According to Dr. Chris Thornberg of Beacon Economics, the US economy and real estate market are currently extremely healthy, so we should appreciate it and focus now on fixing the retirement crisis we’re facing in 10-15 years. Plus, Joe and Big Al answer your money questions: Why is owning a home considered “profitable”? Is it a good idea to own real estate in a self-directed IRA? And should you buy a fixed index annuity?
- (00:53) Dr. Chris Thornberg: California and US Real Estate Markets, the Economy and the Coming Debt Crisis
- (10:03) Dr. Chris Thornberg: Recession, Monetary Policy, and Tariffs
- (19:32) Why is Owning a Home Considered Profitable?
- (24:05) Should I Own Real Estate in a Self-Directed IRA?
- (30:36) Should I Buy a Fixed Index Annuity? (video)
Dr. Chris Thornberg is the founder of Beacon Economics and an expert in economic and revenue forecasting, regional economics and real estate markets. Today on Your Money, Your Wealth®, Dr. Thornberg shares his opinions on the California and US real estate markets, the economy and tariffs – as well as the debt crisis he says we are facing in just 10 to 15 years. Plus, Joe Anderson, CFP® and Big Al Clopine, CPA answer your money questions: why is owning your own home considered profitable? Is it a good idea to buy rental real estate property in a self-directed IRA? And should you buy a fixed or fixed index annuity? Plus, rich dad, poor dad, my two dads, golf and more in the Derails. I’m producer Andi Last, and here with our guest, Dr. Chris Thornberg, are Pure Financial Advisors’ Director of Research, Brian Perry, CFP®, CFA, and Big Al Clopine, CPA.
00:53 – Dr. Chris Thornberg: California and US Real Estate Markets, the Economy and the Coming Debt Crisis
Al: Chris you’re a noted economist, you know a lot about our economy, and I think I want to start with real estate because we’re here in the local market in San Diego, and we’ve got clients all around the country, but I kind of want to start in San Diego and Southern California and get some of your thoughts because we’re starting to see articles – this is one that came out maybe a couple months ago by KGTV here in San Diego and here’s the headline: “US housing market cooling down, new report shows” and it’s talking about “San Diego ranked third on the list the housing markets seeing the biggest slowdown.” And the report shows that “conditions in the San Diego market are favoring buyers more than they did a year ago. More than 20% of homes for sale in San Diego had a price cut in January 2019.” So I would love to start there and kind of get your thoughts on what’s going on in real estate?
Chris: Yeah sure. I chuckled there because the idea that California – anywhere in California – is a buyer’s market is is sort of funny. Prices here, of course, are astronomical compared to much of the United States driven largely by, well, the lack of building. But the broader question about the health of the market, it certainly isn’t just California that’s seen this slowdown. If you look at the national sales, they slowed down pretty sharply at the end of last year coming into the beginning part of this year. Price appreciation started to slow down as well. And that combined with I think some of the broader fears of the health of the expansion, you had, of course, all those bears who’d been hibernating for the last couple of years come out of their cave and start to predict doom and gloom about the housing market. And you know, it’s understandable for people to channel if you will, their inner Great Recession. It was only a decade ago when of course the real estate markets across the United States were in total shambles. But the idea that this is going to turn into a real estate rout like we saw in 2008, ’09, and ’10 is really, on its face, why not. But when you dig a little deeper you start to realize just how preposterous a forecast that would be. If you go back in time and you talk about what happened to real estate back in 2008, ’09, and ’10, one thing to keep in mind is that was singularly unique. We’ve never seen a real estate collapse like that in the last 50-60 years in the United States – that was unbelievably bad. It’s really amazing. And you ask why. Well, there were three reasons: The first reason, of course, was there was a massive bubble going on driven by subprime credit. Subprime credit was driving prices, particularly in second-tier markets – think Inland Empire, suburban Phoenix, Vegas – wasn’t San Francisco, but those more secondary markets were exploding because so much funny money was driving the market to a crescendo that was completely not sustainable. The second big part of it had to do with the fact that you had a massive amount of overbuilding in the United States. At the peak, we were building 2.1 million household housing units per year, vastly more than population growth would actually suggest we needed. And then last but not least, remember that households were borrowing tons of money and spending that money pretty rapidly. So you saw the very dangerous build-up in debt to income ratios even as consumer savings rates fell. So you really had, if you will, that kind of perfect cocktail for just a massive meltdown which is what we experienced. This time around, none of those factors are in play. We’re not building too much nationally, we’re certainly not building too much in California. If you think about the mortgage markets, mortgage credit has been growing at a very slow base, largely driven by the new rules passed under Dodd-Frank. And of course, the quality of that credit is better than it’s ever been. Over the last decade, the median credit score for a mortgage borrower has been well above 750. A decade ago, and before that, it was around 700. And then last but not least, the household sector. There’s no dangerous build-up in debt. Incomes are rising nicely. Again, you look across the board, and what you see is one of the healthiest housing markets we’ve had in 40 years. So this is nothing more than a temporary blip driven by the temporary increase in mortgage rates last year. Well, guess what? Mortgage rates are back down again. Trust me when I say, the second half of this year is going to be a great year for real estate – and for those of you sitting on the fence waiting for those big price declines, you’re not going to see them.
Al: Well, and I think it’s important to note that you are one of the ones in probably 2005-2006 that predicted the housing crash, and I find it very interesting and reassuring that what you’re saying is it seems like nothing of the same right now, which is great to hear. What does concern you though, economy-wise?
Chris: You know, it’s not the short run. You know, the short-run economy is extremely healthy. What concerns me is the politics, which are saying the exact opposite. I mean, if you go to Washington D.C., if you go to Sacramento California, you don’t hear anybody talking about, “OK, well things are pretty good right now. Let’s tackle some of these long-term challenges like educational reform or pension reform, entitlement reform, infrastructure investments.” Instead, everybody in DC and Sacramento are in crisis mode. And you know, all by itself being in crisis mode when there isn’t a crisis is a good way to pass bad policy. And that’s exactly what you continue to see is a lot of bad policy being passed. Take for example the tax cut that happened at the end of 2017. That was horrible. Why did we do it? We cut taxes and we increased government spending. We used fiscal stimulus in a late expansion, full-employment economy. I mean, the disconnect there, from any macroeconomic policy standpoint, is really hard to get your hands wrapped around. But, we went and passed fiscal policy and took a bad budget situation and made it that much worse. The United States borrowed well over a trillion dollars last year in order to backfill federal government spending because of those tax cuts. So because we’re in a crisis mode, “Oh my God, the economy’s bad, we have to have fiscal stimulus!” We took a long-run problem and made that long-run problem – that is to say a lack of fiscal discipline, this ongoing deficit – and we made it worse. That’s the kind of thing that scares me.
Al: Yeah. And so let’s chat about that. So clearly, any kind of stimulus is going to help us in the short term. But what does that mean for us longer-term?
Chris: Well, you’ve got to remember that the United States is has made promises to seniors that we can’t afford. It’s as simple as that. And we’ve been the kind of hear no evil, speak no evil, see no evil over the last couple decades on this issue. We’re not talking about it. But the reality is, now that boomers are starting to retire, you’re going to see over the next 30 years an explosion in retired folks. According to the census, over the next decade, 22 million more Americans, of which 18 million are going to be 65 plus – people who are drawing Social Security. People are drawing Medicare – there’s going to be a collapse in the support ratio. That is to say, the number of working people to the number of retired people. And this is going to put an incredible amount of stress on the federal budget. Now, is it an immediate crisis? No. The debt crisis that this is going to drive is something that’s going to happen somewhere between 10 and 15 years from now. But you know what? We need to get ahead of it now if we want to fix this problem in a way that causes the fewest distortions in the short run, the way that creates the least amount of harm to the residents of the United States – retirees and working people. We have to get in front of this now and start dealing with it. But no one in DC can possibly think 10 years down the line. Everybody, again, is in a complete panic, hair on fire, run around screaming about nonsensical crises that don’t exist right now. That’s what politics is. And you know, it’s the kind of thing that, in 10 years we’re going to look back at 2019 and go, “What were we thinking? Why were we doing that?” And I don’t know if we’re going to have a clear answer.
As investors preparing for retirement, we may not have total control over what happens in government in the next 10 to 15 years, but we can control how we prepare and deal with it. This week on the Your Money, Your Wealth® TV show, Joe and Big Al are taking us to Investor Boot Camp to get our portfolios and our retirements in shape. Watch it online at YourMoneyYourWealth.com. And for a limited time, sign up for our special offer: get a free copy of the book Think, Act and Invest Like Warren Buffett by Larry Swedroe. This book is only available for the next couple of days, so click “Special Offer” at YourMoneyYourWealth.com and sign up for your free copy. Now, more with Dr. Chris Thornberg of Beacon Economics.
10:03 – Dr. Chris Thornberg: Recession, Monetary Policy, and Tariffs
Brian: So eventually we will have another recession, and it sounds like you don’t think that’ll be in the short-term. But what you’re referring to in the longer term, whenever we do have a recession, it strikes me that there’s just not a lot of tools to put in place to really support the economy the way that we did coming out of ’08-’09 or even out of the early 2000s. With monetary policy rates are pretty low, the Fed can’t necessarily do quantitative easing again forever, they can’t just expand their balance sheet. Fiscal stimulus is limited by the fact that the budget deficit is already pretty large. So when we do get another recession, what’s it going to look like? Because while maybe the excesses in the economy aren’t the same as what they were before the last recession, it also strikes me that the tools at policymakers’ disposal to counteract it aren’t as robust either.
Chris: Right. Well, I think you’re half right. The fiscal stimulus part of that, you’re exactly right. I mean, we’re already in a bad budget situation and trying to borrow that much more in the middle of a recession is going to be really ugly. So, couldn’t agree more with you on that. As for the Federal Reserve, I would have to completely disagree. Look, quantitative easing is something they can do again. There’s not a problem. Filling up the Fed’s balance sheet is irrelevant at some level. As long as they’re pumping money into the system in order to offset deflationary pressures and to make sure that monetary flows are moving appropriately through the economy. Yes, at some point in time, you’ve got to worry about the potential for inflation, but inflation doesn’t kick in in recessions. That’s not the issue. And remember, even if quantitative easing isn’t working very well, you can always go to to the last but not least stimulative effort of the Federal Reserve, which is just basically direct cash infusions into the economy. You know, Ben Bernanke, he used to be called a helicopter Ben because somebody said to him, “Well, if you can’t use traditional monetary policy what do you do?” He says, “quantitative easing.” And they said, “well what if you can’t use quantitative easing?” He said, “Well, then you fly helicopters around and you throw hundred dollar bills out of it.” Now, that’s a little extreme, but it gets to the point that you can always stimulate the economy through a direct cash infusion. The Federal Reserve has the ability to do that.
Brian: What would that mean for financial markets though? Because it strikes me that we’ve had the Greenspan put that they call it, that financial markets expected Greenspan to come in and every time there was a sell-off or a slowdown, he’d put a floor under it like he did in the early 2000s, and then the Bernanke put, helicopter Ben, and then Yellen and Powell. I mean, if every time that the economy slows the Fed starts taking what used to be considered extraordinary measures, what does that mean for sort of the structure of the financial markets? Or for the long-run well-being of the US economy? And these may not necessarily be concerns that I personally have, but I certainly hear a lot of clients and a lot of the general public that are afraid that the Fed has too much influence and if they’re single-handedly—
Chris: No. (laughs)
Brian: Right? (laughs) The Creature from Jekyll Island or whatever, is single-handedly supporting the economy – what does that mean longer-term?
Chris: First of all, The Fed isn’t single-handedly supporting the economy, the economy is single-handedly supporting the economy. You know, one of the things that I think people get wrong about recessions is the idea that– you know, a recession is when the economy’s broken. And when the economy is broken, the only thing that can fix the economy is the Federal Reserve or Congress. No, that’s not how it works. The economy suffers a temporary shock. And that shock will work its way out of the system eventually. Economies are self-healing. The role of policy iis not to get rid of a recession or fix the economy. It’s largely to minimize the negative impact of the recession on people through the downturn. Right? You don’t want the recession to get out of hand. You don’t want the recession to become worse. You don’t want people to suffer and lose their homes and starve in the streets. So we have unemployment insurance and we use fiscal policy, we use monetary policy, and we do all this to smooth the symptoms until the economy heals itself. I would argue people give way too much credit to the Federal Reserve. I’m amazed by how, particularly on Wall Street, how a lot of the economists talk about the Federal Reserve in these hushed tones of awe, almost like talking about a greater power. And they’re not. It’s just another institution. They have some power, not nearly as much as we give them credit for. And they could do some right things to, again, minimize the negative impact, but ultimately the economy is going to get better and move forward. So the next recession, how bad it’s going to be, to be honest with you, is less a function of government policy and a lot more of the shock to the system that created the recession in the first place. The Great Recession was so bad because our economy was so out of whack. So much debt, too much spending, not enough saving, a giant trade deficit, vastly too much home building. We were a train wreck of an economy in 2006, no matter how good it looked. You know what? We got through it. As bad as it was, we bounced back in a couple of years. Now, the next time I don’t think the shock is going to be that big. I don’t think it’s going to be that dramatically of a negative downturn. That was truly unusual. And we haven’t seen the underlying conditions, the underlying imbalances forming in the economy today, that could possibly come close to creating that type of recession again.
Al: Let’s talk about tariffs. How does that affect what you just said?
Chris: Not much. Because remember, tariffs are really only on Chinese products coming into the United States. And the Chinese have far more to lose from tariffs than we do – and they know that. You know, we end up paying a little bit more for our stuff, they end up having a huge amount of trade diverted from China to other countries, which is a threat to the health of their economy. So one of the reactions to the tariffs has been to allow the yuan to depreciate. They’re picking volume over profit. And they’re doing so deliberately to play this out, to play the long game. You know what’s amazing is, for all the talk, chatter of tariffs, there really hasn’t been much of a reduction of trade with China. There really hasn’t. Because of the fact that, outside a few key industries that China is deliberately punishing for political purposes, like soy, they’ve actually continued to buy most stuff they buy from us. And equivalently, the depreciation of the yuan has made the sting of the tariffs really not all that bad. And keep in mind, think about a lot of the things we import from China. People don’t think about this too much. But let’s take a pair of pants. Let’s you walk into Macy’s and you see a pair of pants that were made in China. Let’s say they cost $60. What do you think Macy’s paid their Chinese manufacturer for that pair of pants?
Al: Yeah a lot less. Let’s say 15 bucks.
Chris: Probably six or seven. So again, does a 10% or 15% increase in that $7 pair of pants really have a dramatically negative influence on our economy? There are pressure points. I’m not minimizing things. There are parts of the economy that are a little more sensitive to this than others. But overall, again, it’s one of those issues that’s been so highly overstated. It’s a fascinating game. Candidly, I’m glad Trump has finally said, “enough is enough.” Maybe he’s doing it for the wrong reasons, he’s focusing on the trade deficit as opposed to all the other things they’re doing, but I’m glad he’s doing it. So in a sense, I think we should be less worried about the short run, and more pleased about the potential positive long-run effects this can have by forcing China at some level to start to play nice.
Al: Dr. Christopher Thornberg, great information as usual. Any other final thoughts before we let you go?
Chris: Yeah. Don’t mind the miserablists, right? Don’t listen to all those pessimistic folks who just are finding yet another reason to tell you how terrible things are. Times are pretty darn good. We have a lot of long-run issues our economy has to deal with. It’s sad that we can’t appreciate how good it is right now and get down to the very real business is tackling these long-run challenges.
Al: Chris, I love your message. We love having you on every time we can. Hopefully, we can get you back. Thanks so much for joining us today.
Chris: Pleasure to be here.
Al: Dr. Chris Thornberg who founded Beacon Economics, really enjoyed your info – and I love the positive spin. And I remember talking to a few years ago where even things were tough and you still got us through it. So appreciate that positive spin.
Read the transcript of this interview in the podcast show notes at YourMoneyYourWealth.com, share the episode via email or across social media, and subscribe to the YMYW podcast so you don’t miss what’s coming up: Our friend Jonathan Clements returns to YMYW to talk about market risk, rebalancing, and Roth conversions, Tyrone Jackson joins us from The Wealthy Investor, and as always, Joe and Big Al will be answering your money questions. Scroll down and click Ask Joe and Al On Air at YourMoneyYourWealth.com to send in your question or comment as a voice recording or an email.
19:32 – Why is Owning a Home Considered Profitable?
Joe: We have Ross up the street here in L.A. He wrote in, he goes, “I continue to enjoy you characters whenever I get a chance to watch and learn.” So he continues.
Al: It wasn’t just once. Twice at least.
Joe: So he goes on with some interesting ideas here, so bear with me as I go through some of this stuff. I’ll break it up because it’s somewhat long.
Al: Yeah there’s a lot here.
Joe: All right. He’s got a few things to ask, so Ross says, “I have a few things to ask if you get the time.” Well, Ross, the time is right now, my friend. “First, I bought a residential house,” so he bought a primary residence. He bought it, Alan, for $770,000. It’s worth – can I round here? Do you mind if I round?
Al: I don’t mind. (laughs) You gonna round to 800?
Joe: Yes. He bought a residential house for $800,000 and today it’s worth $1.3 million.
Al: Okay. So it’s gone up about $500,000.
Joe: $500,000 increase. That’s pretty good. Not bad. So then he goes, “people talk about this as some kind of profit, but it cost me $26,000 per year for the mortgage. Another $5,000 a year for insurance, and $10,000 property damage,” or is that – what do you think property damage is? Taxes?
Al: Well it’s probably a combination of insurance and repairs, maybe.
Joe: Okay well $5,000 insurance, he forgot about taxes. I’m guessing taxes unless he got property damage. I don’t know. Ross, what did you do to your house?
Al: Tough on his home. (laughs)
Joe: I know he’s just beating it up. (laughs)
Al: Every year he’s got a full-time contractor, “Well, I’ve put my fist through another wall, can you believe it?”
Joe: Yeah, “I listen to these characters on this stupid podcast, got me so mad I’m just hitting my walls, I’ve got $10,000 of property damage a year! Idiots!” (laughs) So, “in 14 years, my house cost $41,000 per year for a total of $574,000.” All right. So he’s saying he bought his house for $800,000, it’s up to $1.3M, so that’s a $500,000 increase in overall market value of the home. But he’s like, “Wait a minute, did I really make $500,000, because I said I spent all this money? I’m paying the mortgage, I got property damage.” (laughs)
Al: It’s crazy. Every year! (laughs)
Joe: (laughs) I got damages! And then some insurance. So he’s like “well, I spent $574,000. So prior to Trump with interest write off, you could save a net $2,000-$3,000 per year. So let’s say $30,000 or so increase….” I can’t understand what Ross is saying.
Al: (laughs) So here’s what he’s saying: he’s saying it cost him $574,000 but he saved about $30,000 in taxes. So his net cost is about $544,000. That’s what he’s saying.
Joe: Oh, okay… But that’s not what he wrote.
Al: I know, I had to read it a few times to get it.
Joe: (laughs) All right. “It seems to me your house is only a savings account, in this case, a loss. Am I right on this?”
Al: So what he’s saying is he spent $544,000 to own this house for 14 years and he made $500,000 appreciation. So he’s out of pocket $44K. So why is home investing such a good deal? That’s what he’s saying. Well, you have to consider the alternative.
Joe: Yes. It only cost him $44,000 to live for 14 years. (laughs)
Al: So think about rent. So I already did the math. So $3,000 rent per month, just if that’s what it rents for.
Joe: Well an $800,000 house?
Al: You would think so. I think that’s conservative. So $3,000 a month for 14 years is $500,000. So that’s what it would cost you, $500,000. That’s out of pocket.
Joe: That’s out of pocket versus $44,000.
Al: Yeah. Versus $44,000 is exactly right. So there’s your answer. I mean, you have to compare it to renting. You have to compare it to the alternative. Now if you live on the street, in a tent by the river, then I agree with you. (laughs)
24:05 – Should I Own Real Estate in a Self-Directed IRA?
Joe: “Second, I have since age 32 – I am now 59 – so for 17–” this guy writes very uniquely. I like it.
Andi: You’re following it really well. I was totally expecting you to fall over this one.
Joe: Yes, I was like Man I feel like I’m in, I don’t know, the 1800’s. (laughs)
Al: How do you figure that?
Joe: I don’t know. He kind of puts things in a way…
Al: He drove his rode his horse up?
Joe: Or no, it’s like how Yoda speaks.
Andi: OK. So he has since age 32, he is now 59, for 17 years put all his retirement in Vanguard 500 Index Fund, S.E.P. IRA…
Joe: It’s a SEP IRA. And he let it alone, good and bad times.
Al: Good, I agree that.
Joe: “It is now worth…”
Al: $1,650,000. Or is it $1,650?
Andi: I think it’s a million 650 but I wanted to leave that.
Joe: “Hardly enough to retire on.” – $1.6 million. Hardly enough to retire on.
Al: Well that’s about what $70,000 of income, something like that?
Andi: He’s 59 right now.
Joe: All right. So what do you guys think of a self-directed IRA where you buy turnkey property for income for life, knowing some percentage will not be rented? It seems in California everyone is trying to buy and rent. I looked at some guy named Morris and he invests in deals with $50K properties and gets $500 per month. So in essence, a 10% return and you have the property, versus taking 4% each year out of my SEP IRA. So at this time $66K per year while you hope the remainder continues to grow at least 4% or more.” What do you got there, Al?
Al: (laughs) I’m not a big fan of that. And I’ll tell you why. Well, first of all, you’re in Los Angeles, so these $50,000 properties are not in California. They’re probably in Texas or maybe Tennessee or somewhere like that that has better cash flow.
Joe: He’s buying properties for $50,000
Al: Yeah. So it’s some other place besides California. So it’d be out-of-state ownership for you or maybe it’s Morris that does all the work. So you have no control over your investments. I’ve seen people do stuff like this, I have seen a few people happy. Many people that have done this have not been happy because they have no control over it. The market changes, the properties can’t be rented. It can be a nightmare. Then you can’t sell the properties, you can’t have debt on the properties. So I wouldn’t go that route. You can’t spend a property, you can only spend the cash flow. But what if you need a new roof that year? Well, you don’t have cash flow for two years because you gotta save the money for the roof.
Joe: Well he usually gets $10,000 of property damages. (laughs)
Al: Yeah true. (laughs) Well, maybe it’s better that he doesn’t manage the properties. So no I’m not a big fan of that. I like real estate. I would invest in real estate outside of your retirement accounts because you get depreciation benefits, if you pass away your beneficiaries get a step up in basis, all kinds of benefits outside of a retirement account. Inside the retirement account is just a big hassle in my opinion.
Joe: So “how does converting this to a Roth work? I don’t think I qualify.” Well, Ross, you can always convert and anyone qualifies for a Roth.
Andi: I think he’s specifically asking you about this IRA that he would put real estate in – can he still convert that to a Roth?
Joe: Yeah yeah yeah.
Al: Yes you can. You can, it depends on the custodian that’s holding the account, whether they’ll let you do a partial conversion or whether they have to convert the whole property. Maybe you can convert a fractional interest.
Joe: I have seen that before.
Al: Yeah I’ve seen that before too, but I wouldn’t necessarily presume that’s true for all custodians because it’s a level of complexity that I’m not sure they get paid any more for it.
Joe: Right. But if it’s a $50,000 property maybe you just convert one of the properties, convert $50,000, now you got the one property in the Roth.
Al: That would be the cleanest way to do it. Yeah, as long as the custodian allows it the answer is yes you can do that.
Joe: Yeah because you’re not going to a typical Vanguard, Schwab for this, you’re going to someone that specializes in self-directed IRAs. It’s a totally different animal. So he’s thinking about buying in Colorado and Texas, so…
Al: Well first of all, if it’s in your IRA it doesn’t matter. But secondly, if it’s not in your IRA, it doesn’t matter, because you’re a California resident and you will be taxed in California. You will pay taxes in Colorado too. You just get a tax credit in California for the tax you pay in Colorado.
Joe: So then he finishes up, “anyways, just some thoughts, appreciate your input. I continue to enjoy your show” – until he listens to this I’m sure – “I would like to retire soon but always worried I won’t have enough.” Isn’t that the truth. We all kind of have that same worry, Ross. “I have one daughter taking her nursing boards,” congrats, “and another daughter, second-year law school.” Congratulations there. “Son’s a realtor.” That’s where he’s getting the real estate bug. “My wife and I are doing everything we can to get them into a moderate condo to start their life before we focus on ours. You’ve always been kind to respond to my inquiries,” so that’s what we’re doing now. You know, Ross, you’ve got to really good handle on all this stuff. I mean you’re dabbling and you’re doing the research, you listen to clowns like us. You know I think he’s good. I mean he’s worried. He’s definitely taking some actions. So we wish you the best, if you want more information Ross, you can always go to YourMoneyYourWealth.com.
That you can Ross, as a matter of fact, Big Al Clopine did a video about buying real estate in your IRA and I’ve posted it in the podcast show notes at YourMoneyYourWealth.com, along with our latest blog post on Real Estate Investing 101. And stick around, Ross, because you’re getting ALL your financial questions answered today – in a few minutes Joe and Big Al will address your annuity question as well. And since Your Money, Your Wealth® is for everyone, we are taking questions from people other than Ross too! All you gotta do is go to YourMoneyYourWealth.com, scroll down to Ask Joe and Al On the Air and send in your question as a voice message or an email and the fellas will respond here on the podcast. If you’re subscribed, new episodes with answers to your email questions will automatically download to your device.
30:36 – Should I Buy a Fixed Index Annuity? (video)
Joe: Emails you say. Let’s go to Ken from San Diego. He goes, “Being considerably risk-averse. I’m curious about your opinions related to FIAs,” which stand for fixed index annuities – or some people call them equity-indexed annuities. But I think the S.E.C. or someone got upset and they said, “no, you can’t put the word equity into it.”
Al: Yeah they used to be called EIAs. I remember that.
Joe: “Specifically the growth options where you just park cash and let it grow. I’m considering parking a million dollars from my recently retired wife’s 401(k) for about five years while I’m still working. I’m looking at a fund that will give a percentage bonus on the initial balance, but it’s seeming a bit like too good to be true. I realize I have to pick the index and the upside is clipped, but… Appreciate your thoughts.” Okay, Ken.
Al: Wow, I’m just going to sit back and listen. It sounds great.
Joe: Well – this is how it’s sold. So all right let’s talk about it. It’s a fixed annuity. So let’s start there. Let’s just start really basic. What a fixed annuity is, is that you are giving your dollars to an insurance company and what you receive from that insurance company is a fixed rate of return. Fair enough? Like a CD, Al. You have CDs.
Al: I do.
Joe: Most people don’t know how this stuff works. So let’s say you go to the bank and you want to purchase an FDIC insured CD. So you give U.S. Bank – whatever – $100,000. They’re going to pay you 2%. What do they do with that $100,000? They’re not putting it in the vault and waiting for you to come back in 6-8 months or 12 months or whatever the term of your CD is. They’re investing it.
Al: Yeah they’re trying to make more than the 2% that they’re paying you.
Joe: And they’re making a lot more than that most cases, because —
Al: They’re loaning money out for whatever.
Joe: Yeah. Boats. Boat loan, car loan, credit cards, house loan.
Joe: Right. Credit cards, 24%, a boat loan, 12%. Whatever. So they’re lending the money out. And so they’re trying to reach higher than that 2%. That’s called a spread. And so when people hear that with the banks, they go, “OK, that makes sense.” Insurance companies, when it comes to fixed annuities, do the exact same thing. They’ve got a reserve. So you give your money to the big insurance company, they’re going to give you a fixed rate of return. So I could buy a fixed annuity. The difference between a fixed annuity and a CD, in layman’s terms, is that the interest on a CD that I receive is taxable each year that I receive it. In a fixed annuity, it grows tax-deferred. So let’s say I get a five year, 2% fixed ability. That 2% on my principal I’m not paying taxes on until I take the income out of the annuity. Annuities also have special terms that you have to be 59 and a half to get the money out or there’s a 10% penalty. Every interest is taxed at ordinary income rates. Now that’s a fixed annuity. They’re like, “OK well, that’s great, but that’s boring.”
Al: I want a better return.
Joe: I want something cooler.
Al: I want something more like market returns. But I don’t want to lose money.
Joe: Yes. Right. And so how it’s sold and how it works are two different things. I’m not opposed to how it works as long as it’s disclosed appropriately. But like right here, Ken. He’s saying “I’m getting a bonus.” So what he’s getting himself into is a fixed indexed annuity. So it’s a fixed annuity and they’re going to promise him a bonus. “Give us $100,000, we’ll give you 5% right up front. Now no questions asked.”
Al: Yeah, you got $105,000.
Joe: Yep, all of a sudden, $105,000. Or it could be even a bigger bonus – maybe it’s 10%.
Now you got $110,000. 18%!
Al: Day one.
Joe: We’ve seen that before. $18,000 right up front.
Al: Yes we have.
Joe: How do they do this?? This is great! It’s like a free toaster when I open up a checking account!
Andi: Expensive toaster.
Joe: Yes. So how the fixed indexed annuity works – and there are all sorts of different flavors. I have no idea, Ken, what you’re buying. If you want to show me the contract I’ll be more than happy to dive in a little bit deeper for you. Not me, but someone in my firm. (laughs) Let’s be clear. You’re buying into… how do I say this in layman’s terms – like a zero-coupon bond with a call option on whatever index that he chooses.
Al: Okay. That’s in layman’s terms? (laughs)
Joe: Kind of. (laughs) That’s why I had to think about it for a second. Because l on your fixed index annuity it says, “how about you can invest in the S&P 500? Or how about the Russell 2000? How about the Wilshire 5000?” “Oh, well now I’m a stock market investor. But I’m never going to lose money.” Because how it’s sold is that “you can get stock market-like returns with no downside risk. So if the stock market does 6%, you’ll get 6%. The market does 8%, you’ll get 8% but if it goes down 20, you don’t lose a dime.”
Al: Yeah. Now that sounds great.
Joe: That sounds perfect. Who doesn’t want that?
Al: Yeah. Now, what’s the problem?
Joe: Of course it doesn’t work that way because you have to look at the fine print on these products. Most of them, they’ll have a participation rate. So let’s say the market does 10% but what is your participation in it? Maybe you only have a 50% participation. So now the market does 10%, but my participation is only 50% so I’m getting 5. Then there’s also caps with how much that you can make. Maybe it’s a point to point on a month to month basis or year to year basis or things like that – so you have to look at that. Maybe I can only get 2% per month on a 50% participation contract.
Al: Right. And the market goes up in one month…
Joe: Yeah it goes up 8% in one month. Well, I’ve got a 50%, so that’s 4% plus the cap on it, well it’s 2%. You’re like, “well, what the hell, the market’s up 10, I only got 2!” Right! That’s how the insurance companies make all the money! Because he got a bunch of guys out there saying, “stock market-like returns with no downside risk. Oh, and by the way, I’m gonna give you a 10% upfront to boot! And a free toaster. What do you think?”
Al: (laughs) Where do I sign?
Joe: Yeah! Because you get all these conservative investors that are now retired, they’re looking at their statements because they need to live off this stuff. He’s retiring in five years – and I like how Ken goes, “Well I want to take my wife’s money and put it in this thing. I’m not going to put my money to it.” (laughs) So if they would say, “Would you like a fixed annuity that will probably tie you up into this product for 10 years?” You have to look at, “how long how long am I going to be in the contract?” If they’re giving me an upfront bonus, you know it’s longer than 10 years in most cases. 7 to 15 years. So now I’m stuck in this product. Now I try to take the money out, I’ve got huge surrender charges because they’re lending that money out – the insurance companies are doing all sorts of stuff with it.
Al: Now you can take 10% per year.
Joe: Oh yeah! That’s what the brokers are telling them or the insurance agents: “Why would you want to take it all out? Come on Ken. You only want to take 4% out per year. Don’t you know the 4% rule? Why are you taking out 10? You know – we’ll give you 10!” So there’s a lot of really bad sales practices behind it. But if it was like, “OK, here’s my commission you give me -” He’s gonna get a million bucks. Guarantee the commission on that product, at a bare minimum, is what?
Al: I was going to say $70,000 to $100,000.
Joe: It could, very easily.
Al: I don’t know what a minimum is but that’s what I’ve seen. Seven to 10%. We’ve seen higher.
Joe: Right. So you’ve got 10% and gonna put a million bucks? You’re paying the commission on that is $100,000. We’ve seen a little bit higher than that too. 18% commissions, we’ve seen. We tried to go help – this guy comes in, 90-some years old, or 87 year old, right?
Al: He was in his mid-80s, yeah.
Joe: Mid 80s, couple million dollars in, like, seven different contracts. And I was like, “well why do you have all these?” “Well, it’s diversification.” No bull– it’s all different breakpoints and stuff like that.
Al: And every contract with 17 years.
Joe: Yes. And this broker went to like different types of — because one insurance company is going to be like, “you’re putting this in this gentlemen’s entire net worth in this annuity?” This is illegal, sir. ” That’s why he’s breaking it up and he’s putting it all over the place. I mean there’s a lot of crooked s-it out there.
Al: Right. OK. Got it. Anyway, so what’s the advice? I guess just be really careful, know what you’re getting into.
Joe: Yeah. Because you’re right, if it sounds too good to be true, Ken, what do you think? It is. If you want the skinny and just say, “OK, I’m willing to tie up my money for it anywhere from let’s say 10 to 15 – or let’s say 7 to 14 years. I don’t know what contract he’s getting sold here. It’s a million bucks. Or maybe it could be annual liquidity. If that’s the case, well then that’s a totally different story. Maybe there’s no commission in the overall FIA, but if there’s a bonus involved? I’m guessing. I’m just guessing.
Al: It’s a pretty good hunch, so I would agree with you.
Joe: So without me knowing anything about what product you’re thinking about going into, that was kind of with a broad brush. Just buyer beware. Think about the pros and cons of everything, because it sounds to me that he only knows the pros. Ken does not necessarily know the cons.
Al: Well he knows the upside is clipped. He is aware of that.
Andi: And he knows that it sounds too good to be true.
Joe: “I realize I have to pick the index and upside is clipped,” but here’s how it sold. “If the market does 12, I could get you 11. What do you think?” (laughs)
Al: (laughs) That sounds pretty good.
Joe: “We can’t get you the full upside of the market but almost, almost.” So I don’t know hopefully that helps, Ken. But if you’re a conservative investor – but to be honest with you we’ve seen just straight fixed annuities performed better than some of these indexed annuities or fixed indexed annuities. It depends on, again, participation rate, your points and caps, and all that other stuff. So all right.
Let’s see, Ross from Los Angeles. He writes in too, the same type of question that we did from Ken. He goes, “boys, I need your intelligent thoughts. What do you think of a fixed annuity within your IRA that pays an average of 3 to 6% with no loss ever and a cap of 10% when the market does well. No fees. Really value your opinion since it appears so many financial advisors don’t like annuities.” Okay, well this is just another way to explain what we just went through. So on average 3 to 6%.
Al: Which means 3.2%.
Joe: Well look at this, Alan. If I’m looking at the expected rate of return – let’s say if Ross here – let me put my little Larry Swedroe hat on.
Al: Okay. Can you talk like Larry?
Joe: (imitating Larry Swedroe) “Hello! (laughs) hold on a second, gotta shut the door, get the dog out.” (laughs)
Al: (laughs) Every time we call him, that’s what we get.
Joe: I love Larry.
Al: It’s wonderful.
Joe: But if you think about it – so he’s getting sold this now. Average 3 to 6% in a fixed annuity! Averaging 3 or 6%. Come on! Where are interest rates right now, what’s a 10 year Treasury at? Two??
Al: Two and change.
Joe: Okay. So of course, the insurance companies are going to pay you 3 to 6. And it depends on what index you select, because it’s like, “when the market does well.” Well, what market are you referring to Ross? Is it the S&P 500? Is it the Russell 2000? Is it the international? There are so many different types of indexes. But let’s just assume he’s going to select the S&P. S&P price-earnings ratio is pretty high. You look at the earnings yield on that, the future expected return of the S&P is probably around 3%.
Al: It’s lower than usual because it’s so high right now.
Joe: Right. So when you have prices that are high your expected returns are going to be lower.
Al: Yeah. I think a lot of people don’t understand that – when prices are low, future expected returns are higher. It’s kind of almost the opposite of what you might think.
Joe: So he’s saying 3 to 6%. If that were the case, if you could get an average 3 to 6% with zero loss and a cap of 10, why the hell wouldn’t you?
Al: Yeah that sounds great.
Joe: I would do it. But it’s not true. It’s not going to happen. It’s not like financial advisors don’t like annuities. Financial advisors that are fee-only fiduciaries don’t like how annuities are sold. If they said, “here’s a fixed product that you’re stuck in and here’s how it works, and you’re probably going to get 2%”– I mean, what’s a fixed annuity? Can we look it up on FixedAnnuity.com or something like that? What’s a standard fixed annuity paying? I would guess, what, two and a half? Three?
Al: Well they don’t say it that way.
Joe: No no no, this is a fixed indexed annuity – I’m just saying if I wanted to buy a straight fixed annuity.
Al: No, but I’m saying they talk about the distribution rate, which is also getting your own money back. That’s where I’m going.
Joe: Oh yeah. No that’s an immediate annuity.
Al: Right. So that might be 4% or even 5, 7, but they’re giving you your own money back.
Joe: Principal back. Right. So if that was the case, Ross, then yeah by all means. But I just don’t think you can average over the next, let’s say, 10 years, 3 to 6% in a fixed annuity. Why would they cap it? So the caps at 10? So if the market does 9? If the market does 11, you get 10? So again, you gotta always look at the fine print.
Al: Yeah. So we don’t know the details here. But wouldn’t it be safe to say, Joe, that we’ve looked at a lot of these and have you found one that you would recommend?
Joe: A fixed indexed annuity?
Joe: There are things that I hear it’s like, “OK well here, there’s you no surrender charges.” They say “no fees.” It’s BS.
Al: Lots of fees.
Joe: It’s not a fee. It’s something else, it’s called a spread. It’s different. It’s just different terminology. They’re making a ton of money. You’re not giving any dividends from the stocks because they’re buying options on the stuff. And it’s not like in a per se “fee” that you see it’s a spread and there’s commission. It’s just all it’s just word games anyway. All right. That’s it for us, hopefully, you enjoyed the show. Andi, wonderful job today.
Andi: Thank you, Joe.
Joe: Big Al, good job.
Al: Thank you, sir.
Joe: You got it. We’ll see you guys next week. The show is called Your Money, Your Wealth®.
Special thanks to our guest Dr. Chris Thornberg from Beacon Economics. For the transcript of today’s interview, the link to his website, to hear Dr. Thornberg’s previous YMYW appearances, and for links to share and subscribe to this podcast, visit the podcast show notes at YourMoneyYourWealth.com.
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Pure Financial Advisors is a registered investment advisor. This show does not intend to provide personalized investment advice through this broadcast and does not represent that the securities or services discussed are suitable for any investor. Investors are advised not to rely on any information contained in the broadcast in the process of making a full and informed investment decision.