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Wednesday, January 13, 2016

Savings: Is it the gateway to Wealth?

Many individuals confuse the notion of Tax Loopholes and Government Subsidies. Typically, these two are confused in the conversation of "big business" getting special favors from the Government. While it is true that many larger firms rent seek, or lobby, the US Government for subsidies, this does not mean both Tax Loopholes and Government Subsidies are the same.
Many financial advsors are placing all sorts of recommendations for individuals to build wealth for retirement. For example, many advisors state one must "Buy Term Insurance, and Invest the difference". Or, others may only swear by using permanent life insurance as a method to build wealth for retirement. Some advisors state using personal savings accounts, so their clients can "play it safe". It is my assessment, which most mainstream financial planning models fall short of their objectives, if "savings" is the only pathway to financial freedom and wealth.  It will fall short for various reasons, as detailed in this brief blog entry.

Savings loses value over time

If your financial advisor recommends simply saving money for retirement, this is a highly risky proposition. For starters, the time value of money impacts a client's ability to properly save for retirement. As the Federal Government spends more on various programs, this expands the size and scope of Government. Concomitantly, individual savings rates decline, as Government spending expands. When this happens, this makes the money for retirement less and less "valuable" over time. It will take more "money" to purchase goods and services, in the future, as Government has declined the purchasing power of the currency in the present. The Central Bank's monetary policy, in recent decades, has placed a heavy emphasis on expanding the money supply. It also has lowered interest rates to all time lows. This is done to encourage consumption in the present, however, it debases (devalues) the currency. This is especially difficult for new retirees, who live on a fixed income. Their income is "constant", but the prices of goods and services continue to rise.

Investing to Save

Many Financial advisors eschew building up wealth via simply savings. They recommend strategies that require their clients to invest in the market. This is typically done via qualified retirement accounts (e.g. 401k plans, IRAs, 403b, and the like). The rationale behind using these accounts is multifaceted: (1) The monies can grow faster than the rate of inflation, and (2) The client can grow their money tax deferred. While on the surface, these two reasons seem highly plausible, it leaves out some factors to consider. When investing in the market, as the investment return yield percentage increases, but so does the risk. While there is risk in every investment, the difference in this method is that the user can not do much of anything to offset any down side risk. So, if the market goes down, the user must continue to purchase more, in the hopes that the market for that equity increases. This is a very passive strategy, and highly risky. Does it make sense to have a $1 million dollar home, yet have no home owner's insurance? No. Using this method is no different. Currently, with the loose monetary policy generated by the Central Bank, it impacts the over the counter market. The Central Bank increasing the money supply, price fixing interest rates, and the Federal Government massive expansion, all leads to excessive volatility in the over the counter market. This inflationary risk, the increase of the money supply, creates havoc. With qualified plan holders, they are exposed to this volatility, without the ability to mitigate the risk. Once these qualified plan holders reach retirement age, they can not continue to ride this financial roller coaster. If they opt to go into a fixed investment strategy, the risk of inflation still remains, as it can erode the purchasing power of goods and services.

Buy Term and Invest the Difference

This popular strategy is usually coupled with the first two strategies. The pitch is that the client purchases term insurance, since it is "cheaper", then the client will accumulate enough cash to be "self insured" at the end of the Term Life insurance period.(i.e. 10, 15, 20 or 30 years). This strategy seems plausible, yet it is riddled with all sorts of risk. For starters, term insurance is cheaper, but only during the term period. At the end of the term period, the premiums skyrocket, and continue to sky rocket each year. Next, at the end of the term period, the client is hoping that he/she has enough cash, from the investments, accumulated to become "self insured". This proposition is extremely risky.  If one has their home paid off, and it is totally debt free, why would that person remove the home owner's insurance? Let us suppose that the person has a house valued at $500,000, and the home is paid off free and clear. Let us also suppose that the person has $1,000,000 in cash sitting in his retirement account. Why on earth one cancel their homeowner’s insurance? In the event of the claim, without insurance, this client would need to rebuild his $500,000 home using his cash. Purchasing homeowner's insurance, in this case, protects the client's cash.  Seeking to be "self insured" with life insurance is no different.

Conclusion

These popular investment models are riskier than advertised. The advisors do not take into account the external risks that exist in the marketplace. The ideal strategy would allow the client to have more control over his/her cash. The best start, for most clients, is to increase the financial IQ.

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