for the 15-year.  This leaves a difference of $681.20.

Scenario A

You take out a 30-year mortgage for $300,000 at 5.16% with a monthly payment of $1639.93 and save an extra $681.20 per month.  This savings over 30 years (360 months) grows to $684, 276 with a 6% rate of return.

Scenario B

You take out a 15-year mortgage for $300,000 at 4.67% with a monthly payment of $2321.13.  Once you pay the mortgage off you continue to save $2321.13 per month for the subsequent 15 years.  This savings would grow to $675,028 with a 6% rate of return.

I would say that scenario A beats scenario B.  If not just for having an extra $9,000+, how about for having more liquidity if something were to happen.  Or maybe because of paying more interest you would actually have more tax deductions and would technically pay less taxes over the 30 years.  How about that?

Okay well let’s be fair what happens with different returns.  I mean it is the power of compounding that gives scenario A the edge.  The money there is compounded over a longer period of time.  Well at 8%, scenario A: $1,015,233 and scenario B: $803,200.  I guess that helps make my point.  Let’s go the opposite direction with a return of 5%, scenario A: $566,935 and scenario B: $620,412.

Conclusion

For those of you with or thinking of a 30-year mortgage, I think this might just make you feel better about it.  It can work better for you by providing more tax deductions, more liquidity and with solid returns you will be in a better financial position in the end.

For those of you thinking about a 15-year mortgage, can you get a 6% rate of return or better?  That’s a big question.

Yes, I’ve probably oversimplified this a bit but hopefully it makes you think.  That’s the point right?

Related posts:

1. Mortgage Acceleration Experiment – Full Picture
2. Saving $71,000 in mortgage interest continued…
3. The Way The Banks Want You To Pay Your Mortgage.

Did you read When Returns Lie?  This will be a continued discussion so make sure you read where it started and check the comments.  Now I want to thank Paul Escobar for pointing out that there are more accurate ways to measure the returns on your investments (not for laying into me while doing it).  I wanted to show you how some financial people talk about rates of returns and how they can be very deceiving.  I’ve seen a recent push by financial people to talk about how great market is and paint a positive outlook on the market in order to get people to invest more with them.  I’m not commenting on the market here I’m instead making you aware of the tactice people are using.

What can you do about it?

The fist thing to do is the take a lesson from Paul.  Make sure the financial professional that you are talking with or working with is using the geometric or compound average rate of return.  I think All Returns Are Not Created Equal from Investopedia does a great job of explaining the differences between these two calculation techniques.  Unfortunately, if you look around the internet you will learn that mutual funds sometimes advertise the arithmetic mean or simple average.  When you have positive returns these numbers are very closely related.  When you throw in a big down year, such as 2008, it throws numbers wildly off as represented in my previous post.

There is was a question posted on LinkedIn for me titled Interested in your take on this.  See how people responded.  Most acted as if they know about the way in which returns are falsely advertised.  I hope they are sharing this with their friends and in some cases their clients.  I also recommend Average Long Term Returns vs. Compound Annual Growth Rate and Mutual Fund Return Lies: Average Annual Return vs Compound Annual Growth Rate which both help support my point.

Did you learn something new?  How does your adviser show you rates of return?  I guess I hope that you will realize that a rate of return that is sold to you or shown to you during some sales presentation might very well be nothing but a number and have no real meaning behind it.  Or maybe worse yet, it’s that a trusted adviser might be using these false methods to predict your future.  Am I naive to think that people will learn from this post?

Related posts:

1. When Returns Lie
2. Universal Life Failure Part I
3. Universal Life Failure Part II

I was reading the local paper this past Sunday.  Yes, I am the one person that reads the paper.  Actually I read my dad’s paper.  That might be worse but I digress.  In the Sunday Business section there was a listing of the 25 biggest mutual funds.  (I would link you to it but I can’t find it online on the newspaper’s website)

For those who didn’t know the largest mutual fund (excluding money market funds) is Pimco Total Return Institutional(PTTRX).  The simple reason it is the largest is because it’s the largest bond fund so it didn’t suffer from the huge stock market losses in 2008 and early 2009.  The chart in the newspaper lists the 5 year percent return.  So I went through and pulled out the top performers according to this number.  I got Pimco Total Return Institutional (PTTRX), American Funds Capital World Growth & Income (CWGIX), American Funds EuroPacific Growth (AEPGX), Dodge & Cox International Stock(DODFX) and American Funds New Perspective (ANWPX).  I later dropped DODFX from the conversation because there is no 10 year return numbers that I was looking for.  Funny that 3 American Funds for top performers, I guess their reputation is well earned.  Is this another topic for active versus passive?  I won’t go there now.

So why did I pull these 5 (now 4) funds out?  I wanted to look at their rates of returns to see what these numbers mean.

Now my disclaimers about these numbers that you should know.  What I did was take the annual returns for each of these funds over the time frame.  So for 10 year it runs from 1999-2008 and for 5 year numbers it runs from 2004-2008.  The newspaper included year-to-date performance that I through out to make the analysis easier.  I also didn’t account for any sales loads, which of course American Funds has and thus, might eliminate them from being top performers depending on the structure of the account.  Also in the last column I looked at what $10,000 would have grown to over that time period.  Now this is dollar value using the annual performance numbers for the funds.

Now let’s look at what we can get from this chart.  Did anyone think that a 5% rate of return could beat 7% or even 8% rate of return over 5 years?  I didn’t think so.  How about a 6% rate of return beating an almost 7% or almost 8% rate of return over 10 years?  This is pretty eye opening isn’t it.

So what does this mean?  I would love to hear your opinions.  What does this mean to you?  What do you think it means to investment or financial people?  How does this affect you?  Hopefully, I’ll get some good answer and I can’t wait to chime in.

Related posts:

1. When Returns Lie Part II
2. Money Is Not Math…
3. Destroying Your Compound Interest

Have you heard of compound interest?  I think it comes up in just about any financial conversation when investments are involved.  Compound interest is basically the concept of interest compounds on top of interest.  This way you begin to get exponential returns.  They start of slow but as they gain moment things really begin to take off.

The whole concept and idea of starting as early as possible is based off of compound interest.  The longer money is left to compound the more compounding that occurs.  This is really shown in a graph as the majority of the growth at the end happens in the latter part of the graph.  This is due to the exponential growth.

You search anywhere on the Internet and they will tell you how great compound interest is.  Well I’m going to take a different approach.  Compound interest is just like any other financial tool.  When managed properly it can be one of your best allies.  However, if you aren’t aware of a few things, it can destroy your dreams.  Most financial planners focus on the power and benefits of compounding interest and don’t help people understand how to protect it.  From my experience, this sets people up, giving them unrealistic expectations and 20, 30 or 40 years later they are wondering where all their money is.

$10,000 at 8% over 40 years

So here are 4 things that will destroy your compound interest dreams.

2008

2008 is one of the worst down years in the stock market since the great depression.  A down market can ruin your compound interest.  Think of it.  Just as your interest compounds on itself in positive years, in negative years not only is the principle affected but also the compounded interest.  This means that as more of your money compounds and grows, you have more and more money exposed to a downturn in the market.  The key here is to realize the true effect a down market has on your portfolio.  If you loose 60% (as the S&P 500 did from early 2008-early 2009) it means you need to get a return of 150% to get back to where you started.  Also, remember, as you look at performance numbers and you work with your financial planner/adviser Money is Not Math.

Time

Compound interest’s best friend is time.  The longer time you have the the greater the growth.  Something to realize for compounding interest is when the greatest growth occurs.  It occurs in the last 20% of the time the money is invested.  It’s pretty similar to the Pareto Principle or the 80/20 rule.  In this case close to 80% of the value comes from the last 20% of the time.  So what’s important about this?  If you miss a year, no matter which year it is (a year in the beginning, middle or end) it all comes off the end.  Think of it from the compound interest curve.  If you put off investing in the beginning you loose a year off the end.  If you skip a year in the middle, you loose a year off the end.  If you take your money out a year early, you loos a year off the end.  Are you starting to get the picture?  Don’t forget that 80% of the growth occurs during the 20% of time at the end.

Taxes

I wrote a previous post related to this called, Compounding Interest, Compounding Burden.  One of the certainties in life is taxes.  There are only a few limited options to growth wealth tax-free.  So as you utilize compounding interest it is important to manage how the taxes will affect your money.  Think of it this way, just as your money is compounding if you owe taxes on it, the taxes will compound as well.  In a tax-deferred account, such as retirement accounts, since taxes are paid on a percentage basis.  So when your investment grows in dollar value so doesn’t the dollar value of your taxes due.

In a non retirement account the taxes get even more confusing.  You then have to deal with capital gains taxes vs ordinary income taxes.  The capitals gains rate is usually lower for most people because it maxes out at 15% currently.  The biggest mistake most people make is they let their money compound and receive a their end of the year present, a 1099.  Then they pay their tax bill out of their pocket.  This leaves the money and the tax burden to continue to compound.  It also takes money out of the persons pocket that could be saved, invested or spent.  The compounding, in this situation, not only compounds the investment but also compounds the taxes and it compounds the out of pocket expense for the individual.  If not properly aware of and accounting for these three things failure is inevitable.

Asset Allocation

I’m sure we’ve all heard of being properly diversified and how that helps spread the risk and minimize the downturn.  Let’s look at how it applies to compounding interest.  The mistake that people make is that they let their interest compound without rebalancing.  What this means is, let’s say you start off with a 50/50 stock to bonds split, to keep things simple.  Let’s assume that over time the stocks perform better than bonds, since this is what people are brainwashed to believe.  The higher performance and thus, higher compounding of the stocks might cause your portfolio to become heavy in stocks.  Before you know it you end up with a 60/40 or 70/30 stock to bond portfolio.  Now if the stocks have a 2008 then all of a sudden instead of 50% of your portfolio taking a huge hit almost 3/4 of it does.  That can make a huge difference.

What I think is a bigger mistake is the mistake that most financial planners/advisers make.  I’m not really sure why they make this mistake, but what they do is preach diversification, asset allocation and rebalancing.  In doing so they talk about how as you get older you should shift your portfolio to more and more conservative investments so that you are exposed to less risk.  This makes sense, as your time frame decreases so doesn’t your risk tolerance because your dependence on the money is increasing.  Well if you are shifting towards being more conservative it might be valid to say that you are probably going to expect a lower rate of return.  Now when does this shift happen on a compound interest curve.  Correct, it happens at the end.  What did we learn earlier?  That 80% of the growth occurs in the last 20% of the compound interest curve.  So then by shifting your portfolio and getting a lower rate of return towards the end of your compound interest curve, you essentially, handicap your growth.  You never get full participation in those end years when your money could really soar.  Most advisers never mention this.  Instead they run all their projections and analysis based off up until and sometimes, into and through retirement.  The preach that as you get closer to or into retirement we will be investing more conservatively but then don’t show that.  They instead set your expectations on a consistent compound interest rate that never even has the chance to occur.  Does this set you up for failure?

So has these 4 things been brought up to you by friends and family?  How about your trusted advisers?  Or do they tend to just focus on the positives of compounding interest?  What if they taught you how to manage it?

Related posts:

1. Compounding Interest, Compounding Burden
2. What do you think of investment fluctuations?
3. Saving $71,000 in mortgage interest continued…

You’re missing the conversation and we want you to be a part of it.  There’s a conversation going on in the comments at Financial Highway.  We want your input.  What do you think?

Look for my post later in the week about how compound interest is one of the most widely misunderstood financial theory.  Most people, especially financial advisors/planners, don’t fully understand how it works and what it means.

Related posts:

1. Investment Industry Secret
2. Destroying Your Compound Interest
3. When Returns Lie Part II

Do you like Dilbert?

I think he’s onto something.  Which mutual fund company do you think is run by Dogbert?  You are allowed to answer more than one.  Isn’t this what you see in the advertisements.  Most companies have a ton of mutual funds and they advertise the rates of returns of the best funds.  Is it worse that people buy them?

It has been shown that the biggest inflows into the market is when things are going well and the biggest outflows are when things are bad.  That goes against rule number 1: buy low, sell high.  How do so many people miss rule #1?  Is it the advertisements?  Is it the investment companies?  Is it psychological?  Emotion drives so many things in our lives.

Or maybe it’s the “imaginary expertise” that’s got you thinking.  Then that puts us in the Trust Agents conversation with Chris Brogan and Julien Smith.  How do you distriguish between ‘imaginary’ and real in today’s world?

Related posts:

1. What do you think of investment fluctuations?
2. Life Insurance Secret