by Brian Brady
Commercial Real Estate Finance Expert
Structured Debt and Equity
Licensed Real Estate Broker in AL, CA, and FL
One of the tenets of financial advisory is the principle of fiduciary responsibility. Today, Wall Street Journal reporter, Jonathan Clements, openly criticizes the strategy Doug Andrew outlines in his best-selling book, Missed Fortune. Mr. Clements’ article, When the “Self” in Self-Interest Isn’t You, attacks the strategy as being completely self-serving for the financial advisers who recommend it.
The author is trapped in the mindset I call “Boomer Economics“: paying down the home and socking away as much as possible in employer-sponsored, qualified retirement plans. The problem with Boomer Economic Thinking is that it is becoming dangerous. The economy dramatically changed on September 12, 2001. We saw a shift of wealth from financial assets to hard assets, hyper-fueled by leverage.
Doug Andrew advises people to redirect monthly contributions for retirement. He advises that they fund a 401-k plan only to reap the benefit of employer matching. He advises that the remaining monthly contribution be earmarked for variable universal life insurance contracts so that the withdrawal from those assets is tax-free. Mr. Clements suggests that this advice comes from “unscrupulous advisers”.
Equity harvesting is another principle promoted in Missed Fortune. It is recommended because home equity fails the litmus test of sound investing. It is illiquid, volatile, and it has absolutely no return. Equity harvesting protects property owners from volatility. Kris Berg describes the challenges experienced Realtors face with panic selling, induced by illiquid property owners and inexperienced sellers’ agents. An equity harvesting strategy, invested in a side bucket to provide liquidity, can mitigate that risk. Mr. Clements directly attacks that principle as being a fee-driven recommendation and misapplies a disclosure offered by the NASD in 2004.
It is a brave new world with extraordinary challenges for the under-60 population. The World War Two generation was able to rely on the paternalistic retirement plans offered by the government and growing corporate America (Social Security and defined benefit pension plans). The Boomer generation presented the government with a distinct threat to those plans. The government answered with a tax-banking solution; the 401-k qualified retirement plan.
Mr. Clements fails to recognize the paradigm shift in the post 9-11 economy. It is characterized by a need for individuals to educate themselves about investing for retirement and positioning assets in various “buckets” so that they don’t become over concentrated on one specific asset class.
His method of criticism is deplorable. He employs the age-old fear tactic of “someone else is getting rich off of you” and encourages a generation of investors to do two things: limit costs and trust the government. The largest transference of wealth in history is happening and the average family is ill-equipped to deal with that transference. Criticizing new investment strategies is one thing. Calling the promoters of those strategies “unscrupulous” or “unethical” is the act of a desperate xenophobe.
Americans have caught on to the fact that the mainstream media are on rubbery legs. This professional journalist has never counseled clients nor dealt with the real financial planning cases. Report the performance of mutual funds, Mr. Clements. Leave the formulation of personal financial plans to the professionals .
Jeff Brown says:
Brian – What cracks me up about so-called journalists who write ‘hit’ pieces about subjects for which they know very little – is that they end up being embarrassed when their friends in the financial world clue them in privately.
All this guy had to do was the simple arithmetic and he would’ve changed his tune completely. A high school freshman can do this math. Geez.
Oh to be a fly on the wall when that happens. 🙂
Great piece Brian.
July 15, 2007 — 9:47 pm
Dan Green says:
It’s not just the WSJ that misses the point on Missed Fortune — most financial planners do, too.
My favorite chapter in the Missed Fortune book is the one that describes how home equity fails the four basic tenets of a “sound investment”.
For individuals that own homes, Missed Fortune is a worthwhile read, if only to understand the options your financial planner may not feel comfortable discussing with you.
July 16, 2007 — 5:45 am
Chuchundra says:
There’s an old saying that applies to both poker and business. If you sit down at the table and you don’t know who the sucker is, it’s probably you.
July 16, 2007 — 8:10 am
Greg says:
Wow, well said Brian. I’m tired of hearing how “safe & sound” it is to pay down your mortgage!
July 16, 2007 — 11:13 am
Susan Wight says:
Wow! I feel like I’ve led to and found, what an insite, and permission to question both jounalists and my financial planner?! who knew?! I’m having fun here, I’m coming back! Thanks!
July 17, 2007 — 12:15 pm
Chuchundra says:
You can question everything, Susan. Just remember, sometimes the conventional wisdom is right.
They laughed at Einstein, they laughed at Galileo, but they also laughed at Bozo the Clown.
July 17, 2007 — 3:56 pm
Brian Brady says:
Chuch,
Are you suggesting that Doug Andrews is Bozo the Clown? You’re last two cryptic messages confused me.
July 17, 2007 — 4:07 pm
Chuchundra says:
I don’t know if Andrew is Bozo the Clown. I haven’t read his book and I have no intention to. The only thing I know about him is what you’ve posted here.
Some things I do know.
Using life insurance as an investment vehicle has almost always been a bad idea. Big ees, sub-starndard returns and the promise of “tax free income” that is neither income nor tax-free. Maybe this new type of “investment grade” life insurance is a better bet, but somehow I doubt it.
Counting money that I don’t owe as a “bad investment” is nonsensical sleight-of-hand. Thinking of the equity in your home as your money that you can “draw out” when the whim strikes is a bad idea and that philosophy is going to cause people a lot of pain as the real estate market regresses to the mean. You know, I have a $20K line of credit with my bank that I keep in case of emergencies. Is that a “bad investment” too? Should I be pulling that out and investing in some BBB MBS funds or other high yield instrument?
Never play with money that you can’t afford to lose. Call me crazy, but the equity in most people’s homes falls right into that category.
There’s always people around who like to talk about how things have changed, how the old rules don’t apply anymore and how there’s money just out there for the taking for people smart enough and bold enough to take it. A lot of these people get rich pretty quickly. A lot more get poor even more quickly.
July 18, 2007 — 8:53 am
Brian Brady says:
Chuch:
Your answer was helpful. I appreciate your comment. While I disagree, the comments section is hardly the place to have a detailed debate about why there is mathematical proof that the Missed Fortune concept works.
I’ll post some links over the next few days here to direct you to some reading. I think you’ll find it educational and worthy of commenting. As always, your insight is an invaluable part of this forum and I appreciate your view.
July 18, 2007 — 11:48 am
Chuchundra says:
Brian,
I look forward to reading the links and seeing the math. I’m always ready to be convinced that I’m wrong if the facts are persuasive.
July 18, 2007 — 4:25 pm
Geno Petro says:
Brian…Just had an hour or so to catch up on my required reading so I came to you. You have a great mind there BB. I stopped routinely reading WSJ after they fired that ‘Heard It On The Street’ guy back in the 80s. Also, I heard…psssst…they’re Libertarians…
July 20, 2007 — 7:52 am
Dave Shafer says:
Just discovered this post. Maybe we can get it going again? I have used the strategy outlined in DA’s MF books for about 3 years both personally and for some of my clients. The problem with the book is not the strategy outlined (DA was hardly the first to suggest it), but the fuzzy numbers and the all encompassing theme he used. This is really a book written as a sales tool for funding EIUL’s. Not surprising coming from an insurance salesman. Here are the real world issues that he doesn’t do a great job with:
1. If you use home equity to purchase a life insurance policy the mortgage interest is NOT tax deductible.
2. His latest book recommends option arms as the mortgage product when it is inappropriate product for arbitrage strategy.
3. His suggestion that the internal rate of return for cash value is in my opinion to high.
4. His suggestion to finance 100% under most conditions not a good idea.
5. EIUL is only one of many options that should be considered.
On #1,There are ways to get around the interest deductibility issue mainly by asset substitution or by limiting the amount of borrowed money used to less than 40%. This should have been discussed in the book.
On #2, anytime you are using an arbitrage the interest rates paid and made matter. Option arms carry a much higher interest rate than all conforming products. In addition, most folks put a three year pre-pay on the option arm which limits the ability to get out of the home or the loan. Finally, combined with a high loan to value and a declining re market the option arm quickly puts people upside down which is a dangerous position to be in. If one had to get out of the house for any reason, and you were upside down or near and you had a pre-pay you are basically screwed. Check the foreclosure rates for option arms versus conforming I/O’s or 5-1, 7-1 variable loans!
On #3. Despite what the insurance companies illustrations show, I think that a realistic rate of return for EIUL’s is 5 1/2- 6 1/2%. That is what I run the numbers using for myself and my clients.
On #4. The cost of high LTV loans has gone up significantly. Once again in a arbitrage situation the rate you pay is important. I believe in the I/O products for cash flow consideration because you are only taking a small interest rate hit and to keep the LTV to 80% if possible, but no more than 90%. However, since a normal amortizing loan pays majority interest over the first couple years, it is probably best if cash flow is not an issue to use an amortizing product.
On #5. Insurance is still insurance no matter what you call it. If you have no need for it, or if you get rated it is not a good fit for you. If you need it for protection or estate planning then great, if not then I advise to look elsewhere, perhaps real estate, REIT’s, annuities (although has the same issues with mortgage interest), business opportunities etc. Depending on what the client has experience investing in (I suggest staying away from equities) it it quite individualized.
December 14, 2007 — 12:54 pm
Phil Caulfield says:
Responding to Chuchundra’s comment 0f 7/17/07 – I wonder if her equity line has been frozen or reduced recently? I think we have learned in the last few months that there is no guarantee that an equity line will act as an emergency fund because the lender usually has the right to reduce and/or freeze the equity line.
March 26, 2008 — 6:49 pm
Priscilla Chavez says:
Responding to Churchdra’s comment. I guess you know nothing about the I.R.S codes eaither. You should read TEFRA-DEFRA and TAAMERA, maybe then you’ll understand that equity had no rate of return, and that you can have tax-free income, and that the death benefit is just the cherry on the top of the cake. Like Doug says ” you don’t know what you don’t know”
April 22, 2008 — 10:22 am
James Burns, Esq. says:
I wanted to chim in because I think we are in a grey area. It is a fact that you can arbitrage simple interest with compound. Also, the old insurance products do not peform as the new and will get better results, especially as we see a less robust market for the next decade or two because PE ratios hit an all time high at the start of 2000. Most prognosticators agree that the liklihood of expanded PE ratios is next to no way. Hence, with the guaranteed products in the life insurance wrapper you stand a pretty good chance of a decent return.
However, the book in question did not elaborate on Section 264(a)(1) of the Internal Revenue code relating to the loss of the mortgage interest deduction. For some folks the deduction may not ovrride the potential to compound over the next 20 years or so. This was a little irresonsible or lacking not to provide this and the other strategies that are available.
Most of the option arms were sitting on the shelf like aging nitro glycerin and many have exploded. This was a loan meant for salespeople or those with seasonal income not the average joe so that an originator with not duty to anyone could make a point on the front and three or more on the back for selling the people down the river with a prepayment penalty.
In sum, for some folks this may be appropriate…usually higher net worth who are younger and healtier so that the IRR (internal rate of return) is not obviated by insurance costs.
May 5, 2008 — 10:45 pm
Brian Brady says:
Thanks for the balanced observation, James.
May 6, 2008 — 7:25 am