Bear Markets and the Danger of “Safe” Investing

March 9th, 2017 marked an interesting anniversary in the world of investing.  On this date, we celebrated the eight year anniversary of the current bull market which as of this writing, remains intact. It is the second longest bull market in history (the longest being October 1990 to March 2000) and during this period the US stock market (S&P 500) has returned over 250%!

What’s interesting is just how fearful the investing world seems to be given the crazy news cycle marked by Trump’s latest tweets, constant political wrangling, North Korean missile tests and a Russian conspiracy de jour.    Mix in above average stock valuations (relative to history) and it’s no surprise that we are hearing more and more of our clients indicating they want “safe” investments for what they think will most certainly be a market crash. market-correction-bear

Now we have long believed and written many times that we don’t know what the stock market will do in the next few days, weeks or months.  What we do know is that bull markets do inevitably end, and yes, there will be a bear market (defined as a 20% decline in stocks) again at some point.  We just don’t know exactly when this will happen, when it will end and when we should re-enter the market.

However, we do know that when bear markets do end (with an average return to prior levels of about 3.3 years), it’s best to be invested in order to take advantage of what is typically a strong rebound.

But herein lies the conundrum, if we know a bear market is coming, shouldn’t we invest our portfolio in “safe” assets like 100% bonds?   Quite simply:  No- not if we are investing for the long term.

The reason for this is, as indicated by the oxymoronic title of this blog post, it can be very dangerous to be safe when investing over a long period of time.  By forgoing risk and accepting “safe” returns from say a 100% bond portfolio, we are ironically, taking on even MORE risk by sacrificing the underappreciated magic of compounding returns over the long term.

To illustrate this, we have designed a draconian scenario comparing two basic investment portfolios over a 20 year period.

Here is the scenario:  A 45 year old couple starts with a healthy $750,000 portfolio and wants to retire at age 65 with $3,000,000.  They commit to contributing $15,000 per year to their portfolio.  Since they think we’re going to have a bear market soon, they are concerned they won’t reach their goal.  So in our simplistic scenario, they have two choices The “Safe” Portfolio and the “Dangerous” Portfolio.  Let’s define each:

The “Safe” Portfolio:  100% bonds, comprised of 50% short term US government bonds and 50% intermediate term US government bonds.  The starting point is $750,000 and the investor contributes $15,000 per year as they save for retirement over 20 years.  For annual growth, we will assume historical returns (from 1926 – 2016) of 4.31% per year.

The “Dangerous” Portfolio:  60% stocks (60% large cap US, 20% small cap US, 20% international) and 40% bonds (50% short term US government bonds and 50% intermediate term US government bonds). Again, the starting point is $750,000 and the couple contributes $15,000 per year.  Annual growth in this portfolio is assumed to be the historical growth rate of 8.74%.

The “Bear Markets”:  As you would expect, without the stomach-churning bear markets the higher returning portfolio with stocks will be much higher after 20 years of compounding.  But what if we added two loud and nasty “growls” from the Bear?  What if we added a bear market of a 20% stock market decline (0% decline for the “Safe” portfolio and a 12% decline for the “Dangerous” portfolio) in Year 2 and then another awful bear market in Year 16?  For this awful Bear in Year 16, we’ll assume a repeat of the historically worst annual return of each portfolio in the last 50 years.  For the 100% bond portfolio, it’s a 1.15% decline- not bad at all.  For the “Dangerous” Portfolio it’s a 20% decline- ouch!

The Result:  What might be surprising to some, is that even with two terrible bear markets, the “Dangerous” Portfolio far out performs the “Safe” Portfolio.  Looking at the chart below, we see that our retirement saving couple will NOT reach their goal of a $3,000,000 portfolio in retirement because their “safety” cost them dearly.  In fact, the difference between these portfolios is $935,000 with the “Safe” Portfolio at $2.027 million and the “Dangerous” Portfolio at $2.963 million!  That is VERY expensive safety!!!

safe investing

Now we must temper our conclusions with a few “real world” factors.  First, as our couple moves closer to retirement we would certainly monitor and modify the allocation to align with their retirement date.  Second, we would also implement “psychological firewalls” to help keep the couple fully invested in a growth portfolio.  This typically includes a tailored portfolio of individual high quality bonds, providing assurance of cash flow as retirement approaches.  Third, in order to keep this simple, this scenario does not assume systematic re-balancing of the portfolio, which we also execute for clients.

But the bottom line is this:  No one really knows when the next bear market is coming even though we all know the next bear market IS coming.  But even if it comes in 2018 and even if there’s a worse decline 5 years before retirement (in this scenario), it is still much more beneficial to stay vigilant about keeping a balanced portfolio.  Because the irony is, our attempts to keep a safe & conservative portfolio actually results in taking on much more risk that we thought.  In this case, the “price” for this risk is almost $1,000,000!

Benefits of the Front Page

It’s that time of year again:  while some may think we might be referring to the Masters’ Golf Tournament (maybe our favorite sporting event, coming up in a few weeks), we’re actually referring to something much less pleasurable:  income tax filing.  This year, the deadline is April 18th and for many people it’s annoying at best and downright terrifying at worst.masters image

Without proactive tax planning, most people are staring at either a Turbo Tax screen or their accountants’ mystifying tax documents and ultimately just want to know one thing:  “Will we have to write a check to Uncle Sam or will I be getting some cash back?”

It doesn’t have to be this way.  In fact, as integrated financial advisors we think it’s prudent to always be cognizant of federal and state income taxes, typically our clients’ largest expenditure each year. (DISCLAIMER:  We are not CPAs, nor enrolled agents so this should not be construed as formal tax advice as all families’ tax situations are different.  You should consult your CPA or enrolled agent for specific tax advice.)

tax guyEven though we are not CPAs nor enrolled agents we still partner closely with CPAs to ensure our clients are always compliant with tax laws and regulations.  This means our CPA-partners fill out tax forms, research the applicable issues, sign the returns and work with tax authorities, if necessary.

As financial advisors, nobody is more involved in our clients’ financial lives. For this reason, we believe staying sharp on taxes throughout the year is essential, and potentially profitable, for our clients.   Realizing this, we always try to employ what we think might be an underappreciated approach to tax planning:  the “front page” deduction.

“Front page” deductions are those tax deductions that actually lower AGI (adjusted gross income) on the “front page” of the federal tax return (Form 1040).  These tend to be more “valuable” because they can positively impact other parts of the tax return, much more so than the typical, and similar, “Schedule A” deductions (a.k.a. itemized deductions).  Why is this?  In general, because other Schedule A deductions use the AGI number as the basis to determine how much of these expenses can be deductible.

For example, if you have lower AGI you could see a larger tax deduction for:

  1. out-of-pocket medical expenses
  2. miscellaneous deductions (such as financial planning and tax preparation fees)
  3. casualty losses and others

In addition, you could also lower the amount of social security income that would be taxable (assuming you are currently taking social security).

But the trick is to lower the AGI in order to benefit more from those deductions.  This can be accomplished by employing the “front page” deductions.  For instance, instead of contributing to a charity and deducting it on Schedule A, maybe our retired clients should use a Qualified Charitable Deduction as part of their IRA required minimum distribution.  Also, as financial advisors we keep a sharp eye on those investment accounts and try to offset capital gains with capital losses during the year so as to either lower the capital gain income (on the front page) or maybe even maximize the $3,000 annual allowable capital loss.  Other examples include contributing to Health Savings Accounts and ensuring all expenses for a small business are fully (and legally) recognized as offsets to income.

This may all sound too nerdy for some but if we illustrate with an example, you may sit up and take notice at the material tax savings which could be realized by knowing how to employ these strategies.

Let’s say we have a retired married couple with the following gross income totaling about $118,000

  • $8,000 of interest & dividends
  • $5,000 of capital gains
  • $50,000 of IRA distributions
  • $40,000 of Social Security income ($34,000 taxable)
  • $15,000 of consulting work income

And let’s say they have the following expenses, some of which are deductible:

  • $10,000 of out-of-pocket medical expenses ($300 is deductible because their income is so high)
  • $8,000 of real estate taxes
  • $10,000 of charitable contributions
  • $7,500 of tax and financial planning fees

Overall, we estimate this couple would owe about $10,372 in federal income tax or about 12.8% of taxable income – not too shabby.

But, what if we made the following changes (with all other deductions remaining the same) with “front page” deductions to lower our AGI and the tax burden?

  • Make a QCD (qualified charitable distribution) to donate the $10,000 directly to charity from our RMD instead of donating from our checking account and deducting on Schedule A
  • Maximize the contribution to the HSA (if qualified) and pay most medical expenses with these funds
  • Incorporate a tax-loss harvesting strategy in taxable investment accounts to deduct the maximum $3,000 capital loss each year
  • Document and deduct $5,000 of expenses related to the consulting work

By making these changes, we have lowered our taxable income from $80,640 to only $50,246 which means our tax bill is now only about $5,841 – an annual savings of over $4,500!

In our minds, this illustrates the difference between financial planning and having “an investment guy”.  Sure, it may not be the latest & greatest stock tip (which usually crashes & burns anyway) but tax savings is real cash flow.  In addition, these savings can compound year after year adding materially to families’ net worth.

The point is this:  taxes can be confusing, boring, scary and annoying all at once.  But knowing how the 1040 tax return works can add substantial value when combined with prudent investment advice. This is why when we meet with our clients on the various financial topics throughout the year, we always have our ears open for how to lower that AGI and potentially lower the tax liability, putting real money back in our clients’ pockets.

Comments?  Questions?  Feel free to enter them below and we’re happy to address.

The Doctor Test: Your Guide to Evaluating a True Fiduciary

When it comes to providing financial advice, we like to think our advice is not unlike the “treatment” and advice doctors provide for our physical condition.  But, instead of treating a torn achilles, a heart condition or the flu, we provide advice on “healthy” asset allocation, tax strategies and retirement projections, etc.

Recently, the Department of Labor has brought to light a concept known as “the fiduciary standard” which in the most basic terms means “always acting in the client’s best interest”.   So in the medical field, it’s the equivalent of having the assurance that your doctor’s advice and recommendations are what’s best for you and not for them.  On the surface, it makes perfect sense.  Of course, the devil is in the details as it relates to someone who calls themselves a “fiduciary” as this is not a black-and-white question.  Rather – there are shades of grey that must be defined in order for you to know exactly what kind of a fiduciary you are looking for.  And we think the best way to illustrate this is to compare it with how we work with doctors.advisor-taking-money

We call this The Doctor Test and below we detail the four types of fiduciary.  (Note: For a more detailed analysis and background on how these standards developed, feel free to read a recent and comprehensive post from Michael Kitces, a financial planning industry expert.)  In short, we would like to see the financial industry operate with the same high ethics as the medical industry.

Keep in mind, each of the following types of advisors can certainly claim to call themselves “fiduciaries” just like a medical professional earns the right to call themselves a “doctor”.  However, the TYPE of “fiduciary” or the means by which they practice is critical in evaluating whether your definition of a fiduciary aligns with your financial planner’s.

1. The “SEC” or State Registered Investment Advisor (RIA): This type of advisor complies with the Investment Advisors Act of 1940, which states they must not act in any way that is fraudulent or misleading.  Sounds great right?  BUT, this just means they must disclose their conflicts of interest, it doesn’t mean they don’t actually HAVE conflicts of interest.  So they could be paid on commissions for recommending that mutual fund, they just have to disclose it in their filings.  Did you really read the small print in the disclosure they provided?

The “Doctor” Test:  You’re having chest pains and your doctor correctly diagnoses you need to take a particular prescription that would help treat the condition.  He or she recommends an expensive drug even though there’s a generic alternative at a fraction of the cost.  In the paperwork you signed, it says he could get taken on a fishing trip or a nice seminar in Barbados for recommending this drug.  Would you be OK with that? Of course not, and that’s why doctors don’t operate in this manner.

2. The Department of Labor (DoL) Fiduciary: This advisor complies with the new DoL regulation that requires “always operating in clients’ best interest” when providing retirement advice. Again- sounds great.  However, the problem is this standard only applies to investment advice on retirement accounts.  It says nothing about broader financial planning topics and does NOT apply to non-retirement accounts.  This makes no sense.

The “Doctor” Test:  You’ve been experiencing knee pain and turn to a doctor for help.  She evaluates your knee and recommends an effective knee brace (with no financial incentive) to help you alleviate the symptoms.  But then you mention your aching back and while it could be directly related to your knee problems, she doesn’t have to provide the same heightened standard of advice and recommends an expensive, high-risk procedure to be performed by a doctor she gets a referral fee from.  Any doctor we know would never practice like this.  But just like our bodies are one system of interacting components, so are our financial accounts.  It shouldn’t matter if one is classified as a retirement account or one is not!

3. The Certified Financial Planner ® Fiduciary: The CFP certification is an outstanding program as it is comprised of a rigorous series of education requirements, comprehensive (and very long) exam and continuing education which covers almost all aspects of personal financial planning.  We are CFPs here at Magis Wealth Planning so we certainly endorse the high standards the CFP Board requires of its members.  While the certification is a great start in evaluating a planner, it’s not a legal  standard. Which means that to call oneself a CFP, you must pass their exam and agree to adhere to their Code of Ethics.  That’s fine but what if a CFP doesn’t comply?  There is no legal recourse. The CFP Board can’t fine anyone or subpoena anyone or force anyone to testify in a legal matter.  Their only recourse is to strip a violator of the certification.  While this might be detrimental, stripping one of their CFP mark does not preclude them from practicing as a financial planner.

The “Doctor” Test:  Let’s say you’ve heard there is a doctor who has some high-level certification for rotator cuff surgery.  Of course if you need that procedure, you would certainly seek them out.  But what if he hasn’t kept up on the latest & greatest techniques and technologies associated with the surgery.  What’s the risk to him?  Well, he could lose that high-level certification.  But with a solid reputation already established, maybe he might not care.  But you would certainly care.  The point is the downside risk to the doctor is not as equitable to you as it is to him.

4. The “Crystal Clear” Fiduciary: In our minds, this is the most stringent standard that we believe all people seeking financial advice should demand.  These are financial advisors who usually are members of networks of like-minded advisors such as NAPFA & Alliance of Comprehensive Planners (full disclosure:  we are member of both organizations) which actually document and sign a contract with clients which explicitly states on paper they are ONLY compensated by client fees and there are no other means of compensation like commissions, referral fees or golf-junkets to the Bahamas for selling annuities.

The “Doctor” Test:  We wish we could walk into a doctor’s office or a hospital and among all the paperwork we have to fill out (over and over again, it seems), see an explicit declaration that this doctor is only compensated by what we pay them and their medical advice is not “clouded” by potentially more lucrative recommendations from third parties.  We’re confident doctors actually do operate without the conflicts, we just wish the same were true for the financial industry.

The point is this:  The advice business, be it medical or financial, can be confusing enough with all the acronyms and esoteric terminology.  What should be completely transparent is the compensation model that may or may not be driving recommendations from our practitioners.  In short, we would like to see the financial industry held to the same high standards as the medical industry.

We think a great way to cut through the confusion on all the standards, acronyms and certifications is to simply apply the “Doctor Test” when evaluating a financial advisor.  This should go a long way toward aligning your physical health with your financial health.

Optimizing Cash Flow for Retirement – Part 1

Today, we are introducing the first of four articles detailing our unique set of tactics which we believe, when integrated as one cohesive strategy, optimize cash flow for retirees in a tax efficient and cost effective manner.  This is accomplished without conflicts of interest or the exorbitant fees and restrictions of annuities as we do not sell any financial products.

Together, we call our strategy the Cash Flow Optimization for Retirees and it is comprised of “Four Cornerstones”.

  • Bond Ladder Implementation & Management
  • Social Security Optimization
  • Systematic Roth Conversion
  • Tax Efficient Asset Distribution

This strategy is ideally suited for people who are 1 to 15 years from retirement but this can also be very effective for people already in retirement.  It combines low cost investments, tax efficiency and most importantly, peace of mind that our clients’ portfolios are “doing their job” by effectively matching future liabilities (living expenses) with assets (portfolio).cash-flow

While we cannot control the stock and bond markets, we can control our reaction (or lack of reaction) to the markets and our investment costs.  In addition, we believe legally minimizing our client’s tax liability provides extra “alpha”, which could enhance portfolio returns and extend the life of the portfolio in retirement.  While we would never guarantee returns, we believe our strategy maximizes the chance of success, which we define as funding a retiree’s lifestyle without falling victim to high fees and sales commissions paid to an annuity salesman.

Part 1 of our series starts with the Bond Ladder.  Throughout 2017, we will outline the other three strategies.  Again, we believe the combination and coordination of these strategies is unique, differentiated and ideal for individuals or couples either in retirement or anticipating retirement in 15 years or less.

The Bond Ladder

In the simplest terms, a bond ladder is nothing more than a series of individual bonds, each maturing at a specified date in the future.  We believe integrating this seemingly simple concept into a coordinated strategy is a critical component to optimizing the long term cash flow needs for retirees.

What It Is:  The bond ladder is a series of bonds (not bond funds), each with a maturity date that corresponds to a year of living expenses above and beyond pension or social security income.  To build this bond ladder, we first determine how much “income” is needed from the maturing bond each year.  We then purchase (at existing rates) US Treasury STRIPS, which do not pay annual interest but instead are purchased at a discount and then mature at the par value over time. (Income tax is still owed on the “imputed” interest each year).

How It Works: Our sample clients are 58, looking to retire in 5 years at age 63.   They are starting with a portfolio of $2,000,000 and they expect to receive $35,000 / year from Social Security at age 67. They spend $100,000 per year in today’s dollars and we would like to build a 10 year bond ladder to provide peace of mind that their living expenses are covered for 10 years, regardless of stock market fluctuations.  To ensure an inflation adjusted $100,000 “matures” each year from 2022 to 2031, we would need to take $675,928 (or about 1/3 of the portfolio) and invest it in US Treasury STRIPS that mature over that time frame.

This leaves the remaining portfolio (about 66%) eligible to invest in stocks (and even some additional bonds) for long term growth as we won’t have to rely on what will likely be a fluctuating value over the years.  So even if the remaining portfolio were 100% stocks, we wouldn’t worry too much about year-to-year volatility as we have reasonable assurance, based on long term history, that over 10 years a stock portfolio is almost always higher after 10 years!

In fact, a great article in the Wall Street Journal last year (please click HERE for a copy) noted that the average recovery period for the stock market from a bear market (down 20%) to a new high is about 3.3 years!  We all remember 2008.  The recovery period from that terrible bear market was 5.3 years.

Now what happens if it’s 2021 and the stock market were to drop 10%?  The bond matures and their living expenses are funded.  But now we’re not forced to sell any of our portfolio because we know we still have the remaining 9 years for our portfolio to recover and likely, outgrow its current level.  Now, what if (in 2021) the stock market rose only 4%, the client could still fund their living expenses with the bond that matures that year.  We could then sell about $52,000 of stock (the 4% gain of the non-bond ladder funds) and fund another year of living expenses buying a 2032 US Treasury.

Why It Matters:  First and foremost- we must emphasize the implementation of a Bond Ladder is not intended to maximize portfolio returns.  In retirement- that’s not the job of a portfolio!  Instead, we think of the portfolio in risk adjusted terms that must be custom-fit to fit retirees’ cash flow needs.  This is NOT a market-timing, stock picking or “reach for yield” strategy.  Instead, the Bond Ladder provides psychological comfort and insulation from knee-jerk reactions to stock market volatility.  Instead of fearing a bear market, we can have reasonable assurance the client’s lifestyle is protected for up to 10 years without having to liquidate the stock portfolio at fire-sale levels.

In addition, we are effectively self-funding an annuity-like stream of income, without paying egregious up-front commissions (as high as 10%) and annual fees (~3%) to the annuity company.  Using our example client, buying an income stream with an annuity could cost our retirees $67,598 up front and about $20,300 in annual fees!

Finally, the psychological impact of knowing you have 10 years of retirement income fully funded cannot be understated.  As we discussed in our prior post ROI vs. ROS, we’re much more concerned with providing retirees ROS (“Return on Sleep”) than we are taking too much risk for ROI (Return on Investment).

2017 Market Outlook

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Yes, it’s that time of year again.  It’s that nostalgic week with Christmas / Hanukkah behind us and the New Year’s Celebration front and center. There is something about flipping the calendar that seems to spark a thoughtful review of the year gone by and to wonder what’s in store for us in the next twelve months.

For some reason, Wall Street prognosticators (who like to refer to themselves as “strategists”) seem inclined to provide readers & clients with their official predictions for the upcoming year as a means to provide the incremental perspective they so often claim to have (and sell).

In that light, we’re happy to jump into the fray and provide our own “official bold prediction” on where stock and bond markets are going in 2017:

“We don’t know.”

Sorry to disappoint you all but if you read our blog posts enough, you should have seen that coming.  We readily acknowledge to NOT being able to accurately predict what’s going to happen in the next twelve months.  But we are happy to admit what many other advisors have so much difficulty admitting:  we don’t know because NO ONE knows.  And anyone that claims to provide you with assurance as to what’s going to happen in calendar year 2017 should be classified in the same category with tarot card readers and astronomers.

Now this doesn’t mean we don’t have an opinion.  But having an opinion on near-term market moves and a long term investment strategy are not the same thing.  In fact, these two mindsets often conflict as knee-jerk reactions to market moves often works to the detriment of building wealth over the long term.

So why don’t we provide predictions?  Two main reasons:

  1. Predictions are almost always wrong: Since 2000, people with important-sounding titles like “Chief Market Strategist” predicted the stock market to go UP every single year by an average of 9.5%. In reality, it was up about 3.9% and actually declined in 5 of the 16 years.  That includes the massive decline in 2008, when the average prediction was for an 11% rise and the S&P 500 declined 38%!  So why are the predictions so biased to be bullish?  That’s because…..
  2. Predictions drive commissions & fees:  In the short term (less than a few years), selling predictions as “market strategy” provides some insight on the mindset of the source. Predictions are usually issued by entities who benefit from trading and gathering assets. Keep in mind who is issuing these forecasts: banks and brokerage houses who make their livelihood on some mix of trading commissions, selling high-fee mutual funds or gathering assets.  A business model with these compensation structures might have their crystal ball clouded up by the potential for a large bonus.  Said differently, these folks are speculators and/or salespeople, not investors. In fact, the louder and more outrageous these predictions are, the more they remind us of the weekly NFL “Vegas Insiders” who claim to have some unique insight as to why the Browns might cover the point spread against the Steelers this week, a dubious bet indeed.

The point is this:  we have no control over the stock and bond markets and while we might sound like a broken record, we have to emphasize again: we all need to focus on the aspects of our financial lives that we can control.  Again, these factors include our risk-adjusted asset allocation, investment fees, savings/spending rate, tax liability, value to employers/clients and most importantly, our emotions.

Over the last century or so, patient investors in the U.S. have been rewarded with owning a piece of the miracle that is capitalism.  This assumes of course, they can keep their heads despite the occasional roller coaster ride of gut-wrenching declines and euphoric increases.

Sure those predictions are fun and you might even find it slightly amusing to hear a market “expert” opine on exactly where the S&P 500 may close 2017.  But we’re in the business of helping our clients maintain and grow wealth.  We are not in the entertainment business.  Ask yourself this:  If someone really knew exactly where things are going, why would they be so generous to let us in on such valuable information?

Best wishes to all for a happy and healthy 2017!

Why Timing is NOT Everything

As we all know, the old phrase “timing is everything” seems to capture the seemingly random, but impactful, chance events which occur throughout life.  Of course these sometimes life-changing events can be either negative or positive.  The examples are innumerable and we all have them:

  • You have to stop for gas on your drive to work and find out you miss a 10-car accident by 2 minutes
  • You run into an old friend, get invited to a cookout the next weekend and end up meeting a future business partner
  • Your son is studying in Italy and runs into a girl from grade school who ends up being your daughter-in-law

We could all rattle off an odd set of circumstances which ended up profoundly impacting us and can be perceived in any number of different ways, depending on one’s belief system.  One person might think their situation was a result of divine providence, another- mathematical chance, still another- a mystic power in the universe or another- just dumb luck.  Regardless of the belief system, it’s almost universally perceived that “timing is everything”.

While that may help rationalize things for us in everyday life, we believe applying this mind-set to investing is at best unprofitable and at worst, downright hazardous to your financial health.  market timing image

Why? Because the financial markets are so unpredictable, it’s almost impossible to accurately time the market in a consistently profitable way.

With the stock market touching new record highs the last few weeks, we seem to be getting more and more questions about whether or not it makes sense to continue investing “at these levels”.  Our immediate question is: “When will you need to use this money?”  We certainly can’t provide appropriate advice without knowing the answer to that question as we always consider each family’s individual circumstances.

But taking it a step further, history suggests missing just a few days of market moves can have dramatic effects on a family’s portfolio.  In fact, a recent study by JP Morgan Bank shows just how volatile markets can be and how for example, missing just 10 of the best trading DAYS out of 20 YEARS of investing would have nearly cut your return in half!  Even more importantly, the study points out that “six of the 10 best days occurred within two weeks of the 10 worst days” (see accompanying chart), which means when things looked their darkest, those that remained invested usually recovered and made healthy profits.  Keep in mind, the typical year has about 252 trading days so 20 years of trading days is over 5,000 days!

market timing graph

Source: J.P. Morgan Asset Management analysis using data from Morningstar Direct

Now those percentages and the dollars shown in the chart may not be too compelling, but what if we applied this using $500,000 instead of $10,000?

The math is certainly the same but the difference in dollars all of a sudden becomes life changing.  Starting with $500,000 and making 8.18% (compounded annually) results in about $2.41 million after 20 years.   If instead, someone missed the 10 best days over the 20 year time period and earned only 4.49% (compounded annually), they would only have $1.2 million – JUST HALF!

Would starting your retirement with an extra $1.2 million would matter to you and your family?

The point is this: investing is critically important to retirement and achieving many other life goals.  But we believe diverse asset allocation, consistent re-balancing and keeping investing expenses low are the key strategies to employ – NOT market timing.

Too often, families are “sold” on the idea that some market wizard has a crystal ball and can predict the future.  But the fact is, no one knows the future.  And as demonstrated by missing 10 days out of 5,000 trading days, timing is certainly NOT everything.

The Good, The Bad and The Ugly of Annuities

I don’t know if it’s just my imagination but it seems to me with each volatile streak in the stock market, annuity sales pitches become more prevalent on the radio.

You may have heard them pitched as a “personal pension” or “your money is guaranteed to go up and can never go down”.  While these sound like great concepts, the most skeptical among us might react with “If it’s too good to be true, it probably is….”.  And it is of course, it is too good to be true.  Given this backdrop, I believe it would be helpful to walk through some basics of annuities and provide some perspective.  I believe my view can easily be summed up by the title from the classic 1966 western starring Clint Eastwood called, “The Good, The Bad & The Ugly”.  But I want to change up the order of my opinions in order of priority as I think about annuities:  “The Bad, The Good & The Ugly”.  Given the length of each list (below) most readers can probably guess where I usually come out on annuities.eastwood_good_ugly

But before getting into that, I’ll first define an annuity in the most basic terms.  An annuity is a contract you sign with an insurance company, usually to exchange a good chunk of money for a promise of future payments.  Now there are many, many variables that get applied to this agreement- from the underlying investments, to the time period for payment, to the time for payments to start, to who might get paid if the annuitant dies, etc.  Despite all the variances, it’s a contract between you and an insurance company.

Example: a 60 year old male, who wants payments to start immediately, might plunk down $250,000 in exchange for lifetime monthly payments.  How much will that buy him (according to About $1,245 / month for the rest of his life or a payout of about 6% per year.  Not bad right?    Well, read on for The Bad, The Good and The Ugly:

The Bad

Your Money Is No Longer Liquid:  Once you sign up for most annuities, you’re turning over a large chunk of change for future payments.  However, once your money is with the insurance company in most cases, you no longer have easy access to it, and neither do your heirs. If an emergency comes up and you need your money back, the contract usually stipulates there are onerous “surrender charges” of 10% or higher for somewhere between 7 or 10 years!  Also, if you were to spend $250,000 for some types (not all) annuities and drop dead in a year, your heirs get $0 (or a very small death benefit).

Usually Expensive with Conflicts of Interest:  Most annuity salesman will say “you don’t pay me, the insurance company does” but do you really think the insurance company would have the same payouts for their annuities if they didn’t have to pay some guy 5%, 6% or more UPFRONT for your annuity (that would be $12,500 payout on a 5% commission for $250,000 annuity).  Not only that, do you really want to ask an annuity salesman (usually posing as a financial planner) for advice on whether or not it’s a good idea to buy an annuity if he has a $12,500 payout hanging in the balance?

Limits on investment returns in exchange for “not going down”:  You may hear “your money is safe and it goes up with the stock market but is guaranteed to never go down”.  This has two nefarious aspects to it:

  • Nothing is guaranteed: I don’t care what any insurance company says- nothing is guaranteed. If an insurance company goes out of business because they were selling high-payout annuities and could not make good on those payments, then you are out of luck.  There are no guarantees.
  • When your money “goes up” with the stock market, your “upside” is usually capped and you don’t capture all the gain. So yes, your money won’t go down but if the stock market goes up 16% (like it did in 2012) or 30% (like it did in 2013) or 14% (like it did in 2014) your money can “participate” and go up but could be capped at something like 8%.  Who pockets the gain on your money above 8%? The insurance company.  Given the market has gone up 71% of the years between 1825 and 2013 AND only 26 of 189 years did stocks finish down more than 10%, who wins that bet most of the time?  I’ll give you one guess.

Ever hear this on the radio?

Annuities are Complicated:  Ever see an annuity contract?  It looks like a small print version of Tolstoy’s War & Peace.  Why do you think that is?  To clearly communicate the costs and benefits to you?  As usual, the devil is in the details on these contracts and the more complicated the details, the less able we are to adequately judge the value.

The Good

Despite all the bad attributes, annuities CAN, in limited circumstances, serve a purpose for some people.

“Peace of Mind”: One could argue there is value with the peace of mind in knowing fixed expenses in retirement would be covered by a combination of social security and annuities.   While I would argue this is expensive peace-of-mind, for some folks it’s worth it.  So I don’t dogmatically eliminate annuities from consideration but it’s not my main focus.

Mortality Credits help with “returns”:  When you and thousands of other people contract with an insurance company, the insurance is betting some of you are going to die early – and they are statically correct.  This calculated bet, allows for the insurance company to afford higher payouts than just passing through the earnings on their investments of your dollars.

Some low-cost options available:  Not all annuities are high-fee and high-commission.  There are low-cost options from Vanguard and other providers.  If a client is dead-set on an annuity, this low-cost providers are first on my shopping list.

The Ugly

Unfortunately, I still hear ugly stories of these products being pushed heavily on people, especially older people who may not know better.  For example, I recently heard of an 80 year old signing a contract and handing over a large sum of money in exchange for “guaranteed payments for life”.  In addition, this particular contract had a 7 year surrender period.    Who do you think is going to win that bet and how much did the salesman pocket?

Bottom Line: Overall, I’m usually not a fan of annuities in many cases but then again, I’m not compensated by having people buy them.  For select & limited situations it can make sense but like most financial products, annuities are usually “sold not bought”.  Hammer and nailOf course those that are compensated to sell annuities will have a different opinion but I’ll go back to an old phrase that I think applies to those who think annuities are always the best tools for retirement planning- “When all you own is a hammer in your toolbox, every problem looks like a nail.”