Ed and Chuck explain the difference between investment and personal assets. Is your house an investment? Nominal vs real rates of return. Life insurance? Good, bad, or just ugly? Do you have a financial adviser or simply a good friend?

Welcome to our listener-supported podcast, Money Talk, uncompromised absolute financial truths behind financial perceptions with host, Ed Sutkowski and Chuck LeFebvre. Let’s listen in.

Chuck LeFebvre: Hello, I’m Chuck.

Ed Sutkowski: I’m Ed.

Chuck: Today this is our first episode and we’re going to be talking today about the accumulation process and specifically about investment assets defined. Ed, I think this is an important place to start our conversation with our listeners because in conversations with people I think there is legitimately a lot of confusion about what people consider to be part of their investments or their investment assets versus what we, you and I, consider to be a true investment.

Ed: Sure. Well, look at my definition of an investment asset. They can either be a tangible or an intangible asset which is purchased and sold for the purpose of generating income or capital gain. In other words, you’re selling at a profit. While perhaps antique coins and artwork can in some instances be characterized as an investment asset. Other assets are often perceived as you’ve suggested to be really investment assets or not. In my world, they’re hobbies and nothing more and nothing less than raising horses as a part-time activity. Specifically, vacation homes. Your personal residence is not an investment, it’s a hobby in the sense that it’s not productive other than your intellectual well-being, and you fall in love with it, you tend to improve that beyond reasonable expectations thinking that it is an investment when in fact the marketability of the home, the competition is such that your home is nothing more, nothing less than a hobby.  Chuck, your views on what I’m just suggesting? Maybe you like homes as real investments.

Chuck: Well, I understand why people think of them that way because it is a repository of value, and for many people, their home and their retirement plan represents the majority of their life savings so to speak. I think that’s where the idea comes from that the home is an investment. I think that yes, it’s a little bit of a fallacy. Part of the reason it’s a fallacy is because of the fact that as you said these are things that are very personal you get personally attached to them. I think that erodes their value as a method of truly building wealth. The other thing is with the home it is something that you’re constantly using it obviously. Yes, I think that the way I would maybe create a definition here is to say that to differentiate between something that is a repository of wealth or a repository of value, that does not necessarily make it an investment. In order for it to be an investment, it has to be part of the grand plan to grow wealth. The home simply doesn’t fall into that category.

Ed: Well, I define value as the word has two meanings. That is the quantitative value, which is what we’re talking about dollars and cents. That value is measurable. What it can be able to sell the home for? If you’re going to take a loss what’s the personal undetectable loss. Yet, if it’s a qualitative side of the definition of value, your mental well-being, your happiness, your a repository of thinking time, yes, there is a value there but that’s a qualitative value that’s not quantitative. I’m talking about quantitative value. Everything else is a qualitative or hobby and nothing more nothing less. It’s not in between. Other people will say, “Well, I sold my home in Arizona for $100,000 more than I purchased it.” Well, what was the cost of that investment? What could you have done with it otherwise? Yes, you could talk to people who always tell you how much they made, but they will never tell you how much they lost on the home, which is common. You’re not going to talk about your failures, you want to talk about your achievements. What about cash, Chuck?

Chuck: I have pretty strong opinions about cash. I think that at some point we’re going to have to have a discussion about the effect of inflation and how that impacts anyone’s plans to really think long-term. This is where you run into problems with cash or really most cash equivalent type quote-unquote investments in the sense that inflation is ever-present and to the extent you’re holding an asset that is not growing in value at a rate that exceeds the rate of inflation, you really need to start getting into the mode of thinking of that as losing money because in real dollars, you are losing money if you stuff money in a mattress or if you hold money in a checking account or some other cash equivalent account where the interest rate is not going to effectively achieve a growth greater than inflation after tax. What you end up with when you’re holding cash is an investment that if you have a money market account, for instance, and you might feel like you’re getting this great rate of return these days, that 2% to 3% rate of interest return, well, that really is not in my mind a rate of return at all because all that is maybe keeping up with inflation when you disregard the fact that you have to pay tax on that income, and after you pay tax on that income, you’re almost certainly not keeping up with inflation and so you’re losing money. The question is, if you’re holding a lot of money in cash or a cash equivalent, you have to think of that as spending and what are you spending that money on. It’s hard to imagine an honest answer to that question where that spend that loss of your nest egg versus inflation is somehow gaining you something that grows in the long-term.

Ed: But Chuck, one of the issues we find with inflation, you can’t measure it. You see the cash, X dollars, in this checking account and it doesn’t decrease by 2% every year, and so that also gets to the question of fees, costs, expenses. If those are being paid other than by you directly, you don’t recognize them as a cost, so you don’t recognize the erosion of inflation on the cash that’s sitting around. That’s, unfortunately, the way it is.

Chuck: No, I think that’s exactly right. Inflation, fees, costs, expenses, taxes that are inevitably incurred on whatever income is being generated, these are all things that are very easy to lose track of that effectively erode the ability of any plan to develop wealth. In the case of inflation, that’s why I pointed it out. It’s something that’s incredibly easy to ignore because on paper you don’t see it at all. You can put a $100,000 in a bank account and 10 years later you open up your statement and there’s still $100,000 sitting in that bank account, and so you feel like you haven’t lost any money, and yet you really have lost money. There’s a reason why economists use the adjective real to refer to an inflation-adjusted value. They refer to a real rate of return, meaning an inflation-adjusted rate of return as opposed to the nominal rate of return, which is a rate of return that ignores the effect of inflation.

Ed: That’s the $100,000 in the account three years from now.

Chuck: Right, so on that nominally, you haven’t lost any money, but really you have lost money and you may have over the course of 10 years, lost 20% of the value of that account. You can purchase 20% less with that account 10 years down the road than you could have at the time you opened it, and that’s a genuine loss in addition to the lost opportunity of what a different investment could have done with that money.

Ed: Trust me on this, I couldn’t agree with you more, but to convince someone about that is trying to suggest that you’re going to go to the moon tomorrow.

Chuck: I agree and I don’t know if it really pays to try to convince people to change their behavior. I think all we can really do here is let people know what the facts are. They can either absorb them and act on them or not. The fact is when it comes to cash and cash equivalent investments, that heuristically, the best way to think about that is a method of spending money. If you’re holding money in the form of cash, you have to think about that as spending a certain amount each year and the amount that you’re spending is essentially the rate of inflation on that. You have to ask yourself, “What am I buying with that?”

Ed: That’s invisible. It’s a mystery. You don’t write a check to whomever for the amount of the inflation, and so it’s there but– but the typical response is, “I feel good about it.” Our function is not to tell you where to invest or how to invest. It is to suggest that these are not investments.

Chuck: Right, and cash is not an investment.

Ed: I recall a guy, I can’t believe this, he never has cash. He has a couple lines of credit. When bills are due, he draws down the lines of credit. If he needs something to live on, he draws down the lines of credit. There is never cash. Now that’s a bit extreme. On the other hand, I think that represents what’s really going on here.

Chuck: Yes. That’s a person who has been able to internally absorb this concept to an extreme degree. Ideally, we would all be able to do that. I think it’s important to point out that very few people really can. Everybody’s going to end up having some cash sitting around in order to feel like they’re comfortable, but they just need to understand exactly what that cash really represents.

Ed: What it means, turning to another hobby, is life insurance. Let’s talk about cash value, ordinary and/or Universal Life Insurance. Specifically, the premiums paid are non-deductible. The death proceeds are an income tax-free. If you can borrow against the cash value, that borrowing is not a taxable transaction, you may not be able to deduct the associated interest, and if you cash the policy out before death, you’ll report as income, the excess of the amounts received over the premiums paid. Any observations about this cash value or accumulation life insurance, Chuck?

Chuck: Yes. The main concern I have with life insurance, and I want to be cautious here because sometimes it can be a good move for people, but I think usually it is not and it always is presented in a way that I think is a little misleading or disingenuous, the reason that I am always extremely hesitant about life insurance is because there’s so much opacity to the way those contracts are set up. First of all, when a person purchases a life insurance policy, there is an enormous fee associated with that that’s completely hidden from the consumer.

Ed: More specifically, 100% of the first-year cash value premium goes to the agent. 55% first year and five years of 9%. Never disclosed by the way.

Chuck: Right. It’s just an astonishing fact that effectively the first year of premium, it does not really go to purchase what you are presumably purchasing. In other words, it can’t go to work on whatever is supposed to be happening inside that contract representing an investment. Usually, these life insurance policies are presented in a way where they’re depicted as like a mutual fund, sort of like inside this life insurance contract, there’s some kind of a purchase being made of stocks or some kind of index fund or some other market-based investment that grows inside the life insurance policy.

Ed: Well, then that’s not real-life insurance.

Chuck: Well, that’s exactly right. First thing that a consumer needs to understand is peel these things apart. When you purchase the life insurance policy and it’s festooned with all of these different features and everything, it’s try to figure out “How much am I paying for the actual life insurance?” What I mean by that is this year I give you X dollars that does nothing other than guarantee that if I die during the next year, my estate or my beneficiaries of this policy will receive the death benefit on the policy. There is a specific cost to that particular feature of the life insurance contract and you can buy that feature alone as a term policy. When you buy one of these policies that has all of these investment features in it, they’re still embedded in there a term policy, and so that money is coming off the top essentially and the rest is going into whatever sort of investment feature that this policy is being presented as representing, and out of that there’s this commission that’s being paid to whoever sold the policy to you. I think that as a consumer, the question of, “Okay, if I give you a $10,000 check for a premium on this policy, how much am I really investing?” is usually impossible to answer.

Ed: Another approach, let’s assume you have cash value power, a cash barrel policy, and we know that a term to 65 policy is interesting but at age 65 those premiums can quadruple. Now let’s use that assumption in looking at a cash value policy. You bought it at age 25 and you’re now 65, the cash value has built up significantly, notwithstanding those charges perhaps not as well as it would have been had you done it outside the policy, and so on a $100,000 policy you may have $80,000 in cash value, so the insurance feature is only $20,000, and we lose sight of that, and yet you’re paying the same premium for the coverage so it level payment. The point is the coverage decreases as the cash value increases.

Chuck: Right. The clean or the pure life insurance aspect of that contract is actually decreasing over time, and it’s being replaced with essentially a return of the funds that you have essentially overpaid on premiums plus whatever credit towards growth the contract provides for. I’m always really careful with these life insurance policies, not to adopt a language that is adopted by the life insurance companies and their agents, because they’ll refer to what’s happening inside that policy as being, for instance, an investment in a particular mutual fund or a particular index or whatever. It’s not that. I think what’s really happening is you simply have a contract with a life insurance company in which they are obligated under the contract to pay you back under certain circumstances certain amounts of money. The contract might provide that what they pay you is based on the performance of some investment that exists out in the marketplace, but you’re not actually buying that investment. What you are buying is you’re simply giving money to a life insurance company, and as part of a contract whereby they are guaranteeing that they will pay that money back under various circumstances after subtracting various charges. What I find with these policies is that they are almost impossible for a layperson to figure out what all those charges are, that will be applied against their withdrawals from that policy.

Ed: Chuck, a useful analysis would be to look at turn to 65 and determine the difference in the premiums for this whole life policy versus the term to 65, knowing that 65 the premiums are going to quadruple and you’re not going to have any coverage. Is a proper comparison or meaningful or illogical comparison would be determined the difference in premiums and invest that difference in an index fund over that same period every year, you make that investment every year?

Chuck: Yes. I think that anybody who does that math is going to find that in almost all circumstances they will be better off investing that difference and essentially separating the life insurance aspect of this contract from the investment aspect of the contract and make the investment occur completely outside of that life insurance contract. Part of the reason for that is that the access that ordinary people have to investment markets has changed in such a way where an example you just gave, for instance, you can buy an index fund or even an exchange-traded fund or very, very low friction costs and so the money you put into that goes completely into that investment and very little is going to pay commissions or fees and other charges, versus inside this life insurance contract, there’s always a tremendously larger amount of friction that’s associated with that.

Ed: Now, Chuck, let’s assume I’m a salesperson, and by the way we’re not cascading life insurance salespeople, we’re just suggesting that you should know what’s going on. Specifically, I’m now the salesperson and I’m saying to you potential insured, but this life insurance is a forced savings program. Sure, you can invest the difference, but you’re not going to do that every year, you’re not going to make an IRA contribution here if you don’t have to. This is a means of self-discipline. Is that fair?

Chuck: Certainly, if a person needs that in order to save.

Ed: But, Chuck, you need it, you really do. How much money have you saved over the last 10 years?

Chuck: I understand that there’s probably not the right person to ask the question, but it is a legitimate question to ask most people and they’re not in the habit of saving and so this idea that “Hey, if we force you–” I’m going to put that ion scare quotes, “- forcing you to pay the premiums on policy.” Then maybe that has a coercive aspect to it that’s beneficial for some people, although keep in mind that that can flip on its side too. If somebody misses that premium, it’s not like the police come knock on your door and they haul you off to jail. What happens if you miss that premium is that there are typically, depending on when it happens, you can have some pretty significant surrender charges that are associated with that. Rather than simply not saving any money that year, you can end up losing some of the money that you had already put into the contract. Now if that’s the coercion that a person needs in order to be convinced to save each year, then I don’t know exactly what that to tell that person other than that they’re missing out an opportunity to do far better for themselves by exercising a little more discipline.

Ed: Now, that’s the question suggested the tax benefits at death tax, income tax-free even though there may be an estate tax. Using the term and invest the difference approach, it’s never suggested that if you do that and you have a substantial amount accumulated at the date of your death, you get a new tax basis on those side funds that you’ve invested. In other words, that appreciation goes untaxed forever at death, which is the same in a way that the death proceeds are income tax-free, but that’s never mentioned.

Chuck: Right. The tax-based sales pitch for these life insurance contracts is typically one that says, “Hey, during your life you can borrow against the cash value of this policy and there’s no-“

Ed: I can borrow against the side funds.

Chuck: Right, exactly, but most people don’t realize that. I’m playing the role of the life insurance agent here, and I’m saying, “Look, unlike a savings account or a stock investment, with this life insurance policy you can take money out in the form of a policy loan at any time during your life, and by doing that you do not incur any income tax. Then guess what? At death, the proceeds of the death benefit are also income tax-free, so it sounds great everything gets to accumulate in there tax-free, you can borrow the money back out tax-free and at death the death benefit is tax-free.” Now as you pointed out, a lot of that benefit can be achieved outside of a life insurance contract as well. First of all, if you buy, for instance, a S&P 500 ETF exchange-traded fund, the growth of the value of that investment will occur tax-free, now you’ll be receiving some tax qualified dividends which will be partially taxable although the amount of those if you pick an efficient and investment. First of all, those are at a lower rate of tax than an ordinary income tax. There are some partial tax benefits there, but until you sell that investment the capital gain is deferred and of course at death the capital if you want to think of cashing that investment in at death that’s the equivalent of a death benefit on a life insurance policy, you get the same result, no income tax.

Ed: But you can borrow against it.

Chuck: You can borrow against it just like with a life insurance policy. Now most people are uncomfortable doing that for some reason with a stock investment when they’re not uncomfortable at all doing that with a life insurance policy, and that’s simply a matter of-

Ed: Fear.

Chuck: Yes.

Ed: My view is you’ve got to consider the source, who is making the suggestions and what sort of skin in the game is there and you do not fall in love with an advisor, lawyer accountant salesperson, whatever. If you really want to have a friend as I’ve suggested, get a dog.

Chuck: Well, one of the most honest forthright people I’ve known in this industry, whose business card says financial advisor on it, just bluntly says to me and to everyone else who will listen, “I’m not a financial advisor. I’m an investment manager. I’m a relationship manager.” That is effectively what most of these people who are referred to in the industry as financial advisors effectively are, is that they are managing a relationship with the client and not necessarily bringing a lot of expertise to the table with respect to investment decisions. Unfortunately, they do bring to the table quite often a number of conflicts of interests that are nearly impossible because of the structure of the industry there’s nearly impossible for them to extract themselves from no matter what sort of back flips they do to try to prevent conflicts of interest, they’re always there.

Ed: Chuck, on the future episodes we’ll be expanding on the different forms of investments what they need very specific. The first one I’m thinking about it will discuss going forward is an annuity which is kind of an investment but really not an investment, it’s not quite a hobby it has some investment characteristics to it but it’s typically so complicated that no one can understand it with the bells and whistles and get to the point if you cannot explain it to a seventh-grader, don’t buy it.

Chuck: That’s probably good advice. Yes, the annuity is really a form of a life insurance contract in a way. With all of these life insurance type contracts there are there’s just tremendous complexity and a lot of hidden fees, and that is by design.

Ed: Going forward, I’d like to summarize, we’ll have very specific podcasts on each of these investments, but let me just list them, individual stocks, mutual funds, index funds, EFTs, bonds, farms. You show me a farmer and I’ll show you someone that is greatest thing in the world is the farm, never sell the farm, whether it’s a good investment, a different question, commercial real estate and apartments and then we get in a combination of those types of investments. We’ll be focusing on what I call a real investment that is detached from a hobby, detached from a personal return, psychological return, dollars and cents, and we’ll be covering those topics going forward.

Chuck: Sounds good.

Ed: Any other comments, Chuck?

Chuck: I do not have any other comments other than we’ve beat up on the life insurance industry a little bit here. I don’t want to give the impression that it is always bad. I think with a lot of these, with everything we’re going to be going through there will be times when a particular investment or approach is appropriate in times when it is not, but with so much of what happens in the industry and with so many of the things that we will be covering and episodes that come up, what happens is that particular concepts and ideas are grotesquely oversold and they are suggested to a great many people for which they really are not a good choice. The comments here are really a word of caution that a great degree of skepticism should be brought to any conversation about anything essentially that is being sold to you as opposed to something that based on your own research you have decided is worth your time and your money.

Ed: That’s the bottom line, your own research, your own reading, paying attention, reading the Wall Street Journal, the economist, thinking before you act, and not another fair, but out of the objective analysis.

Chuck: Hopefully, we will help in that process.

Ed: Thank you. See you next time.

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