Back To The Future – Wicked Cool Retirement – OR – “Sorry, We Can’t Afford To Go…”

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I realize this post is long. But given its topic is possibly one of the most important to millions of Baby Boomers and their offspring, I would ask you to gimme a pass on the length, OK? Thanks

Last week’s post wasn’t new for me, as I’ve been tellin’ folks my thoughts on the relative merits of ‘Qualified Plans’ for quite awhile now. I used a specific example of a couple who had a 401(k), compared the long term results of staying with the original plan ’till retirement vs cashin’ their chips in, taking the after tax/penalty cash, and buying real estate instead. ‘Course, it wasn’t just ‘buying real estate’ as there was a particular strategy to be implemented. You can see it here if you haven’t already. Notice one of the commenters who had a different take — which is why we’re on the same subject today.

Before we get goin’ though, I’d like to gently address one of his observations. He seemed put off a bit cuz I’d made mention, at the post’s beginning, of the wife who’d had an emotional moment during a conversation we’d been having about how they’d been forced to postpone their retirement. (her husband was part of it too) The reason? The huge losses inflicted on their 401 due to the recent market crash.

Regardless of how detached my analysis of any given problem might be, that lady, and her husband, who blamed himself, aren’t alone. I wonder how many Titanics we could fill with couples who had their retirements significantly reduced, postponed, or even eliminated by a few horrific days on Wall Street? That scenario in my opinion must have been played out thousands of times across the country, as the brutal reality hit home.

My agenda was to show, through empirical analysis of real life numbers, the difference between the two approaches. Frankly, the emotion in the post was mostly mine, as the conversation that day had affected me deeply — still does. Surely though, and as the commenter said himself, “…the analysis part — that’s where your story really shines.”

So today, in honor of his request — no emotion whatsoever. I suspect, however, that there will be more than a few readers who will see the obvious conclusions to be drawn from the empirical nature of the analysis, and become a tad emotional without me tellin’ a story. 🙂

For the record, I liked the commenter. He was straightforward, and always a gentleman. It was an enjoyable give ‘n take.

So Here’s the Deal

We’ll go back in time to 1990 San Diego. We’ll take a couple with enough to acquire six local duplexes in the area in which I office, La Mesa.

Here are some ground rules.

They earn $80,000 a year. They opt to cash out of their 401(k), netting enough after taxes and penalties to put $100,000 into an EIUL while simultaneously acquiring the above mentioned six San Diego county duplexes — all starting 20 years ago in 1990 at the age of 45. It should be noted that the cash to buy those duplexes is quite a bit less than in the post last week. So don’t think they’re spendin’ almost $500,000 to get that done. Not even. Roughly 60% of last week’s example.

Note: For the stock market approach, I’m givin’ them an addition decade in order to be fair. 🙂

The Real Estate Approach

1. They’ll take all the cash flow and pay the duplexes off one at a time, each one more quickly than the other, completing the task on or before August 1, 2010. (This is exactly what was done in the first post.)

2. The cash flow at retirement will be whatever today’s real life — real time NOI (net operating income) is. Note: I’ll be penalizing the SD duplexes’ NOI by increasing their operating expenses due to their age. Fair is fair.

3. As in the first post they’ll have put $100,000 into an EIUL over a period of four years and a day. Furthermore, since they’re not puttin’ $5,000/yr in a 401(k) they’re also gonna take the after tax equivalent — about $3,150 — from Day 1, and for 20 years add it to the EIUL each year.

The 401(k) Approach

1. We’ll have them put in the same $5,000/yr I alluded to in the first post’s comment section. As the commenter did, I’ll use a 37% tax rate to calculate their annual tax savings.

2. Instead of holding them to what the Dalbar, Inc study showed as empirically historic fact, (3.17% annual return for equity investors the last 20 years.) I’m gonna double that annual return for them — 6.34%. We’ll touch them with the double-return magic wand. 🙂 (Am I havin’ too much fun?)

Note: If you want to see the Dalbar, Inc study, you will hafta buy it from them. It’s not terribly expensive, and well worth the nuggets provided — all of which are empirical in nature. Dalbar’s studies are the gold standard.

3. Furthermore, I’ll say, unlike anyone I’ve ever met who holds truth dear, that they also invested every single dollar of their annual tax savings and were able to generate the same return — double what the Dalbar Inc. study conclusively demonstrated. That’ll be an additional $1,850 a year invested.

4. Every year the employer will match their $5,000 contribution dollar for dollar. Since they make $80,000 a year that’s a pretty generous and unlikely 6.25% match. This means that every year they’re gonna have $11,850 a year invested. Not for 20 years, but 30 years. They will have started at 30 years old, continuing ’till 65 –which will be in 2010. Hey, that’s now!

Let’s look at the comparative results, shall we?

Jay — Please, tell everyone what’s behind curtain #1!

“Well Monte, we have a grand total of $994,850 in their very own 401(k) retirement plan! As long as they can somehow guarantee it’ll return double the last 20 years return of 3.17% — an impressive 6.34% — they’ll be able retire on $63,000 a year. Oh, and Monte, we’d be remiss if we didn’t say that figure is before both state & federal income taxes, and is subject to the government forcing them to pull out principal if they don’t take enough out after they’re older. This will, of course, lower the dollar amount generated by their incredible ‘double the average’ yield of 6.34%. Also, Monte, according to the Dalbar Inc. study, the average annual yield of those converting from equity to fixed income for retirement the last 20 years was a whopping 1.02%!”

In too small to read text at the bottom of the TV screen, it says: Of course, they’re not gonna come close to double the average — who do they think they’re kiddin’? If they produced the normal 3.17% average annual return, their pre-tax retirement income would actually have been $18,372 a year — possibly more than Social Security. What an achievement! Even that’s a joke, considering the 1.02% fixed income return Wall Street investors have averaged the last 20 years.

(Camera pans over to Monte.)

“Let’s see what’s behind door #2 — show ’em what they missed out on, Jay!”

“Well Monte, they could’ve owned six completely debt free La Mesa (San Diego) duplexes. They’re spittin’ out $95,000 a year in cash flow.”

“Thanks Jay, let’s….”

“Wait Monte, there’s more! They’ll also be enjoying $50,000 a year in tax free income from their own personal EIUL — this is over and above the real estate income. How cool is that, Monte?!”

Seems curtain #2 sports $145,000 a year, over a third of which is tax free. Hhmm.

All the numbers are either taken out of today’s exact market, as in the case of the duplexes — OR — as with the EIUL, I had my in-house expert, Dr. David Shafer do the numbers for me.

Comparing these two approaches should be part of a stand up routine, except for the fact most Americans have seriously bought into the concept as explained to them by the government itself, and the folks managing their employer’s Plan.

Um, this hasn’t worked out well for them.

Let’s do one final ‘what if’, as I know there will be those who’ll hate that their bull has been gored. They’ll insist I rain down a plague on the real estate approach. As it should be.

What if the rents for the duplexes fall significantly? Good question. Let’s ‘gut’ the net operating income by almost half — 48%. That results in an annual income of ‘only’ $50,000. Together with the tax free $50,000 generated by the EIUL, they’re STILL gettin’ $100,000 annually — half of it tax free.

The coup de grâce

It’s now 2010, and they’re about to retire. Their units in La Mesa have performed like champs. Even after the brutal market correction they’re now worth roughly $400,000 apiece.

Hey — I have a idear! Let’s exchange them to eight Texas duplexes — brand spankin’ new — and have them go from $95,000 a year in cash flow, to over $146,000 a year in cash flow. Yeah, that’s the ticket. 🙂 This will also, as luck would have it, divorce them from day to day property management, something for which they’ve been longing. This move is the poster child for no-brainer.

Updated Retirement Income Score

Having begun 20 years ago with six La Mesa duplexes and an EIUL, they now have the EIUL and eight shiny new, very well located Texas duplexes. The EIUL is now supplying them with $50,000 tax free bucks a year. Add to that happy number the $146,000 they’re now makin’ from their real estate portfolio’s cash flow, and what do we have?

An embarrassment of riches, that’s what. Nearly $200,000 a year in retirement income. Though they got ‘bent over the bar’ back in 1990 with both taxes and penalties by gutting their 401(k), their net worth in real estate alone is now over — wait for it — here is comes — $2 MILLION. This is exclusive of their home.

Come on now, this is gettin’ painful. Is there any question you can do far better than you are in your company’s retirement plan?

I take this very seriously. Less than one of 10 people will beat the odds takin’ the 401(k) route to retirement. The others are the exceptions who can, on their own, pick stocks, use stellar timing, and spend the time it takes to get returns high enough to match the real estate example.

So when I suggest the vast majority of people will be far better off in retirement by ‘gutting’ their 401(k)s, I do it with full knowledge. I know what I’m asking. Read this — do your own numbers — then ask yourself just how you’re gonna measure up to the folks who took my plan, predicted 0% increases in value or income, yet will retire far better than those takin’ the Wall Street route.

You know where you are now, right? If you don’t change anything, what will your retirement look like in 10, 15, or 20 years? How’s your  plan workin’ out for ya so far?

Are you gonna be able to join your well retired friends and family when they ask you to go on that island cruise you’ve always liked? Or will you be sayin’, “Sorry, we can’t afford to go.”

Your call. Have a good one.

About Author

Jeff Brown

Licensed since 1969, broker/owner since 1977. Extensively trained and experienced in tax deferred exchanges, and long term retirement planning.

5 Comments

  1. Jeff Brown

    Jason — The income on this example went from age 65 to 99. It can be structured though, any way the investor wishes. This was based upon actuarial predictions based upon the owner of the policy. Premiums for this one consisted of five big payments followed by 15 much smaller ones for a total of 20 years.

    The assumptions are conservative in that Dr. Shafer tends to understate what any single EIUL will produce. I like that approach, but suspect the income might be larger in most cases.

    David should answer this question himself. I’ll give him a nudge.

  2. The assumptions for the EIUL are indeed conservative. The 20 year look-back for the Minnesota Life EIUL with a 15% cap is 8.86%. I used 8.25%. All expenses inside the EIUL are current charges. One noteworthy point is that the current cap is at its all time low because of the poor interest rate environment we are currently in. Historically, the cap has averaged 18% which would push the 20 year look back up to 9.2%. For those who think the future will produce smaller returns than the last 20 years, there is an option of 140% of the S&P 500 with a cap of 13.3%. Also a third option of large-cap companies minus the USA based. Finally, I assumed a variable loan rate of 7.25% which is the average over the last 20 years.
    Hope this helps!

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