John opens his portfolio, revealing seven popular investment types he doesn’t own and sharing why you should carefully consider whether they’re right for your objectives. (1:40) Plus, learn essential strategies for college planning, what you need to know about the U.S. credit rating downgrade (24:22), and where to find the silver linings in today’s often negative world. (46:08)
Presented by Creative Planning, each week Host and Managing Director John Hagensen cuts through the headlines and loud takes to challenge the advice you may have been given and reaffirm what you know to be true. Plus, don’t miss his weekly interviews with Creative Planning specialists as they cover investing, taxes, estate planning and many other areas that impact your financial life!
John Hagensen: Welcome to the Rethink Your Money Podcast, presented by Creative Planning. I’m John Hagensen, and ahead on today’s show, the seven things I don’t own in my portfolio, what does the United States credit rating downgrade mean for your investments, as well as a simple breakdown of Roth IRA conversions. Now, join me as I help you Rethink Your Money.
I recently went on a road trip with my family. But instead of the normal road trip dynamic of us in our 12 passenger van, my wife and I had to drive two cars. We split the kids up and let me tell you, just subtracting two children from the equation made the car ride so much more peaceful. Of course, we strategically divided up which kid in a way that would hopefully create as much peace as you possibly can have with a one-year-old and a three-year-old and all sorts of other ages in the car.
We see this play out in other aspects of our lives as well. You’ve probably been in a work dynamic at one point in life where you weren’t wondering who else you could hire to make the situation better or bring the culture up a bit. It’s like, no, the answer’s simple, just get rid of that toxic person. We just need to eject them from the equation and there will be addition by subtraction. The same is true when it comes to our investment portfolios. It’s typical to wonder what else could be added to your plan to improve your outcomes.
But what I found to be true is that so often it’s not what’s added, but what is removed that can make the biggest impact. I want to share with you the seven things I do not own in my portfolio and why I don’t own them, so that you can make better money moves for yourself. The first thing I don’t own are actively managed funds. Now, I spent the beginning of my professional life as a financial advisor building portfolios by selecting what I believe to be the best, and I’m putting up air quotes, investments for my clients.
Well, because future returns are unknown, what do you think an advisor bases those recommendations on? Well, of course, it’s past performance. That’s all we have to go on. The problem with that, study after study has shown us that past performance has no correlation at a broad level of future returns when it comes to money managers. 85% of actively managed mutual funds, which by definition means that the manager is buying and selling securities with an attempt to outperform.
Buying low, selling high, it sounds great. Too bad 85% of active fund managers lose to their benchmark. The average fees are around 1% instead of almost free for a passive strategy and which managers over perform is statistically random. I keep my assets passively managed, which lowers costs, simplifies my portfolio, and then what’s important is you are able to redirect the majority of your time and your energy on making sure your overall asset mix aligns with your financial plan and your time horizons and your risk tolerance, as well as evaluating your tax strategies and your estate planning.
You also get some time back because you’re not trying to keep track of whether an active fund manager is still adding value, or whether they need to be replaced with someone who’s been doing better, which by the way, as I’ve said now multiple times already, does not correlate to expected future over performance. I do not own actively managed funds. I also do not own sector funds.
There’s no question that there are innovations and healthcare and technology and communications, and it may be tempting to want to own those specific sectors and extract those from a diversified portfolio and say, “I just want to own healthcare and tech.” But there’s often a disconnect between the growth potential of a given sector and its investment merit. And here’s the real key, the market is forward-looking.
By the time people start getting intrigued about the growth prospects of a given sector or more specifically an industry within that sector, much of the potential is already placed into the valuations. Exhibit A is Nvidia when it comes to tech or specifically artificial intelligence. In Morningstar’s most recent edition of their annual Mind the Gap study, they found that dollar weighted returns for sector funds over the last 10 years ending in 2021 trailed time weighted returns by more than four percentage points per year.
Now, let me break down what that means. It means that investors get in at the wrong time and in turn don’t capture the full growth of the sector as a whole. Unfortunately, that gap has been 4% a year. One other consideration to keep in mind, if you are well diversified, you own those sectors. Many of the largest companies within our major indexes are tech companies and healthcare companies. Number three, I don’t own gold. If you’ve read either of my two books or listened to the show for any amount of time, then you know my advice is to wear gold, don’t invest in it.
Because fundamentally, gold is not a growth asset. Its value typically remains in line with inflation. The classic example is 100 years ago, an ounce of gold would’ve bought you a nice suit, and today an ounce of gold will buy you a nice suit. That’s what you should expect out of gold. If you’re truly worried about some sort of financial Armageddon, it probably makes sense to hoard guns and cigarettes and water bottles. You’re not shaving off a piece of gold from inside your backpack at the local 7/11 to buy a six-pack if the world’s ending.
At a broader level though, I like things that pay me. It doesn’t mean you can’t make money in classic cars or art or collecting baseball cards, but as is with gold, you’re simply hoping that someone down the road will pay you more money than what you purchased it for. With stocks, you receive dividends from the profits of that company. With bonds, you receive interest. With real estate, rental income, and that’s why I like owning companies and owning buildings or lending to governments and corporations.
In short, I don’t own gold because it’s paid T bill returns with more volatility than the stock market along the way. And speaking of bonds, I do not own high-yield bonds. High-yield bonds, that sounds okay, right? They’re just another word for junk bonds. Junk bonds sounds risky. High-yield bonds, who doesn’t want high-yield? Great marketing. High-yield bonds offer a yield premium in exchange for additional credit risk. Who you’re lending money to is far less likely to pay you back and far more likely to default on your principle than government Treasuries or AAA rated corporations.
And as a result, they have historically paid more than five percentage points higher than government Treasuries. But the problem with this is they tend to be more like a stock than a bond. When things go bad, junk bonds go bad, which makes high-yield bonds far less useful as portfolio diversifiers than other fixed income securities such as investment grade corporations or government bonds and cash. My belief is that the moment I pull money out of my diversified stock portfolio, I’m expecting lower returns for more predictability and volatility dampening.
Junk bonds do not accomplish that and are not compelling to me from a risk adjusted basis. The first four things I do not own in my portfolio to recap are actively managed funds, sector funds, gold, and high-yield bonds. Before I get to my final three, if you have questions about your portfolio, maybe you currently own one or many of the things I alluded to and you’re wondering if you should, we offer a free portfolio review here at Creative Planning, and you can request to meet with one of our 300 certified financial planners just like myself by visiting creativeplanning.com/radio now.
You don’t need to go about this alone, get the answers to your most important questions. After all, you’ve worked far too hard to not have confidence in your investment strategies. One more time. That’s creativeplanning.com/radio. Number on the list of things I do not own in my portfolio or hedge funds. Now, you’ve probably heard about hedge fund managers in their $100 million mansions out in The Hamptons. Well, let me break down what hedge funds are. They are investment pools that are relatively unconstrained in terms of what they can do.
They’re fairly unregulated, at least for now. They charge really high fees, two and 20, normally, meaning 2% management fees plus 20% of the profits. They won’t necessarily give you your money back when you want it, so limited liquidity, and will generally not tell you what they’re even doing with the money. It’s very much a black box and their premise because they hedge so they can go long or short is that they’re supposed to make money all the time in every type of environment.
When they fail to do this, investors generally leave them with a mass exodus and go to another hedge fund manager who’s had more recently better performance. Now, there’s all sorts of problems with this, but for the sake of time, I’ll leave it there for now. Every three or four years you’ll have a hedge fund deliver that once in 100 year type flood. I love this Cliff Asness quote, “They’re generally run for rich people in Geneva by rich people in Greenwich.” Earlier this year, Larry Larry Swedrow wrote on the nonsensical growth of hedge funds.
And here’s what Larry found when looking at the global hedge fund index over the last 20 years. The annualized return, and I do not want you to miss this. Because if you’ve ever felt FOMO around wanting to be in hedge funds, ah, it’d be so great, they’ve made 1.7% per year for the last 20 years. Five-year Treasuries during the last 20 years have made 2.7%, so have beat the hedge fund index by 1% a year. Hedge funds have lost to inflation.
By the way, the S&P 500 during that same 20 year period has averaged 9.8% per year, so call it 10% a year, while hedge funds haven’t even been able to pull off an annualized return of over 2%. All the empirical data shows that they’re not very good at hedging in down markets. They massively underperformed. The fees are really high. Why then have hedge funds grown from about $300 billion 25 years ago to now about $5 trillion today? One possible explanation is the need for us to feel special. We want to be part of a club.
We don’t want to just do the boring vanilla stuff that everyone can do to that. I would leave it to Groucho Marx advice where he said, “I wouldn’t want to belong to a club that would have me as a member.” And while that’s a bit tongue in cheek, it applies perfectly to hedge funds. There are a couple like Jim Simons at Renaissance that have made phenomenal returns over long periods of time and they’re closed to any new investment. Sometimes it’s hard for us to accept that simple, less expensive, easier to understand is better, and that’s the case when it comes to hedge funds.
Next, I do not own whole life insurance. Whole life insurance is insurance, expensive insurance. It is not an investment. Consider this. There are more than 400,000 insurance agents in the United States and almost all of them would love to sell you a whole life insurance policy. Because if you buy a policy with premiums of 40,000 a year let’s say, the commission would typically be around $40,000. That’s right. You didn’t mishear me. Almost 100% in many cases of your first year premium gets paid to the agent upfront as a commission.
And as you might imagine, that commission is highly motivating. And to make matters worse, many of the most awful policies pay the highest commissions. As a result of this ridiculous conflict of interest where the salesmen are masquerading as financial advisors, they throw out some serious myths to persuade that this is just a phenomenal investment. Look at how safe it is. Look at the returns. Look at the tax advantages. Well, all you really need to know is that 80 plus percent of those who buy a whole life policy get rid of it prior to death.
The seventh and final thing I do not own in my portfolio is cash. Aside from an emergency fund, which you should have, you should not be carrying cash in your portfolio. To recap the seven things I don’t own in my portfolio, I don’t own actively managed funds. I don’t own sector funds, gold, high-yield bonds, hedge funds, whole life insurance, or cash.
If you have questions about your asset allocation or the specific investments within your plan, we’ve been helping families for 40 years as we manage or advise on a combined $210 billion across all 50 states and over 75 countries around the world. Why not give your wealth a second look at creativeplanning.com/radio? Most people think of Creative Planning and they think of a wealth management firm. $210 billion in combined assets under management and advisement.
We’ve been helping families since 1983. Yes, we are one of the largest, longest standing independent registered investment advisory firms in the country. But at our core, we’re a firm that helps our clients with anything that has a dollar sign in front of it, and one of those important aspects of personal finance is estate planning. And that’s why we have 70 attorneys specializing in all sorts of various areas of the law, and one of those attorneys is my guest today. His name is Jerry Bell.
Jerry plays an incredibly important role guiding our special needs families. Let me tell you, Jerry has forgotten more just this last week about special needs planning than most generalist attorneys and wealth managers, myself included, have learned in our entire lifetime. With that said, Jerry Bell, thank you so much for joining me here on Rethink Your Money.
Jerry Bell: Hey, I’m glad to be here. Appreciate a chance to talk more about special needs community, things we’re doing there.
John: Planning for family members with special needs is obviously an important topic. Anyone who has a family member with special needs knows that. Unfortunately, it can be really confusing, and I found it to be overwhelming for families. A good place to start is how a special needs trust fits into a special needs situation.
Jerry: It basically becomes the landing spot for any inheritance or any wealth transfer that’s going on typically from the parents, could be from other members of the family to the beneficiary that has special needs. The big thing on the special needs trust more than anything else is whatever goes in there doesn’t count against the beneficiary for their government benefits. Usually it’s professionally managed. It’s protected. It gives a lot of peace of mind to that parent, and it serves a good purpose for the family.
John: What’s the trustee’s role with regards to special needs planning and how does that differ from what maybe people are more familiar with in terms of what they need to do as a trustee in a traditional plan?
Jerry: Trustee always throws people off. A lot of people think, oh, that’s the one that owns the special needs trust. No, there’s no ownership. They’re really the manager of what’s in that special needs trust. It’s a complex role in the case of special needs, because special needs can involve all different types and different levels of that.
But compared to a general trust where the individual can probably communicate pretty effectively to you for their needs, over time they’re going to get more and more self-sufficient, a lot of times in a special needs trust, one, you have that fundamental challenge of what are the needs of the beneficiary and trying to understand that both from a medical perspective and just from them communicating with you, but you got to interface with the guardian, typically, if there is a guardian involved.
You have to interface with the investment community, of course. A lot of times this complicated thing called government benefits comes into play, which our government, God bless them, they do a good job of confusing things when we talk about government benefits sometimes.
John: I get a lot of questions, Jerry, around this, a lot of questions with special needs families around if we do this, is it going to impact our benefits? How is this going to affect our application for this or our qualifications? That is a very common thing that people are just wondering, I don’t want to do anything if it potentially makes me lose these benefits.
Jerry: Well, and the challenging thing on that, John, is a lot of families don’t know for sure what their benefits are.
John: Exactly.
Jerry: They could have SSI. They could have SSDI. Well, there’s only one letter difference there, but there’s a huge difference in how that is impacted by inheritance or things of that nature. That’s always a challenge. Those families are doing so much keeping track of what they have and how it’s different. We usually have to get involved there sometimes. The real gold mine is finding someone in that family that has a good handle on a lot of those issues, which a lot of times is difficult.
John: You mentioned guardianship. How does the trustee role differ from the guardian role if the beneficiary with special needs requires a guardian?
Jerry: A guardian, first of all, is appointed by the court, so you’ve got a court proceeding involved there, but really they’re the voice of that special needs person. They’re helping them with all the life decisions, healthcare, things of that nature, compared to the trustee, which you can call it the money person, because it’s the money manager. They’re responsible. They have a fiduciary duty to the beneficiary, just like a general needs trustee does, but they’re managing that from an investment side.
But more importantly, they’re working with that guardian hand in hand to figure out what that individual needs, what benefits could they qualify for, can I distribute for this, and if I do, how does that impact that? The guardian is more handling life needs and a very critical role and trustee is handling more the money aspect of it.
John: That makes sense. Back to this complex maze of government benefits, how does that fit in with the role of the special needs trustee?
Jerry: It’s interesting, when we’re working with the different trust companies, you can tell who’s worked with special needs trust and who hasn’t, but most of the time you’re not having a special needs trust unless someone’s on government benefits. For instance, if you distribute for the wrong reasons as a trustee that perhaps replace some benefits that they’re getting from the government, the government might turn off those benefits or reduce those benefits. The trustee has to understand, A, what benefits are they on?
You don’t get that handed to you in a silver platter. And then two, what do I understand about those benefits and how can I as trustee supplement those, which is fine, and I want to make sure I don’t conflict with those. Most of the trust companies usually have people that are especially trained on special needs because of those government benefits. The other thing about government benefits, just to be clear, is some states have very significant government benefits.
California’s example, they’re very rich in the benefits they offer to people with special needs. You have to understand the state level, as well as the federal level. It just gets a little complicated much more than a general needs trustee.
John: I think the message there is you want to work with someone who’s experienced at a federal level, as well as at a state level with your specific situation. There’s a lot of nuance. There can be major implications to messing it up is what I hear you saying. Make sure you have good counsel on that. I’m speaking with Creative Planning estate attorney Jerry Bell. Let’s shift our focus over to some of the challenges family members have that you’ve seen when they become a special needs trustee.
Jerry: Usually they’re not appointed to trustee unless they really care obviously about their brother or sister, but people lose track of the fact, I can have the biggest heart and be a caring person, I might make a great guardian, but I might not be a very good trustee. There’s always the duty the brother or sister feels to take care of their family member. We just have to accept that, supplement that, but also help them understand it’s okay to ask for help. If I’m a family member that could be a trustee, but I’m also willing to hire someone to help me through some of these stumbling blocks, that’s okay.
But the bigger problem we get is, as a parent, I don’t know that I want to burden my other sons and daughters with the duty of being guardian, as well as trustee. They might be a mother or father of their own kids. That becomes the biggest challenge is they need help. We just make sure when they set this up that they have options to be able to have a co-trustee or something of that nature so that the other brother or sister is not drowning in their duty to take care of their special needs brother or sister and really hurting them perhaps more than helping them.
John: As you mentioned earlier, guardianship and being the trustee are two different things. It’s a massive amount of time even for someone who would like to be involved to realistically take on that responsibility for in some cases decades.
Jerry: The average family is coming in and usually thinking they’re going to use a family member. A lot of it is just getting over the hump, if you will, of having someone outside the family involved in taking care of their loved one. Once they understand the complexities with that, which is an education process, then it’s a matter of, okay, it’s okay. Corporate trustees aren’t a bunch of bad guys trying to take your money. They’re really trying to help and they do a good job of that. Most families are not familiar with any of that at all.
John: Well, I think the biggest thing is cost, Jerry. I think the people that I’ve spoken with say, “Well, how much is that going to drain our account?” Is the cost worth it, do you think, for most people?
Jerry: Well, in some cases, John, they don’t have enough money, to be honest with you, but cost is clearly the number one question that comes up. An easy threshold that I get from professional trustees, if it’s smaller than 100,000, it’s going to be difficult because the costs start eating it up.
John: Sure.
Jerry: They ask about that. Obviously we can provide them the fees.
John: What about hybrid options, Jerry?
Jerry: Reliable son or daughter is co-trustee perhaps with the corporate trustee. That means the corporate trustee is doing the heavy lifting, but the son or daughter is very involved in the decisions. You can even spice that up further by adding some language to the trust that gives the son or daughter some leverage. I jokingly call it hire and fire language. That if for some reason the corporate trustee is not fulfilling the needs that they think they should do, they have the ability to switch that.
There’s a lot of things you can do in the structure of the special needs trust to leverage the benefits of that family member, but also get the true benefits of the corporate trustee at the same time. Back to the cost, it’s like anything else, John, if you look at the cost of making a mistake.
John: They’re huge.
Jerry: It’s usually pretty easy for the mom and dad at that time to nod their heads and say, “No, we need to do that. It’s just a cost of doing business.”
John: What steps should a family take if they’re considering a professional trustee? Obviously they can call you and speak with your team here at Creative Planning, then go to creativeplanning.com/radio if they want to speak to a local advisor. But what are some general steps they might be able to take to begin this journey?
Jerry: I always make sure they have two or three options to look at the public information on, and then they’re going to settle on who they want. I try not to have one specific trust company that we’re talking about. And then I’d encourage them, we’ll set up an interview for them to sit down and do their own due diligence with the company to meet the people there, to understand their procedures. And really we’re just trying to help them get comfortable with how that company will take care of their loved one.
John: Yeah, that makes sense. Spend time on the front end investing in a great decision so that hopefully it takes something off your plate over the coming months, years, decades. Well, what you’re doing, Jerry, with special needs families, with elder law, it’s inspiring to me. You’re making a huge difference in the world and in the lives of those that you’re helping. I love having you here on the team at Creative Planning, and thanks so much for joining me today on Rethink Your Money.
Jerry: Thanks, John, I appreciate your time.
John: That was a estate planning attorney Jerry Bell. If you have a special needs family member and you have questions about your current plan or getting one established, don’t wait. We’ll help you simplify this. Contact us today at creativeplanning.com/radio. Why not give your wealth a second look?
A little over a week ago, the credit agency Fitch Ratings downgraded the trustworthiness of the US government, saying successive standoffs over the nation’s debt ceiling and rising federal debt have casted doubt on the US’ ability to meet all of its payment obligations. The downgrade moved the federal government’s rating as a currency issuer from AAA to AA+. One small notch down. A lower credit rating could make borrowers less likely to lend money to the federal government on favorable terms, potentially raising costs for US taxpayers.
But the last time this happened, the stock market dropped 7%. In this case, the market basically shrugged it off, down a little over a percent for the day. And while some people see the downgrade as step one for the dollar going to zero, it’s not that big a deal. But over the last week, I’ve had a few clients ask me about how it might impact our strategies or their portfolio. And in short, it doesn’t. Because if it’s not our debt being downgraded, it’s a natural disaster or a terrorist attack or a slowing economy or a bubbling economy or stagflation or inflation.
Uncertainty is all around us at all times as investors. I think the broader question that’s worth visiting and reaffirming is, would this cause us to potentially lose our status as reserve currency? Well, Creative Planning President Peter Mallouk spoke about this at length on his podcast with Jonathan Clements, and I want to play a three-minute bite pertaining specifically to this topic. Have a listen.
Peter Mallouk: Now, what do you need to be a reserve currency? Nobody woke up one day and named the US Dollar king. What happens is the world is looking for certain things. One, they’re looking for political stability. They are looking for a currency that’s backed by a big, strong growing economy, that’s got very transparent financial markets, a legal system that has some credibility, a country that pays its debts. It’s looking for all those things. Well, guess what? That’s the United States, right? The United States is more capable of doing that than anywhere else.
Now, the other thing worth pointing out is there’s not only one reserve currency. I think we talk about this like it’s the dollar and there’s nothing else. As you pointed out, about 60% of business is done in the US dollar and there has been a decline. 15 years ago it was 70%. Some business is done in Euro, some in Japanese yen, and then everything else makes up a very, very tiny fragment, but the US is the dominant force here. What’s happened that’s created this conversation recently where people are concerned about the dollar losing its reserve status?
I think we really look back to when Russia invaded Ukraine, the US took a lot of actions against Russia and one of them is we kicked them out of a system that allowed them to convert to dollars. We used our status as a reserve currency nation as a geopolitical weapon, which is another advantage of having the reserve currency. If you’re the reserve currency and you get mad at Iran, you can cut them off from the international system. If you get mad at Russia, you can cut them off from the international system.
Now, the irony of that is every time you cut a country off, you encourage the rest of the world to go, wait a second, forget about our military and our cyber and all this stuff. We’re at the mercy of the United States because the US has the reserve currency. It puts them in a very weak position. And when the world saw us do that to Russia, you saw China and other countries get very concerned and they’re trying to find coalitions to trade in different currencies. I think that’s what’s really brought this to the forefront.
I think there’s some credibility to this, which makes people nervous because there have been plenty of reserve currencies before the United States. The US has been the reserve currency for almost 80 years. Before that, Great Britain for about 130, France for about 95, The Netherlands for 80. No one stays on top forever. You combine, there’s a lot of countries on earth that do not like the United States now for a lot of different reasons. We’ve weaponized money. We can argue about whether that was smart or not.
One of the advantages of being the reserve currency again is you can weaponize money. The disadvantage is when you weaponize money, it makes people not want to use you as the reserve currency. If we’re not going to be the reserve currency, there has to be an alternative. Well, it’s not going to be the Euro. I mean a lot of people aren’t sure the European Union is even going to be a real thing 10 years from now. I don’t see the world clamoring to have the Euro. We all talk about China. Chinese currency right now is 2.7%. No one trusts it. The system’s not transparent.
It’s missing a lot of the pieces that are required of a reserve currency, which is being really able to count on it and open transparent financial system. I think there’s a real narrative here and there are real problems with the dollar, but there is no alternative. We are nowhere near having an alternative currency. It’s impossible to imagine that happening anytime in the near future. Investors can find 100 other things to worry about besides this.
John: There you have it, directly from Creative Planning President Peter Mallouk, and I completely agree. In short, one agency downgrading us by the slightest of margins shouldn’t play a role in your financial outlook. Let’s move on to our first piece of common wisdom to rethink, and that is that investing and trading are the same thing. That those two words are synonymous. No, they’re not.
Someone who bought meme stocks in 2020 only to watch those returns evaporate a year later and then says, “I’m just buying Treasuries and CDs. I’m going to stay in cash. I don’t like stocks. I’ve invested in the stock market and I got burned. It’s not for me.” No, that person did not invest in the stock market. That’s not investing, that’s trading, which is akin to gambling and speculating. You may as well just pull up your FanDuel account or your online poker because it’s much closer to that than being a disciplined long-term strategic investor.
Which leads me to a follow-up point, and that is it doesn’t need to be all or nothing. Investing isn’t answering a singular question of whether to be in or out of the stock market. Most of our clients are partially in and partially out all the time. You see, investing focuses much more on the long-term and how you can strategically place your dollars in alignment with the objectives that you have and the time horizons that are in place, which is not the same as market timing and trading individual stocks on a daily basis.
Although the names are often used interchangeably, they’re really not even close to the same thing. Let’s rethink this idea that investing and trading are the same. Another piece of common wisdom is that real estate is the best investment. What prompted this is I received an email from one of my realtor friends, and at the top of the email it said, investors voted for the 11th consecutive year that they believe real estate is the best investment. I found the entire thing somewhat comical.
For the 11th consecutive year, they think, they believe that it’s the best investment. Notice it didn’t say for the 11th consecutive year, real estate performs as the best investment. It doesn’t say that because that’s not true. It’s not to say that you can’t make a lot of money in real estate, you can’t grow your net worth, or that real estate’s a terrible investment. No, I’m not comparing real estate to gold, but let’s walk through briefly the historical returns of real estate. There are two things that really can make real estate pop, potentially being a really good investment.
The first is leverage. I know it’s not what Dave Ramsey says, and I understand the idea of having peace around your money by not over leveraging and having debt. I get it. The borrower is the slave to the lender. But when it comes to real estate, leverage is how you produce good returns. The second component is individual knowledge and skill. If you purely look at housing as an investment from 1890, so going back 130 years, until now, the US housing market is up 0.6 of 1% per year over the rate of inflation.
For all intents and purposes, it’s basically treaded water with inflation. Now, for the first 100 years, from 1890 until the end of 1989, it appreciated just 30% above inflation, so 0.3% per year. Essentially it went nowhere for 100 years after inflation. But from 1990 on forward, it’s now up more than 70%, about 1.6% above inflation per year. We do have recency bias. It’s performed much better recently than it had in the past, but the biggest misunderstanding around real estate is that we massively underestimate how much we spend on a house.
One of our clients had an investment property on the East Coast. They own the house for a little under 10 years, bought it for $1 million and just sold it for right around $3 million. At first glance, one to 3 million, you say, “Yeah, the people in that study that your realtor sent out are right.” But in fact, this specific situation makes my point and resolidifies why people think that it’s the best, but they should actually rethink that.
When we broke down what they spent on property taxes, maintenance, furniture, they did a small renovation, landscaping, we concluded that over the last 10 years, they spent $1.2 million in total costs. Then they paid 5% in realtor fees when they sold the property. There was 150 grand, which put them at about 600,000 of profits that they then had to pay taxes on. After all was said and done, they were up about 30% on their $1 million, 3% per year. Basically, the property that at first glance made them $2 million ultimately kept up with inflation.
But back to why leverage is truly the key component to making money with real estate is that when they bought the house, they didn’t put $1 million of their own money to purchase the house. They put down 20%, 200 grand. They financed 800,000 at 4% interest. They then took the $800,000 that they didn’t need to shove in the sheetrock of that house, had a diversified portfolio in the market that earned about 10% a year the last 10 years. Their $800,000 had more than doubled while only needing to pay a little over 300,000 in interest over the 10 years.
I know I’m going through a lot of numbers, but in summary, when you factor in what they did with the money that they didn’t have to purchase with the property but could still own the property and receive all the appreciation on the total asset value without a lot of their money being locked up in it, that’s how they ended up with such a great total return. While real estate on its own the past 100 years has earned only about 4% while the stock market has earned nearly 10, it can be a diversified strategy within your overall investment plan, but only if you have an expertise on what to buy and are willing to leverage up along the way.
If you have questions about how investment real estate might fit into your financial plan, maybe you already own real estate, you’re wondering about what the tax implications would be to sell some of those properties, or how in general does real estate compliment the other pieces of your plan, well, that’s why you need a financial plan. If you’re not sure where to turn and you’d like our help, visit creativeplanning.com/radio now and together we’ll build out your customized, tailored, written, documented financial plan.
Again, that’s creativeplanning.com/radio, because we believe your money works harder when it works together well. I want to take a moment to extend my heartfelt condolences to my friends in Maui who have recently suffered devastating losses due to the wildfires there in Hawaii. Lahaina has a special place in my heart as it was once our home. Often we think of Maui and we think of the natural beauty of the ocean and mountains and waterfalls and sunsets.
I mean, all of those things are undeniable, but the friendships that we formed while we were there were even far more beautiful. We didn’t know a single person when we arrived, certainly didn’t have any family there. And quickly, our friends who welcomed us so openly, they became our ohana, our Hawaiian family. And to see those that we love have their homes burned to the ground, their places of business gone, and the island that they love ravaged, it’s truly heartbreaking. I want you to know that you’re loved.
You’re in my prayers. And on behalf of all of us here at Creative Planning, our hearts go out to each and every one of you who have been affected by this tragedy there in Maui. One of my producers, Lauren, is here as always to read our questions for the day. Hey, Lauren.
Lauren Newman: Hi, John.
John: Who do we have up first?
Lauren: Our first question comes from Paul in Pennsylvania and he writes, “I have 1.5 million in my 401(k), 200,000 in outside investments, and plan to retire next year. I’m 69 now, will take social security when I retire at 70. My question is regarding Roth IRA conversions, should I convert from 70 until 72 when I have to start taking RMDs?”
John: Well, Paul, I understand your concern about taxes and retirement planning. It’s a great question. You’re thinking about the right things. Given your current financial situation and how much of your overall portfolio has never been taxed, considering Roth IRA conversions could indeed be a smart move. As a reminder, a Roth IRA conversion is a financial maneuver where you transfer funds from a traditional IRA into a Roth IRA.
Unlike traditional IRAs or in this case your 401(k), Paul, which offer tax deferred growth and tax-deductible contributions, Roth IRAs provide tax-exempt withdrawals in retirement. There are a few key points involved in a Roth IRA conversion. The tax implications. When you convert from a traditional IRA to a Roth IRA, you’ll owe income taxes on the amount you convert, and then there are conversion strategies. You have the flexibility to convert all or in most cases part of your traditional IRA to a Roth IRA.
I think sometimes we overcomplicate Roth conversions. There is one primary consideration that trumps everything else and that revolves around the core question of whether your taxes today are higher or lower than you expect them to be down the road. Period. I mean, that’s the question that has to be answered. But here are three reasons why I think it could be beneficial for you, Paul. Number one is your tax bracket consideration. As you rightly mentioned, taxes are likely to increase over time.
We know that the current tax rates, even if nothing is done, sunset at the end of 2025 and the rates are going up. By converting a portion of your deferred dollars today, you’ll pay taxes at what we assume to be a lower rate, and this could potentially save you some serious money in the long run. And you’ll happen to be in a window where you’re retired and you don’t have required distributions from the accounts. You have a lot of flexibility and wiggle room to do sizable conversions without pushing you above the 22 or the 24% tax bracket.
The second considerations are RMDs, required minimum distributions, and tax efficiency. See, those are going to kick in at age 72. That increases your taxable income and they grow larger every year you get older. By you strategically converting to a Roth IRA before your RMD start, you can lower your future RMDs. Roths, because the tax has already been paid, have no required distributions. And lastly, this helps you achieve tax diversification. We talk a lot about diversification with your investments.
No big bets in any one spot, but the majority of Americans are sitting in a situation like you where 80, 90% of what they’ve saved and will be depending upon for retirement has never been taxed. That exposes you to the mercy of what will tax rates be over the next 20 or 30 years. Adding this Roth to your retirement mix will give you flexibility in managing and controlling what your taxable income is during retirement. With all that said, it’s important to carefully plan and calculate the amount you convert each year.
Keep in mind, Roth IRA conversions are irreversible, so it’s crucial to have a CPA assess your current and future financial needs and expected taxes before making any decisions. Ideally, that CPA is working with your financial advisor like we do here at Creative Planning so that these conversions can be factored in with your investment mix? Which assets will you convert? How does that align with your risk tolerance and your expected distribution strategies? How does it affect Medicare means testing or social security taxation?
But overall, your plan to convert from age 70 to 72 at a high level aligns well with your goal of optimizing your taxes in retirement while you have a couple of years with some wiggle room. A great question, Paul. We have offices in Pennsylvania. Reach out to us at creativeplanning.com/radio if you’d like to speak with one of our wealth managers like myself. All right, Lauren, who do we have for our last question?
Lauren: Our final question today is from Theresa in Denver, Colorado. She says, “Hello, John. I have two young children, ages three and six, and my husband and I are thinking about college planning. What are your thoughts on 529s? Is there a strategy you use with your own kids?”
John: This is a great question, Theresa, one that I receive often. Let me start by saying you want to put your own mask on first before assisting others. You want to make sure that your financial plan and your sustainability in retirement is on track before you start funding education accounts. Now, I say that as a broad rule of thumb. Certainly there are families where the number one priority is to help their children with education, but college unlike retirement is something that you can borrow for to obtain an education that leads to you earning great money that you then are able to use to pay back the cost of your education.
Of course, the student loan crisis is a major factor in our country, and it’d be great if everyone graduated with no student loans. But in retirement, you can’t fund it once you’re retired. It has to be funded in advance of your retirement date. And while you may be able to help a child out with college, does it really help them financially if they then have to support you later in life? Theresa, you may have $10 million saved for retirement already, and this doesn’t apply to you, but I think that’s an important point whenever we think about assisting our children.
Let me outline a few of the pros and cons of 529 plans, which are a very popular tool for saving and investing for higher education expenses. The pros, first off, the tax benefits. One of the primary advantages of 529 plans is the potential for tax savings. While the contributions to a 529 plan are not deductible on your federal taxes, the earnings on your investments grow tax deferred, the qualified withdrawals for education expenses are entirely tax-free at the federal level, and some states also offer state tax deductions or credits for contributions to their state sponsored 529 plans.
Another pro is that their portable. If your six-year-old gets a full ride and doesn’t need the funds for education, you can change the beneficiary to another eligible family member without incurring tax penalties. You could shift all of that to your three-year-old. 529s also provide for high contribution limits. Most 529 plans have no annual limits, although you do want to be careful how much you gift into those for estate tax purposes. You can give up to 17,000 per year per kid, and if you’re married, 34,000, without it impacting that exemption.
But 529s allow you to save a substantial amount for education expenses over time. Each state’s a little bit different, but they don’t max out until somewhere between about 230,000 and 550,000 that you can put into a 529 for a beneficiary. Another benefit to the 529 plan is that you keep control. Theresa, you’re the account owner. You maintain control over the investments and how the funds are used, and this control can be transferred to the beneficiary once they are of college age.
And lastly, while they’re not the most flexible account in the world, they do offer a wide range of qualified expenses. You can use the funds for a variety of higher education expenses, tuition, room and board, books, supplies, and even some technology expenses. Those are the pros, and I’ll summarize those by saying if your retirement’s on track and you felt very confident that these funds would in fact be used for education, 529 will be the most efficient. But we live in an uncertain world.
Here are the cons of why two smart people arrive at different decisions regarding 529 plans. You have limited investment options. 529 plans are offered by individual states and don’t have a wide range of investment options. Certain states still have more expensive funds that we wouldn’t typically advise be put in the portfolio. There are big penalties for non-qualified withdrawals.
If something changes in your life and all of a sudden you need those monies for your own retirement, you’re going to be subject to income tax on the earnings plus a 10% federal tax penalty on the earnings portion as well. It also has a negative impact on financial aid. While the 529 plan assets are considered an asset for you, Theresa, the account owner, for federal financial aid purposes, distributions from a 529 plan may affect the beneficiary’s eligibility for need-based financial aid.
The final con is a lack of control over beneficiary designations. Once the beneficiary reaches college age, they gain control over how the funds are used. This could potentially lead to funds being used for non-education expenses. Here is my conclusion, Theresa. Assuming that your retirement’s on track, I would go with the 529 if you’re not concerned about the lack of flexibility. Because I do think the tax benefits outweigh the limited investment choices if the funds ultimately are used for higher education.
We have an office there in Denver, Theresa, if you’d like to speak with us directly about your financial plan. And if you have questions like Paul or Theresa, email those to [email protected]. I want to leave you today as I close with a dose of optimism. I mean, obviously we live in a complex world and there are always challenges with the economy, the markets, society in general, and we’ve got billions of imperfect human beings trying to work together with varied interests and values.
It’s not easy and sometimes it can be discouraging, but consider some of the good right now that we often overlook. The projected growth of our GDP is now 26 trillion up from 21 trillion, which speaks volumes about the robust foundation and resilience that we have as an economy. This isn’t just a statistic. It’s easy to gloss over it, but it’s a testament to the innovation, the productivity, and the untapped possibilities that still lie ahead as we continue to move forward. I mean, take a glance at the housing market.
It’s been steadfast and unwavering. House prices have stood firm in the midst of historic mortgage rate increases. We’ve seen the market come back this year due to better than expected corporate earnings, even with high interest rates that the Feds instituted in an attempt to slow down this engine. We’ve got record levels of low unemployment. And let’s not overlook the equity nestled within homes across the country. And that serves as a cushion of security offering both stability and potential avenues for growth when we experience economic challenges.
And at a high level, if you think about the financial realm, the Federal Reserve’s strategic decision to raise interest rates and to continue to do so even last month is a response to an economy that’s too good and signals a proactive approach to managing inflation. And that, my friends, is where the hidden gem lies. That’s where your optimism should be found, because the silver lining that often escapes the limelight is that we now have five percentage points of wiggle room.
We have a strategic buffer that’s now crafted to cushion any unforeseen shocks that might come our way. When interest rates were near zero coming out of the financial crisis, had another event occurred, what sort of monetary policy could the Fed put in place to re-energize the economy? It’s hard to lower rates from zero, but we are currently better positioned in the event the economy slows to ensure that that recession is shallow and short-lived.
Your financial journey will have plenty of highs and lows. And whether you’re in the valley today or up on the mountaintop, I hope that you feel a sense of optimism for accomplishing your goals. And remember, we are the wealthiest society in the history of planet Earth. Let’s make our money matter.
Announcer: Thank you for listening to Rethink Your Money, presented by Creative Planning. To hear past episodes or learn more about the topics and articles discussed on the show, go to creativeplanning.com/radio. And to make sure you never miss an episode, you can subscribe to Rethink Your Money wherever you get your podcasts.
Disclaimer: The proceeding program is furnished by Creative Planning, an SEC registered investment advisory firm that manages or advises on a combined $210 billion in assets as of December 31st, 2022. John Hagensen works for Creative Planning and all opinions expressed by John or his guests are solely their own and do not represent the opinion of Creative Planning or this station. This commentary is provided for general information purposes only, should not be construed as investment, tax, or legal advice, and does not constitute an attorney-client relationship.
Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed. If you would like our help, request to speak to an advisor by going to creativeplanning.com. Creative Planning Tax and Legal are separate entities that must be engaged independently.
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