Paul Winkler: Well, good afternoon. This is “The Investor Coaching Show.” I am Paul Winkler, and what we talk about is money and investing.
We got a fun new toy, guys. I haven’t even said hi to Jeff. Are you running the board today?
Radio Producer: Yes I am, sir.
PW: I haven’t even talked to you. I mean, it just got in here and I’m just jumping in front of the mic right now man. Good to hear your voice. I heard you during the week.
RP: Yeah, I was working on the Matt Murphy show. That was a lot of fun.
PW: You are getting to be a regular on this station, are you not?
RP: Well, I hope so. It was fun. You were on the show too, and that was fun as well.
PW: Yeah, yeah, yeah, yeah, that was a lot of fun talking about the interest rate decrease, the Fed, and all of that stuff. Do you think they got it? Did they understand?
RP: I think so, I think they nailed it.
PW: I think they’re pretty sharp guys.
RP: Yeah, I don’t doubt that for a second.
PW: Yeah, well Cameron, he was trying to stump me with that whole thing with the reserve requirement thing. He really got in the weeds there on me.
RP: Oh, he was planning that for days, I bet you.
PW: I think he may have been. But yeah, it was interesting.
Oh, by the way, we got a new text line where you can ask me questions. I need to get a sponsor for it. Can we get anybody to pay for this text line, like WTN has?
But yeah, you can actually ask questions while I’m on the show here. It’s (615) 965-5777. So yeah, (615) 965-5777. I’ll repeat it from time to time.
Decreased Interest Rates
So the Federal Reserve, the big news this week was the interest rate decreased. A friend of mine was asking me, “Paul, what do you think is going to happen? When do you think it’s going to happen?”
And I said, “Quarter point, half a point.” I was like, “Ah, it seems like it’s a little bit political to go to half a point, but it could be. It might happen.”
And indeed that’s exactly what happened. Because the Fed really only controls the short-term interest rates, they’re really dealing with the short-term stuff. So like your variable rate loans and those types of things, CD rates will be affected by that, and annuity interest rates can be affected by that.
Your short-term stuff can be affected by that particular interest rate coming down.
But the longer-term interest rates, when you’re looking at the government bonds and you’re looking at mortgages and things like that, that’s more of a market-based type of a thing, and interest rates were coming down slightly on those.
But you actually have a bigger differential right now between the short-term interest rates and the long-term interest rates. And what that means is you have more of a positively sloped yield curve.
Now, for example, you typically historically have about one and a half percentage points difference between a one-year or a very short-term bond and a ten-year bond. And it’s not near that yet. It’s not really that big of a difference right now.
But we had for quite a while a smile-shaped yield curve, which is where your short-term interest rates were relatively high, intermediate, like ten-year bonds, were lower interest rates, and then your long-term interest rates were higher. So it was kind of a smile shape.
And now at least we’re positively sloped and it’s looking a little bit more normal. But one of the things that people were wondering about is how this affects things. How does this affect mortgages? And the answer is not really that much.
People will say that it does and say “Here’s what’s happening.” I’ve heard people even do commercials saying now that the Fed has done this, interest rates are coming down. Well, the interest rates were coming down before, so it wasn’t necessarily the case that that was happening.
A Softer Labor Market
But how does this impact things? And why? And I think really one of the points that I was trying to make on there was that in the marketplace if you’re looking at the economy and things that are going on, the Fed tends to get information before anybody else.
They get a lot of information, they get a lot of data that comes in. And they must have seen things. Some people can say, “Well, it’s a conspiracy that they’re trying to affect the election by it,” but my take on it was not necessarily that. My take was that maybe things are a little bit worse than what we thought they were and that’s the reason that they’re dropping interest rates more than what we thought that they would drop the interest rates.
In fact, there was something my wife had sent me, I think it was yesterday, I don’t know. But it was about holiday hiring in the U.S. The retailers are set to drop it. That was in an article in one of the papers talking about U.S. retailers hiring fewer seasonal workers this holiday season.
And it’s due to a softer labor market, which is something else that I mentioned in the clip. You have a softening in the labor market and there were increases in hiring at the federal level — which yeah, I love it. The government’s hiring more people, that’s really great for the economy.
Where does the money come from for the federal government? It comes from corporations and businesses and taxes. It comes from us.
So for them to do more hiring isn’t necessarily something we look at and say, “That’s great economically.” So I think that’s partially the reason that the Fed reduced the interest rates on their end or what they had access to or what they had the ability to do.
Changing Reserve Requirements
Now as far as Cameron and his question regarding the reserve requirement, what I made a comment to him about was that if you look at reserve requirements, they’re not messed with as much with the government. The government or the Fed doesn’t mess with that as much as they do other types of things like government bonds.
The point that I made there was about “It’s a Wonderful Life.” You remember watching that movie? The bank scene I love is very instructive. When you put money in a bank, they hold a reserve requirement, and let’s say it’s 10%, you put $100,000 in, they’re going to lend the other $90,000 out.
They’re going to take $10,000, 10%, hold it back in the vaults, let’s say, or hold it in. They’ll keep it in the bank. It’s not necessarily a vault. But it’s just to get an idea.
They have this money on reserve, they have it readily and can turn it into cash in an instant, and then they lend the other money back out. And what they lend it back out for is homes, car purchases, and business loans. They buy government bonds — a lot of government bonds — is what the bank will do with that money.
And then that money will flow through the system and then some of it ends up getting deposited back in the bank — a smaller amount — and there’s a reserve held on that. So let’s say the money flows through the system. That $90,000 goes out there and let’s say $70,000 of it goes back into the bank — they’re going to hold a reserve on that deposit of $7,000, 10%.
Now the reserve requirement isn’t messed with at the fed level as much as what they’re doing is what are called open market operations. That’s really what the government does more of. An open market operation is where let’s say they buy or sell bonds, that would be an example of that.
So if they took some of this money that was deposited with them and the bank bought bonds with that money, government bonds, because they’ll do that, then what happens is the Fed comes in and says, “Okay, we’re going to buy those government bonds off of you.” And they will do that if they want to reduce interest rates.
That’s one of the tools that they have in their bag. They’ll do that because that will drive the price of the bonds up because they’re creating demand for the bonds when they buy them.
When you push the price of bonds up, you can drive interest rates down.
Then when you do that, you’re also freeing up money at the bank because the bank has that money tied up in these government bonds, now all of a sudden they have gotten a big stash of money from the Federal Reserve. And when they get the money from the Federal Reserve, now they’ve got to do something with it.
So they’re going to go out and lend it out to somebody that’s going to buy a car. They’re going to lend it out to somebody that puts money into their business or whatever.
So that’s the tool, the main tool. Now, could you change the reserve requirements? Could you lower them to put more money out there in the economy? Yeah, technically you could, but it’s a little bit more dangerous and that’s really why that’s a longer more complete answer.
But it was a good question. I mean, what do you do there?
Different Types of Annuities
Somebody had asked a question also regarding annuities, about a specific type of annuity. And with annuities, there are all different types of annuities out there, and I have to be really specific when I talk about them, but there are a lot of sales of these types of products out there.
There are a lot of lawsuits going on where attorneys are going after some of the insurance companies for misleading sales tactics and things like that. There are a lot of different types of annuities.
Not all annuities are bad. I don’t like commission-based annuities.
That’s one of the things I do tell people. And with the vast, vast majority of annuities that are actually marketed out there, go out and listen to an investment advisor. If the investment advisor’s saying, “Hey, we need to put so much in an annuity,” you’re probably hearing from somebody who is making commissions on these things.
Almost always. Unless they’re a completely fee-only, no-commission type of operation, almost always you’ll see that.
You own the banks, and I’ve actually been in conversations with bankers and overheard people being sold annuities in other booths and things like that, and I’ll go, “Oh my gosh, if they only knew what they were getting.”
But the types of annuities, I want you to get an idea of, number one, there’s a regular fixed annuity and that will be just a fixed interest rate. There are immediate annuities.
This is what annuities were designed for. So you put money into an annuity and they pay you an income for the rest of your life based on the deposit amount. Rarely do I ever look at these things and say, “This is a good idea for a younger person,” and the reason is inflation.
If you are in your 60s or 70s, you might be around for 20 or 30 years. And if you look at the devaluation of the dollar just in the last 20 years, you literally have about a 70% decrease in the value of the dollar. I mean, it’s huge. That’s a really big deal.
So if you’re getting paid the same amount of money that you were just 20 years ago, you’re looking at a huge pay cut over that period of time. And immediate annuities, that’s what they’re going to do.
Now, there are types out there that actually do pay a cost of living increase each year, but the payout is so low because they’re going to increase it each year that it’s really kind of a joke. I remember looking at some of these products and you give them $100,000 and they’ll pay you $2,000 to $3,000 a year, and they’ll increase it for inflation.
But you’re looking at it thinking, Oh my gosh, that’s awful. Awful. And then they’ll have a cap on it from inflation.
So with immediate annuities, there can be cases when they may work if you’re in your later years of your life and you have a very, very limited amount of money, you’re really super worried about running out of money because you’re just so, so low. I remember one lady who had less than $100,000 to her name and she needed as much income as you could give her, and she was in her late 80s. It made perfect sense because she didn’t care if the money was gone when she died.
Indexed and Multi-Year Guaranteed Annuities
Now the thing that you’ll have are indexed annuities, and I am just not a fan at all. Period. End of sentence on these.
With indexed annuities, you’re actually trying to give somebody some of the market return. There are so many different governors on the return, as in taking away your upside potential return because of the way they’re structured.
I don’t see myself ever recommending that. Commission-based or non-commission-based. I mean they’re pretty much, I don’t even know if there are any non-commission based in that particular product.
The question that came in was on the multi-year guaranteed annuities. That was one of the questions that somebody asked. “Hey Paul, what do you think about these?”
Now, with multi-year guaranteed annuities, you will typically have a period of time where you’ll have a guaranteed interest rate with these types of products. So in other words, what’ll happen is you give them a premium and it’s a fixed deferred annuity and it’s designed to avoid market volatility. You’re supposed to get tax-deferred growth because there are tax advantages of annuities.
Now, recognize that annuities are very poorly positioned when it comes to how the taxes are paid on them.
I’m not a big fan of the taxation of annuities in general because when I put $100,000 in, let’s say that it grows to $150,000, I’ve got to burn through the $50,000 of gain before I get my principal back, which is tax-free. It can be very, very problematic, and especially if you’re somebody inheriting one of these things, they’re just a bad product to inherit because of the taxation.
Now, if you look at the products out there right now, and you were to look at the interest rates on these products, a lot of them, I was looking around at the different products out there. I got a pretty good list of the ones out there just to see what they were paying.
They’re only somewhere in the neighborhood of about a 4.5% Interest rate. That’s about it. And you’re locking your money up because they have back-end surrender penalties.
You might have seven years and some of them will be 10 years. Typically, if the interest rate is a little bit higher, it’s because the period of time that your money is locked up is a little bit longer.
The Problem With Private Equity
Now, some people talk about doing laddering to avoid that problem. So you buy one that matures in seven years and then you’ll ladder it, and you’ll have one that matures a little bit shorter, and you’ll have various different maturity levels. But you still don’t get over the problem that it’s a fixed rate investment, and it’s literally sitting in, if you look at what an insurance company invests in, it is typically sitting in, they’re going to invest in a lot of bonds.
Insurance companies that issue annuities typically sell a lot of bonds. That’s where most of their money is. Fixed income securities. You might have treasury securities, and highly liquid, low-risk bonds.
You might have some corporate bonds in there. They want to try to pump up the yield a little bit. You’ll see a little bit of that in there. The insurance company is going to invest in some equities typically.
Sometimes they’ll invest in some blue chip stocks and things like that. Common stocks. A little bit in real estate.
It’s going to be less of that type of stuff though, but they’ll have alternative investments. That’s a really big thing with insurance companies right now: alternative investments. And that to me is danger territory.
When we’re talking about alternative investments, you’re looking at private equity.
Instead of buying publicly traded stocks, you have private companies. The problem with private equity is that you don’t have a lot of information on the companies, and that’s why companies will remain private because they don’t have to give away information. So they can keep their books closed to the public, and the problem is you don’t know everything you might need to know to determine if you’re paying a fair price.
Matter of fact, a friend of mine used to work with CalPERS, I think it was, it was the California Public Pension, and it was a pension in California. I don’t remember if it was that.
But he was at this meeting, and he told me all about it. He was talking about the problems that they were having with private equity, and they were talking about pensions. They’re just getting the garbage. They’re getting really bad private equity deals.
And just in general, the lack of information was making it challenging for them to actually get good returns on that. Matter of fact, there was an article not too long ago about the bad returns in private equity, and I’ve never been a fan of that.
Hedge Funds
Another thing that they might invest in is hedge funds. Hedge funds are problematic.
One of the things I’ll never forget is being at a meeting one day and I was teaching a workshop and this guy came up to me afterward, and this was probably 25 years ago. I used to go around to civic groups and I would teach workshops, and this guy came up to me and said, “Hey, Paul, what do you think about hedge funds?”
And I said, “Well, not much.” And he started telling me all the reasons that you ought to do them. This is what wealthy people can invest in because you have to be an accredited investor.
You had to have so much in net worth. You had so much income to even invest in these things.
So you’ll typically hear about hedge funds and wealthy people in one breath.
Not too long ago, there was an article about this, as a matter of fact, and the article was talking about hedge funds. And the title is, you can actually look it up on the internet, it was “How Hedge Fund Geniuses Got Beaten by Monkeys.” Yes, you heard right, “How Hedge Fund Geniuses Got Beaten by Monkeys.”
So it’s pretty typical that these head fund managers don’t do that. And so often what they’re really doing with your money is gambling.
And what we find in general is a lot of times wealthy investors, they’ll have these investment portfolios that are individual stocks. They’re trying to create their own mutual fund, and they’ll be using private equities in the portfolios or commodities and things like that, and it’s all these sophisticated sounding investments, and they’ll use maybe puts and calls or those types of things, hedging strategies and things like that.
Investing out of Fear
I just shake my head when I see it. I start to point things out to these people when I’m analyzing the portfolio, when somebody comes in and they’re working with this high-end investment manager, and I’ll point out what’s actually happening in their portfolio because they don’t have a clue.
They don’t even understand that they’re having losses, relative losses. They may be making money, and that’s the problem. They’re making money and they don’t recognize that the areas of the market they’re investing in, they’re underperforming those areas because of all these crazy strategies being used.
But that’s really, when we look at the insurance companies, that’s the problem that we run into. They’re investing in these same types of things. So I made a point about that recently when I was talking about it, how people are scared.
They invest in these guaranteed products because they’re scared of the stock market.
The point that I like to make is that you invest in these annuity products because you’re scared of the very things that the insurance company’s actually investing your money in. They’re just a go-between, between you and where your money is ultimately invested.
Now, I’m going to take a quick break, but I’m going to talk a little bit about the problem with inflation, and I’m going to talk about how to calculate after-inflation rates of return so that you get the problem here. Because once you start to understand where the problem really lies in investing in this manner, then you start to realize why this is not typically a really great long-term investment strategy. Unless you’ve got money to burn.
And inflation, maybe just luck out and inflation remains incredibly low over the next however many years that you’re alive. But don’t bet on it because inflation is here with us to stay. Matter of fact, there is a target that the Fed likes for inflation. I’ll talk about that as well after this.
Increased Healthcare Inflation Rates
There was a question that came in. The guy said he was retired, listening to the show, and he was curious about my thoughts on the annuity industry as the MYGA, the multi-year guaranteed annuity, had set up a five-year ladder that seems to be working well.
And he was just wondering about it as far as a portion of retirement for funds that we do not need. He said it seems to be working well so far as a portion of retirement for funds that we do not need unless we have health issues way later on.
Okay, so that’s really the issue. And you look at healthcare inflation. Let me get a little bit more specific.
And Daryl, thanks for your question. And by the way, you can ask a question here. You go to the text line, we have a text line running now: (615) 965-5777.
So anyway, healthcare inflation actually has, I haven’t seen the data recently, but the healthcare inflation rate has actually exceeded regular inflation rates. So it’s more of a problem when it comes to healthcare inflation, putting money in a fixed-income investment that doesn’t keep up with inflation. It just doesn’t.
And how do you calculate that? Well, when you’re looking at calculating after-inflation rates of return, what you’ll do is take the return and the nominal rate, which is the rate of return that you’re going to be paid. So it’s called the nominal rate.
So that’s basically what they’re telling you the interest rate is, and then you take that plus one and then you divide it by one plus the inflation rate, whatever the inflation rate happens to be. And then you take that, divide those two, minus one, and it equals your after-inflation rate of return.
So let’s say that my rate of return is — some of these things out there are paying — just over 4%. Let’s say it’s 4.1%, one plus 4.1% divided by one plus just about 2.9% inflation. Which, going back from 1926 through 2023, that’s the inflation rate that gives you a rate of return after inflation of just 1.16%.
Now the problem that you run into is you have to pay taxes on those gains as well if you pull the money out for that particular purpose.
And then the other issue is that’s not necessarily going to be the inflation rate going forward. If we look at the inflation rate since 2020, the actual inflation rate since 2020 has actually been 5.6%. What will it be going forward? I don’t know. But let’s say that they pay just a 4.5% rate of return and then you have a 5.6% inflation rate.
Well, you’re actually losing about a percent after inflation. You’re looking at a rate that’s negative.
Balancing Stocks and Fixed Income
So typically if I’m looking at money that’s longer term, and I may need it for health reasons, those types of things, I’m going to have a balance between stocks and fixed income because I’m not going to need all the money at once. I’m not going to need it all. Hopefully, I’m not going to need it all in one year.
Whatever I’ve saved for healthcare expenses, the money that I’m not using currently for let’s say living, I don’t need it all at once for even medical expenses. I might need to spread it out over a few years or something like that. We look at, let’s say an investment mix that is half stocks and half bonds, let’s just use that as an example.
There are different time horizons when it comes to investing. And those time horizons, what they really mean in the academic world is how long can I go without a return?
How long, if I look at all of history, might I have gone and not had any return whatsoever on my money in a really bad case scenario?
And that will vary based on how much I have in stocks versus bonds. If I’m all stocks that period of time, maybe 10 years now, it’d be incredibly rare. I mean, we literally have to go back to the Great Depression to see that 1929 through 1938, you have to go back that far to have seen no return in stocks.
But we’re always thinking, What’s the worst case? What could happen? And even back then you have to look at it and go, Is that even accurate?
Simply because we couldn’t diversify back then as much as we can now. So there’s really a big difference in what you can do now versus back then.
Diversifying Investments
But let’s just use that in general. If I drop back and put, let’s say 25% of my money in fixed-income investments, five-year bonds and four-year bonds and three-years, and governments keep the bonds super, super safe, shorter maturity, and then I have my stocks divided between big, small, big value, small value, international, international, large, small and emerging markets and all those types of things.
Now your time horizon drops back to in the neighborhood of six to nine years if I go half stocks, half bonds. Now we’re dropping back in the neighborhood of three to five years. And like I said, that’s pretty doggone rare.
But here now what we’ve got is half the portfolio in fixed-income investments. And if we think about this, let’s say that I am needing to pull money out for healthcare expenses and I need it in a fairly short period of time, and the stock market half has to be down.
Well, I’m going to be pulling the money from the fixed-income investments. Most of that money is going to be coming from the bonds, is what will happen. So I’m not even selling the stocks low, which gives me time.
I don’t need the money all at once for the stocks to recover because historically it doesn’t take that long for markets to recover. We go back and we say, “Well, what was the absolute worst?”
Well, again, Depression in 1929, 30, 31, and 32. So you had that four-year period right there where stocks were down. But not all areas of the market were down equally back then either.
Now, if we look at value companies, let’s say we look back at the 2000 downturn, value stocks actually went up those years. So if I’m looking at that time horizon, I would still go, “Gee, I really need to protect myself from inflation.”
And if I’m putting all my money in a fixed type of investment like a MYGA, a multi-year guaranteed annuity, I still have that problem. I’ve walked away from something that is fundamental to investing, which is diversification.
Because what is the insurance company doing with your money? They are just the intermediary investing your money in these other assets, most of them being government bonds. And government bonds historically haven’t done anything really to protect us from inflation. They just don’t.
So historically we look at that and go, “Wow, yeah, this doesn’t do a good job of protecting me.” Especially if you have a long-term goal like this where you’re saying, “I might need this for medical expenses.”
It just depends on your situation. But in general, I don’t like product approaches like that for those types of goals.
Typically, I would want to make sure that I have something that has some fighting chance of protecting me from price increases.
I mean, that’s literally what we’re dealing with. And this is something I’ve talked about. I was saying this to a friend of mine, as a matter of fact, let me say this just because it’s important.
Increasing Capital Gains Taxes
We were just talking about capital gains taxes, and I made a comment about capital gains taxes. I said, “The problem with capital gains taxes is that much of your return on an investment is due to price appreciation that is really inflation driven. And remember, the government gets a lot of money from capital gains taxes.”
So you think about that. What if there are people out there that want to increase capital gains taxes?
We hear people saying, “Hey, let’s just crank ’em up.” And the point that I made to my friend about this was that if you have increases in capital gains taxes, you’re literally incentivizing the government even more to have higher inflation rates.
Well, why is that? What caused great increases in the value of properties over the past 30 to 40 years? Inflation.
What is taxed when you sell a piece of property that has appreciated in value capital gains? So you’re paying taxes on inflation. And he was like, “Whoa, I never thought about it that way.”
Here’s the other incentive for the government with inflation: If we have lots of inflation, it devalues the dollar.
And what is the government? Were they borrowing dollars? And what are they issuing government bonds with?
And when they repay that debt, it’s with devalued dollars. It’s helpful for the federal government if you think about it that way.
So in essence, we’re looking at some real danger when it comes to inflation. The Fed has its target of 2%, but they only have so much they can control.
It’s a challenge for the Federal Reserve, quite frankly, to try to keep the inflation rate down to where they want it to be. Try as they may because they’re not in charge of government policy. That’s politicians.
Advisory services offered through Paul Winkler, Inc an SEC registered investment advisor. The opinions voiced and information provided in this material are for general informational purposes only and not intended to provide specific advice or recommendations for any individual. To determine what investments are appropriate for you, please consult with a financial advisor. PWI does not provide tax or legal advice. Please consult your tax or legal advisor regarding your particular situation.
