A Few Random Criticisms Of The Book
Now, before we move on to my criticisms of the other part of Douglas Andrew's strategy (investing in universal life insurance contracts), let's pause for a minute to point out a few other random issues with the book, which are not uncommon with books of this type. On page 29 (where's he's busy bizarrely explaining how paying taxes is an asset) he puts out a chart that shows what happens when money doubles over 20 periods. The casual reader may make the assumption that money grows to the sky as he shows $1 becoming $1.05M over those twenty periods as the money doubles every period in a tax-free manner. What he doesn't make clear is that at typical rates of return (say 7.2%) money doubles every decade. So the chart is showing a 200 year investing horizon, four times as long as that of most investors. I can only think of one way to keep money growing for anywhere near that long in a tax-free manner (besides giving it to a charity or a university endowment), and that's to use a stretch IRA left to a great grandson upon your death. Compound interest is what it is, but it's important for investors to realize that even with a good return $1 isn't going to become $1 Million in your lifetime.
The estate tax scare is also common in financial books. “Your money might get taxed not just once, BUT TWICE!” Yea….at least the portion over $10M (married, indexed to inflation) that you don't give away prior to your death. That is such a non-concern for nearly all Americans it almost shouldn't be mentioned. The assumption that the estate tax is something you should worry about leads to the wrong conclusions- buy unnecessary permanent life insurance.
The example Andrew uses to explain how tax brackets could be higher in retirement than during working years shows a teacher who never made more than $60K would get $16K in SS income, $36K in a pension, and $30K from an IRA ($82K total) and then be shocked that she is in a higher tax bracket in retirement than during her working years. Uh….newflash….higher income means a higher tax bracket. That doesn't change the fact that most retirees live on less money throughout retirement than in their peak earnings year. How big of a portfolio would a doctor earning $400K in his best year need to generate $400K of income in retirement? $10 Million. Getting close? I didn't think so. The teacher should have used a Roth IRA, of course, knowing she was expecting such a big pension in retirement. Problem solved, without a need for life insurance.
Andrew also suggests employers should be willing to match dollars for their employees into either IRS-qualified plans (like 401Ks) or non-qualified plans (like life insurance) and that they should hold seminars to educate themselves and their employees on these options (perhaps you could call Mr. Andrew to schedule one, no?) What a bizarre world Mr. Andrew and his associates appear to live in where they see a universal life policy as not only a reasonable option for investing, but the only option anyone ever ought to use.
This idea that a $6000 mortgage interest deduction is just as good as a $6000 401K contribution is also a common one carried throughout the book. He never mentions that while they both provide the same deduction (assuming the mortgage interest is fully-deductible) that with the 401K contribution you not only get the deduction, but you also get to keep the $6K. I occasionally explain this one to my wife- “Yes, honey, I spent $10K on Roth IRAs, but we still actually have the money. If you want it, we can pull it out and spend it.” Yes, there may be taxes and penalties, but the money isn't gone like with making mortgage payments.
Mr. Andrew also uses some bizarrely high expectations of investment returns, which likely also affect his willingness to go into debt to get them. He often uses returns of 8-10% for life insurance, 12-15% for equities and 7% for real estate appreciation. All are ridiculously high, especially given today's interest rates. I understand the book was written a few years ago, but please show some appreciation for historical and expected returns on investments. Again, bad assumptions mean incorrect conclusions.
Using Universal Life As An Investment
Now, I'm 4000 words into this critique and I haven't even gotten to the biggest problem with Missed Fortune. I could forgive someone for choosing to highly leverage his house on an interest only mortgage in order to invest, as long as he realizes that adding that leverage is significantly increasing his risk. In fact, I think it probably isn't very smart, at least mathematically, to pay down a low-rate mortgage rather than investing in a tax-free account such as his Roth 401K or a Roth IRA. But, finally on page 182 (of 272) of the book, after countless mind-numbing pages of number-filled charts demonstrating the wonders of compound interest, Mr. Andrew finally reveals what this wonderful tax-free “alternative retirement account” he's been alluding to for 182 pages actually is. Insurance salesmen don't like mentioning that the product they're selling you is life insurance, probably because it causes them to lose sales because most people have learned at some point that life insurance generally makes for a poor investment when compared to alternatives. But eventually, the cat comes out of the bag, and hopefully for them, it's after they've convinced you that life insurance isn't really life insurance. They like to tell you all the ways in which insurance companies are better than banks, the government, and your mother's apple pie.
The Issue Of Life Insurance Returns
Then the typical salesmen goes through all the benefits of cash-value life insurance (and there are some very real benefits) and finally arrives at the issue of the fact that life insurance has a relatively low return as an investment. At this point, the salesman has to convince you that it doesn't matter. Mr. Andrew does it in this manner: He quotes an insurance professional who says that “Contrary to belief, rate of return is generally not the main factor in accumulating wealth.” I actually agree with that statement in that I think your income and your savings rate are probably the main factors, at least early on. However, later in life, rate of return actually IS the most significant factor. Mr. Andrew, however, thinks the most important factor is the fact that you get the money away from yourself. He even goes so far to suggest that most people would be better off burying their money in a tin can so they didn't spend it than putting it into a guaranteed 8% investment because then they'd be more likely to spend it. Well, if this investing theory is for people that dumb and undisciplined, it certainly isn't for me or my typical reader. It's bizarre that he spends the whole book talking about how liquidity of your money is so important, then he suggests that illiquidity is the main reason you should invest in life insurance.
What If You're Not Insurable
There's a very real issue with recommending life insurance universally as an investment. This investment still has to masquerade as insurance. That means you have to be insurable. If you have poor health or participate in dangerous hobbies, it's going to be a very expensive investment, if you can get it at all. Mr. Andrew's Solution?- buy the policy on your spouse or kid. Seriously. Then not only do you get all the great benefits of this investment, but you hit the jackpot when your kid gets run over.
The Costs Of Insurance
Insurance has significant expenses when compared to a more traditional investment. I mean, it's got to pay out when someone dies. Plus you have to pay the commission to the salesman and all the other costs of the insurance company. Mr. Andrews actually explains this process very well. He envisions a properly structured universal life insurance policy (basically one you pay up in 4-5 years with as low a death benefit as legally allowed to still call it insurance) as a bucket with an open spigot at the bottom. You put money in and some drains out (the expenses). In the early years, the spigot is quite widely open, then as time goes by, it gradually drains slower (not entirely true as the insurance component of a universal life contract actually gets more expensive as time goes on, but that cost is generally a lower percentage of the cash value each year). That open spigot certainly explains why a traditional universal or whole life policy has a cash value less than premiums paid for the first 10-20 years. He estimates that over the long-term, the cost of this open spigot is about 1%. I think that estimate is far too low, but it's a place to start. Since the money is growing tax-free and also was contributed “tax-free” (not true, but more on this later) and will come out tax-free, he feels that the savings on the taxes more than makes up for the costs of the insurance. Is this true? It depends on what you compare it to.
Mr. Andrews compares everything to an investment whose returns are taxed at 33% each year, which obviously favors anything compared against it. But what investments should be compared to the life insurance contract? If you compare it to money in a Roth IRA, there are no taxes. If you compare it to a traditional IRA, there are no taxes as it grows, but obviously a tax upon withdrawal, making comparison hard. A tax-efficient mutual fund in a taxable account seems a reasonable thing to compare it against (unless you made the mistake of not maxing out a retirement fund before buying investment life insurance or the even bigger mistake of withdrawing your IRA to do so). In the lower tax brackets, long-term capital gains are taxed at 0%, although recent changes with the fiscal cliff and Obamacare raise these as high as 23.8% for higher earners (still well less than the 33% used in all his examples.) Qualified dividends are also taxed at highly-favored rates. Appreciated mutual funds are passed income tax-free at death just like life insurance, so we'll just look at the ongoing tax drag.
If you have an indexed stock mutual fund with a return of 8% a year, yielding 2% a year, and we assume you're paying 20% on that yield, your tax drag is 0.4% a year, well less than the 1% (again, that's too low in my opinion) drag on the life insurance. So if the investments in the portfolio grow at 8% a year, the mutual fund grows at 7.6% and the life insurance grows at 7%. After 30 years on an investment of $100K, that 0.6% means a difference of $139K. If the life insurance costs, spread out over 30 years, were closer to 2%, the difference would be $326K less, over a 30% decrease. The lower returns available from life insurance investments are a real issue, and they are caused primarily by the costs of the insurance policy and secondarily by very conservative portfolio held by the insurance company (often 90% or more in bonds.) All of Mr. Andrew's examples assume the life insurance investments grow at the same rate as a non-insurance investment, which just isn't true. Life insurance mathematically CANNOT provide the same return as the same investments without the life insurance wrapper, because the wrapper must be paid for. The investment managers at the life insurance company simply don't have access to investment returns that you as an individual cannot get without a life insurance company. It's all the same stuff- stocks, bonds, real estate etc. In fact, insurance companies invest primarily in bonds. Given their current very low yields, life insurance dividends are likely to continue to decline as they have been doing for years. Worse, when rates go up, the insurance company will still be holding the long-term bonds it tends to invest in. At best, your returns will be locked into lower rate investments and dividends will fall and stay low for years. At worst, insurance companies will go under and all or part of your investment will be lost, depending on state-organized guarantee associations.
Come back tomorrow to learn more about the ridiculously low returns currently available with universal life policies in the final part of this series.