In my most recent issue of The Oxford Income Letter, which happened to be our 100th issue, I reverse engineered a structured note.
Structured notes are financial products that, depending on the individual product, can limit losses while supplying income or allowing an investor to take part in the market’s gains.
They’re complicated products shrouded in a bit of mystery. And not surprisingly, you pay for all of that convenience and minimized risk.
In the case of a structured note, there are usually no fees, but the financial institution behind the note is not a charity. It is making money off your money and paying you back a little less.
The same is true with other products, like annuities and whole life insurance.
These products are designed to be complex. The less you understand and the stupider you feel, the fewer questions you’ll ask and the more likely you’ll be to pay to let the “experts” handle it.
I hate that strategy. I believe the more information you have, the better choices you’ll be able to make that will help you secure your finances – rather than some financial institution’s executives’.
Annuities and whole life insurance are similar.
Annuities in particular are such intricate financial instruments that 99 out of 100 annuities salespeople couldn’t tell you the mechanics behind how they actually work.
And with interest rates so low these days, investors, particularly retirees seeking income, are willing to put up with just about anything in order to get a few percentage points of yield.
I dislike annuities so much that I wrote a chapter on them called “The Worst Investment You Can Make” for my book You Don’t Have to Drive an Uber in Retirement, which was named the 2019 Investment and Retirement Planning Book of the Year by the Institute for Financial Literacy.
Whole life insurance policies are also more complicated than they need to be.
If you need life insurance, term life is the cheapest and simplest way to go. If you need to save and invest for retirement, then save and invest for retirement. Just don’t combine it with insurance.
You’re paying for that convenience – and for other “benefits” that are likely not going to affect your life in a meaningful way and will probably cost you money.
When you buy a whole life policy (or any policy that has a cash value), part of your premium pays for your insurance, part goes to your investment and a big chunk goes to pay those hefty commissions that salespeople enjoy.
Insurance agents typically collect up to 100% of your first year’s premium as commission. Over the life of the policy, they’ll receive 15% to 25% of your premiums.
That is a tremendous amount of your money that is not working for you. How much more money would you have if you invested 20% of a proposed whole life insurance premium in the market over the long term?
Furthermore, there are all kinds of ramifications if you miss your premium payments. You could lose your insurance or could be charged fees for letting the policy lapse, and if you want to take your money out early, you’ll be charged more fees.
Conversely, if you have a cheaper term life policy and a regular investment account and can no longer contribute to the investment account, there are no penalties or fees and you’ll keep your insurance as long as you continue to pay your premium, which may be one-tenth or less the cost of a whole life policy.
For example, let’s say you’re 50 years old with a $500,000 whole life policy. You will pay a minimum of $9,432 per year versus just $842 for a 20-year term policy.
Going back to that 20% commission on your premiums… If you’re paying $9,432 per year and your insurance salesperson earns 20%, you’re paying them $1,886.40 per year, or $37,228 over 20 years.
If you put that money into the market and earn 8% per year compounded, after 20 years, you’ll have an extra $102,083. And remember, these figures are with the cheapest policy. You’ll likely pay even more.
Of course, the whole life policy will pay a death benefit for the rest of your life as long as you pay the premium. The term life policy will expire when you are 70 years old.
But since life insurance really should be used to replace lost income, not to provide a windfall for one’s heirs, most people probably don’t need a lucrative life insurance policy in their 70s, 80s and 90s.
The good news is that with all of these ornate financial products out there, the most effective way to invest is actually the simplest and cheapest and keeps more of your money in your pocket. Invest in quality companies for the long term and reinvest the dividends.
With today’s low- and no-commission brokers, it hardly costs you anything at all to be a long-term investor.
Investing the right way isn’t hard. Avoiding the noise about why you need complicated products is.
And by the way, in that 100th issue of The Oxford Income Letter, I also discuss an investment that is risk-free, has no fees and is guaranteed to yield at least 3.5% (and likely more).