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The Never Ever Assumption? July 9, 2008

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When speculating about the future, assumptions matter, in fact they are the only thing that matters.  All those calculators on various blogs and financial firm web sites contain blanks for some essential assumptions for folks to put it and get out how much money they might have for retirement.  You input assumptions like rate of return, monthly input, time to retirement or age and out comes assumptions of how much money you would have.  But it means little because all those assumptions are totally speculative.  And what do we humans do when we speculate, mostly we put in numbers that are we wish for.  People can speculate about those items all they want, but what gets missed is the underlying assumptions.  Assumptions like folks will make monthly inputs into their retirement plan for 30 years (yea right). 

The really big one is what I call the never ever assumption.  The built in assumption that you will never ever use the money in your retirement account.  What, you say?  Yes, you see all these calculators assume an average rate of return, but that is not how it works in real life.  In real life any investment will have variability.  In other words some years you will get a negative return, some years a meager couple of percentage points and some years 20%.  You can only use the average rate of return if you assume you will never access your account.  Say, for example, you retired in 2004 and started accessing your money in some mutual fund.  Well, you mutual fund’s performance since 2000 had been negative so your average return had been severly curtailed.  But you need some money now.  In order for it to get back to that average return you would have to leave your money in for the rebound.  But you can’t.  Now if you retired anywhere in the last 8 years you have some serious making up to account for.  In fact the whole decade will likely show little capital growth.  Conversely if you retired in the early 1990’s then you have a much higher average return because the first 10 years of your retirement saw your accounts going up magnificiently.  Bottom line, if you are depending on this money for retirement then you need to hope that you retire in a good time for returns or you have issues.  Funny thing about averages, they really don’t tell you much unless there is little variability.

Here is the other issue.  The rate of return for the last few years are critical.  Say you have 3 years to retirement and $500,000 in your account.  For the last 3 years the rate of return is 8%, 22%, and 12%.  Great you have over $737,000.  But less say instead your last three years looks like this -12%, 5%, -7%.  Instead you have around $430,000.  Quite a difference!  Now remember both of these have equal possibilities given the variability of mutual funds.  So financial planners say you should give up on some returns to control the varibility as you approach retirement.  But remember that assumption you put in 20 years ago.  What happens to that if you start giving  up on returns as you approach retirement.  Then your overall returns go down at the most critical time.   Hopefully you now understand that the rates of return are much more critical as you approach retirement and the first few years of your retirement.  And this is the most highly speculative time as it is the time period furtherst removed from now.  Finally, this is the time financial planners encourage you to reduce risk (variability) and the corresponding rates of return!

Best have a plan for those years other than a prayer for good rates of return!

What’s your Net Worth? June 16, 2008

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This week we will spend some time discusssing important financial equtions that all folks should know and understand.  The first and single most important equation that is critical to know is “working net worth.”
This is a basic finanical number everyone should calculate every month until your net worth is ingrained in your brain.  If it isn’t going up, then you have major issues in your financial life.  So let’s calculate it. 

First, list all your assets and their approximate values.  Now break the list down into two categories.  The first category is appreciating assets.  Place all your assets that appreciate over time in this category.  This should include your home, other real estate, stocks, bonds, mutual funds, savings accounts, etc.  The second category is non-appreciating assets.  Here you put your cars/trucks, furniture, TV’s, personal items, etc.  Next create a list of your liabilities/debts. Your mortgage, credit card balances, car loans, etc.  Now subtract your liabilities from your assets.  This is your net worth.  Don’t panic if this is a negative number!  Now, subtract your liabilities from your appreciating assets.  This is your working net worth.  This is our most important metric.  This is the number that we want to see grow and will determine how well your wealth plan is working.

Now here is where some interesting things happen.  First off, you can have growing amount of debt and still have a growing working net worth.  In fact, done with a porposeful plan, you might end up with much debt at retirement, yet be in great financial condition.  Now I know this is contrary to what many folks out there are hearing.  The “no debt” crowd is really yelling their nonsense these days.  The bottom line is that as long as your working net worth is rising you are reaching your goals.  We will talk about debt service later this week after we have discussed cash flow.

Now, my requirement is that my working net worth should appreciate 15% per year in order to reach my goals.  Once you are fully conversant with this number, you can calculate what your rate of return must be to reach your goal.  Fortunately, I have been beating my goal over the last ten years (since I have started this habit).  There are some years that I haven’t while other years I have, but the bottom line looking at the long term I have exceeded my goal. 

There are two basic ways to increase your working net worth.  The first is to add to your investments.  Of course, everyone should do this annually, but the question is always which investments.  For this I have a plan.  At the Shafer Wealth Academy (www.shaferwealthacademy.com)  we spend much time in both figuring out our net worth and developing a plan to increase it.  The second way is the rate of return you are getting on your investments.  This becomes more critical as your working net worth increases, since your total assets will start to dwarf your annual investment additions.  Basically, it is my belief that folks must get a rate of return from their investments above 12% in order to achieve meaningful wealth.  There are many strategies that have proven effective at getting that return.  And, by now my readers know, that investing in mutual funds will not give you a return any where near that mark.

So go ahead, figure out your working net worth now.  And if you want a proven technique in building that number up, contact me at dave@shaferwealthacademy.com or continue with the herd, your choice!

         

Equity Indexed Universal Life Insurance May 28, 2008

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When BawldGuy asked me to blog on equity indexed universal life insurance (EIUL), I thought no problem, since I had been blogging on it for a couple of years on both my site and others.  Then he asked me to look at the archives from Bloodhound to see his previous blogs and I knew I had to write something a little different.  In order to make sense of EIUL contracts you really need to understand the misinformation that underlie the arguments being put out by folks in books, the mass media and blogs on both sides of the issue.  You need to be clear on what your wealth creation plan is and what it isn’t.  So bear with me for a few paragraphs as I burn down the straw-men arguments before we get into the mechanics of EIUL’s.

 

 Usually these discussions surround a common theme, EIUL’s versus mutual funds inside a tax deferred wrapper (401K, IRA’s).   First let’s talk about mutual funds.  Mutual funds were designed to reduce risk or as financial experts describe it variance.  They were a boom to Wall Street as mutual funds induced many folks to invest in stocks, something they were not inclined to do in the past.  They have been around for 2 generations so we have plenty of data to tell us accurately how people do investing in mutual funds.

 

 

We have plenty of studies of wealthy folks too; many specifically designed to find out how they became wealthy and what wealthy folks invest in.  What they tell us is very clear.  The higher the net wealth, the smaller percentage of wealth is in mutual funds.  Or to be more exact, the super wealthy (net worth in excess of $10M), have less than 5% of their wealth in mutual funds (mostly bond mutual funds), the wealthy (net worth $1M to $10M) has only a slightly higher percentage of wealth in mutual funds, and the mass affluent ($100,000 to $1M) has close to 30% of their wealth in mutual funds (second in percentage only to home equity).  And if you look at this class closer you see a curve that continues the trend with the higher the net worth ($500,000-$1M) looking more like the wealthy and those under $500,000 in net worth having the highest percentage of their wealth in mutual funds.

 

So it is very clear that those that invest primarily in mutual funds are planning to be in the $100,000-$500,000 net worth category.  Now there are some real reasons for this and they can be summed up quickly:

  1. The rate of return people get from their mutual funds is meager.  Study after study has pointed out that individuals’ rate of return from mutual funds on average ranges from 7-10% BELOW market returns (Dalbar, Inc. Vanguard, etc.).  Average fees range from 2-4% of value for mutual funds.  Employer managed 401K’s have the highest fees sometimes as high as 6%;
  2. People don’t consistently put money into mutual funds as they are instructed to, because life intervenes and the money is used to cover expenses; and
  3. The experts advising folks on mutual fund investments actually cause folks to have a lower rate of return than if they did it themselves.

 

The bottom line is that when your advisor or the mass media you are listening to tells you to invest in mutual funds they are putting you on a plan to have low six figures in net worth in today’s dollars.  One can reasonable assert that investing in mutual funds will not make you wealthy, only keep you from being poor.

 

Tax deferral programs (401K, IRA’s) were designed by the government for two reasons.  One was to encourage folks to save money.  It should be noted that it was never thought to be the only retirement vehicle, but an adjunct to defined benefit pensions and social security.  The second reason is to increase tax revenues.  By giving a tax break as you put the money in and taxing it as you take it out, even getting a meager rate of return will assure greater tax revenue.  It is pretty simple to understand.  From these meager beginnings 401K/IRA’s have become the only retirement vehicle most people have outside of social security. 

 

Those that oppose the use of EIUL’s accurately state that most people upon retirement have a decrease in income, and tend to move down a tax bracket.  And they also accurately point out that the advantages of EIUL’s goes up as your retirement tax bracket goes up.  So for those who plan to have a drop in income and/or a drop in tax bracket EIUL’s might not be advantageous.

 

By now you are probably wondering why I am talking about mutual funds and 401Ks instead of the topic at hand EIULs.  I am trying to bring some clarity into the readers’ thinking in order to break down certain categories in your mind.  Categories created by folks surrounding investing, retirement, wealth.  Frankly, most people are on a snipe hunt when it comes to creating wealth through mutual funds.  They are looking at the amount of fees charged, or which mutual fund returns slightly better than others last year, or speculation on how much their 401K’s will be worth somewhere in the future.  Frankly, all that stuff doesn’t matter.  It only appears to be important because of the categories you have created and put mutual funds/401Ks into; retirement funds or wealth creation.  Truly, mutual funds don’t belong in those categories; they really belong in the asset protection category or more specifically the asset transfer category.  I know that is a hard pill to swallow, but if you really look at information I have given you, and really think about it, you will understand why.  You really are just moving some of today’s income into tomorrow’s income hoping to account for inflation.

  

Now let’s talk about the EIUL.  It is a life insurance contract.  Life insurance is designed to solve two problems.  The first is to protect against the loss of income in the case of death of an income producer.  The second is asset protection from the tax man.  Life insurance like mutual funds will not make you rich.

 

 

So let’s burn down those straw men right now.  Neither mutual funds nor life insurance have demonstrated the ability to make their owners wealthy.  Anytime a mutual fund salesman/financial planner/CPA tells you that the rate of return from mutual funds is 8, 10 or 12% they are not being entirely truthful.  (Don’t respond with your own fantastic returns from mutual funds, it simply doesn’t matter in this argument).  Planning to live on less money in retirement than in your working life is planning to fail, no question about it.  And not planning to have enough assets to have to protect them from the tax man is not what I call a real wealth plan.

 

Now it’s time to put the pedal to the metal.  Everyone who is planning to have a net worth less than $500,000, please raise your hand.  Everyone who is planning to have a big drop in income when you retire, please raise your hand.  Everyone who has no dependants or who plans to not have dependants and/or who plans to not have any assets to protect, please raise your hand.  O.K., all those with your hands raised, EIUL is not for you.

 

Now, for the rest of you, here is how it works.  Permanent life insurance has two sides, an insurance side and a cash value side.  The cash value side either earns a fixed amount of interest or in the case of a variable universal life can be invested in the stock market.  Equity indexed universal life insurance is of the fixed interest type, although your interest credited is connected to a stock index.  EIUL’s have a floor in which the interest credited can’t go below and a ceiling in which the upside is capped.  So you know each year the cash value of your life insurance will go up between those two figures, say 2% and 12%. So each year, you look at how much the benchmark index (usually the S & P 500) goes up or down and you know how much your cash value will appreciate.  Now here is the key provision.  You can access your cash value through policy loans.  The loans costs are generally no more than the interest credited (companies have different plans so make sure you understand how your company treats loans).  When you take out a loan against your policy there are no tax implications as long as it was set up correctly initially.  You are under no provision to ever pay back the loan.  Now previous to 1982 you could load these contracts with as much cash as you wanted.  Many of the wealthy loaded up their contracts with massive amounts of cash, enough to get the attention of the IRS.  The IRS subsequently put limits on how you fund the cash value and how much insurance you need to go along with the cash.  So the strategy is now codified into tax law.  Follow their guidelines and you have no tax problems.

  

Properly structuring these life insurance contracts now means minimizing the face value of life insurance, which maximizes the cash value.  The cash value increases in value depending upon the index, but never goes negative.  By maximizing the cash value the cost of insurance stays low.  The contracts I sell have a rider on them that precludes the owners from taking out so much cash that the insurance is not covered, keeping these contracts from lapsing and a taxable event occurring. Surrender fees generally stop at year 10 to 15, but the point is once you fund the contract to keep it for life, so surrender fees are really meaningless.  Expenses and commissions are front loaded, so it takes about 10 years for these contracts to really start performing.  That means if you are in your 60’s this strategy probably doesn’t make sense for you. 

 

Anytime during the contract you can access your cash value with a policy loan tax free.  Some people use them for retirement income, while others use it as a bank, purchasing automobiles and paying the policy back instead of occurring interest by getting a bank loan.  They can also be used as a reserve account for emergency funding.  This liquidity and flexibility is what makes them so attractive to folks like me and BawldGuy.  What rate of return can one expect?  Well, I run them with 6.5%, but the historical amount (using data back to 1950 and plugging in that historical figure is 7.5%).  I like to be a little on the conservative side.  Once again, the point is to transfer assets so as to protect them from the tax man, not create wealth.  Look, the bottom line is an unleveraged investment must get a rate of return well over 12% to really build wealth; neither mutual funds nor EIUL’s are likely to get that high of a return!

 

So what is the bottom line?  You use real estate investments to create the wealth.  Leverage, depreciation, 1031 exchanges, etc. all do the wealth creating.  Then you protect those assets against the tax man by using EIULs.  And if something bad happens to you, your family is protected.

  

When you take away all the “straw men” arguments it all gets clear.  Protect or not protect assets?  Protect or not protect dependants? Accept a moderate rate of return for these benefits?

 

You choose? 

Simple Statistics for Investments! May 7, 2008

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Today there were several reactions to my letter to the editor in the St. Petersburg Times on teacher pay.  The first letter from a teacher made it clear she did not understand what “average” meant as in “average salary.”  So I thought I would spend a few minutes going over some basic statistics with the readers.  As many of my friends know, I taught statistics at the Univesity of South Florida for several years so please excuse this post if you already have a good understanding of basic stats or find it to didactic.

Average is one of the central tendency statistics that represents the middle of a data set.  It is the most used stat and is easily calculated by simply adding up the data set and dividing by the amount of integers in the set.  For example the average or mean of  the following numbers:  1,2,3,4,5 is three (1+2+3+4+5/5) or 15/5.  This is a good stats if you have a somewhat homogenous group like if you wanted to know what the average school teacher’s income in a school district.  It is not a great stat if you have a large number of outliers (numbers that are far away from the main group).  For example say you were looking at a group of people where 9 made $100,000 and 1 made $1,000,000.  The average would be $190,000.   That really doesn’t represent what the middle of the group makes so a better stat is the median which looks at the middle number in this case $100,000. You simply arrange the set from lowest to highest and pick the middle number.  If you have an even amount of integers you simple average the two middle numbers to get the median.  The median is really a better stat to use for income or wealth for example  because there are a few people who make so much more than the majority that it skews the average up and gives a really wrong impression.  This is why if politicians want to give a number that makes the average income look better they quote the average, while those who want a more accurate number quote the median.  Anytime you see a quote about “average income” among large groups you know they are trying to hide the real middle income which is what the median would give you.

I have posted about leverage many times before.  It is simple to calculate.  For example if you purchase a home with the traditional 20% down you have a 4 to 1 leverage situation (80%/20%).  Or if you put down 10% you have a 9 to 1 leverage situation (90%/10%).  Or if you have equity in a home worth $300,000 of $150,000 you have a 1 to 1 leverage situation (50%/50%).

A simple way to calculate capitalization rate in real estate is to add up all the yearly expenses (management fees, maintenance fees, taxes, etc.) then add up all the income (rent) and divide it by the cost of the real estate.  Say your total expenses are $15,000 and your total income is $30,000 so you have a net gain of $15,000 or a cash flow of $15,000.  You paid $150,000 for the property so the cap rate is 10% ($15,000/$150,000). Cap rates are a great way to value investment real estate, but they are usually an unleveraged valuation that doesn’t take into account debt service or leverage.

Finally rate of return is the ratio of money gain or loss on an investment.  This is calculated by looking at the total appreciation or depreciation over a given time period.  Usually, this is calcalated in years, for example the rate of return for the last 10 years for Berkshire Hathaway is 18.3%/year.  Note this is calculated by looking at the change of asset value each time period (usually a year) for example on Jan 1 the asset value is $1000 then on Dec. 31 the asset value is $1100 there is a 10% rate of return (1100/1000-1).  Also important is that you simply can’t average the annual rate of returns to get the overall rate of return because negative numbers don’t mix well with positive numbers in this statistic.  A simple way that will get you close to the annual rate of return for an investment is to divide the initial investment into the current value + any dividends paid out to get the overall rate of return and then divide that number by the amount of years the investment has been held.  For example initial investment was $1000 and the current value plus dividends is $2,000 and the investment was held for 5 year then it had a 20% annual return (2000/1000-1)/5. Note that most investments state an average rate of return which doesn’t accurately reflect the real dollars made or lost as losses count more than gains. (A $100 investment that goes up 10% one year and goes down 10% the next is worth $99 not $100).  A litle trick of the trade to fool folks!

Hope this helps some folks.