Paul Winkler: Hey, welcome. Paul Winkler, “The Investor Coaching Show.” Joining me this hour is Mr. Jim Wood, certified financial planner.
And I want to talk about something. You know, when we talk about financial planning—and we may get into this a little bit as the hour progresses—a lot of stuff to know. A lot of stuff to be known.
I was hearing a commercial. First, it was talking about there’s so much to be known about financial planning.
You need to know taxes. You need to know Social Security. You need to know pensions.
And I’m thinking it’s interesting, because a lot of times, people don’t really know a whole lot about it.
I think back to my history, when I was a broker and investment advisor. What I pretty much was taught about pensions were things that I needed to know in order to sell life insurance was really what it was.
We had private pensions and things like that, deferred comp programs. And we had a lot of sales sizzle, annuity contracts, those types of things.
It had a lot of sales sizzle to try to get me to sell the products for the company, but there were a lot of things that we didn’t necessarily cover that I think were really, really important.
I didn’t really—until later, I got into a lot of the academic information that we teach here on the show—didn’t really quite get it.
But I thought I would use some of that to help people understand one topic that they often have to make a decision on. It’s important not only for making this decision, but it’s important just from an investing standpoint in general.
So if you don’t have a pension, let’s say with your workplace plan or whatever, there’s still some stuff in here that I think it’s going to be really, really important to understand about the investing world right now that I think you’ll find helpful.
Questions About Pensions and Payouts
But in effect, what we’re talking about when I’m talking about a pension: Typically what happens is companies will either fund a pension, and they will pre-fund it, and we call those funded pensions. And then you have unfunded pensions, which is where the company will pay the pension to their employees out of assets or out of sales in the future.
So you’re an employee. You work for a company, and you work for them for 30 years.
They tell you they’re going to continue your income to you at some percentage, maybe some formula based on top income out of the past five years, top three years, or whatever, and they’ll pay you 60%.
There are always these formulas. They’ll pay you this for the rest of your life.
This is, in essence, an unfunded or unpromised pension. Well, it’s promised, but it’s not necessarily cut in stone, because if the company is no longer around, and they can’t actually fulfill on that, there could be problems.
Now, you could have companies that are paying into the PBGC (Pension Benefit Guaranty Corporation), so you can have some guarantees on that. So I’m not talking about those types.
But one of the things that we were talked to about selling were these funded pensions using life insurance as an investment vehicle.
It’s not a very good investment vehicle, typically, for these long-term things, because of the life insurance cost and because the whole life policies are backed by bonds, fixed income investments, which it takes historically, if you look at treasuries, over 100 years to double your money after inflation.
Then with regular bonds, it’s not much better than that. Whereas with stock markets, you get protection against inflation, as we talk about many times.
But then you get the life insurance cost that goes up as you get older. What that does, it has a huge drag on the performance, but it was a very high commission product and high dollar sale.
So did you ever do much of that?
Jim Wood: I didn’t sell tons of life insurance. I sold a little bit of term, a little bit of permanent insurance, and stuff.
I didn’t do a lot of fancy cases or anything like that. But it’s funny, something that you had mentioned in terms of what I was taught. What I was taught at the broker-dealer level the first few years of my career was how to move product.
It wasn’t, “How does this stuff work?” or, “What’s best?” or analysis of this versus that.
JW: It was, “How do you get someone to buy it?” It’s very different.
It’s really why I came to where I am now in terms of, okay, I want to do a process that’s based on the academic evidence, not trying to talk somebody into something that they don’t necessarily want but I want them to buy for a big commission.
PW: Yeah, and also what happens is, many times, if you talk over somebody’s head or they’re just, “I don’t understand this at all,” they end up putty in your hands is really what—
I remember one manager actually kind of leading us that direction. I was like, “Well, this is really kind of deceitful.”
Now, the guy is no longer even in the business, which is interesting.
He used to draw these things. He’d draw a financial plan on the board in front of the class, right?
Now, a classroom full of financial advisors, right? He would draw, and it would be, “So what you do is you’ve got to take the interest off the real estate investment trust, and then you take that money and you buy a universal life policy.
“That kicks off a tax-free income into the future. Then what you’re going to do is you’re going to use these tax credits, and those tax credits on low income housing are actually going to help fund the life insurance purchase. Then you take—”
You’d sit there and go, “Calgon, take me away!” I don’t even know what the guy is saying after a while.
I was able to follow him, but unless you were really, really on top of it, you had a hard time following what he was saying.
Then he looked at us with eyes glazed over in the audience, and he would go, “So that’s exactly what I want you to do with your clients. You get them to that point, and then literally they realize how much they need you.”
I was like, “That’s really deceptive.”
Calculating Lump Sum Versus Monthly Payout
JW: Yeah. There was a sign where my dad used to hang out, and I’m sure people have seen this from other places and everything. But it said, “If you can’t dazzle them with brilliance, then you baffle them—”
PW: Baffle them with BS. Yeah.
JW: Exactly. Yeah.That explains a lot. It really does.
PW: It really does in life.
So with the pension world, what happens is this, and here’s the challenge right now. A lot of people are coming in and saying, “Hey, I’ve got this pension. Paul, Jim, here’s the payout on the pension, or they’re going to give me a lump sum. Which should I take?”
Now, there is no just blanket answer to that, because sometimes it does make sense to take the pension. There are typically calculations that we look at based on your life expectancy, your age, what the lump sum payout is, and those types of things.
But here’s one of the things that we do look at, is what are the pension payouts based on expected returns, internal expected returns?
So the complicated thing is this. Look at a person’s life expectancy and say, “Okay, this person has a 20-year life expectancy.”
So the present value of that calculation, which is what you put in the calculator—PV is present value—is what’s the initial amount? What’s the future amount?
Well, zero, because once you die, the pension’s gone. If you have a survivorship benefit, you’ve got to look at that and say, “Okay, what’s the survivorship benefit?”
It gets a little bit more complicated, but I’m just using a single life right now, just you.
Then what you do is say, “Okay, it’s going to pay off for 20 years. Present value is $100,000. Payout per year is $5,000, let’s say 20 years.”
I’m using that because it’s really simple. You’ll get the math in a second.
“What’s the internal rate of return?” $5,000, and then in essence, what you do is you think, “Oh, I’m getting just my money back,” right?
“20 years, and I’m going to get my money back,” which is $5,000 times 20 is $100,000.
Okay. Zero internal rate of return. Okay.
Now, typically there’s going to be a rate of return. What you do is you figure out what that is and you go, “Okay, does that look like a rate of return that might likely be beaten by something else that I might do with my money, number one?
“Number two, is there some utility to me, some benefit to me to have liquidity where I can access more money if I need it five years down the road, ten years down the road?” Because if I go and just take the pension, that’s just going to pay that $5,000 a year for 20 years.
Now, if I live longer, then it might be a different deal, but if I do that, then in essence what I’ve got to look at is, is there a likelihood? Is that liquidity of benefit to me?
Now, here’s one of the things that I look at and think about in regards to this. What’s my life expectancy?
The longer my life expectancy, the more need-worthy it would be for me to think twice about taking the annuitization route because of the fact that, hey, I’m looking at a longer period of time, and fixed income investments, like what would be backed by a pension, is very challenged to protect me from inflation.
I mean, good grief. Right now, we’re looking at record inflation numbers that possibly …
Now, it might be transitory. We’ve talked about that.
I’m sure you talk about that a little bit, the aspect of inflation, the numbers coming out right now. Are you finding that people are kind of concerned about that?
JW: I think it’s one of the biggest concerns. I even had a conversation by email earlier this week that was just on that very topic. I know you’ve talked about it on the show.
JW: You see article after article. I mean, people are just concerned. They hear about it.
When you go to the grocery store, you notice it. They think, “How’s this going to affect my portfolio?”
PW: Yeah, and the answer would be?
JW: Well, in the short term, I think that there can be all kinds of different effects, and we just don’t know. That’s the whole thing about markets being unpredictable.
PW: True. Yeah, true.
JW: If the Fed thinks that they have to raise interest rates to combat inflation in the short term, that can definitely give markets a shock.
But over long periods of time, you still look at stocks as being one of the best ways to deal with inflation for all the reasons you’ve talked about on the show, in terms of you’re buying the companies that are raising prices, which that means a company’s earnings are likely to go up, which long term is one of the chief, if not the chief, driver of stock prices.
PW: That’s what you’re buying. Yeah, that’s exactly what you’re buying when you buy stocks, is you buy rights to the earnings.
Yes. So if we look at the pensions, they’re going to be funded by bonds, which are in essence backed by a fixed income investment that historically has not protected against inflation.
So that’s one of the things I look at is “What’s the payout?” For a lot of pensions—I’m just going to tell you right now, more of a blanket statement—most of the pensions I see, the payout is not that great because of the fact that the insurance companies are struggling right now.
Quite frankly, it happened in Europe. You probably heard me.
If you listen to this show for a while, you heard me talk about it, I guess about a year ago now that I was talking about how the insurance companies were really concerned for their welfare.
Why? Because interest rates were so low.
And what we’re seeing right now is interest rates being very, very low, which tells me that it’s a possibility that inflation could be transitory. In English, that it might not be long-lived, but you never know. So that’s why you always diversify.
But here’s the point. If you look at long-term interest rates, like 30-year government bonds, good grief! Less than 2%.
Less than 2%, which shows you the markets look around and go, “How big is this inflation problem?”
What they’re looking at is, “Hey, our supply chain is going to be long term affected by this. Are people going to stay out of work, thereby having to pay lots of overtime? Are there things that are driving up labor costs long run? Or is this a short-term thing?”
The Fed seems to think it’s short term, but we don’t know.
But here’s the thing, is if markets right now are looking at inflation and saying it could be transitory, it could be short term, and thereby long-term bond rates are under 2%, insurance companies investing your money right now—which is what you’re looking at when you’re looking at the difference between, “Do I take the pension or do I take the lump sum?”—they are looking around there, and they have no choice but to go and invest in bonds as they are right now.
And the interest rates are extremely low.
So in essence, if we do have inflation in the future, it could be very painful for the investor that took the long-term annuity payout, because the annuities—unless you work for a governmental agency or a governmental operation—don’t have cost of living increases built in.
Whereas at least when I have the money and I’m investing it myself, I do have that ability to hold investments that historically have protected us from inflation, hence equity usage.
JW: That’s one of the first things I talk to people about as soon as they start talking about having a pension, is finding out, “Well, how does it work? Does it have a cost of living part of it?”
Like you said, usually that’s found in some type of government pension, that type of thing, not very often in the private sector.
PW: Right, and typically the reason the government would give that to you, whereas a private company would not, is simply because of the fact that the government knows that they’re going to have ongoing revenue coming in from taxes.
So they can promise to pay you and increase your pay in the future, and they’ll figure it out down the road. “We’ll figure out how to pay this. We don’t have the money right now, but who cares?”
It may be somewhat unfunded. It may be underfunded or something like that. So they can figure it out down the road, how they’re going to do that.
Whereas a private company, they know that down the road, they’re going to have to be competing with other companies around the world, and they might have to figure out some way to cut their costs.
It can be a problem.
JW: Which is one of the reasons, and it really is the chief reason, that so many large corporations have dropped their pensions.
PW: Very good point.
JW: And switched over to where you get a match on your 401(k), because that’s a known cost.
PW: Right. Sure.
JW: They say, “Okay, year in and year out, we know we’re going to have to put this much aside for retirement benefits.”
The pension, on the other hand, has all kinds of variables that they have to deal with.
Markets might be good. Markets might struggle, and the amount that they have to fund the pension year to year can vary drastically.
Companies really got in trouble, like 2007, 2008, and 2009, for those very reasons. That’s why you started seeing more and more companies saying, “We don’t want to deal with this pension stuff anymore.”
PW: Yeah, yeah. Very, very, very true. Yeah.
Which Option Makes Sense for You?
So yeah, when it comes down to it, that is typically a decision that you want to make looking at the numbers and really going through and determining which one makes more sense.
There are tax implications, survivorship, and for some people, leaving an inheritance is an important thing, or leaving something behind.
If you look at studies on people actually annuitizing, which is taking kind of a pension payment from a lump sum of money, most people don’t like to do it, the reason being that they don’t like losing that control.
If something happens to them, the money’s gone. They’re no longer going to be getting that.
PW: So pensions, that’s one of the decisions that people typically have to make.
But realize that if somebody is trying to sell you a private pension and using life insurance or annuities, you’re dealing with the same problem. You’re dealing with a problem of the fixed income investments.
Now some of the companies are coming out with these index-based products. But if you look at the long-term studies on the indexed life insurance policies, the indexed annuities, you’re seeing the same issue, because there is no risk.
And that’s how they’re sold. “You can get market returns with no risk.”
What you end up with is very, very low returns. What the studies show: very low returns, bond-like returns, and illiquidity problems that you run into with those products.
Realize there is no such thing as a free lunch. If you want more return, you’ve got to take more risk.
There are types of annuities and life insurance policies that do have direct backing in mutual fund-type things, sub-accounts, but the reality of it is very, very expensive. And because the cost of life insurance goes up as you age, they tend not to work very well as accumulation vehicles.
So just keep that in mind. Very complicated world out there.
Paul Winkler, along with Jim Wood.
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