Rent Term, Let it Lapse and Squander the Rest.

For decades, the rallying cry of the financial advice industry has been for clients to buy inexpensive term life insurance rather than more expensive whole life insurance and invest the premium savings on their own. The only problem is most clients never execute the second part of the equation, leaving many of them uninsured in later life and unprepared for retirement.

Just how unprepared are they?  A recent study by the Government Accountability Office looked into the question and the answer is sobering.  The study found that in households with members 55 and older, nearly 29% have no retirement savings nor a traditional pension plan.  Twenty three percent of those households have a form or defined pension plan, but NO retirement savings plan.  What about the other 48%?  The GAO determined that they have "some retirement savings."

In case you are a generation X member or even a millennial, your generation is not fairing much better, in fact many are worse off.

Why are things so bleak for seniors and others when considering retirement? According to a recent study¹ by David F. Babbel, professor at the Wharton School of the University of Pennsylvania the answer is: “People don't buy term and invest the difference."  Professor Babel co-authored and published the report in the May 2015 issue of Journal of Financial Service  Professionals.  (“Buy Term and Invest the Difference Revisited")

“Our study sheds light on Wall Street guidance that has been taken as an article of faith, but that clearly underperforms for many who follow it,” said Mr. Babbel.

 “People most likely rent the term, lapse it and spend the difference,” he said. "And even the minority of those who do invest the difference are prone to the real-world emotional investing when individual investors tend to buy high and sell low, perennially underperforming market indices," he added.  

 

ANALYSIS FALLS SHORT

"Typical economic analyses that compare the cost of buying term and whole life policies fail to properly assess the guaranteed cash value growth component of permanent life insurance," Mr. Babbel said. He noted that cash value guarantees always grow, while a more volatile portfolio of stocks and bonds can rise and fall with the market.

Mr. Babbel pointed to whole life insurance policies that he and his wife bought decades ago as examples (neither of which are New York Life policies). The cash value of his wife's $25,000 policy, purchased in 1988, is now worth $61,138 and his $178,000 policy, bought in 1997, has increased to $307,520. The growth, which has significantly outpaced inflation during those respective holding periods, represents both the annual guaranteed increase plus the policy dividends from their “participating” policies that are reinvested to purchase additional coverage. 

Finally, traditional buy-term-and-invest-the-difference models, referred to as BTID models, ignore the valuable options of whole life insurance such as the flexibility to borrow against the cash value or to take tax-free distributions, he said.

Although it is common to think about term vs. whole life insurance as an either/or decision, it may be more appropriate to think of both.  For example, a young client with a family will not be able to afford all the death benefit he needs via whole life insurance.  So this client should purchase a small, $50,000 or $100,000 whole life policy AND then also purchase the rest of the needed death benefit using convertible term insurance.  As the client's income increases, he can shift more of the term to whole life.

"But I will not need life insurance when I get to age 65," you regurgitate what you have heard on the radio and elsewhere.  The fact is, that statement is coming from the same source that has put so many Americans in the retirement saving perdicament they are in with the Buy Term and Invest the Rest mantra. Real life happens and other factors need to be taken into consideration.

What are some of those factors? Have you heard of  kids moving back in with parents?  What about aging people having health issues? Ever heard of a 65 year old who still has a mortgage on their home? (According to the same GAO study discussed above, 65% either do not own a home or still have a mortgage.)  If you are able to escape these three factors and have gone against human nature and actually saved, then possibly your life insurance can go away when you turn 65.  But then again, think for just a moment; wouldn't it be a bummer if on your 65th birthday your insurance ends and you die the day after?  Tell me seriously when would you not want a tax free benefit for your family?

There are other tax advantaged features of whole life, such as converting the cash value to guaranteed income or borrowing against it. Such tax-free distributions can also be used in retirement to pay for Medicare premiums. Life insurance distributions are not counted in the Modified Adjusted Gross Income calculation that determines monthly Medicare Parts B and D premiums that increase with income.

 Generations of Wall Street professionals have been trained by their firms to trash cash value life insurance so the investment firms could maintain those dollars under management.

To sum it up, this new academic study, using rigorous economic modeling, has debunked Walls Street's heavily marketed, but largely erroneous path to financial security.

 

1. This study received partial funding from New York Life, but Mr. Babbel noted that all of his previous research and that of other researchers cited in the paper were not subsidized and all have undergone rigorous peer review. 

Taxes Destroy Wealth

My title is a bit bold, but math will prove me right.  No, I am not going to use multi-dimensional calculus or other forms of advanced math.  The "complicated" math I am going to use is simply done using a compounding or future value calculator that can be found several places on the web or even in the app store for your phone.  For ease, here is one you can use to verify the math.

Let's do this whole thing telling a story.  October 21st this year marked the day on which Marty McFly used the time travel machine that Doc Brown built out of a modified Delorean.  Let's assume for moment that while Marty and Doc are out doing their thing, you find the DeLorean and go back in time to visit your great grandfather late in the year 1912.  After recovering from the shock, you convince your ancestor to take the $100 dollars you hand him and invest it in the stock market on January 1, 1913.  Your ancestor does your bidding and invests in a mutual fund that does exactly what Dave Ramsay says happens with good mutual funds: "gives you an average rate of return of 12%."

By the skin of your teeth you make it back to 2015, get out of the car, and return it to its hiding place without being noticed.  Awesome plan right?  I am sure you are wondering, "How much money do I now have?"  Using the calculator I mentioned above, the year (N) is 102 (the number of years from 1913-2015), starting amount is $100, and the interest rate is 12%. The result is: $10,477,033 (I am rounding: the actual amount is $10,477,033.01)

Eureka!  Congratulations! You can now retire.  But hold on a minute my dear Watson; you do not have the whole story.  I know this is a story, but any good story is rooted in reality.  The reality is, you have had to pay taxes on your growth every year.  Looking through the history of the tax rates in the US, we learn that the average maximum tax rate is 58.3%.  When we factor in that average tax rate what do you think the account value would be? (This requires a slightly more complicated calculation - i.e. doing 102 calculations each time subtracting out the taxes paid from your account) Would you be surprised to learn that your account would now be worth a massive $14,554?  Immediately you feel jaded and cheated by our blood sucking government for stealing $10,462,479 from you.  But guess what? Looking at the history, the government has only collected $20,209 in taxes over that time.   

That is only a total of $34,663 that your $100 dollars has generated over the last 102 years. WHERE IS THE OTHER $10,442,370 you demand!  The simple answer?  Taxes destroy wealth.  Notice I did not qualify whose wealth they destroy.  To put a finer point on it, the title of the article is not “Taxes Destroy YOUR Wealth.” 

Here is the odd thing, if taxes were lower what would have actually happened?  Making the same calculation using a 25% tax bracket your account value would be $656,905 and the government would have collected $218,935.  Certainly not $10 million, but a whole lot more than $14,554, and better for the government as well.

That is a cool you say.  Let's lower the taxes to 15%.  What is your account value now? $2,006,886 and the government collects $354,139. Getting better…

This entire discussion proves what is called the Laffer curve.  Simply defined, there is an optimum tax rate that gives the maximum to the individual and the maximum to the government.

In our scenario the optimum tax rate is 9%.  Under these conditions you have $3,899,472 and the government collects $385,652.  This total wealth generated by the original $100 you took to the past is still $6,192,009 less; wealth has simply been destroyed because the growth of the money was hampered by taxes. (Note: the optimal tax rate does vary based on what we believe the growth rate will be, but generally the optimum rate is between 10-15%.)

What I am showing you is not new; it is well documented and understood.  In fact, Ibn Khaldun, a 14th century Muslim philosopher, wrote in his work The Muqaddimah: "It should be known that at the beginning of the dynasty, taxation yields a large revenue from small assessments. At the end of the dynasty, taxation yields a small revenue from large assessments."  It is this same Ibn Khaldum that Laffer gives credit for "his" curve.

Need further proof this is well known?  Listen to the politicians when the talk about tax rates, they are all talking about 10-15% flat taxes.

So how do you want your money?  In a taxable or non-taxable environment?  Tax-deferred is exactly what is says: tax deferred, i.e. pay taxes later.

Don't misunderstand me, taxes are necessary, we need roads, bridges and other basic things, but the more they take the less they and us get.

Conclusion: Taxes Destroy Wealth.

Why are Americans so angry?

 

 

Are you angry?  It seems to me that those who are not angry are blissfully ignorant of what is really going on.  I have had readers of this blog complain that my illumination of the truth tends to shatter their "reality."  I am interested in helping people grow and protect their wealth.  One of the biggest sources of risk to our wealth is our lack of financial education.  That lack of education can be blamed on primarily two reasons.  The first is our own laziness.  However, that laziness is exacerbated by the second reason: too much confusing and misleading information.  

We are constantly bombarded with information about what we should be doing to "invest" for retirement or college or how to finance a car etc.  The problem is many times the information that is  being marketed to us is not the whole truth.  Let me give you an example.  It is a well known fact that a significant portion of the profits for major car manufacturers comes from car financing.  Here is the question:  How can a company make a profit on car financing when the rate is 0.00%?  The answer is: they raise the price of the car to include the interest charges and then say it is 0.00% financing.

The sources of other misleading, or not complete information are endless.  The media is one of the biggest sources.  You always have to ask, how does the commercial benefit the originator of the commercial?  (Ask that about what I write as well.)

Recently there was a surprised admission from “Too Big to Fail"  Wall Street firm Bank of America, the American peasants are informed about a reality with which they are all too familiar. That the U.S. government and the Federal Reserve Bank bailed out the rich and powerful, while leaving average citizens high and dry.

It always amuses me when I come across a mainstream media headline to the effect of: “Why are Americans still so angry?”

Why are Americans so angry? Let’s see. Perhaps it’s because one of the greatest heists in American history was just perpetrated against them by their own government in collusion with the largest multi-national corporations and the country’s most undemocratic institution, the Federal Reserve Bank.  Are you angry?  It seems to me that those who are not angry are the very people I talked about above - financially uneducated.

Continuing why Americans are angry; because not only were the individuals who caused the most severe financial crisis in recent memory not punished for their crimes, but they were showered with trillions and trillions of dollars in bailouts and taxpayer backstops, and made far wealthier than they were before the crisis they caused.

Because 99.99% of the population have been crushed by this policy of “socialism for oligarchs” and they feel the intense pain of this decent into poverty every single day of their live.

That’s why Americans are still angry, and if more of them understood what actually happened, they’d be much more angry. If I have anything to do with it, there will be more American angry - or maybe better said thus: better informed.

Moving along, Bank of America essentially admitted the above in a recent research report. As explained by Bloomberg:

Wall Street is counting its winnings from seven years of easy money.

In a report sent to clients on Sunday, Bank of America Corp. strategists totted up the results of 606 global interest-rate cuts since the collapse of Lehman Brothers Holdings Inc. and the $12.4 trillion of central bank asset purchases following the rescue of Bear Stearns Cos.

The results represent a clear victory for Wall Street over Main Street, according to the team of Michael Hartnett, BofA’s chief investment strategist.

For every job created in the U.S. this decade, companies spent $296,000 buying back their stocks, according to the New York-based bank.

An investment of $100 in a portfolio of stocks and bonds since the Federal Reserve began quantitative easing would now be worth $205. Over the same time, a wage of $100 has risen to just $114.

Zero rates and asset purchases of central banks have, thus far, proved much more favorable to Wall Street, capitalists, shadow banks, ‘unicorns,’ and so on than it has for Main Street, workers, savers, banks and the jobs market,” the BofA team wrote.

My motivation?  I want to help you help yourself.  As I help you, I am helping myself.  Plain and simple. 

Jason@financialtailwinds.com