Thursday, March 11, 2010

Debt Free and Being "Self Insured" is Risky

"Become Debt Free then Eliminate your Insurance! Pay off your home, then you dont need the insurance! Once your home and kids are grown, you dont need more life insurance! Stop paying all that additional insurance, its a rip off! You can save on the cost of insurance and invest in the Stock Market. You will grow your paper assets to the point where you are self insured." All of these concepts are given out by prominent Financial Advisors and TV Finance Gurus. They may not say these items verbatim, this is the underlying theme of this philosophy. In my opinion, this type of thinking is like betting on horse racing. Let's look into this stupidity in more detail.

Let's suppose you have a home that is worth $300,000. The mortgage is paid off, and you are DEBT FREE! You have accumulated in your 401k plan $1,000,000. You follow the advisor's advice and take off your homeowner's insurance since you have enough assets to be "self-insured". A violent tornado hits your local town, and destroys your home. It is totally eliminated. Nothing is left. What happens?

These kind of scenarios take place all the time. If you don't believe me, ask the people that were victims of Hurricane Katrina. If this scenario happens, your 401k plan must be used to pay for all the expenses related to the destroyed home. Keep in mind, the house will not be rebuilt in one day. The cost to rebuild the home will be around $300k, but you must stay in a hotel, or must have alternative living arrangements while the home is being rebuilt. Since the home was not empty, the items inside the home must be replaced:i.e jewelry, Electronics, furniture, guns, appliances, etc. After its all said and done, you may spend around $600k to move back into a "normal" life with the home rebuilt. Your hard earned cash that was accumulated in your 401k plan is now been reduced to $400k. This scenario can be avoided IF the proper Hazard Insurance was still on the property. The accumulated wealth in the 401k would have been preserved without having to use those funds to rebuild the house. The annual premium for the Hazard insurance is a VERY TINY FRACTION of the overall value of the house and belongings.

How about the assets inside the 401k plan? How are you insuring those assets against risk of loss? No one ever really ponders that question, they just dollar cost average through the scenario or assume that they will be in a lower tax bracket at retirement. In 2008 people on average lost more than 40% in their 401k plans! What "insurance" was used to protect the assets against losses? With these 401k type plans, it is similar to purchasing a home, but not having hazard insurance. You have no insurance against downside risk, and the investor bears 100% of the risk, but the Mutual Fund company gets paid regardless of what happens.
Taxes is another form of risk. The contributions into a 401k plan is tax deductible, but what happens at retirement? You are taxed at your earned income tax bracket upon withdrawal of the funds after 59 1/2. I know what you are thinking, "I will be in a lower tax bracket at retirement!". Really? Are you paying attention to all the bailouts and stimulus packages? How about the Health Care debate? What about the unfunded liabilities of Social Security and Medicare? The Govt is going to raise taxes, since taxes are the lowest currently in decades. If you withdraw your money from the 401k plan after 59 1/2, look for your money to last around 5-9 years, then you will be out of cash.

Suze Orman talks about life insurance as only a temporary need. Wealthy people do not have a philosophy of ANY TYPE insurance as a temporary need. The see insurance as a permanent need regardless of what type of insurance it is. Its an integral part of the over all investment plan and strategy. They may adjust how much risk or insurance is needed relative to the price of the insurance, but they will NEVER stop purchasing insurance. In fact, the more wealth they accumulate, they purchase more insurance to protect their wealth from loss or taxes. They don't see the PRICE of insurance as a hindrance in investing. They don't just dollar cost AVERAGE to wealth, they grow wealth with planning while taking in account all aspects of the ownership of that asset. They leverage the use of insurance to transfer risk to reduce or mitigate losses. They don't get "debt free" to only become self insured.

How does one insure the assets inside of a 401k plan? These plans provide no ability to mitigate risk for the average investor. The Mutual Fund company can make money regardless if the investor loses or gains money. Statistics show that the average stock market investor LOSES money. What insurance are they purchasing from their stock broker? I hear you saying now, "Robert, there are no guarantees in purchasing stock?" I agree their are none, but I will make sure that the situation has more risk sharing than the average investor. The average investor is satisfied with purchasing a Mutual Fund in a 401k plan, pick the mutual funds that the employer picks for him, hand over his hard earned money to a mutual fund manager; someone that he will never meet. If the investor loses money, the losses are passed to the investor 100%. The Mutual Fund company still makes money. That does not seem fair.

It makes no sense to not have your fixed assets uninsured. It is equally irresponsible to have your liquid assets "naked" or uninsured also. The risk management piece must be taken into consideration when placing capital into any asset. Typically, people are excited the acquisition of the new asset, but a novice just looks at the potential earnings, while an expert looks at all aspects of the deal. All of your assets must have some form of insurance, so coveryourassetsnow!

If you are seeking to protect your downside risks in your wealth building strategy, call me directly at 919-352-9260. If you lost money in your retirement plan, and you are seeking shelter from the storm, call! We will perform a free analysis to show you strategies that will allow you to sleep better at night!

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