Mark Twain reportedly said that he tried to not let his schooling get in the way of his education. I think he was describing a paradox similar to what most advisors know as the “arrival syndrome.” Said in yet another way, your education should be an ongoing process. Such is the case with your clients. We recommend that you schedule regular discussions to help your clients understand the whole truth about money. And, of course, we are totally biased in thinking the best way to help your clients, is by illustrating situations with our calculators.
I admit it had been far too long since I had met with John and Jane Jones. In our previous two meetings, they had come to understand the power of Jane’s whole life policy in helping them get out of debt. They had also learned that even small differences in money owed can have a huge impact on their overall financial situation.
When we were able to meet again, Jane and John were both anticipating their 30th birthdays coming in about 6 months. To begin our third meeting together, we reviewed what we had discussed before. They had also updated their client fact finder sheet, and I was anxious to talk to them about those newly revealed facts.
Both John and Jane had been diligent at work and both had been rewarded with a $5,000 annual raise. Their raises were actually awarded to them almost 5 years before, a short time after our initial meeting, but they had not told me. I should have uncovered that fact in my questioning, hadn’t quite asked enough questions in our subsequent meetings. Around the same time they were given raises, they also hit anniversary milestones at work and became eligible to participate in the company’s sponsored 401(k) plan. They told me how they had met with an investment professional who had explained the wonderful tax benefits and the “free” money they would get from the company. In fact, they repeated his words to me, “There is no better place to put your money.” The “free” money or company match was 50% of their contribution, up to 2% of their salaries. In other words, the max contribution by the employer would be $500 a month.
“How do you feel about your decision to participate in the 401(k) at work?” I asked John.
“Well, it has been awesome these last 5 years, “John answered quickly. “Both the investment professional and our accountant said the returns are phenomenal.”
“What has been your return thus far?” I asked.
“So far we’ve gotten a 4% return, and as you can see,” he said, pointing to the statement on my desk, “we already have $29,125.” John proudly stated. “I know that doesn’t sound like a huge number, but our accountant tells us we are really getting about 15% return when we consider taxes.”
“Isn’t that a good feeling to have a good sum of money in an account somewhere?” I stated. Both Jane and John nodded in agreement. “I am going to put your numbers into my rate calculator and verify what your accountant is saying. When you started, you had a zero balance of course. You have been putting your entire raise of $5,000 a year into your qualified plan. But if the money just came to you as part of your income, you’d only get $3,750 because you get a tax deduction at your 25% tax rate. Your current balance as you said is $29,125.” I then pointed to my computer screen and said; “Yes it looks like the number is about 15%.”
“Wow, there are the numbers,” John said. “Oh but wait, you forgot the company match. Some of that 15% is because we work for such a generous company.”
“Yes, you are right.” I corrected myself. “I am glad you pointed that out. As I said to you before and I say often to myself, my family and others; when making a financial decision, it is always good to have the whole truth. With that in mind, let’s take a closer look at things. Since you two seem to have a good grasp of things, I am going to use a more sophisticated calculator. This one is specialized for analyzing qualified plans.” I quickly put in their numbers, being sure to include their employer match and pointed to the screen. “Here are the numbers.”
“Something is not right,” Jane said or maybe asked. “Our account balance is $29,125 not $30,981.”
“You don’t miss much do you, Jane?” I complimented her. “Do you know why my number is different from your statement?” I asked her.
After a moment of silence, she simply said, “No, but I am guessing you know.”
“I wouldn’t be a good advisor if I didn’t know what was going to come out of a calculation before I did them,” I said. “Actually you do know why there is a difference, you’ve just forgotten. I am pretty sure the investment professional that came to your work to help you get enrolled in the plan, told you they had some of the smallest fees in the industry. Well, when we put those fees 2% fees in, we should see a number that agrees with your statement.”
“I’m not sure that makes us feel more comfortable.” John retorted. “I know your calculator has the same numbers as our statement, but wow that is a lot of fees we’ve had to pay so far,” John complained.
“When will you stop paying those 2% fees?” I asked John.
“I guess never,” was his response. “But now I see something that doesn’t seem right to me. Our accountant says – and you verified – that we are getting 15.06% on our money.”
“Yes, you’re right again, but you are getting ahead of me – but that is awesome.” I smiled and said to John. “I am going to put in the effect of your tax deferral. You are in a 25% tax bracket so when I put that in your rate of return is…?”
“Exactly what we’ve said – 15%,” John said sounding a little more relaxed.
“Okay, let’s shift gears a minute and talk about how accessible this money is to you,” I suggested. “Let’s say for some odd reason you needed or wanted to take money out of this account. How much of a penalty or tax would you be required to pay?” I asked.
“If I remember correctly, we will have to pay our income taxes and since we are not 59 and 1/2 years old we will also have to pay a 10% penalty,” was Jane’s response.
“You are right – at least as the law now stands. But it could change right?” I said. “I will adjust my calculator to show what the tax cost and penalty would be if you withdrew your money.” Pointing to the calculator I asked, “Now what do you see?”
“Something I do not like.” John frowned as he spoke. “This calculator is telling us that the actual rate of return on our money if we decided to use it today is a measly 0.32%. That is not what the accountant or the investment professional told me. And, it’s not a number I find anywhere on our 401(k) statement.”
“How many people do you think would sign up for a program like this if that number were discussed?” I asked John. “I am willing to bet there would be very few. But let’s not dwell on the past because there is nothing you or I can do about it. But when you learn new information, you might want to change it if possible or make a different decision next time. Let’s imagine the economy improves and you are able to get 6% from now until you turn 65. At that time you decide to use your money. Do you see your effectual rate of return is 4.18%?”
I continued, “Please take note that your net account value is $410,341. Please write that number down so you’ll to be able to remember it. The next question – and I already know the answer, but here it is anyway: Would you like to have more money than that? Of course, you would. The easiest path to achieve that is simply getting a higher rate of return. But for a moment, let us just assume you decide to drop your contribution to $1,000 annually. What does that do to your rate of return?” I said pointing to the calculator.
Before he could answer I continued, “it went up didn’t it? Just so you know, the rate of return went up because a higher percentage of your contribution dollars were being matched by your employer. However, as expected, your net account value went down to $174,454, right? When we subtract that $174,454 from the previous number of $372,798 we get $198,344.” I handed John a basic hand-held calculator and allowed him to verify my numbers.
“That is what I get,” John said.
Now if we were to use a different financial tool, say a whole life policy, we would need to make sure we made up that $198,344, right?” I asked them.
“Right,” Jane chimed in.
“Since we fund the policy with after-tax dollars, we will have to pay our income taxes up front. So instead of having $4,000 to use, we will only have $3,000, i.e. $3,000 is the result of $4,000 minus 25% taxes. Are you following me? I want to be clear here, you do not get a tax credit when you put money into a qualified plan. When you earn money, you have a choice to either include that money and pay the tax, or not include it as part of your income and avoid paying the tax on it immediately. However, you will pay tax on it when you do include it as part of your income – in other words when you take money out of your qualified plan.”
I quickly put into the funding calculator a $3,000 annual premium for a male age 30 with a preferred health rating. Then I asked, “If you use that $3,000 and pay the premiums on a whole life policy, what will be your projected cash value at age 65? And how does that compare to the qualified plan?”
John and Jane looked at each other and smiled and then Jane started to talk. “For some reason, I knew you were going to show us something better. The difference is not huge – $198,344 less in our qualified plan, but having $209,820. Again, not huge, but about a 10% difference. John and I were talking about this on the way over. We are losing our confidence in the economy in general and in the stock market in particular. The numbers in your calculator for our qualified plan are based on the market always going up. The numbers here in the whole life policy, have guarantees, and the track record of the life insurance industry is much more reassuring.”
“I have never told you, but my uncle is a dentist. He followed to the ‘T’ everything his financial planner told him to do. He thought he had the world at his feet and was planning a comfortable retirement late 2008. But then the market went south. Well, the short of the story is, he is at work today trying to recover what he lost in the downturn. I simply like the safety of the whole life route.” Jane finished.
“Other than the track record and the guarantees, why do you like the whole life route?” I asked Jane.
“In one word, CONTROL,” Jane said rather emphatically. “With the qualified plan, just as you have already shown us, we do not have the ability to use the money in there. Our money is locked away in a type of prison until we are 59 and 1/2. Sooner or later we are going to have children and I am hoping I can stay at home and help them learn and grow. But I am not confident we will have enough money from just John’s salary. I am thinking I will need to start a business where I can stay at home.” Then looking at John she said, “Where will we get the money to start a business? Certainly not from our qualified plans because of the steep penalties and tax bite.”
Without looking at me, John answered Jane, “You’re right, I am feeling the same way. I like the whole life route so much better. In fact, I am going to HR this afternoon and cutting my qualified plan contribution to $1,000.”
John then addressed himself to me and said, “Thank you.”
Listening closely to our clients, sharing our experience and using stories to illustrate important financial concepts is essential to creating results and a high level of impact. It also helps to have the right tools to simplify and prove the financial concept- both to our clients and ourselves. If you haven’t yet tried Truth Concepts software, you can get your free trial right here.
-Jason Henderson for Truth Concepts