4 Personal Finance Moves You Probably Don't Need to Make

In this financials edition of Industry Focus, Gaby Lapera and longtime Motley Fool contributor and personal finance expert Dan Caplinger talk about four financial planning topics involving products that are often recommended but that many people don't actually need. From annuities and life insurance policies to car rental protection and load mutual funds, Gaby and Dan discuss why advisors sometimes overuse certain products and how you can decide whether they're really right for you.

A full transcript follows the video.

This video was recorded on July 31, 2017.

Gaby Lapera: Hello, everyone! Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. You're listening to the financials edition, taped today on Monday, April -- just kidding, today is Monday, July 31, 2017. My name is Gaby Lapera, and joining me on Skype is Dan Caplinger, personal finance guru. How's it going, Dan?

Dan Caplinger: I'm doing good, but it's a Monday, definitely, Gaby.

Lapera: It's definitely a Monday. I also thought it was a Monday in April, but it's definitely July. Just in case anyone's wondering, it's definitely July. Unless you happen to be listening to this in April. Then maybe it's April. I don't know. But right now, in the second that I'm taping it, it is July. Today, we're going to be talking about, I guess what you would term personal finance schemes. I think that's what you would call them. It's stuff that you shouldn't fall for, that maybe someone in the personal finance space is going to try to sell you. I think the first one I want to start with is annuities. I don't think a lot of people understand annuities, but a lot of people are told that they need an annuity. Dan, can you give a basic explanation of what an annuity is?

Caplinger: It's actually harder than you would think to give a basic explanation of what an annuity is.

Lapera: Exactly.

Caplinger: That's a big part of the problem. It's huge. If you've ever tried to look at the fine print on a standard annuity contract, it's dozens if not hundreds of pages long, often, and it's even worse than usual. Most of the fine print you would never be able to read anyway. But with annuities, it's particularly obtuse, because there are so many of these complex financial aspects to the way that an annuity works. And it's sad, because at its core level, what an annuity should be is what one particular type of annuity actually is, and my favorite kind of annuity is an immediate annuity. 

Basically, the way that that works is really simple. You give the annuity company an amount of money up front, and they promise to give you back a certain amount of money every month or every year for the rest of your life. If you live longer than expected then you're going to end up being a winner, and the insurance company is going to pay you more back than you paid up front. If you live less time than the life expectancy tables say, then the insurance company wins. The insurance company makes a profit by setting things up so that all other things being equal, it works out in their favor modestly with an immediate annuity based on what they pay you and what you pay upfront for the premium. That's the simplest aspect, but things can really get more complicated from there. In general, the less you understand what your annuity salesperson is talking about, the more concerned you should be about what they're doing for you.

Lapera: Definitely. I feel like with annuities, it's basically exactly what you described, it's a gamble. And like most gambling, you shouldn't bet against the house, generally.

Caplinger: Where things get really complicated is, there are favorable tax rules that apply to life insurance products, which include both regular life insurance policies and annuity contracts that are offered by life insurance companies. So, there actually are some potentially attractive things about annuities. The income inside of an annuity can grow on a tax-deferred basis until you take the money out of the annuity, at which point you're going to get taxed on it. There are also some negatives. If you take money out of an annuity early and you don't qualify for one of the exceptions, there's a 10% penalty that applies, same sort of thing that you would get from an IRA distribution, a penalty that can apply for taking that money out early. 

In addition, probably one of the most painful things about a lot of annuities is what's called a surrender charge. A lot of people are familiar with, if you try to take a certificate of deposit out from a bank, if you try to take the money back before the end, you'll pay this early withdrawal penalty, it's a few months worth of interest. But, with annuities, this surrender charge is basically the same thing. It can be huge. It can be as much as 10% if you change your mind really quickly up front. And that's such a huge fee to pay. Add that to the generally high expenses and the generally low understandability factor as far as how they work and what your options are, and a lot of times, it's just not worth the effort.

Lapera: I think there's also restrictions when it comes to inheritance with annuities as well, right? Because, some people purchase them and think they can pass them onto someone, and you can, but it gets complicated, correct?

Caplinger: Yeah, it's an insurance product, so you have to make sure that you understand what the death benefit aspects of the particular annuity are. With immediate annuities, a lot of the time, if you don't set things up so that it allows a spouse or another family member to keep getting annuity payments after you pass away, then a lot of immediate annuities stop paying as soon as you pass away. So, like you said up front with the gambling aspect, if you buy an immediate annuity and three months later you pass away, you got three pretty small monthly payments back out of a relatively large premium payment, and you're going to end up a big loser. 

Now, insurance companies will be aware of that risk, and will offer you these extra provisions called riders that try to address that risk. But there's always a cost with any provision that the insurance company adds into it. So, you might get an extra benefit, but your monthly payment might be smaller, or you might not get as high of an interest rate. There's usually a trade-off there, but it's not always obvious, so it's important to ask a lot of questions if you're insistent that you really want to look at annuities. Ask lots of questions and make sure you get good answers so you can feel comfortable that you understand what this thing is going to do and what steps you have to do to make sure it does what you want when you want it done.

Lapera: Yeah. And, generally, the more complicated it is, the more likely it is that you should stay away from it. Are there any good reasons for someone to want an annuity? I think I could see it maybe working out for someone who thinks they're going to spend -- like, they got a lump sum payment from something and they're worried about spending it all at once. Would that be a good reason to potentially consider an annuity? What do you think?

Caplinger: Using a piece of a retirement nest egg to buy an immediate annuity can actually make a decent amount of sense, because annuities are really one of the only products that offer protection from the risk of you outliving your money. Again, it comes back to that gambling aspect. If you want to protect yourself from potentially having a much longer retirement than you expected, then having an immediate annuity can be almost as good as the money that you get from Social Security every month, because you know that annuity is going to pay out month in and month out for as long as you live, even if you live a lot longer than anybody ever expected up front. So, it can be useful. 

And these things vary from company to company, as well. Some providers are better about keeping things simple. Others are really interested in building these gimmicky product promises, that it becomes much more difficult to crack into exactly how the annuity achieves that, and what the net cost is of implementing that strategy. A lot of the time, you can do the same sort of thing that an annuity does with other types of products that aren't as expensive. Really, the only thing that's particularly useful with the annuity is that mortality issue of being able to protect against longevity and the risk of outliving your money.

Lapera: OK, that is a lot to think about. I think a lot of people don't like to think about dying. So, this next topic is definitely not for you, [laughs] because we're going to talk about life insurance. I think I mentioned this a couple weeks back. A lot of people think they need life insurance when they potentially don't really. There's all those commercials on TV that are like, "Are you under 35 and you don't smoke and whatever? Your life insurance will be so cheap through us." The reality is, a lot of people get life insurance through their work, and not everyone needs life insurance. For example, I don't need any life insurance beyond what my work already automatically offers me, because I have no one to really give the money to who is relying on me to support them. I have no children, I have no significant other, I don't own a house, nothing. Basically, if I die, I die alone in the world. [laughs] The end is nigh, embrace the oblivion. But, yeah, what insights, what pearls of wisdom can you grant us about life insurance, Dan? 

Caplinger: There's no one-size-fits-all rule for life insurance. Basically, the reason that you want to have life insurance is that there's some reason out there that you want to make sure that, if you pass away unexpectedly, somebody gets a chunk of money that they can use to do whatever it is you had in mind for what they're supposed to do with it. The most common example where people do life insurance is when they start a family, and they want to make sure that if something happens to them, then their loved ones are going to have the money they need to replace basically everything that you would have earned in the period of time that you're raising that family, so that your loved ones don't have to freak out and try to figure out how to make ends meet without the income that you would have been able to contribute to the family. Most insurance needs really boil down to that kind of metric, and it's just what's important to you that matters. If, for instance, you decided that you wanted to make sure that your good work buddy, Dan, was able to take a vacation for a month to get over your loss if you passed away, then you could go ahead and buy a $25,000 life insurance policy, make me the beneficiary, and I will grieve in style.

Lapera: [laughs] That sounds like a hella good vacation that you have planned out there on my imminent demise.

Caplinger: [laughs] I'm not going to tell you that's not the right thing for you to do, because that's your personal decision, and life insurance could help make that work. But if you don't have a need for anybody to get money after your death -- like you said, you don't have a family, you don't have anybody depending on you, you don't have a bunch of outstanding debts that won't get taken care of automatically if you die, then yeah, the need for life insurance is a lot less.

Lapera: Yeah. And there's a couple of different types of life insurance. This is the other thing. There's term life insurance, which is basically, you buy a policy that lasts a certain amount of time, so like, 30 years or something like that, that's a pretty common term. Then, when the 30 years runs out and you haven't died, no one gets the money. But there's also this thing called whole life insurance, which you might be more familiar with in terms of people trying to actually sell it to you actively, because in theory, it can be used as an investment vehicle. But, again, much like the annuities, it gets really complicated really fast, and there's all these fees associated with taking money out of it, and you can take money out of it, but it just gets so complicated.

Caplinger: Yeah. There's whole life, there's universal life, there's a lot of different life insurance products that basically put a life insurance envelope around what you could get, generally, with some other kind of investment outside of a life insurance context. Like we were talking about a few minutes ago, one reason to do that is that life insurance products get a tax deferral benefit that other types of investments don't. A lot of life insurance professionals will build up that aspect of it. In my opinion, you're generally better off using regular investments in a tax-favored retirement account like an IRA or a 401(k). Then, if you're making enough money that you're able to max out an IRA, max out a 401(k), then maybe you can start looking at whether or not the added costs of investing through a life insurance vehicle make up for the tax benefits that you can get. But, it does get complicated in a hurry. 

And again, if the primary goal is to make sure that whoever you need to have money after your death gets that money, then a term life insurance policy can get that job done, and you can figure out, you were talking about lengths of time you can get insurance policies that will have a guaranteed premium for 10 years or 15 years or 20 years. It doesn't mean you have to stop the policy after that period goes by. It just means that at that later point, the insurance company can then raise your premium up to reflect the fact that you're older, and that your risk of death has gone up accordingly. But, term life gives you the flexibility to decide how long you need the protection, and it has a very easy exit strategy when you don't need the protection anymore. You just stop paying the premiums and the thing goes away. 

Lapera: Yeah. And it's a lot cheaper than whole life. Anyway, let's talk about our next thing, which could or could not involve death, depending on how badly you drive, which is rental car insurance. I'm assuming most people who have attempted to rent a car have been asked, "Do you want rental car insurance?" And they panic and say yes. But you don't necessarily need to say yes to them. A lot of credit cards actually carry rental car insurance on them, and if you pay for the rental car with that credit card, then in theory you should be covered. You obviously need to check your credit card's terms to make sure that your rental car insurance coverage is covered in full. But there's a lot of benefits to using your credit card to cover your rental car insurance, including that if you get into an accident, generally, you don't even have to report it to your insurance company, it's just taken care of by the credit card company, which means your premiums won't go up with your insurance company.

Caplinger: Right. That's one of the sales pitches that the rental car companies will make when they try to sell you that insurance. If you don't have it, like you're saying, and you don't have this supplemental insurance through a credit card company, then you're going to have to talk to your own car insurance, and even if they cover it, you're likely to see a premium increase. Wouldn't you rather pay $19.95 a day to avoid all that hassle and just go through our folks and call it a day? I think that one way that a lot of those companies are able to sell that insurance is, if you're a business traveler and you're traveling on an expense account for your company, then there's no incentive not to take it, because you're protecting yourself personally using the company's money. So, I think they get a lot of revenue that way.

But like you said, as long as you've checked with your credit card company and know exactly what kind of coverage it offers, and you're comfortable taking on whatever that risk might be -- because there can be risks. Not every credit card company gives you dollar one coverage where you're not going to be out some money if you have an accident. Some are going to charge you a deductible, some are going to charge you some coinsurance amount. So, your credit card insurance might not be as good.

Lapera: And some even won't cover personal liability stuff, so that's another thing to look out for. Like, maybe they'll cover actual damages to the car, but they won't protect you from having to pay out $100,000 for driving recklessly.

Caplinger: But that's important to know, too. If you buy the insurance from the rental car company, if you buy the full coverage, then yeah, you remember, you initial all of these lines, and each line is talking about each of those types of coverage. One line might be the personal liability, the other might be repairing the car if something happens to it. But, a lot of the time, the car companies will also offer you, "You don't want to pay $19.95, but what if you just get this other coverage? It's only $8 a day." You might get that, thinking, "At least I'm a little bit covered," only to find out that the thing you thought it was protecting you from it has nothing to do with, and you just wasted that money and didn't get the protection that you thought you were getting.

Lapera: Yeah. So, basically, much like annuities and life insurance, what it comes down to is, read the fine print. Luckily with rental car insurance, there's not quite as much fine print as there is with the other two. And, be educated about what kind of stuff you already have through your credit card company or even potentially through your own auto insurance. But like we said, if you use your own auto insurance for the rental car, your premiums might go up. 

The last thing we want to talk about doesn't have to do with death, lucky for us. We'll end on a high note. We're going to talk about load mutual funds. I don't know that a lot of people even know what these are anymore. But just in case you have an unscrupulous personal finance person trying to "help" you out in your life, let's talk a little bit about load mutual funds. A load mutual fund is basically a mutual fund that comes with a commission for the person who sold it to you. If that sounds fishy, that's because it is.

Caplinger: Yeah. It's really just as simple as that. The problem with these load mutual funds isn't so much that there's an advisor who's getting paid, because financial advisors do work for you, so it makes sense that they should get paid somehow. But the way it's done is less transparent than it would be if the guy just handed you a bill and said, "I helped you out here, here's what I'm going to charge you for my help," and everyone could feel much more comfortable about it. The way that the load mutual fund works is, they charge an upfront amount, and it comes out of the money that you invest. So, if you have $1,000 to invest and you use a load fund, say it has a 5% sales load on it, then $950 will go into the investment and $50 will go to the investment professional who sold it to you. And from then on out, you'll spend the first period of time getting yourself back up to the $1,000 you started out with, and only then after that will you start earning returns for yourself. 

The big issue is, there are so many mutual funds out there that don't have these loads that it seems like a shame to go with one that does. Again, a lot of investment professionals -- there's nothing really unscrupulous about it in the sense that, again, it's the way that they make sure they can get compensated for the work that they're doing. But, it doesn't have the right flavor in terms of being upfront about exactly where this money goes, and that it's coming out of your pocket and going into the investment advisor's pocket, and it never gets invested in the first place. It's sort of the behind-the-scenes way of doing that, rather than just being upfront and doing that transparently and in full view.

Lapera: Yeah. And like you said, there are a ton of mutual funds that are no-load now, and it's really easy to find those because somewhere on their prospectus, it says "no load mutual fund." The other thing is, there are so many ETFs and index funds now that they have fees associated with the management, but so do mutual funds, and you don't have to pay a load fee for any of them, you just pay whatever the initial fee is to buy the shares of it and that's it.

Caplinger: Yeah. You'd think that load funds might have lower expense ratios because they are able to pay these commission costs up front. But a lot of times, it's the funds that charge loads that also have these high annual expenses going forward, as well. Like you say with index funds and exchange-traded funds that will give you that same investment exposure for, sometimes, 10% of what you would pay in annual expenses for a regular actively managed mutual fund. You really have to ask yourself if it's really worth it to have this particular fund with this particular investment professional, over just using an ETF, a simple ETF or index fund.

Lapera: Yes. I think that pretty much wraps up the show. I think, in conclusion, what I can say that we've learned is that we should embrace the void and understand that we will die soon, and make better decisions based on where we are in our lives. Make sure that you do your homework, make sure that you really think about what you're doing. I think those are the general messages of today's show. What do you think, Dan?

Caplinger: Yeah. I want to give one little shout out, because it's important to understand, all of these products that we talked about today -- we talked about annuities, we talked about life insurance, even the rental insurance and the mutual funds -- the people who are working with these products often really believe very strongly in the products. And there are situations in which they work really well for people, that things turn out perfectly well in part because they used these products, and if they hadn't used these products, it wouldn't have worked out as well for them. So, we're not saying that these products never work. It's just that on the whole, they tend to be more problematic than you would expect, and they aren't as useful, in every case, as people seem to make it out to be. So, I just want to make that very clear. It's not that these products shouldn't exist. It's just that they aren't as useful for general purposes as you would think from the way they're often portrayed.

Lapera: That's actually a really good reminder, and I'm really glad you said that. On that note, thank you everyone for joining us. As usual, people on the program may have interests in the stocks they talk about, and The Motley Fool may have recommendations for or against, so don't buy or sell stocks based solely on what you hear, and/or personal finance advice. Contact us at [email protected] or by tweeting us @MFIndustryFocus to talk about whatever you want. I run the Industry Focus Twitter now, so I'm happy to chat with you via Twitter because I'm learning how to do that. Thank you to Austin, today's excellent producer. Austin, are you going to buy whole life insurance for you and your puppy?

Austin Morgan: I am not. I think my puppy will do just fine.

Lapera: [laughs] Fair enough. Thank you to everyone for joining us. Everyone, have a great week!