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Why mutual funds are really a bad idea for retirement income funding. December 2, 2011

Posted by shaferfinancial in Finance, Uncategorized.
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I have blogged on this before. But, recently talking to folks looking into EIULs it has become clear it bears repeating. There are three problems with mutual funds that create real problems for those who use them for retirement financial planning.

1st: Most people purchase them inside a tax-deferred wrapper like 401Ks or IRAs. They are sold on the idea that they save money paid for taxes. This is demonstrably wrong. When you purchase mutual funds inside a 401K you are not avoiding taxes just deferring them to later. So instead of paying income tax on the income you receive you reduce it based on how much you put into your 401K. Most people hope there will be gains inside their retirement account. Indeed over the long run there should be. Here is the problem, the taxes you saved are based on how much you put in, while the taxes you pay will be based on how much you take out including the gains. So if you put in $250,000 over a lifetime and take out $500,000 during retirement you are saving $250,000 times your marginal tax level and paying $500,000 times your marginal tax level. You can see that the result is paying considerable more than you save. Bottom line this scheme does nothing but increase your taxes. A great deal for the government, a bad deal for you. And that doesn’t count any penalties or taxes you pay if you don’t follow their rules on withdrawals.

2nd: As many of you have discovered recently, market risk is understated by most who push this retirement scheme. That is severe market downturns are very dangerous to folks with limited time to invest. If you have an unlimited time line on investing, then there is always time to make up for the severe downdrafts that are always happening in the market. However, as your time line to retirement and using these funds go under 10 years, the risk you take on goes up dramatically. Imagine retiring anytime in the last 15 years dependent upon market returns! These folks simply have no where to turn. There is not enough time to make up for over a decade of real market losses. Many of these people have had to downsize their expected retirement income by over 50%. And the scary part is this isn’t the result of a once in a century bad market. No, these types of markets are as predictable as the sun setting. Since WWII you have the 1960s and early 1970s, you have the early 1980s, and the first decade of the new century. Those are all examples from the life span of current retirees. Try to find 25-30 years in there where there wasn’t significant market downturns? You can’t. This means that there is a certainty that you will experience this market behavior during your retirement years too! Imagine saving your whole life and a couple of years before retirement you have accumulated $1M. You think you can take $50K per year from your accounts during retirement and be pretty assured of not running out of money. But then on the eve of your retirement that $1M turns into $700,000. So now you are down to $35K per year. And then a decade of sideways movement turns your once comfortable nest egg into something that might last you to 80 if you really skimp or maybe not. This is called sequence of return risk and no manner of asset allocation advice will avoid this issue.

3rd: Expenses. Did you know that most of the major mutual fund management companies raised the internal expenses in their mutual funds during the great recession of 2008-09? Why did they do this? Because people were pulling out of mutual funds and they needed to maintain their profits. So while their customers were losing in their 401Ks, the companies did their share by taking more out of the pot! You see, not only do the companies not take on the market risk with you, but they think they bear no responsibility for the results of people investing with them. All that matters in their eyes are the companies profits. And these are the same people who are giving you advice to stay in mutual funds and what a great way to invest for retirement mutual funds are!

4th: Admittedly, this is a personal pet peeve. Their rules…..your money. Take your money before age 59 1/2 and you get penalized. I even had a client whose 401K was kept from him as long as he worked at the company or 59 1/2!!!! Don’t take the money in time, more penalties. Save too much…no can’t do that.

My personal journey had me realize all this over 10 years ago. It took me a few years to find a suitable replacement strategy and a few more years to divest myself of those pesky mutual funds. It was all worth it. And by the way since I have accomplished this my real returns have skyrocketed compared to mutual funds.

As many of my readers understand I am very open about what I am doing now and in fact starting selling one of the strategies [EIULs] I found works well. Many of my clients from both the Shafer Wealth Academy and EIULs have similar stories to tell about their awakening from the propaganda of Wall Street and the US Government. Other’s are not ready yet to open up their minds to the reality of the failure of mutual funds and 401Ks. Interestingly, Fidelity, a large mutual fund company, just released the average 401K level of its customers. $67,000. How long will $67,000 last in retirement?



1. Rob - December 2, 2011

I totally agree. Between taxes and understated market risk, I think mutual funds for retirement savings are dangerous. I too have moved over to EIULs as a way to address taxes, market risk, and pesky government rules…but it was a journey of discovery that took some time. Most folks that hear about EIULs are so skeptical because of all the propaganda from Wall Street (and even big-name finance experts).

2. Robert Platt Bell - December 21, 2011

You make some good points. However I think your math is off on the taxes. To begin with, there is no ‘increased tax’ by putting money in a tax-deferred account.

Using your example, if you invest $250,000 and have gains of $250,000 (I wish!) when you retire, you will pay income taxes on $500,000, over the time period you withdraw the money.

On the other hand, if you invest $250,000 in AFTER-TAX money, you pay taxes on $250,000 up-front, and then later on, pay taxes on the $250,000 gain.

From a basic tax perspective, this would appear to be a break-even proposition. There are some caveats, however.

1. For High-income earners, in the 25% or 33% brackets, it is possible you may avoid paying taxes in the higher brackets this way, and then when you retire, take out money at a lower rate (15%) and thus save money.

2. “A tax deferred is a tax not paid” as my Tax Law professor explained. Since the tax is deferred by 20, 30, or 40 years, you have the opportunity to earn money from that deferred tax money. The excess income on a tax-not-paid, over 40 years, is substantial.

3. Of course, it depends on whether you are earning money on income or capital gains – and how the tax laws in 10-40 years will be structured. If you make money on capital gains, your tax rate may already be lower than your income rate.

4. For people in lower-income brackets (15%) the savings in terms of taking out money in a lower bracket at retirement, are nil.

5. If you die before cashing in all or part of your 401(k), that money may transfer, tax-free to your beneficiary. So the taxes are never collected on the money. This is not a long-shot, but a predictable outcome, which is why the laws require you to start withdrawing a certain percentage every year, once you reach a predetermined age.

Of course, there are many other issues as well. For example, some mutual funds are just raw deals – loaded with fees and loads to the point where your effective rate of return is very low.

On the other hand, statistically good mutual funds tend to outperform individual investors who try to stock-pick, invest in minerals, or whatever.

Rather than say “All of this” or “None of that” I think a better approach is to diversify. Yes, invest in a mutual fund, but don’t make that your ONLY investment. Stocks, bonds, real estate (no, really) life insurance, CDs, Treasury Bills, even minerals. The more you can spread out your risk, the less chance you will have of being broke at retirement.

And yes, that is my strategy – to diversify. I don’t put all my eggs in one basket – whether it is mutual funds, stocks, or life insurance.

Life insurance (which seems to be what you are promoting here) is not a bad investment, but seldom a stellar one. And it can go horribly wrong, of course, if the underlying company goes bust.

Don’t put all your eggs in one basket!

shaferfinancial - December 21, 2011

Thanks for your thoughtful reply. We will have to just disagree about the tax issue. At this time for most people their income tax rate is substantially higher than the capital gains or dividend tax rate. No one knows what the future tax rates will be down the line but with that fact alone it seems to be illogical to defer income tax rather than plan on getting dividends or having to pay capital gains. Diversification is extremely important as I tell all my clients. Real estate investing has many tax advantages. That is why I suggest a combination of real estate investing, purchasing equities for their dividend stream and an EIUL. As the tax laws are now, that combination would assure you of paying much less tax than mutual funds inside a 401K.
You did not mention the sequence of return risk, which is the critical point in the post. Ask anyone who tried to retire in the last 15 years with mutual funds what that did to their income stream?
Finally, there is no risk less place to put one’s money. But, to my knowledge there has been no one that had a life insurance policy that did not get paid because the company went bust since WWII. When life insurance companies get in trouble the LI book of business has been bought up by other companies. Proper reserves are required by the state regulatory commissions. And unlike the banks they are not allowed to be leverage 20 to 1!
Thanks for you comments and pushing the conversation on retirement forward!

3. Robert Platt Bell - December 21, 2011

I have invested some in Life Insurance – whole, adjustable, variable (yes, he was a good salesman). And recently, I converted to Paid Up status, as the premiums were getting kind of steep. These policies now pay me, in dividends and continue to increase in cash value.

In terms of return on investment, however, life insurance is not really a good bargain – it takes years and years to pay off, and in the interim, costs can be very high.

However, at my age (51) buying life insurance is cost prohibitive, and investing in an EIUL is out of the question. And some of these vehicles have load fees that make American Funds look thrifty.

Again, the big tax savings is in deferring the taxes over a number of years. If I invest $100 at age 30, in the 33% bracket, that investment only costs me 67 dollars. That 33 dollar “free” investment, over 35 years, adds up to a lot of money.

At retirement, if my combined income is less than $63,000 (at the present time) I pay out in the 15% bracket – far less than 33% I paid in at.

So lower brackets is one advantage, but also the interest on all that deferred tax money is another.

But, like any other deduction (such as the home mortgage interest) it really is a screw-job for the people in the lower brackets. If you think about it, the “advantage” of home ownership is almost nil for someone in the 15% bracket, while it is lucrative for someone in the 35% bracket.

You make some interesting points, and I agree that a lot of the Mutual Funds are a pig-in-a-poke, but I am not sure EIULs are the answer.

Good Luck!

shaferfinancial - December 21, 2011

Thanks. Just a note on the returns inside life insurance policies. They can be increased by lowering the life insurance amount down as low as the IRS rules allow at inception. Also EIULs historically have internal rates of return about twice as high as whole life. Variable Life has that problem with negative returns which can cause big issues in the early years. When I structure an EIUL the total costs as a percentage are usually between .4% and 1.8% depending on age and premium payment [time].
Sounds like you are well diversified and hopefully will have a great retirement.

4. The LIES We Are Told « Uncommon Financial Wisdom - May 17, 2012

[…] I have talked at length about the damage of sequence of return risk for retirement funding. [here & here]. By decreasing expected variance and eliminating negative years it dramatically reduces […]

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