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Welcome to personal finance for
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long-term investors, where we believe
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Benjamin Franklin's advice that an
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investment in knowledge pays the best
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interest both in finances and in your
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life. Every episode teaches you personal
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finance and long-term investing in
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simple terms. Now, here's your host,
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Jesse Kramer. Hello and welcome to
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episode 104 of Personal Finance for
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Long-Term Investors. My name is Jesse
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Kramer and today we have an AMA episode,
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an ask me anything episode. This is our
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sixth AMA episode and if you enjoy
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today's episode, I highly recommend you
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go back and listen to our first five
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which were in in descending order
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episodes 99, 95, 90, 86, and 81. We've
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taken listener questions and we will do
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some deep dive answers to those listener
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questions about financial planning and
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investment management and retirement
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planning, all sorts of those kind of
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topics. And if you have a question that
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you'd like to contribute to a future
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episode, you can email that question to
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me. My email address is
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jessebestinterest.blog. And before we
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dive into the first question today, we
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have a review of the week from that Ritz
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like a cracker. And that Ritz says,
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"Great voice in personal finance. Five
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stars. I was introduced to Jesse through
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stacking Benjamins and I'm so grateful.
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He has a refreshing, well- balanced and
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informed point of view. I appreciate his
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balanced discussion on the implications
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of student loan forgiveness. As a fellow
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U of alum, I'm impressed. Urum will mela
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that ritz. Thank you for the kind words
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and the five-star review. Shoot me an
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email to
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jesse@bestinterinterinterinterinterinterinterinterinterinterinest.blog
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and we will get you hooked up with a
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supersoft bestinest t-shirt. Yes, the
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t-shirts still are best interest
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t-shirts. We'll get some t-shirts for
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the new podcast soon enough. Okay, the
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first question today is from Mark on the
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California wildfire situation. Jesse,
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I'm not sure if it's a financial
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planning topic, but can you talk about
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the California wildfires and some of the
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tangential financial topics there? Well,
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it's an interesting topic, Mark.
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Interesting question. And there are some
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important financial planning and
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adjacent topics to talk about here.
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First, for example, let's talk about
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insurance, not just homeowners
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insurance, but insurance in general. Why
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do we need insurance? Well, we need
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insurance to cover the risks in our
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lives that our finances otherwise could
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not handle alone. You know, if you can't
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pay for X out of pocket, then you should
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probably be insured for X or for
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whatever risk that is. homeowners
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insurance in particular in this case.
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Well, would you rather knowingly pay
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$2,500 a year on an insurance policy
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that you probably never use? Or would
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you rather face the probability, slim
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probability, but it's a real probability
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that your home will burn down and you'll
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have to replace it dollar for dollar? I
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actually found an interesting stat
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online. And warning, it it could be
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total BS, but I actually found it from a
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few different places. And the statistic
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is that about 1 in400 homes will have a
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house fire in any given year. One in 400
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homes. And granted, I mean, maybe some
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of those fires are quite minor and
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small, they won't be like a total house
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fire that burns a house down to the
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ground. But either way, the idea is that
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one in 400 per year. Now, if we take
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that one in 400 and then we ask
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ourselves, what are the odds that I
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dodge this particular bullet every
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single year for my whole life? Right? In
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other words, what are the odds that I
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never suffer a houseire? You'll find
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that over, say, 40 years, the odds of an
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individual having a house fire is about
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1 in 10. So, it goes from 1 in400 in any
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given year to about 1 in 10 over the
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course of our lifetime. To me, that's a
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little bit eye opening. Out of everyone
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I know, 10% of them or so will suffer a
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houseire at some point in their life.
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Anyway, the point of that statistic
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isn't to quibble over whether it's, you
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know, one in five, one in 10, one in 20,
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but instead the point is that it's a
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pretty real probability. And do you want
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to roll the dice and say for this year
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or for this decade or for the rest of my
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life, I'm going to dodge that fire
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bullet? I'm going to dodge the tornado
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bullet, the hail bullet, and any other
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bullets out there. Or would you rather
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pay the 1,000 or 2,000 or whatever your
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homeowner's insurance premium is?
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Because if that bullet hits you, you're
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probably looking at multiple hundreds of
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thousands of dollars of repair,
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replacement, buying another home. And is
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that a financial hit that your current
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situation can withstand? That in a
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nutshell is the entire insurance
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conversation. You know, we can extend
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that same thought process to cars or or
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to your boat or to your life or life
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insurance and think about the same exact
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thing. You know, what are the odds that
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something catastrophic happens? Can your
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financial situation or your family's
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financial situation absorb that
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catastrophic thing happening? And if
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not, you need to strongly consider
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insuring yourself against it. Now,
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homeowners insurance in particular,
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though, has this pretty interesting side
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story that's going on right now. If you
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own a home in Florida, California,
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Louisiana, North Carolina, Texas, or
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Oregon, you've probably already seen the
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bad news in your mailbox. a renewal
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notice with a much higher premium or
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worse, a letter saying that your insurer
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is dropping you altogether. Now, in
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Florida, they're dealing with hurricanes
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and lawsuits driving up costs.
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California is dealing with wildfires,
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wild weather, complicated regulatory
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system. Louisiana and Texas have
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hurricanes and floods. Oregon, wildfires
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and rising risks. North Carolina,
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hurricanes, insurers are pulling out of
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the state. It's like mother nature and
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the insurance company have teamed up to
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make home ownership much harder in those
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states. And it's understandable when we
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look at the economics of it all. You
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know, more disasters leads to more
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damage. Whether it's a hurricane, a
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wildfire, a flood, they're happening
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more often and hitting harder and
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insurers are paying out billions in in
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terms of compensation. So, they either
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have to raise their premiums or they get
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out of the state. Some states have
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regulations that backfire against them.
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They have rules limiting how much an
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insurer can raise the rates. Now, it
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sounds great for homeowners until an
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insurer says, "Well, we just can't do
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business here anymore at these costs. We
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can't offer coverage at these prices and
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we're going to pull out of the state
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altogether." And that leads to insurance
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companies losing money. When claims pile
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up faster than the premiums go up, the
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insurers hit the exits. That's why big
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names like State Farm or Allstate have
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stopped offering new policies in places
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like California and other smaller
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insurers are pulling out of high-risisk
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areas, too. Now, if you're in one of
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these states, you've got a few options.
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You can try as best you can to harden
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your home, to upgrade your home to be
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more disaster resistant. Fireproof
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materials, storm shutters, better
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drainage, anything that makes your house
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less risky. Some insurers will lower
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your rate for it. You can shop around.
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If your insurer drops you, don't panic.
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There's still maybe a regional or
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specialty company willing to cover you.
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A good independent insurance broker can
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help. I use an independent insurance
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broker to shop around just for that
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reason. You can look to see if you have
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a statebacked insurance plan. Some
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states, like Florida, for example, have
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a last resort insurance program. In
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Florida, it's called the the citizens
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property insurance. They're usually more
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expensive, but they're better than
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nothing at all. And last, yeah, this
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this is a political issue, so you can
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get involved. If you're worried about
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rising costs, you can push for policies
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that encourage insurers to stay while
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also protecting consumers. Another
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question that's been kind of interesting
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coming out of the California wildfires
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is should the government step in when
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insurance companies aren't doing enough
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or should the government step in a
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situation like the wildfire when you
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just have this mass destruction. And as
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with any political or government topic,
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there's going to be two sides of the
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story. They're going to be pros and
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cons. Now, first let's talk about some
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of the pros of government intervention.
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First off, it ensures coverage for
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homeowners. When private insurers pull
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out, some homeowners are left with no
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options. Governmentbacked insurance can
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serve as a last resort and that
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stabilizes the market. A well
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ststructured government program can
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prevent massive rate hikes or a total
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collapse of coverage in disasterprone
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areas and states. If the government is
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bullying the insurance industry, it
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encourages home resilience upgrades. For
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example, a government program could
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offer an incentive for homeowners to
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upgrade to, you know, we talked about it
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before, hurricane proof their windows or
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build out of fire resistant materials.
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And that lowers the long-term risks both
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for the homeowners and for the
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government insurer themselves. A
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national insurance program or a a
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widespread statebacked system would
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distribute risk more evenly, right?
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Spread out the risk amongst a bigger
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populace. And then if insurance becomes
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too expensive, homeowners might be
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forced to sell and that negatively
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affects local real estate markets. So
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government intervention could prevent
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that domino effect. However, there are
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certainly some major cons with
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government intervention into the
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insurance industry. One of the first
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ones is what's called moral hazard. It's
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this economic term that basically says
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when an economically inefficient
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behavior becomes encouraged due to some
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other incentive. And this is the perfect
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example of that. If the government
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guarantees insurance, homeowners might
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keep building their homes in high-risisk
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areas, right? coastal flood zones,
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beautiful wooded regions that happen to
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be big wildfire risks without having to
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face the true economic cost of those
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decisions because the government is
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paying the cost and that causes a major
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taxpayer burden. Governmentbacked
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programs rely on taxpayer money to cover
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the losses and a major disaster could
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mean that taxpayers are footing the bill
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for risky homeowner behavior and this
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could push private insurers out of the
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market. If a government steps in too
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aggressively, private insurance
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companies might exit the market
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completely, leaving the government as
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the only insurer, which is not an
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efficient way of doing things. There's
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always a potential for mismanagement,
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whether we're talking private or public
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funds. But the problem is that a private
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company that's mismanaged is most likely
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going to go out of business or be taken
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over by a competitor that's run more
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efficiently. If a government-run program
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is run inefficiently, well, then it
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might just continue to do so. If the
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taxpayer money is still there to support
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an inefficient government program,
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sometimes that inefficiency is
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maintained and that's not a good thing
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for us as taxpayers. And then lastly, it
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is a short-term fix to a long-term
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problem. Government intervention might
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patch up this insurance issue, but it
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probably doesn't address the root cause
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like climate change or poor zoning laws
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or outdated building codes. And speaking
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of controversial government questions
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when it comes to this wildfire, I saw
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another really interesting conversation
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or or series of conversations where
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people were asking the question, should
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wealthy homeowners even be bailed out in
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the first place? Right? So specifically,
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if we think about some of these houses
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that burned down in the California
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wildfires and where they were in
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suburban Los Angeles and nice areas of
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suburban Los Angeles, the idea is if you
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can afford such a nice house in the
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first place, should you get government
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bailouts to to help you rebuild? Again,
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it's a slippery slope argument, but
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we'll just quickly go over some of the
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for and against points in this argument,
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and then you can make up your own mind.
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So, we'll start with the people who say
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that wealthy homeowners should not get
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government bailouts. They would say,
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"Well, these people can afford to
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rebuild, right? They have high-v value
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properties, significant assets, private
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insurance options that make government
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aid unnecessary." They say that public
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funds should prioritize those in need.
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Limited taxpayer money should go towards
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helping low and middle inome families
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who lack the financial resources to
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recover. They bring up the moral hazard,
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personal responsibility, and risk
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awareness topic. Again, many wealthy
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homeowners have chosen to live in these
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high-risisk areas like a coastal mansion
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or a mountain retreat, and they know the
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dangers of that, and they should accept
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the financial risks instead of relying
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on taxpayer bailouts. And then there's a
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a wealth disparity concern when public
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disaster aid, if it disproportionately
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benefits the wealthy, if it helps a a $5
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million house get replaced and it also
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helps a $200,000 house get replaced. You
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know, did one family just receive 20
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times more aid or 25 times more aid?
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That's the disproportionate benefit that
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some people are worried about and that
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probably would exacerbate economic
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equality as government resources are
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spent protecting luxury properties
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instead of helping struggling
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communities. So anyway, that's one kind
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of devil's advocate side of the
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argument. If I take the other side of
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the argument, I say, well, wealthy
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homeowners pay the most in taxes, right?
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Wealthy individuals contribute
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significantly more in taxes, so they
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should be eligible for relief just like
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anyone else when disasters strike. And
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in general, disaster aid should not be
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means tested, right? Means tested
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basically says, do we look to see what
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kind of means someone has, what kind of
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assets and resources someone has before
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we give them any sort of benefits,
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before we give them disaster aid. And
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emergencies don't discriminate by income
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or by net worth, by asset base. Right?
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Government disaster relief should apply
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equally to all affected homeowners
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regardless of wealth. Another great
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point is that the economy depends on
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highv value properties too. You know,
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expensive homes can generate jobs, a lot
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of local tax revenue, a lot of economic
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activity. Letting them be wiped out
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could have a very negative ripple effect
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on the overall economy, which we know. I
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mean, the overall economy is based on
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home ownership in large part. It's one
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of the main drivers of the American
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economy. And then setting such a
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precedent as not letting wealthy
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homeowners get any sort of disaster aid,
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that's really tricky and a very slippery
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slope. If disaster relief is only for
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lowincome homeowners, where exactly do
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we draw the line? Who decides which
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wealth level deserves help and which
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wealth level does not? So, it's a
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complex sticky issue. Anyway, you you
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cut the cake, Mark. And when it comes to
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the stuff we can control, like
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insurance, I have good answers for you.
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When it comes to mother nature and the
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government, I'm just one voter like the
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rest of us kind of looking and curious
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about both sides of the issue, and we'll
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see where the world goes from here. On
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to question number two. treasuries, CDs,
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high yield savings accounts. Bob asks,
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"Jesse, I've been buying short-term
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treasuries for my cash position. When I
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go into my Fidelity account, I can't
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help noticing that for some time, the
00:13:33
Treasury notes have had a higher yield
00:13:35
than the same term CD or certificate of
00:13:37
deposit. Treasuries are considered
00:13:39
safer, right? They also have tax
00:13:41
advantages for those of us living in a
00:13:43
high-tech state like New York. Why would
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anyone choose the CD with a lower rate?
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What am I missing here?" Also, another
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question. Say the Treasury is issuing
00:13:52
$90 billion of a particular note and the
00:13:55
auction has a market price that bids up
00:13:56
totaling $200 billion. Who gets in?
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Well, Bob, the second part of that
00:14:01
question is easy, so I'll answer it
00:14:02
quickly. For listeners who don't know,
00:14:04
whenever the US Treasury goes to sell
00:14:06
more Treasury bonds, they do so at
00:14:07
auction. Large primary dealers they're
00:14:10
called, including the kind of household
00:14:12
names in the investing world that you're
00:14:13
probably familiar with. They're allowed
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to bid at that auction to buy these
00:14:17
tanches of Treasury bonds. When you have
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a situation like Bob outlined where $200
00:14:22
billion of bids have been put in on $90
00:14:24
billion of bonds, then the auction is
00:14:26
divvied out to whichever firms placed
00:14:28
the most competitive bids, which is done
00:14:29
by adjusting the yield on the bond.
00:14:31
That's how you place your bid. And if
00:14:33
there's a tie, then the bonds are
00:14:34
divvied up on a prora basis, meaning you
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only get a portion of the bonds that you
00:14:38
bid for. In Bob's case, where you know
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90 billion divided by 200 billion equals
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45%. than those people who tied in the
00:14:46
auction would only get 45% of the bonds
00:14:49
that they had hoped to win. Now, for a
00:14:52
very famous story about just this exact
00:14:54
issue, you can look at the Solomon
00:14:56
Brothers scandal from the early 1990s.
00:14:58
In short, one of their traders put in
00:15:01
fraudulent bids to this Treasury auction
00:15:03
in order to get more than their fair
00:15:05
share of the auction winnings. And at
00:15:07
the end of the day, right, these are
00:15:08
Treasury notes. This is national debt
00:15:10
we're talking about here. It's the
00:15:11
taxpayer. And when the government when
00:15:13
Uncle Sam found out that a Wall Street
00:15:15
firm was trying to cheat the taxpayer,
00:15:18
the government almost went full nuclear
00:15:20
on the firm, essentially sanctioning
00:15:22
them out of business. And only by the
00:15:25
grace of Warren Buffett, right, friend
00:15:27
of the blog, Warren Buffett, got
00:15:29
involved and through the value of his
00:15:31
sterling reputation did the federal
00:15:33
government give Solomon Brothers a a
00:15:35
sliver of a chance to write their ship
00:15:37
and stay in business. And one of
00:15:38
Buffett's more famous quotes came out of
00:15:40
this saga where in a public at he was
00:15:42
testifying actually in front of
00:15:44
Congress. He said, "As to the future,
00:15:47
the submission to this subcommittee
00:15:48
details actions that I believe will make
00:15:50
Solomon the leader within the financial
00:15:51
services industry and controls and
00:15:53
compliance
00:15:54
procedures. But in the end, a spirit
00:15:56
about compliance is as important or more
00:15:59
so than words about compliance. I want
00:16:01
the right words and I want the full
00:16:04
range of internal controls. But I also
00:16:07
have asked every Solomon employee to be
00:16:09
his or her own compliance
00:16:11
officer. After they first obey all
00:16:13
rules, I then want employees to ask
00:16:15
themselves whether they are willing to
00:16:18
have any contemplated act appear the
00:16:21
next day on the front page of their
00:16:23
local paper to be read by their spouses,
00:16:26
children, and friends with the reporting
00:16:28
done by an informed and critical
00:16:31
reporter. If they follow this test, they
00:16:34
need not fear my other message to them.
00:16:36
Lose money for the firm and I will be
00:16:38
understanding. Lose a shred of
00:16:40
reputation for the firm and I will be
00:16:42
ruthless. Lose money for the firm and I
00:16:44
will be understanding. Lose a shred of
00:16:46
reputation for the firm and I will be
00:16:48
ruthless. What a great quote. And if
00:16:50
this all sounds a little foreign to you,
00:16:52
make sure you go listen to episode 102
00:16:54
of Personal Finance for Long-Term
00:16:55
Investors, where we talk all about the
00:16:57
national debt and the Treasury. Now,
00:16:59
back to Bob's main question. What is up
00:17:01
with treasuries and CD rates and high
00:17:04
yield savings accounts? Why do they have
00:17:05
different interest rates in the first
00:17:07
place? Well, for some background
00:17:08
listeners, all three of these places,
00:17:10
treasuries, CDs, and high yield savings
00:17:12
accounts are good place to put your
00:17:13
money for the short term, right? For
00:17:15
near-term needs, they're places to put
00:17:17
cash that you will earn interest on.
00:17:19
Hopefully, you're earning about as good
00:17:20
of an interest rate as you can in the
00:17:22
current environment. And the interest
00:17:24
rate that you earn does have some sort
00:17:26
of a direct connection to the prevailing
00:17:28
interest rates at the time, the
00:17:29
so-called gravity that pulls on all
00:17:31
financial instruments. Now, CDs will
00:17:34
generally lock up your cash for a
00:17:35
predetermined period of time, a few
00:17:37
months, a year, a couple years, and in
00:17:39
response, you will get a promised
00:17:41
interest rate on that CD. You'll also
00:17:43
get FDI insurance on that CD, which is
00:17:46
nice. and you need to tap into the CD
00:17:48
before the predetermined period is over.
00:17:50
So that's kind of breaking your end of
00:17:52
the bargain. The bank in question will
00:17:54
typically claw back any of the interest
00:17:56
that you otherwise would have earned. So
00:17:58
in this way, a CD should be thought of
00:18:00
as relatively illquid. I mean
00:18:01
technically you can go get your
00:18:03
principal back, but if you want to get
00:18:05
any interest on the instrument, then you
00:18:07
should think of it as an illlquid
00:18:08
instrument. High yield savings accounts,
00:18:10
on the other hand, are very liquid and
00:18:12
short-term treasuries, aka treasury
00:18:13
notes, are also very liquid. And so for
00:18:16
this reason, in theory, over time, you
00:18:18
would see that the average CD rate would
00:18:20
be higher than treasury rates, right?
00:18:22
Because it's an illquid way to get
00:18:25
interest on your cash, CDs generally
00:18:27
have to pay a little bit more than
00:18:29
treasury rates or savings accounts. Not
00:18:31
to mention, CDs issued by a bank have
00:18:33
more risk than a treasury. Full stop.
00:18:35
While the principle of the CD is FDIC
00:18:37
insured, the interest is not insured.
00:18:40
Banks can go out of business or reneg on
00:18:42
their promises. So, we need a little bit
00:18:44
of extra reward for taking on that bank
00:18:46
risk. However, there is another side to
00:18:48
the situation. Treasury rates can and do
00:18:51
move faster than CD rates. As we've seen
00:18:54
over mainly 2022 and 2023, but really
00:18:56
these most recent years, the Treasury
00:18:58
rates can change by multiple percentage
00:19:01
points over a short period of time. And
00:19:03
now, that affects obviously the interest
00:19:05
that we're earning on treasuries. That
00:19:07
also very directly affects the interest
00:19:08
that we're earning on a high yield
00:19:10
savings account because you can kind of
00:19:11
think of that as this overnight savings
00:19:13
account, right? That you can tap into it
00:19:15
at any time. But a good question to ask
00:19:17
ourselves right now is how does a bank
00:19:19
set its CD interest rates? And the
00:19:22
answer is it's not just based on
00:19:24
prevailing treasury rates, but it's more
00:19:27
so based on the bank's own book of
00:19:29
loans, right? Both old loans that it's
00:19:31
made and future loans that it will make.
00:19:33
The business of banking is mostly about
00:19:36
offsetting loans and deposits at
00:19:38
different interest rates with the bank
00:19:40
collecting the difference as its own
00:19:41
revenue. If the bank can borrow at 2%
00:19:44
and that's the 2% that they pay you that
00:19:47
you might be earning in your CD, right?
00:19:49
To the bank it's borrowing to you it's
00:19:50
just depositing. The bank is borrowing
00:19:53
from you at a 2% interest rate, let's
00:19:55
say, but then they're lending a mortgage
00:19:57
maybe at 6%. And that difference between
00:20:00
6% and 2%, that 4% difference, that is
00:20:03
the bank's revenue. Now, what do we know
00:20:05
about the old bank loans right now?
00:20:08
Well, we know that many of them were
00:20:09
made in 2022 and 2021 and 2020 and
00:20:12
earlier, and those loans might have been
00:20:14
made at a 2 or 3 or 4% rate. And so, if
00:20:17
a bank has a bunch of three and 4% loans
00:20:20
on its book right now, then they can't
00:20:22
give you a CD for 4.5%. They'd be losing
00:20:25
money. The way they make their revenue
00:20:27
is by that spread in between interest
00:20:29
rates. So if all their loans are at 3
00:20:31
and 4%, there's no way they can give you
00:20:33
a CD at four or four and a half. So
00:20:35
anyway, Bob, I think that's the answer
00:20:37
to your question and I hope that helps.
00:20:39
Here's a quick ad and then we'll get
00:20:41
back to the show. Did you know my
00:20:43
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00:20:45
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00:20:48
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00:20:50
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00:20:51
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00:20:54
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00:20:56
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00:21:01
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00:21:03
bestinterest.blog. Again, the web
00:21:04
address is
00:21:07
bestinterest.blog. Check it out. Okay.
00:21:09
Question three from Andy about a
00:21:11
tax-free retirement. Jesse, I was
00:21:13
wondering if you've ever done a blog
00:21:14
article or podcast on the topic of zero
00:21:17
tax retirement, implementing life
00:21:19
insurance strategies. This is covered in
00:21:20
books like tax-free income for life and
00:21:23
the power of zero. If not, I think it
00:21:25
would make for a great topic for you to
00:21:27
discuss at some point. Thank you, Andy.
00:21:29
And good idea. We answered a question in
00:21:31
episode 99 about buy, borrow, die, which
00:21:34
isn't quite the same as using life
00:21:36
insurance to live a tax-free retirement,
00:21:38
but it smacks of the same general idea,
00:21:41
which is that, you know, some people out
00:21:42
there, whether right or wrong, think to
00:21:44
themselves, taxes are evil, and I'm
00:21:46
going to do whatever I can to avoid
00:21:48
them. Now, personally, I disagree with
00:21:50
that idea. It's not that I love taxes. I
00:21:52
don't love taxes. I'm not going to go
00:21:54
out of my way to pay more than my fair
00:21:56
share of taxes. But I'll call upon a
00:21:58
wonderful financial planning metaphor.
00:22:00
And it's this question. Would you rather
00:22:02
have 50% of a watermelon or 100% of a
00:22:06
grape? Meaning, in some financial
00:22:08
planning scenarios, they can promise you
00:22:10
zero taxes and you're going to get to
00:22:12
keep 100% of your money, but your money
00:22:15
is going to be the size of a grape.
00:22:17
Whereas in an alternative financial
00:22:18
planning scenario, it might cause a
00:22:20
bunch of taxes, but your starting
00:22:22
portfolio is going to be a watermelon.
00:22:24
And so even if you only get to keep 50%
00:22:27
of your watermelon, cuz the other 50% is
00:22:29
going to taxes, you still have half a
00:22:31
watermelon. And for those of you who are
00:22:33
unfamiliar with fruit, watermelons are
00:22:35
much bigger than grapes. So I'd rather
00:22:37
have 50% of a watermelon than 100% of a
00:22:40
grape. And that's why a lot of the times
00:22:42
when I read these things about total tax
00:22:44
avoidance or the evil of taxes and and
00:22:47
avoid them at all possible costs,
00:22:49
usually there's some of that going on
00:22:51
behind the curtain that they don't want
00:22:52
you to see is that they're taking your
00:22:55
watermelon and turning it into a grape.
00:22:57
And that's how they're avoiding taxes or
00:22:59
that's one of the consequences of their
00:23:00
choices of how they want to avoid taxes.
00:23:02
So when it comes to using life insurance
00:23:04
to avoid taxes, there there are two
00:23:06
overarching things that I start with. 99
00:23:09
times out of 100 or even more, this
00:23:12
particular idea is used as a sales
00:23:14
pitch, not as an educational lesson. And
00:23:16
then the second thing is when the idea
00:23:19
does actually make sense for someone,
00:23:21
it's almost always because the family is
00:23:23
over the federal estate tax limit, which
00:23:26
is currently $28 million for a married
00:23:28
couple. Because the taxes in that
00:23:30
scenario can be as high as 40 cents on
00:23:32
the dollar. Even with the bloated costs
00:23:34
that I'm about to describe in this
00:23:36
answer, it can make sense for someone in
00:23:38
these federal estate tax planning
00:23:40
conversations. I'll describe that more
00:23:42
in a minute. The core idea behind this
00:23:45
use life insurance to avoid taxes scheme
00:23:48
is that permanent, not term life
00:23:50
insurance, but permanent life insurance
00:23:52
policies such as whole life or indexed
00:23:54
universal life offer tax deferred growth
00:23:56
and tax-free access to the cash value
00:23:59
through a loan provided by the policy.
00:24:01
Now, proponents would argue that this
00:24:04
approach can provide a taxefficient
00:24:06
income stream. And I'm kind of using
00:24:07
some air quotes here in in the studio,
00:24:09
as it were, a taxefficient income
00:24:11
stream, sideststepping some of the tax
00:24:14
burdens associated with traditional
00:24:15
retirement accounts. However, while
00:24:17
these strategies can appear attractive
00:24:19
on the surface and can certainly be sold
00:24:22
in a very attractive way, a closer
00:24:24
examination, and by that I mean like
00:24:25
actually looking at the math, reveals
00:24:28
several drawbacks that will make them
00:24:29
suboptimal for most investors. So, the
00:24:32
basics of the strategy works as follows.
00:24:34
An individual purchases a permanent life
00:24:36
insurance policy and funds it with
00:24:38
pretty significant premiums over time,
00:24:40
often exceeding the required amount to
00:24:42
sustain the death benefit of the policy.
00:24:44
Those excess contributions build up as
00:24:46
cash value which can grow tax deferred
00:24:49
based on the way the policy is written.
00:24:51
And then upon reaching retirement, the
00:24:53
policy holder can access the cash value
00:24:56
through policy loans rather than taking
00:24:58
traditional withdrawals like they might
00:25:00
out of a an IRA or a taxable account.
00:25:03
And because life insurance loans are not
00:25:05
considered taxable events, the
00:25:07
individual can access their funds
00:25:08
taxfree. Additionally, if structured
00:25:11
properly, the death benefit can pay off
00:25:13
any of the outstanding loans, ensuring
00:25:15
the borrowed money is never taxed.
00:25:17
However, this strategy does fall short.
00:25:20
I mean, everything I just described
00:25:21
sounds great. You'll notice I didn't
00:25:23
exactly talk about how quickly the
00:25:24
policy was growing, and we'll come back
00:25:26
to that. Here are the reasons why the
00:25:27
strategy falls short. The first is just
00:25:29
high cost and fees. Permanent life
00:25:31
insurance policies are very expensive.
00:25:33
Between mortality charges,
00:25:35
administrative fees, investment
00:25:36
expenses, etc. Policy holders often pay
00:25:40
significantly more than they would in a
00:25:41
traditional investment account. These
00:25:43
costs erode their returns making it
00:25:45
difficult for them to achieve the same
00:25:46
level of growth as they would in say
00:25:48
lowcost diversified funds or ETFs. The
00:25:51
second reason why this strategy falls
00:25:53
short is simply lower investment
00:25:55
returns. The investment component of
00:25:57
permanent life insurance policies almost
00:25:59
always drastically underperforms
00:26:01
compared to traditional market
00:26:02
investments. While insurers may promise
00:26:05
stable tax deferred growth and that that
00:26:07
can even they can deliver on that
00:26:09
promise, the reality is that crediting
00:26:11
rate the rate of growth is so low policy
00:26:14
holders miss out on the long-term
00:26:15
appreciation available through direct
00:26:17
stock and bond investments. The third
00:26:20
downside, complexity and restrictions.
00:26:22
Unlike traditional retirement accounts
00:26:24
which offer straightforward rules for
00:26:25
contributions and withdrawals, life
00:26:27
insurance based strategies come with
00:26:29
layers of complexity. Policy holders
00:26:31
must carefully manage funding levels to
00:26:33
avoid creating what's called a modified
00:26:35
endowment contract or mech, which would
00:26:37
trigger tax penalties. Additionally,
00:26:39
borrowing against the policy introduces
00:26:41
risks like failure to repay a loan,
00:26:43
which can lead to a policy lapse, which
00:26:45
can in and of itself trigger an
00:26:47
unexpected tax liability and a loss of
00:26:49
coverage. The point being, it's pretty
00:26:51
complicated. And then simply, the fourth
00:26:54
reason is just that better alternatives
00:26:55
exist. tax efficient investing in a
00:26:57
brokerage account, utilizing a Roth IRA,
00:27:00
strategically withdrawing from a tax
00:27:02
deferred account, timing up your social
00:27:03
security. These things provide superior
00:27:06
outcomes. You know, lowcost index funds
00:27:09
held in a taxable account can be
00:27:10
structured to generate minimal capital
00:27:12
gains taxes. Roth IAS offer truly
00:27:14
taxfree withdrawals without the
00:27:16
constraints of a life insurance policy.
00:27:18
There's simply a better way to solve the
00:27:21
same kind of retirement problem. So,
00:27:23
while using life insurance as a tax
00:27:25
shelter sounds appealing on the surface
00:27:27
because yes, we're avoiding taxes, the
00:27:29
reality is that this strategy is costly,
00:27:31
complex, and generally less effective
00:27:32
than traditional investing approaches.
00:27:34
It is trying to save 100% of your grape
00:27:38
rather than settling for 80% of your
00:27:41
watermelon. It really is like that. the
00:27:43
high fees, subpar investment returns.
00:27:45
It's just an inefficient tool for
00:27:46
retirement planning for most of us, for
00:27:49
almost all of us, unless we have
00:27:50
literally $30 million plus maximizing
00:27:53
contributions to our tax advantage
00:27:55
accounts, maintaining a well-
00:27:56
diversified portfolio, that's going to
00:27:58
result in a more flexible and and
00:27:59
cost-effective retirement strategy. And
00:28:01
if you do have $30 million or more, you
00:28:04
still want to do all those smart things
00:28:06
that we talk about here with your first
00:28:08
$30 million. And it's only with some of
00:28:10
the extra money does it make sense to
00:28:12
try to play around with this whole life
00:28:14
insurance planning. It can play a
00:28:16
strategic role there. Specifically, if
00:28:18
you're facing substantial estate tax
00:28:20
liabilities, you can use this permanent
00:28:23
life insurance to provide liquidity for
00:28:24
your heirs, which avoids the forced sale
00:28:27
of assets to to cover your estate tax
00:28:30
bill. Additionally, for wealthy
00:28:32
individuals who have already maxed out
00:28:33
their other tax advantage savings
00:28:35
vehicles, they can find life insurance
00:28:37
to be a useful supplemental tool for
00:28:40
some tax-free wealth transfer when
00:28:42
structured properly within what's called
00:28:44
an eyelet and a revocable life insurance
00:28:46
trust. The death benefit from the life
00:28:48
insurance policy can be shielded from
00:28:50
estate taxes, ensuring that wealth is
00:28:53
efficiently passed on to future
00:28:54
generations. Right? It's a corner case.
00:28:56
It's not something that almost any of us
00:28:58
have to worry about. It's infrequently
00:29:00
used and sure it can be a worthwhile
00:29:02
tool. I know in some situations where
00:29:04
some of my colleagues have used it as a
00:29:06
tool for our clients. But that said, if
00:29:09
you go search right now, I guarantee you
00:29:11
can find an insurance salesperson
00:29:12
probably on Tik Tok or Instagram who's
00:29:15
going to tell you that this is a
00:29:17
strategy used by the ultra rich. And
00:29:19
obviously the ultra rich know more about
00:29:21
money than you do. So you should use
00:29:23
this strategy, too. Well, isn't that
00:29:25
kind of devious? You know, tax codes are
00:29:27
a function of income and net worth. And
00:29:29
the optimization game that applies to
00:29:31
someone with $50 million is going to be
00:29:33
different than your optimization game.
00:29:35
It's going to be different than mine.
00:29:36
Unless you also happen to have $50
00:29:38
million, in which case I'd say, you
00:29:39
know, go talk to a trusted financial
00:29:41
planner about the kind of things that
00:29:43
I'm talking about here. Andy, thank you
00:29:45
for that question. And now going on to
00:29:47
question number four from Casey, who
00:29:49
asks, "Jesse, I'm planning to retire in
00:29:51
about a year at age 50."
00:29:52
Congratulations, Casey. with a military
00:29:54
pension and a sizable investment
00:29:56
portfolio, which when combined with my
00:29:58
pension should sustain our spending
00:30:00
needs throughout retirement. So, let's
00:30:01
assume I'm needing to withdraw about
00:30:03
$50,000 a year from my taxable brokerage
00:30:06
account, but I'm also considering
00:30:07
someday having a part-time job just for
00:30:09
fun. And let's assume that job might pay
00:30:11
me 25 grand a year. So, my question is,
00:30:14
which is better? Should I use the 25
00:30:16
grand a year from my part-time job to
00:30:18
meet some of my spending needs, thus
00:30:20
decreasing the amount I need to withdraw
00:30:21
from my taxable brokerage account to
00:30:23
only
00:30:24
$25,000? Or do I invest the 25K from my
00:30:28
part-time job, say into my and my wife's
00:30:30
IAS or 401k, while continuing to
00:30:33
withdraw the full $50,000 a year from
00:30:36
the taxable brokerage account? I hope it
00:30:37
makes sense. Although these numbers are
00:30:39
hypothetical, they reflect something
00:30:40
fairly close to reality. So, thank you
00:30:43
for the question, Casey. And listeners,
00:30:44
in case that question doesn't make sense
00:30:46
to you, here at the brass tax, Casey
00:30:48
needs $50,000 a year in retirement, and
00:30:50
he's planning to work part-time. So, on
00:30:52
the one hand, he could use all of his
00:30:53
earned income from work from his
00:30:55
part-time job, and he could apply all of
00:30:57
that income towards his $50,000 a year
00:31:00
need more money inside his investment
00:31:03
portfolio. Or Casey could use the income
00:31:06
from his job and maybe invest it in a
00:31:09
401k, thus taking advantage of things
00:31:11
like an employer match, taking advantage
00:31:13
of some tax deferred growth. But that
00:31:15
would mean that he'd need to tap into
00:31:17
his portfolio more, potentially
00:31:18
realizing capital gains and something
00:31:20
like that. And his question is, is one
00:31:22
of those better than the other? Well,
00:31:24
first thing first, Casey, if I knew all
00:31:26
the numbers, and and you do know all the
00:31:28
numbers, I know that the numbers will
00:31:30
guide you to a correct answer. If we
00:31:31
have all the numbers in front of us, we
00:31:33
can optimize this problem and find the
00:31:35
right answer for you. But without
00:31:37
knowing more of the specifics, I do feel
00:31:39
comfortable saying that I would bet the
00:31:42
option where you use your income to fund
00:31:44
the 401k and the IAS, I would bet that's
00:31:47
probably the better option. Now, first
00:31:48
off, we have to say, okay, why is that?
00:31:50
Well, first, if your 401k has an
00:31:52
employer match, it's pretty close to a
00:31:53
no-brainer. A dollar for-doll match is
00:31:56
the equivalent of an instantaneous 100%
00:31:58
investment return. You know, we've all
00:32:00
heard that stocks can provide, you know,
00:32:02
10% per year over a long period of time,
00:32:04
and we really like that. Well, if you
00:32:06
like 10% per year, you're going to love
00:32:08
earning 100% instantaneously. Even if
00:32:10
it's not a a dollar for-dollar match, I
00:32:12
still like the idea of getting a 50%
00:32:14
match or a 33% match instantaneously.
00:32:17
Sounds great. But let's say that Casey
00:32:19
doesn't get an employer match. What
00:32:21
then? Well, all else being equal, then
00:32:23
I'd rather be playing in the capital
00:32:25
gains tax bracket than paying income
00:32:28
taxes. Now, what do I mean by that? As
00:32:30
Casey puts more and more of his money
00:32:32
into 401ks or IAS, he will be paying
00:32:36
less and less in the income tax bracket,
00:32:39
at least in the current years, right?
00:32:40
He's deferring income taxes way out into
00:32:42
the future years. He's not playing in
00:32:44
income taxes right now. And at the same
00:32:46
time, we know that if he's putting more
00:32:48
of his money into his 401k, then he's
00:32:50
going to be pulling on his portfolio
00:32:51
more. And since he told us that he's 50,
00:32:53
I'm very comfortable assuming that he's
00:32:55
going to be pulling on his taxable
00:32:57
brokerage account, which means that
00:32:58
he'll likely realize some capital gains
00:33:00
taxes and and be subject to the capital
00:33:02
gains tax bracket. At all levels, income
00:33:06
taxes are higher than capital gains
00:33:08
taxes. And at most levels by 12 or 15 or
00:33:11
even 20%. Meaning at a particular income
00:33:15
or distribution level, a dollar of
00:33:17
capital gains might get taxed at 15
00:33:19
cents on the dollar where that same
00:33:21
dollar of income gets taxed at 35 cents
00:33:23
on the dollar. Or a dollar of capital
00:33:25
gains might not get taxed at all,
00:33:27
whereas that same dollar of income gets
00:33:29
taxed at 12 cents. This is why I'd
00:33:32
rather be in the capital gains tax
00:33:34
bracket and I'd rather not be in the
00:33:36
income tax bracket. And that's why
00:33:38
whatever Casey can do to eliminate
00:33:40
income taxes right now is probably a
00:33:42
reasonable thing to do. And whatever he
00:33:44
can do to realize capital gains, say at
00:33:46
the 0% level, is a really smart thing to
00:33:49
do. But that said, I can also think of
00:33:51
some cons to my plan, Casey. And that's
00:33:53
why I do think it's really important for
00:33:55
you to either yourself or with a trusted
00:33:58
planner crunch some of these numbers.
00:34:00
Now, here are the cons to the idea,
00:34:01
Casey. Now, the main con is quite
00:34:04
long-term, but it's worth considering.
00:34:06
any of you listening right now, what
00:34:08
happens if you die with a whole bunch of
00:34:09
unrealized capital gains? Do you get
00:34:11
taxed on them? The answer is no. Someone
00:34:14
is going to inherit those assets from
00:34:15
you at a stepped up cost basis,
00:34:17
effectively wiping out any capital gains
00:34:19
taxes. So, one could ask, why is Jesse
00:34:22
suggesting that Casey realize capital
00:34:24
gains now, perhaps at 15% when that
00:34:27
number would eventually be 0% when Casey
00:34:29
dies? Now, the reason why is because
00:34:30
Casey's 50 and uh he might not die for
00:34:33
30 or 40 or 50 more years. And the idea
00:34:36
that he's never going to realize a
00:34:38
capital gain from now until he dies to
00:34:40
me is a little bit unrealistic. But
00:34:41
still, it is worth asking that question.
00:34:43
Why realize capital gains at 15% now
00:34:46
when that number might be 0% when Casey
00:34:49
dies? Now, on the other side of the
00:34:50
coin, part of my current suggestion,
00:34:52
Casey, is that you utilize your IRA or
00:34:54
your 401k and defer income taxes into
00:34:56
the future. However, you cannot defer
00:34:59
them forever. Eventually, RMDs will be
00:35:01
forced on you, and that injects this
00:35:03
taxable income into your life. Now, you
00:35:06
can always use RMDs to donate to charity
00:35:07
to avoid that tax, but it also means
00:35:09
that you're not actually personally
00:35:10
benefiting from the IRA assets, and
00:35:12
that's kind of the whole point of this
00:35:14
idea. You're giving them away. You're
00:35:15
giving away the assets, and you could
00:35:16
die with the IRA, Casey, but then
00:35:19
whoever inherits the IRA, at least under
00:35:21
current rules, will have 10 years to
00:35:23
distribute the IRA and pay income taxes
00:35:25
on it. In other words, the tax burden
00:35:27
will be there for you, Casey, or for
00:35:30
your descendants. The income tax burden
00:35:32
from the IRA or the 401k rollover, the
00:35:34
inherited IRA, that tax burden is never
00:35:36
going to go away. So, as I'm speaking
00:35:38
these words and noodling on the idea a
00:35:40
little bit more, Casey, I just I come
00:35:42
back to this idea that it's worth
00:35:43
crunching some of these numbers in a
00:35:44
more hardcore fashion than what I've
00:35:46
done right here. My gut instinct tells
00:35:48
me by the nature of your question alone
00:35:50
that you're going to be just fine no
00:35:51
matter which path you take. This really
00:35:53
isn't a whether you can retire question.
00:35:55
It's simply a retirement optimization
00:35:57
question, but applying some hard numbers
00:35:59
to the pros and the cons that I just
00:36:01
described is going to shine a lot of
00:36:02
light and is certainly going to
00:36:04
illuminate the better of the two paths
00:36:05
for you, Casey. All right, question five
00:36:08
from Chris, a federal government worker.
00:36:11
I'm going to consolidate your question a
00:36:12
little bit, Chris. I do appreciate that
00:36:14
you started out saying that you're a
00:36:16
huge fan of the podcast. You're really
00:36:18
excited to see what's next for us in the
00:36:19
show after our rebrand. So, thank you
00:36:21
very much. And Chris, yeah, sorry to
00:36:23
hear of all the back and forth and
00:36:25
challenging directives that you're
00:36:26
getting as a federal government employee
00:36:28
right now. Chris has a three-part
00:36:30
question and it really comes down to
00:36:31
this. What should Chris do with his
00:36:33
pension? Because one of Chris's options
00:36:35
right now is that he can leave the
00:36:36
federal government and either take a
00:36:37
lump sum from his pension or he can take
00:36:39
a deferred annuity. So that's part one
00:36:41
of his question is should he take a lump
00:36:43
sum, should he take a deferred annuity?
00:36:44
How does he think about that problem?
00:36:46
Chris's second question has to do with
00:36:47
rebalancing investments inside his
00:36:49
Thrift Savings Plan. That's kind of
00:36:51
similar to a 401k but for federal
00:36:53
employees. And if Chris's pension, if
00:36:55
his federal pension goes away or or is
00:36:58
is reduced in some way, should he
00:36:59
somehow rebalance or look at his TSP,
00:37:02
his thrift savings plan investments a
00:37:04
little bit differently. And then the
00:37:05
third part of Chris's question has to do
00:37:07
with preparing for a career change or a
00:37:08
possible career change because that's
00:37:09
something I went through and he's
00:37:11
curious to hear my thoughts on that. So
00:37:12
Chris, let's take it one at a time.
00:37:14
These are really hard questions. I don't
00:37:16
blame you for wondering what the heck to
00:37:18
make of these situations. First on the
00:37:20
pension question, the place where I
00:37:21
would start is roughly trying to
00:37:23
understand what's called the internal
00:37:24
rate of return or IRR of the proposed
00:37:27
annuity plan put in front of you. Now
00:37:29
what does that mean? Well, all annuities
00:37:31
come with a similar structure. You put
00:37:33
down a big lump sum of money today or
00:37:35
you sacrifice some sort of big lump sum
00:37:37
of money today and then usually you wait
00:37:40
a few years. Not always, but usually.
00:37:42
And then after that wait, you'll start
00:37:44
getting money back. someone will start,
00:37:46
you know, whoever the opposite side of
00:37:47
the annuity is, they'll start to pay you
00:37:49
that money back. So the question is, how
00:37:51
do we account for that waiting period,
00:37:53
right? Because if the annuity is, for
00:37:54
example, going to pay me 7% of the
00:37:56
lumpsum per year guaranteed, that sounds
00:37:59
pretty good. But is that the same thing
00:38:01
as getting a true 7%, you know, rate of
00:38:04
return, a 7% ROI? And the answer is no.
00:38:06
It's not the same. Now, some of you
00:38:08
might recognize what I'm about to
00:38:09
describe from our AMA in episode 86, but
00:38:12
it's worth rehashing here. So imagine
00:38:14
this annuity. I give you a million
00:38:16
dollars today and then I wait 10 years
00:38:18
and then 10 years from now you start
00:38:20
paying me $10,000 a month for the
00:38:23
following 50 years. What's my return on
00:38:26
investment? And for what it's worth,
00:38:27
this is a very typical type of promised
00:38:29
return for an annuity. Well, if we go to
00:38:32
Microsoft Excel, our trusty spreadsheet,
00:38:34
and we use the IRRa function, we can
00:38:36
easily solve this problem. You might be
00:38:37
thinking, well, that's pretty easy to do
00:38:39
in my head. $10,000 a month on a $1
00:38:41
million investment. $10,000 a month,
00:38:44
that's $120,000 a year. 120,000 divided
00:38:47
by a million, that's easy. It's a 12%
00:38:49
annual return. But while true, that
00:38:52
annual return only kicks in after 10
00:38:54
years. And meanwhile, our million is
00:38:57
locked up for those first 10 years. So
00:38:59
it takes 9 years of $120,000 payments to
00:39:03
get our million back. That math is
00:39:05
pretty easy. But that's after 10 years
00:39:07
of nothing. So in other words, if you do
00:39:09
the math, your IRRa is actually negative
00:39:12
for the first 18 years, right? It takes
00:39:14
19 years for us to get all of our money
00:39:16
back. Meaning for the first 18 years, we
00:39:19
haven't actually achieved any sort of
00:39:20
positive return on investment. And then
00:39:23
if we keep going, we see that after
00:39:24
roughly 25 total years, so that's 10
00:39:26
years of waiting plus 15 years of
00:39:28
payment. At that point, our IRRa is 3.6%
00:39:32
per year. So it's an annualized return.
00:39:34
After 40 years, our IRRa ends up being
00:39:36
about 5.9%. And if I go out to infinity,
00:39:40
our IRRa reaches a limit at 6.7% per
00:39:43
year. So, just to be clear, this was a
00:39:46
an investment. This annuity, if you
00:39:47
will, is an investment that is illquid,
00:39:50
at least for the first 10 years. It has
00:39:52
a negative rate of return for the first
00:39:54
18 years of its life. And if I literally
00:39:56
held it forever, it would max out at a
00:39:58
6.7% annualized rate of return.
00:40:00
Personally, that's not an annuity I'm
00:40:02
interested in. And Chris, I would ask
00:40:04
yourself what your proposed IRRa is for
00:40:06
this deferred annuity that the federal
00:40:09
government is offering you. And I'd
00:40:10
compare it to other investment options
00:40:12
out there. Take into account the risk of
00:40:13
outside investments, right? Stocks,
00:40:15
bonds, real estate, whatever comes with
00:40:16
risk against the risk of the US
00:40:18
government's pension fund running out of
00:40:19
money or laws changing dramatically.
00:40:22
Now, what are the risks of the pension
00:40:24
fund running out of money based on the
00:40:26
current state of the pension fund? It's
00:40:27
a relatively low risk, but then what are
00:40:30
the risks of laws changing dramatically
00:40:32
or World War II starting or some angsty
00:40:34
teenage demigod playing the simulation
00:40:36
of reality on their PlayStation 10
00:40:38
deciding to start the game over? Well,
00:40:40
those are all questions that I don't
00:40:41
have the answer to. And I understand
00:40:42
that's part of the frustration right
00:40:44
now. It's not only that I don't have the
00:40:45
answers, but really that nobody seems to
00:40:47
have the answers. And part of the
00:40:48
problem with uncertainty and why it's so
00:40:50
hard to deal with is that nobody knows
00:40:52
what's next. So then, where do we fall
00:40:54
back to after that? Well, first I
00:40:55
recommend we control what we can
00:40:57
control. When you bring up your TSP
00:40:59
account, Chris, and again, that's the
00:41:01
federal workers equivalent of a 401k. I
00:41:03
think we have a couple great questions
00:41:04
to answer. You know, if your pension or
00:41:06
annuity disappeared today, what would
00:41:08
you do with your TSP? If all the
00:41:10
uncertainty disappeared today and you
00:41:12
knew your pension and annuity would be
00:41:14
exactly as promised, what would you do
00:41:16
with your TSP then? Well, since we don't
00:41:18
know the future, should we assign some
00:41:20
maybe 50/50 probability, black or white,
00:41:22
to the idea that your pension and
00:41:24
annuity might disappear completely or
00:41:26
that it might be 100% intact, opposite
00:41:28
ends of the spectrum? Is it truly 50/50
00:41:30
that way? Is it a different probability?
00:41:32
Now, depending on your answers there and
00:41:34
and what you feel like the gray area
00:41:36
looks like between those black and white
00:41:37
ends of the spectrum, should we allocate
00:41:40
your TSP somewhere in the middle
00:41:42
accounting for the fact that we don't
00:41:43
know how your pension fits in? We know
00:41:45
for a fact that the TSP allocation won't
00:41:47
be perfect in that case, right? We'll be
00:41:49
hedging our bets. We're hedging our bets
00:41:50
between two possible futures. How does
00:41:53
your personal financial plan work,
00:41:54
Chris, at both those bookends at the
00:41:57
white and the black book end, but also
00:41:59
in the middle? Obviously, I would expect
00:42:01
everything to work a lot better with a
00:42:03
guaranteed stream of future income from
00:42:04
your pension or annuity. But does your
00:42:06
life still work out at the other end of
00:42:08
the spectrum without that annuity? Now,
00:42:10
it's probably the the engineer in me,
00:42:12
but I want to bound this problem. I want
00:42:14
to define the ceiling the best case. I
00:42:16
want to define the floor the worst case.
00:42:17
Where are the limits to this problem?
00:42:19
And then where are the likely spots in
00:42:20
between that floor and ceiling where you
00:42:22
might end up Chris? Then we have to ask
00:42:24
ourselves in the system or in this case
00:42:26
your financial plan. How does the system
00:42:28
how does the plan operate at those
00:42:30
various points? The floor, the ceiling
00:42:31
and in between. And speaking of that
00:42:33
floor and ceiling analysis, it's a good
00:42:35
time to transition to the career change
00:42:36
question, Chris, because that analysis
00:42:38
of thinking about the floor and ceiling
00:42:40
played a pivotal role in my career
00:42:41
change. So, I'm going to read an
00:42:43
article. I'll link it in the show notes.
00:42:44
I wrote in February 22 titled career
00:42:47
change, is it risky? So, when I wrote
00:42:49
this, I was speaking to friend of the
00:42:51
blog, Michael, and he said, Jesse, your
00:42:53
career change, it really seems like a
00:42:55
huge risk, right? And man, what a
00:42:57
question. I wanted to give Michael a
00:42:58
smart answer, and I paused for a second,
00:42:59
and I kind of thought, well, what
00:43:01
exactly is risk in this context? I bet
00:43:04
you all listening have a gut feeling for
00:43:05
risk. You certainly know it when you see
00:43:07
it or you know it when you feel it. And
00:43:08
on its face, any big decision must
00:43:10
inherently be risky, right? I mean,
00:43:12
otherwise it wouldn't really be a big
00:43:13
decision. And for me, after five years,
00:43:16
five and a half years of engineering
00:43:17
school, seven years in the engineering
00:43:19
industry, switching careers must have
00:43:21
been risky, right? Well, risk is also an
00:43:24
important investing topic. We deal with
00:43:26
plenty of risks in our everyday lives.
00:43:28
But how do I personally define risk? And
00:43:29
how does that definition apply to
00:43:31
Michael's question about my career
00:43:32
change? Is career change a huge risk or
00:43:35
is it not even risky at all? So let's
00:43:37
discuss this idea of risk, its various
00:43:38
definitions, and what you can do to live
00:43:40
with some risk in your life. We start
00:43:42
with Warren Buffett, one of my heroes.
00:43:44
Been listening to a lot of Berkshire
00:43:46
Hathway shareholders meetings while I
00:43:47
exercise. Why have pump-up music when
00:43:49
you can learn from Warren and Charlie?
00:43:51
And now I love the answer that Warren
00:43:53
gives in the 1994 shareholders meeting.
00:43:56
There's a video, I play this video in
00:43:58
the article in the linked show notes, so
00:44:00
you can go listen to that. And if for
00:44:02
some reason the link doesn't work, it
00:44:03
starts at uh the time stamp 1 hour 43
00:44:05
minutes and 40 seconds. It's about a
00:44:07
5-minute clip and I'm not going to play
00:44:08
it all here, but there are three
00:44:10
important highlights from Warren
00:44:11
Buffett. The first one, risk is the
00:44:13
probability of permanent harm or injury.
00:44:16
The second one, risk is inextricably
00:44:18
wound up in your time horizon. And the
00:44:21
third, risk is not the same as
00:44:23
volatility. So let's apply all three of
00:44:25
these points to answer Michael's
00:44:26
questions about my career and then we'll
00:44:28
explore some risk in investing. So is my
00:44:30
career change risky? Well, let's go
00:44:32
through Warren Buffett's definitions.
00:44:33
Could I permanently harm or injure
00:44:35
myself or my career with a career
00:44:37
change? Now, for me, I didn't think so.
00:44:40
As I saw it, the worst case was that
00:44:42
after 2 years working in wealth
00:44:44
management, I would not be doing well,
00:44:45
and I would scurry back to engineering
00:44:47
with my tail between my legs. And if I'm
00:44:49
being honest, I'd probably get something
00:44:50
like a 30% pay bump over my prior
00:44:53
engineering salary because that's how
00:44:54
hot the engineering job market is.
00:44:56
leaving and returning to the same
00:44:58
company is a tried andrue income
00:45:00
boosting strategy. And that was the
00:45:01
worst case. And it's really not that
00:45:03
bad. And in my opinion, the probability
00:45:05
of it occurring is low. And the best
00:45:07
case was that I love my new job. I'd be
00:45:09
pursuing my passion. And I might even
00:45:10
earn more money in my new career than my
00:45:12
old one. And I think the probabilities
00:45:14
of those three things occurring were
00:45:15
quite high. It turns out here we are 3
00:45:18
years and 3 months in as I'm recording
00:45:20
this. And pretty much that's point for
00:45:22
point exactly how things ended up going.
00:45:24
So I'm very happy about that. But yeah,
00:45:26
the idea, could I permanently harm or
00:45:27
injure myself? I didn't really think so.
00:45:29
And in fact, I thought I was uh much
00:45:31
more likely to do well. And so far,
00:45:33
that's exactly what's going on. Now, the
00:45:35
next of Warren's points, risk is
00:45:37
inextricably wound up in your time
00:45:39
horizon. Well, what's my time horizon?
00:45:41
While there are short-term repercussions
00:45:42
to my career change, I gave them a
00:45:44
pretty small waiting. Instead, I was
00:45:46
thinking long term, and I felt like I
00:45:47
could do some pretty cool things over a
00:45:49
long time horizon. I was hedging my
00:45:50
short-term risk by ensuring that all my
00:45:52
finances were in order and that my new
00:45:54
career could sustain me in the short
00:45:55
run. I knew I was safe. And then on the
00:45:58
flip side, I thought to myself, well, is
00:46:00
there a long-term risk to me staying at
00:46:02
my old job for the next 20 years? And my
00:46:04
answer was absolutely. The risk is that
00:46:06
I would permanently wound my quality of
00:46:08
life by not really enjoying about 50% of
00:46:11
my waking hours. I was comfortable, but
00:46:13
a little numb. That's a little bit of a
00:46:15
Pink Floyd joke, and that's a risk. And
00:46:17
now, in my opinion, the career change
00:46:19
drastically decreased that long-term
00:46:21
risk. And then the last of Warren
00:46:23
Buffett's uh definitions, risk is not
00:46:25
volatility. Did my career change cause a
00:46:28
short-term shakeup in my life?
00:46:29
Absolutely it did. That's volatility,
00:46:31
but it's not risk. Cuz I didn't. I had
00:46:33
to buy a new wardrobe. And uh if I'm
00:46:35
being honest with you, my first take at
00:46:36
buying my wardrobe probably wasn't good
00:46:38
enough. And quickly, I had to upgrade
00:46:40
that wardrobe again. My day-to-day skill
00:46:42
sets at this job are completely
00:46:44
different than my old job. my commute
00:46:46
increased from, you know, 5 minutes a
00:46:48
day to 15 minutes a day. And there are
00:46:50
plenty more tiny things uh that were
00:46:52
volatile in the short run. And for what
00:46:54
it's worth, this career probably just
00:46:56
has been more volatile in and of itself.
00:46:58
An engineer's work life is fairly
00:47:00
stable. It's flat. It's predictable. And
00:47:03
this work as a financial planner. It's
00:47:05
had more successes. It's had more
00:47:06
failures. It's had a little bit more
00:47:08
randomness. And again, so that's
00:47:10
volatile for sure, but that's not the
00:47:12
same as risk. In summary, my career
00:47:14
change had downsides, both real and
00:47:16
potential. No doubt about it. There were
00:47:18
some risks involved, but I think they
00:47:20
were all small risks. And more
00:47:22
importantly, I thought that the
00:47:23
magnitude of the upside and the
00:47:25
probability of that upside far
00:47:27
outweighed the downside risks. The
00:47:29
scales, in other words, were tipped in
00:47:30
my favor. And just like a Warren
00:47:32
Buffett's coin flip from the video I
00:47:34
linked above where he has seven to five
00:47:35
odds in his favor, that's a wager that
00:47:37
you would take every single time. Now,
00:47:40
the rest of the article talks about risk
00:47:42
in investing. That's something we talk a
00:47:43
lot a lot here. So, I'm going to let you
00:47:45
read that if you're curious and instead
00:47:47
we're going to go on to question number
00:47:49
six. But thank you, Chris, for that
00:47:50
great question number five. I hope
00:47:52
things are working out for you uh as a
00:47:54
government employer. Write me back. Let
00:47:55
me know how things are going. Here's a
00:47:57
quick ad and then we'll get back to the
00:47:59
show. A few of you occasionally inquire
00:48:02
about two different topics that are
00:48:04
actually related. The first type of
00:48:06
question seeks out details about my
00:48:07
professional life and the wealth
00:48:09
management firm that I work for here in
00:48:11
Rochester, New York. The second type of
00:48:13
question involves the best interest,
00:48:14
which operates with no advertising, no
00:48:16
pushy sales, no pay walls. And the
00:48:19
question is, how can the best interest
00:48:20
stay afloat? Well, to answer both of
00:48:23
those questions, I want to point you to
00:48:25
episode 78 of the Best Interest podcast.
00:48:28
I intentionally recorded episode 78 to
00:48:31
shine light on those topics and inform
00:48:33
you how you can actually help the best
00:48:35
interest if you're so inclined. So if
00:48:38
you've ever been curious about the
00:48:40
business of the best interest, please go
00:48:42
listen or download episode 78 and let me
00:48:45
know what you think. Question number six
00:48:47
from Rachel. Rachel asks a great
00:48:49
question about bonds versus bond funds.
00:48:51
Rachel is 59 years old and she started
00:48:53
to transition from work life where she's
00:48:55
living on a salary and saving some money
00:48:57
to now living on a mix of income and
00:49:00
investments, retirement income. Her
00:49:02
portfolio is 70% stocks, 20% of which is
00:49:05
international and 30% bonds. However,
00:49:08
because she values simplicity, the bond
00:49:09
portion consists of a Vanguard bond
00:49:12
index funds, mostly US total bond
00:49:14
market. But her understanding is that
00:49:16
because the price of a bond fund
00:49:18
fluctuates, they don't preserve your
00:49:20
principal in the same way that owning a
00:49:22
bond outright and holding it to maturity
00:49:24
does. Right now, Rachel's bond funds are
00:49:26
down significantly, and she's imagining
00:49:28
how painful it would be if she had to
00:49:29
sell them now to fund her retirement.
00:49:31
Even if she could contemplate creating a
00:49:33
bond ladder or some other way of owning
00:49:34
individual bonds, her money is now in
00:49:36
these bond funds and she wouldn't want
00:49:38
to sell at a loss. So, Rachel says, "I
00:49:40
guess I have two questions. How should
00:49:42
an investor think about individual bonds
00:49:43
versus bond funds when using bonds to
00:49:45
diversify a portfolio? And second, if
00:49:47
I'm approaching fully living off my
00:49:49
investments within the next few years,
00:49:51
and I have enough invested now cover my
00:49:53
expenses using the 3.5% withdrawal rate,
00:49:56
would you recommend shifting to a higher
00:49:58
percentage in bonds at this point? If
00:50:00
so, this could be a time to consider
00:50:02
individual bonds versus bond funds. So,
00:50:04
to answer the first part, bonds versus
00:50:07
bond funds. to do. So, I'm going to
00:50:09
quote for a few minutes one of the
00:50:10
better known investors of the past few
00:50:11
decades, a guy named Cliff Asnness.
00:50:14
Asnnesses is pretty witty, very sharp,
00:50:15
and his writing is worth reading. And in
00:50:17
2014, he wrote an essay called My 10 Pet
00:50:20
Peeves. And one of them was about
00:50:22
exactly this issue, Rachel. So, Asnness
00:50:24
wrote, and I will be quoting him for the
00:50:26
next couple minutes here. This
00:50:27
misconception is perhaps the least
00:50:29
harmful. In fact, it may even be helpful
00:50:31
to investors, but is perhaps the most
00:50:33
annoying to me. I'm not sure why. Maybe
00:50:35
it's because I've been hearing it the
00:50:36
longest given that I started my career
00:50:38
in fixed income. Many advisers and
00:50:41
investors say things like, "You should
00:50:43
own bonds directly, not bond funds,
00:50:45
because bond funds can fall in value,
00:50:47
but you can always hold a bond to
00:50:49
maturity and get your money back." Those
00:50:51
who say this belong in one of Dante's
00:50:53
circles at about three and a half
00:50:54
between gluttony and greed. Bond funds
00:50:57
are just portfolios of bonds marked to
00:51:00
market every day. How can they be worse
00:51:02
than the sum of what they own? the
00:51:04
option to hold a bond to maturity and
00:51:06
quote unquote get your money back. Let's
00:51:08
assume no default risk, you know, like
00:51:09
we used to assume for US bonds, that is
00:51:12
apparently greatly valued by many, but
00:51:14
in reality is valueless. The day that
00:51:17
interest rates go up, individual bonds
00:51:20
fall in value just like the bond fund.
00:51:22
By holding the bonds to maturity, you
00:51:24
will indeed get your principal back. But
00:51:26
in an environment with higher interest
00:51:28
rates and inflation, those same nominal
00:51:30
dollars will be worth less. The
00:51:32
excitement about getting your nominal
00:51:34
dollars back eludes me. But getting your
00:51:36
dollars back at maturity isn't even the
00:51:38
real issue. Individual bond prices are
00:51:40
published in the same newspapers that
00:51:42
published bond fund prices, although
00:51:44
many don't seem to know that. If you own
00:51:46
the bond fund that fell in value, you
00:51:48
can sell it right after the fall and
00:51:50
still buy the portfolio of individual
00:51:52
bonds some say you should have owned to
00:51:54
begin with, which again also fell in
00:51:56
value. Then if you really want, you can
00:51:58
still hold these individual bonds to
00:52:00
maturity and get your irrelevant nominal
00:52:02
dollars back. It's just the same thing.
00:52:04
Those believing in the subject fallacy
00:52:06
often also assert that another negative
00:52:08
feature of bond funds is that they quote
00:52:10
unquote never mature, whereas individual
00:52:13
bonds do. That's true. I'm not sure why
00:52:16
anyone would care, but it's true. But
00:52:18
the real irony is that it's only true
00:52:20
for individual bonds, not the actual
00:52:22
individual bond portfolio these same
00:52:25
investors usually own. Investors in
00:52:27
individual bonds typically reinvest the
00:52:29
proceeds of maturing bonds into new
00:52:32
long-term bonds, often through what's
00:52:34
called a lattered portfolio. In other
00:52:37
words, their portfolio of individual
00:52:38
bonds, each of which individually has
00:52:41
the wonderful property of eventually
00:52:42
maturing, never itself matures. Again,
00:52:45
this is precisely like the bond funds
00:52:47
that they believe they must avoid at all
00:52:49
costs. I'm sorry if I've destroyed the
00:52:51
peace of mind of individual bond holders
00:52:52
everywhere by informing them that owning
00:52:54
only individual bonds does not solve the
00:52:57
problem that bonds are risky. I'm also
00:52:59
sorry if the irrelevant idea that you'll
00:53:01
eventually get your nominal money back
00:53:02
on a bond was comforting to many. It is
00:53:05
actually quite possible that I have made
00:53:06
some readers worse off by destroying
00:53:08
these illusions. It's possible that the
00:53:10
false belief that individual bonds don't
00:53:12
change in price every day like a bond
00:53:14
fund's net asset value does led to
00:53:16
better, more patient investor behavior.
00:53:18
I admit that listening to me is not
00:53:20
always pleasant or even an enhancing
00:53:23
experience. Okay, listeners, that was
00:53:25
Cliff. Back to Jesse. Does that make
00:53:27
sense? What he's saying is there's
00:53:29
effectively no difference between owning
00:53:30
a fund of bonds or owning all of those
00:53:33
bonds on an individual basis. There's no
00:53:35
advantage or disadvantage. I probably
00:53:38
like you have seen people trying to say
00:53:40
otherwise on a personal finance forum or
00:53:42
a financial independence forum. Those
00:53:44
people are wrong. It might be
00:53:45
emotionally comforting to think, well,
00:53:47
in an individual bond, I know I'm going
00:53:49
to get my money back eventually, but
00:53:51
that same bond is doing the same exact
00:53:53
thing if it's within a bond fund. It's
00:53:56
providing interest and eventually it's
00:53:58
providing its principle back to the bond
00:54:00
fund. And if you own that bond fund,
00:54:03
it's providing its principle and
00:54:05
interest back to you. When interest
00:54:06
rates change, the individual bond is
00:54:08
getting repriced and that's affecting
00:54:10
the value of the fund. You just don't
00:54:12
notice things like that because one
00:54:14
single bond explicitly can be easily
00:54:16
hidden by all the other bonds in the
00:54:18
fund. So Rachel, that's the answer to
00:54:20
that question and listeners, I hope that
00:54:22
makes sense. If not, I can dig into it
00:54:24
another time. And then Rachel, you asked
00:54:26
about your portfolio allocation for
00:54:27
retirement. Now, I know there are
00:54:29
different approaches to this question,
00:54:30
but I'm a fan of the goals-based
00:54:32
investing framework, which assigns
00:54:34
specific timelines and use by dates to
00:54:36
the money in our portfolio. And if
00:54:38
you're withdrawing approximately 3 and a
00:54:39
half% per year, and if all you ever did
00:54:42
was keep up with inflation, then you'd
00:54:43
have about 28 years of spending, right?
00:54:45
That's 100 years divided by 3.5%. So,
00:54:48
personally, I would consider putting
00:54:50
your first year of spending in cash, so
00:54:52
you know it's there. And then I would
00:54:54
think about your personal risk
00:54:55
tolerance. How many years of bonds are
00:54:57
you comfortable with? Or put another
00:54:59
way, are you comfortable having, you
00:55:01
know, the year 2030, having those living
00:55:03
expenses in the stock market? What about
00:55:05
the year 2035 or the year 2040?
00:55:07
Personally, something like eight or 10
00:55:10
or 12 years of living expenses and bonds
00:55:12
is a reasonable to slightly conservative
00:55:14
amount, which for you, Rachel, if I take
00:55:17
8 or 10 or 12 years and I multiply it by
00:55:19
3.5% per year, it's going to result in
00:55:22
30 to 40% of your portfolio in bonds.
00:55:25
Beyond that, I would think that you can
00:55:27
introduce more long-term, higher risk,
00:55:28
higher growth illquid assets, things
00:55:30
like stocks, real estate, private
00:55:32
investments, whatever floats your boat.
00:55:33
If you're sticking with a traditional
00:55:35
diversified stock portfolio, great.
00:55:36
you're likely to end up with something
00:55:38
like 4% cash, 36% bonds, and 60% stocks.
00:55:42
It's basically a 60/40 portfolio. Now,
00:55:45
we didn't just snap our fingers and say,
00:55:46
"Ah, Rachel's 59, therefore 60/40."
00:55:49
Instead, we looked at Rachel's future
00:55:51
cash flow, which we know based on her
00:55:53
3.5% withdrawal rate. We understand that
00:55:56
cash flow. So, how she's withdrawing her
00:55:58
money when Rachel needs it, what years
00:56:00
in the future Rachel has earmarked that
00:56:02
money for. And then we've asked ourel
00:56:05
what's the appropriate asset or asset
00:56:06
class to get today's money to that
00:56:09
future date. How much risk can we afford
00:56:11
to take over that timeline? So, I hope
00:56:14
that helps Rachel. Thank you all for the
00:56:16
terrific questions today. Please send in
00:56:18
your future questions if you have an AMA
00:56:20
question to my email address
00:56:22
jessebinterest.blog and we'll get it
00:56:24
answered on a future episode. And if you
00:56:26
enjoyed this episode, this AMA, I highly
00:56:28
recommend going back and listening to
00:56:29
the first five. Those were episodes 99,
00:56:31
95, 90, 86, and 81. And speaking of,
00:56:35
make sure to check out the best interest
00:56:37
blog if you enjoy reading. Or better
00:56:38
yet, I send a quick weekly email that
00:56:40
has my recent blog posts, recent podcast
00:56:42
episodes, and the articles I've read
00:56:44
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00:56:46
from all over the internet, right? Not
00:56:47
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00:56:49
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00:56:51
you don't have to. That newsletter is
00:56:53
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00:57:02
can't miss it. Thank you all for
00:57:04
listening and we will talk to you next
00:57:05
time. Thanks for tuning in to this
00:57:07
episode of Personal Finance for
00:57:09
Long-Term Investors. If you have a
00:57:11
question for Jesse to answer on a future
00:57:13
episode, send him an email over at his
00:57:15
blog, The Best Interest. His email
00:57:17
address is
00:57:19
jessevestinterest.blog. Again, that's
00:57:23
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00:57:25
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00:57:27
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00:57:29
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00:57:31
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00:57:34
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00:57:35
next episode of Personal Finance for
00:57:37
Long-Term Investors. Personal Finance
00:57:40
for Long-Term Investors is a personal
00:57:42
podcast meant for education and
00:57:44
entertainment. It should not be taken as
00:57:46
financial advice and it's not
00:57:47
prescriptive of your financial
00:57:49
situation.