Are You Still Listening to This Dangerous Advice About Personal Finance?
"If you do not change direction, you may end up where you are heading."- Lao Tzu I realize I might be stepping on some sensitive toes when I suggest that the well-intentioned advice your mom, dad, brother, sister, cousin, best friend, employer, newspaper boy, TV pundit, dog walker, financial planner, banker, lawyer, or someone else gave you might actually be doing you more harm than good. Call me crazy, but when one does as much research on these topics as I have done over the years; and when you hear as many money misery stories as I have heard, you tend to start thinking that something is horribly wrong with the idea of "business as usual" when it comes to personal financial planning. Things have taken a turn for the wildly unpredictable in the United States and throughout the rest of the Western world. So torrid is the pace of change these days that politicians can't keep up with all the lies they have to tell in order to avert widespread panic. Economists, flustered by the failures of their cherished theories are consumed with angst and lack real solutions. The economy has become like an out-of-control high pressure fire hose, ready to slap anyone down at any moment, and the people who are supposed to be controlling the spigot are turning it up, instead of shutting it off. The net effect is that all of us are getting hosed. No one wants to acknowledge that money, rather than being static and lifeless, is actually an organic entity; fed by perception and subject to erosive forces, and to a very large extent,uncontrollable. Conventional financial wisdom is being laid to waste by that nastiest of dream killers-reality. The numbers just aren't adding up, leaving people with a nagging sense that their money is at risk nearly anywhere they choose to put it. If you are still listening to yesterday's financial advice, then I encourage you to dig a little deeper and take another look at some common financial planning truths that just aren't cutting it in the new economy. 1. Certificates of Deposit- Better than the coffee can... or ARE they? With interest rates at historic lows, it's no wonder many people, perhaps even you, have decided that the mattress/coffee can method of cash management is looking better every day. The virtual freezing of interest rates by the Federal Reserve, which has been a boon to mortgage applicants but a punch in the gut to savers, does not look headed for a thaw anytime soon. The Fed has repeatedly indicated its' aims to keep the rate between 0% and 0.25 % until at least 2015. Add to that the steady, erosive force of inflation, which some experts believe is actually around 8% (versus the 2-3% of "official" statistics) and you get some insight into just why the average American can't get ahead. Obviously, traditional safe cash management tools are coming under scrutiny from savers who are looking for any relief they can get from artificially low interest rates. One popular way in the past to achieve a measure of liquidity, safety, and higher rates of return in the past was to "ladder" certificates of deposit. Laddering involves buying a series of CD's with incremental maturity dates and was a method employed by people looking for higher returns than a money market account, but still in need of some liquidity. Bankrate.com's Craig Guillot gives an example of how the laddering strategy is supposed to work: "For instance, a person might invest $50,000 by buying 10 CDs with maturity dates every six months. Each CD acts as a rung on the ladder and as each CD matures, the money is reinvested in a long-term CD, typically five years. The proceeds are then reinvested into more long-term CDs, but as each maturity date arrives, the holder of the CD ladder has the opportunity to put those funds into higher yielding CDs or access the cash penalty-free if need be."(1) Success using laddering, however, is dependent upon excess yields stretching out for many months and years, and most financial experts just don't see that happening anytime in the near future. Add to that the fact that laddering ties up your money for five years or longer and you can easily see why it's not a very appealing idea for most people. So, if you can't rely on banks and their products, such as CD's, where CAN you park your cash so that you can keep pace with inflation, access your funds when YOU need them, and have a measure of proven safety? Of course, I believe establishing your own source of financing is the ultimate cash management tool. Now, I know what many of you are thinking: How can becoming one's own personal bank possibly address the issue of inflation if true inflation is over 8%? Well, for one thing, the type of insurance companies that work best for this system have most of their investable assets places in long-term, high-yield bonds. These bonds are exceptionally high quality instruments whose interest rates generally increase as inflation increases. After all, the Fed can only keep the lid on the boiling cauldron so long before they are forced to start raising interest rates. The kinds of bonds in which these dividend-paying companies invest are poised to take advantage of this when it happens. #2. The 529's "You're living in your own private Idaho." 529 Plans are named for the section of the IRS tax code which defines them, allows them and blesses them. They are a bureaucrat-infected scheme over-marketed to parents as the ultimate way to save for their children's' college educations. 529's are a fantastic way to lose all the money you might have gained in interest at precisely at the very moment you need it and, as an ADDED BONUS, you could lose all the money you started with, too. What a deal! I often wonder where in the parenting guidebook it says that mom and dad have to forego their own retirements and go into debt so Junior can get a degree in Early Estruscan Literature. But, that is another topic for another article. For now, let's take a quick look a yet another helpful government plan. There are two types of 529 plans: The "prepay" option allows you to pay tuition in advance for qualified educational institutions. These plans are designed to "lock in" tuition at current rates. It was a fine idea at the time, but now the states are running out of money. The second option lets you fund a tax-deferred account that can later be used to pay for education at future tuition rates. Similar to how Medicaid and other federally-mandated programs are set up, 529 plans are sponsored and administered by each state individually, ensuring that the burden for the status quo's addiction to red tape, inefficiency, and wastefulness is shared equally amongst all taxpayers. States choose asset management companies, determine the plan features, rules, and restrictions, and they do not guarantee any money that is invested. They have total control and YOU assume all the risk. What's not to love? You are allowed to invest in any state's plan, although some plan features may have restrictions for out-of-state investors, some states' plans are more desirable than others, and some states' plans are but a hair's width away from falling into the black hole of insolvency. As you may have guessed, I think 529 plans have some major drawbacks. For one thing you are giving up a great deal of flexibility, use, and liquidity of your dollars for something the results of which are far from guaranteed. You are also being asked to trust the same bunch of miscreants, malefactors, and numbskulls (aka: bankers, brokers, and politicians) who got us into this mess in the first place. Maybe I am being paranoid, but that doesn't seem like such a great idea. Another problem with 529 plans is that they have a voluminous amount of rules and restrictions. You can expect painful penalties should you have to use your own money for something other than college. If your circumstances change (and that never happens, does it?) and you need your cash expect to pay for the privilege of liberating it. 529 plans simply have no room for real life. Also, some states plans will only allow you to use the plan at designated participating universities. So if Junior decides to go to art school and not a "529 University," your money is held captive until you reach the age of 60. Finally, because 529s typically invest in the volatile stock market, there is no guarantee of ANY return on your investment. In fact, there isn't even a guarantee that you'll get your principle back! A properly designed dividend-paying life insurance policy is I believe, the ultimate planning tool. Unlike a 529 plan, this wealth preservation and money management strategy: Does not count against your child for financial aid. Since your funds are in the cash value of a whole life insurance policy, the money is not counted in calculations for financial aid or scholarships. Is available to you quickly (usually in a matter of days) when you need the money. Can continue to grow, even while being spent for other things. For example, when Junior is old enough to drive, you could pay for his car out of your plan, pay yourself plan back with interest, and still have enough when the time came to cover tuition. Grows at a predictable, guaranteed rate. You always know the exact value of your plan at any given time, eliminating the need for a crystal ball. Doesn't penalize you if your kid decides to go to Europe instead of college. The money is yours to do with as you like. (what a concept!) 3. Buy Term and LOSE The Difference... (Yippee!) When I was much younger and far less jaded, I believed in Santa Claus, the Tooth Fairy, "happily ever after," etc., and I fretted that Wile E. Coyote could never catch that roadrunner. Then, as I grew older those childhood myths morphed into more dignified and adult fairytales, fairytales that had all the hallmarks of wisdom but, were in fact, "whizzdumb." Here's one most of us know... "Buy term and invest the difference."(BTID) In the modern era this cringe-inducing maxim has been uttered as absolute truth by all sorts of well-meaning folks with the best intentions, as well as a few financial gurus and television hosts who ought to know better. Indeed, BTID has become such an accepted faux truth that it has spawned entire companies founded on its' questionable premise. The theory upon which BTID hinges is a warm and fuzzy notion of carefree retiree life sometimes referred to as the "theory of diminishing responsibility." This poisonous cocktail; one part hopeless idealism and two parts bunkum, calls to mind bucolic scenes of contented seniors rocking away on the back porch, sipping ice tea and breaking only long enough to read the anniversary card their son the lawyer sent them. They are a happy and carefree couple because the kids have moved away, the house and cars are all paid off, and they no longer have the financial responsibilities of their youth. It's a sweet life all made possible by the power of "buy term and invest the difference." I think you'll agree that, as good as this sounds, this is not the reality for most people, and it never will be using BTID. Now, before I begin deconstructing the fable of BTID, I want to say that I have absolutely nothing against term insurance. In fact, I think everyone should have some as part of their overall financial plan. Term life can be especially useful in your younger years, if you need a little extra peace of mind or worry about creating a legacy for your loved ones. Because it initially costs less per unit than permanent life, term life can offer you larger face amounts for less money and can create instant estates for those in the accumulation phases of their lives. The problem I have with term, however, is that the premiums for permanent life stay the same over the years, while the premiums for term life increase, often dramatically. Increasing premiums make it harder and harder for older folks to hold on to their coverage which results in a lot of lapsed policies. The assumption has been that older people don't need much life insurance because they have made tons of money on Wall Street, they've paid off all their bills, and they have Medicare to take care of all their health needs. However, the stagnant economy has forced more and more seniors to work longer, sometimes because Wall Street has sucked away their life savings, inflation has eaten into their disposable income, or they used all their cash to pay for unexpected medical needs or to send their kids to college. To make matters worse, many women are postponing having children until later in life, and overall life spans are increasing. It is well known within the industry that most term insurance policies never get used. Obviously, many people are dying without any coverage in force because the premiums became far too expensive or their policy was not valid after aged 70 and they couldn't afford to take out a new one. It is equally obvious that from an insurance company's perspective, term life is a gargantuan cash cow. Permanent insurance, on the other hand, has you paying extra premium in the early years that gets invested and grow tax-deferred, minus any agent commissions. If you die during the policy term, your designated beneficiary usually gets the proceeds from the policy tax free. Permanent insurance is often criticized by people who say it is a horrible investment, that people who own these policies are overpaying for protection and are often underinsured. They believe that whole life should never be part of a solid financial plan. They are wrong. Not only do properly structured, dividend-paying life insurance policies provide a safer, less headache-inducing place in which to park your cash, they are also a key estate planning tool used by thousands of wealthy people. Rich people use permanent life insurance in estate planning for the same reasons you should consider doing so. An important reason whole life is being used by wealthier people is for estate conservation. Wealthy people understand that even though they might have invested prudently, sacrificed, skimped, and done everything the right way in order to build their successful businesses, they have an uninvited silent partner waiting patiently for the day they cash in. That partner, is of course, the government, who is more than glad to own a piece of the estate you worked your whole life to build. Through the deferred tax known as the Capital Gains Tax, business owners will see this bill come due, depending on how their financial affairs are set up, either upon their death or the death of their spouse. Let's look at a hypothetical scenario Janeen started her salon business as young woman. After 25 years of hard work and reinvestment in the business, she now has a chain of salons and spas and a business valued at around $10,000,000. Janeen is divorced with one daughter and wants to leave the business to her daughter. A firm believer in "buy term and invest the difference," she purchased a 25-year term life insurance policy with a face value of $250,000 during the early years of her business. In the intervening years, Janeen experienced a series of medical issues which made increasing her life insurance policy limits or purchasing new coverage prohibitively expensive. As the end of her original policy term approached, Janeen considered her options and decided that due to the fact that most of her cash was tied up in the business; she simply could not afford that expense. Instead of paying a ton of money for life insurance, Janeen opted to put most of her earnings back into her business, buying new equipment, leasing desirable locations, and hiring the top stylists. On occasion, she did manage to invest a little in the stock market, with varying degrees of success, but the whole process of risking her money made her feel nervous and insecure. As she currently has the business set up, if Janeen died today, 50% of the gain of $10,000,000 is reported on her final return ($5,000,000.) The other remainder is "tax free." (don't' get me started on the tax free thing...) At today's rates, Janeen's estate would be taxed at approximately 47%, giving her a final tax liability of around $2,350,000. Her legacy to her daughter will now be $7,650,000. If this seems fair to you, then think of it this way. Janeen took all the risk, did all the hard work, made all the sacrifices and the IRS gets to take $2,350,000 of her business earnings. Fairness issues aside, is their ANY way Janeen could have been better prepared to meet this tax liability? I say that there is. By using life insurance as a vehicle to pay estate tax bills, Janeen would have ensured that cash would be created at her death that would pay taxes and other final costs, leaving more of her estate to her daughter. The total cost of having such insurance in place would have been a lot less than what she paid on her final tax bill. With the right kind of dividend-paying whole life insurance (with the special "turbo-charging" rider attached) you can ensure that ALL of what you intend to go to your child or spouse will do so, while the tax man is paid his share from the policy. Not only that, but you would have an added benefit of safe, steady, GUARANTEED growth from your policy while it is in force. It's no wonder wealthy people utilize these kinds of policies when they plan their estates and why you should seriously look into doing so yourself. BTID: Why would any financial advisor ever recommend this? As you can see from the above scenario, "buy term and invest the difference" doesn't make a lot of sense for most people. If it really WAS the way to go, most competent financial planners would be recommending it to their clients as a long-term strategy. Yet, when I speak with other financial strategists, especially fee-based advisors who often manage millions of dollars in assets, they tell me that they don't believe in BTID. Research leads me to believe that the financial virus called" buy term and invest the difference" started around the time mutual funds began to gain in popularity. Insurance companies and mutual fund managers saw a way to make more money by luring people away from more traditional money management plans and into their fee-heavy, risky new funds. So, they convinced people to cash in those clunky, boring old permanent life insurance policies and get some real returns in the stock market. Marketers worked day and night to get people to increase their life insurance limits (buy term) and invest (put your money in their sexy new financial schemes) We'll talk later about the failure of mutual funds to live up to their hype. For now though, I'd like to ask you to consider the hypothetical situation above and ask yourself some important questions about life insurance: 1. What happens if you haven't built your nest egg before you term policy expires? The idea of buy term and invest the difference goes out the window unless you have managed to put aside a significant amount of money upon policy expiration. What if you can't save enough money before your term policy expires? Once the initial term expires, prices for insurance often skyrocket with no guarantee you will qualify for a new policy. Even if you do, the new premium could be as much as 10 times more than your first policy. 2. How can you truly plan your financial future if you can't know how much money you are going to have when you need it? Life is very unpredictable and capricious. Think about it... Is your life now the way you imagined it would be ten years ago? Have you experienced circumstances and issues which have forced you to deviate from your plans? If you are like most people you realize that life has a way of messing with our best laid plans. Anything such as The buy term and invest the difference strategy potentially forces you to live with the decision for the rest of your life, especially if you become uninsurable. Do you want to lock yourself into a financial strategy at an early age, not knowing what the future holds? These are just a few of the most well-known money myths. In future articles, I will discuss more of them and also give you alternatives that will help you create a financial future that is less stressful and more prosperous.
