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The Do-It-Yourself Way to Save Your Retirement

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With memories of last year's bear market firmly stuck in their heads, many investors lately have been looking for investments that offer some form of principal-protecting guarantee. Yet rather than paying the high price of such investments from traditional sources like insurance companies, you can use a do-it-yourself apporach that achieves the same goals -- while letting you avoid paying the costs that would otherwise go to the seller as profits.

Principal protection -- at a price
Recently, I read about an interesting challenge that a financial columnist made with an insurance advisor. The advisor argued that an indexed universal life insurance policy could provide a return in line with the S&P 500 with limited downside risk.

Yet as with many similar products whose returns are tied to stock market indexes, this policy came with some caveats, as the columnist discovered. In particular:

  • The maximum return that would be credited to the account in any given year would be capped at a certain amount. That means that during a year like this one, in which the S&P has risen well over 20%, you might only get credit for a fraction of the overall return of the index.
  • Because the cost of the underlying insurance increases over time, the guaranteed principal protection is only temporary. After a period, it goes away -- and suddenly, you can lose your entire investment.
  • In addition, the return is tied to the value of the index rather than the index's total return. In other words, because dividends aren't reflected in the index's value, you miss out on the extra return that dividends add for those who simply own an index fund.

This last point is actually more important than you might think. For instance, look at just how high the yields are on some of the stocks in the S&P 500:

Stock

Trailing Dividend Yield

Frontier Communications (NYSE: FTR  )

13%

Windstream (NYSE: WIN  )

8.9%

Diamond Offshore (NYSE: DO  )

8.1%

CenturyTel (NYSE: CTL  )

7.8%

Qwest (NYSE: Q  )

7.5%

Altria Group (NYSE: MO  )

6.5%

Reynolds American (NYSE: RAI  )

6.5%

Source: Yahoo! Finance.

Overall, the S&P's yield is currently around 2.2%. That's a respectable fraction of the S&P's long-term average return -- and a big reason why the S&P hasn't suffered nearly as dramatic losses over the past few years as you might think simply from looking at the index value itself.

Create your own hedge
One interesting revelation from the challenge, though, was the fact that the insurance companies that create these policies use a fairly simple investing method to hedge their own exposure. In particular, one company insider explained how insurance companies take the policy proceeds and do the following:

  • They buy zero coupon bonds with part of the premiums they receive. These bonds don't make regular interest payments, but they guarantee that the total assets under the policy will be worth at least as much at a certain point in the future as they were when the the customer first bought the policy.
  • With the remaining funds, they essentially make a low-cost investment in a stock index. Sometimes, they'll add bells and whistles by investing in derivatives like index options, but it still boils down to the same general principle.

That's something you can do on your own. With many discount brokers offering bond trading, you can usually find zero-coupon Treasury bonds for whatever maturity you want, ranging out as long as 30 years from now. Then, investing in some combination of index funds, stocks, and options can help you tailor your stock exposure to match your risk tolerance. And best of all, you don't have to worry about losing part of your money to pay a commission or other overhead costs.

Dig deeper
The lesson here is that the more sophisticated a financial product is, the more important it is that you completely understand what's behind it. Often, you may not need all of the features you're paying for. If you want to protect yourself from stock market losses, doing it yourself can help you save a bundle.

Amanda Kish is worried about next year, and she's especially concerned about one sector of the stock market. Find out which sector you should avoid in 2010.

Fool contributor Dan Caplinger is a terrible do-it-yourselfer in just about anything except investing. He own shares of Altria. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy won't paint your house or mow your lawn, but it'll be glad to stand by the garage and supervise.


Read/Post Comments (3) | Recommend This Article (17)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 26, 2009, at 1:39 PM, JavaChipFool wrote:

    If you want conservative, try looking at Northwestern Mutuals "modified endowment contracts" where you can buy a life insurance policy "paid up life insurance" is how I refer to it when talking to my NWML agent.

    These contracts are basically a whole life policy that can "pay up" and get the benefits of a whole life policy without waiting the 10 years it takes to catch up to "invest and get your own rewards now" plan. Plus, the tax benefits are realized as you "borrow" from your cash value- no taxes owed, no capital gains as the value increases, and if you die before you've "borrowed" your money, the death benefit pays it off-also tax free.

    Its just another hedge I've thrown into our family's retirement portfolio.

    I got into this because I had a increasing whole life policy I got when I was 23- the only investment I had until I was in my mid 30's- we recently "borrowed" from it to pay off our house, and now our "mortgage payments" just go to increasing the value of that policy- minus a miniscule 1% to NWML. Sure, I loose the mortgage tax deduction, but that was doing anything anymore for us anyway. I only wish I had signed up for a larger amount 27 years ago.

  • Report this Comment On January 05, 2010, at 12:33 PM, BrettAndersonLCR wrote:

    I am the Advisor that was involved with the other column you mention in your column. Your comments about Indexed Life (IUL) are proof again that a “Little bit of knowledge is a dangerous thing”. That, and/or you have deliberately made false statements or taken facts about Indexed Life out of context about how it can perform in regard to the returns of the index it is linked to -- in this case the S&P 500.

    I’ll address your incorrect statements in the order you made them:

    1) “The maximum return that would be credited to the account in any given year would be capped at a certain amount. That means that during a year like this one, in which the S&P has risen well over 20%, you might only get credit for a fraction of the overall return of the index … In addition, the return is tied to the value of the index rather than the index's total return. In other words, because dividends aren't reflected in the index's value, you miss out on the extra return that dividends add for those who simply own an index fund.”

    There are two answers to this. First, stocks are traded more than just one day of the yr. If you factor this in, then on a quarterly annual gain basis (March 31 - March 31; June 30 - June 30; etc.) the average gross gain for the S&P 500 for 2009 is actually a LOSS of -13.41%. If you add in dividends it reduces the loss to only -11.32%. Whereas the comparable gain for what I consider to be the top IUL (Minnesota Life) would have been + 4% (this is before fees for either - I‘ll address that shortly).

    Now it is true that in any given year the gain for the actual index - because of the IUL cap - could be more, and that the IUL gain does not include dividends. But for the past 20 years - even with a cap of 16% - this IUL would have out gained the actual index - including WITH dividends - 11 of those 20 years! Attached is a chart that shows exactly what it would have been for each for each year:

    http://www.keepandshare.com/doc/view.php?id=1659209&da=y

    The result is that (with a fee of 0.5% per yr. for the S&P fund) the net annual average IRR of the S&P WITH dividends is (only) 5.59% NET. The NET IRR of the IUL policy is 7.35% for a male 50, and 7.66% for a male 40. So after allowing for dividends and all costs the IUL would of outperformed the S&P on this basis by 34%! Even with no costs, an S&P index fund could not come close to matching this IUL!

    On a Cash Value basis, if these people had saved $12,000 yr., after 20 yrs the S&P WITH dividends would have a NET value of $445,827. The IUL - after ALL costs - would have a NET value of (M50) $548,531 or (M40) $569,192. So a NET result of over $100,000 or 23%-28% MORE! The IUL also did this with NO market Risk (next)!

    You say that the IUL has a cap and so it is possible that in a particular year the actual market could get credited more. True. But what you do not tell your readers is that unlike the actual S&P index the IUL also has a floor guaranty -- it cannot go down in value because of the market. What this means is you keep ALL your annual gains -- so NO market risk. You do not have to keep starting over and hoping next time you are smart enough to get out with your gains. With IUL it is automatic - you keep them. The worst you can do in any given year is a 0% gain. When you keep all your gains you don’t have to be credited with all the gains for any one year to greatly outperform the actual index over time.

    2) “Because the cost of the underlying insurance increases over time, the guaranteed principal protection is only temporary. After a period, it goes away -- and suddenly, you can lose your entire investment.”

    For a properly designed plan with a good company this statement is absolutely false -- the insurance costs decrease over time. The average fee over 20 years for ALL costs is 0.97% per year. The cost ratio for year 20 is only 0.55% (slightly more than the S&P), but unlike the S&P account it is going DOWN each year vs. UP with the S&P!

    As for losing your entire investment, I think you are referring to the mandated assumption in every life insurance policy when using the minimum guaranteed return and maximum possible costs. In regard to this cost factor, this company in over 120 years (and most major companies) have NEVER charged more than the costs used when the policy was issued. As for the potential total gain credited, to put this into context, the gross gain credited to the IUL over the past 20 years was 9.56%. This is a bit LESS than what would have been the average gain for the past twenty, 20 yr periods of 10.23%.

    Based on historical returns of the S&P your IUL account is not going to go to zero. Unlike any stock index though this IUL does HAVE a minimum surrender and death benefit guaranty of 3% per year (less current costs). In year 20 you are guaranteed that - if a M50 saving $12,000 per year - that these values will be at least $283,023. The truth is that with a stock fund this value could be zero - not IUL!

    As for how the company many invest its monies, this is 99% wrong too but it is irrelevant. What matters is what the typical person can do to earn a decent return over their working life. And they want to do so SAFELY! Recently TIME magazine did a cover story stating the 401(k) is dead because earned gains are not protected. The CEO of Putnam Funds recently … called for a new generation of savings plans more resistant to market downturns. Dalbar reported that the average actual 20 year gain in a mutual fund of the average investor was only 1.87% per year.

    Instead of deriding Indexed Life with false information about how it can perform - and outperform almost any other investment - you would better serve your readers by looking at it with an Open Mind and a more valid comparison of its benefits vs. other types of savings. This includes the fact the income withdrawn from an IUL is Tax Free and is NOT included in the formula to tax up to 85% of Social Security Benefits. This effectively increases it net yield vs. the actual S&P by at least 1%! There are many other exclusive benefits listed on the attached chart. You can also participate in a DowGlobal exUS fund where - based on recent history - it may outperform the S&P over the next couple of decades by 1-2% in avg. yield per year.

    If you or anyone knows of ANY other investment that can provide the potential gain and benefits included with Indexed Life - with or without market risk - please let me know. So far no one has.

    Brett Anderson

    brett@lastchanceretirement.biz

  • Report this Comment On January 05, 2010, at 1:07 PM, BrettAndersonLCR wrote:

    I am the Advisor that was involved with the other column you mention. Your comments about Indexed Life (IUL) are proof again that a “Little bit of knowledge is a dangerous thing”. That, and/or you have deliberately made false statements or taken facts about Indexed Life out of context about how it can perform in regard to the returns of the index it is linked to -- in this case the S&P 500.

    I’ll address your incorrect statements in the order you made them:

    1) “The maximum return that would be credited to the account in any given year would be capped at a certain amount. That means that during a year like this one, in which the S&P has risen well over 20%, you might only get credit for a fraction of the overall return of the index … In addition, the return is tied to the value of the index rather than the index's total return. In other words, because dividends aren't reflected in the index's value, you miss out on the extra return that dividends add for those who simply own an index fund.”

    There are two answers to this. First, stocks are traded more than just one day of the yr. If you factor this in, then on a quarterly annual gain basis (March 31 - March 31; June 30 - June 30; etc.) the average gross gain for the S&P 500 for 2009 is actually a LOSS of -13.41%. If you add in dividends it reduces the loss to only -11.32%. Whereas the comparable gain for what I consider to be the top IUL (Minnesota Life) would have been + 4% (this is before fees for either - I‘ll address that shortly).

    Now it is true that in any given year the gain for the actual index - because of the IUL cap - could be more, and that the IUL gain does not include dividends. But for the past 20 years - even with a cap of only 16% - this IUL would have out gained the actual index - including WITH dividends - 11 of those 20 years! Another unique feature is it credits the IUL with 140% of the S&P gain (up to the cap). [This is a conservative avg. est. of IUL crediting for the prior 20 yrs]. Attached is a chart that shows exactly what it would have been for each year:

    http://www.keepandshare.com/doc/view.php?id=1659209&da=y

    The result is that (with a fee of 0.5% per yr. for the S&P fund) the net annual average IRR of the S&P WITH dividends is (only) 5.59% NET. The NET IRR of the IUL policy is 7.35% for a male 50, and 7.66% for a male 40. So after allowing for dividends and all costs the IUL would of outperformed the S&P on this basis by 34%! Even with no costs, an S&P index fund could not come close to matching the IUL IRR!

    On a Cash Value basis, if these people had saved $12,000 yr., after 20 yrs the S&P WITH dividends would have a NET value of $445,827. The IUL - after ALL costs - would have a NET value of (M50) $548,531 or (M40) $569,192. So a NET result of over $100,000 or 23%-28% MORE! The IUL also did this with NO market Risk (next)!

    You say that the IUL has a cap and so it is possible that in a particular year the actual market could get credited more. That is the only thing you wrote that is true. But what you do not tell your readers is that unlike the actual S&P index the IUL also has a floor guaranty -- it cannot go down in value because of the market. What this means is you keep ALL your annual gains -- so NO market risk. You do not have to keep starting over and hoping next time you are smart enough to get out with your gains. With IUL it is automatic - you keep them. The worst you can do in any given year is a 0% gain. When you keep all your gains you don’t have to be credited with all the gains for any one year to greatly outperform the actual index over time.

    2) “Because the cost of the underlying insurance increases over time, the guaranteed principal protection is only temporary. After a period, it goes away -- and suddenly, you can lose your entire investment.”

    For a properly designed plan with a good company this statement is absolutely false -- the insurance costs decrease over time. The average fee over 20 years for ALL costs is 0.97% per year. The cost ratio for year 20 is only 0.55% (slightly more than the S&P), but unlike the S&P account it is going DOWN each year vs. UP with the S&P!

    As for losing your entire investment, I think you are referring to the mandated assumption in every life insurance policy when using the minimum guaranteed return and maximum possible costs. In regard to this cost factor, this company in over 120 years (and most major companies) have NEVER charged more than the costs used when the policy was issued. As for the potential total gain credited, to put this into context, the gross gain credited to the IUL over the past 20 years was 9.56%. This is a bit LESS than what would have been the average gain for the past twenty, 20 yr periods of 10.23%.

    Based on historical returns of the S&P your IUL account is not going to go to zero. Unlike any stock index though this IUL does HAVE a minimum surrender and death benefit guaranty of 3% per year (less current costs). In year 20 you are guaranteed that - for a M50 saving $12,000 per year - that these values will be at least $283,023 - NOT zero! The truth is it is with a stock fund that this value could be zero - not IUL!

    As for how the company may invest its monies, this is 99% wrong too but it is irrelevant. What matters is what the typical person can do to earn a decent return over their working life. And they want to do so SAFELY! Recently TIME magazine did a cover story stating the 401(k) is dead because earned gains are not protected. The CEO of Putnam Funds recently … "called for a new generation of savings plans more resistant to market downturns." Dalbar reported that the average actual 20 year gain in a mutual fund of the average investor was only 1.87% per year.

    In that it outperforms any other stock investment long term, instead of deriding Indexed Life with false information about its performance you would better serve your readers by looking at it with an Open Mind instead and a more valid comparison of its benefits vs. other types of savings. This includes the fact the income withdrawn from an IUL is Tax Free and is NOT included in the formula to tax up to 85% of Social Security Benefits. This effectively increases it net yield vs. the actual S&P by at least 1%! There are many other exclusive benefits listed on the attached chart. You can also participate in a DowGlobal exUS fund where - based on recent history - it may outperform the S&P over the next couple of decades by 1-2% in avg. yield per year.

    If you or anyone knows of ANY other investment that can provide the potential gain and benefits included with Indexed Life - with or without market risk - please let me know. So far no one has.

    Brett Anderson

    brett@lastchanceretirement.biz

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Dan Caplinger
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Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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