The Aftershock Investor: A Crash Course in Staying Afloat in a Sinking Economy (27 page)

Once you make the decision to sell, don’t make the mistake of holding out too long for a high price. If you can’t get a buyer within a reasonable amount of time (a few months, not years), lower your asking price if necessary to make the sale. As we mentioned earlier, if you don’t lower your price now, you will only have to lower it even more later.

Many people find that owning real estate makes them feel comfortable and safe. This is understandable. Owning your own home feels, well, like home. Change, especially when it involves leaving home or losing income, takes courage. Remember that good decision making helped you acquire the real estate you have today and good decision making will also help you create your future during this unusual time. If you choose not to sell your real estate now or soon, while you can get the most for it, that’s perfectly fine as long as you are fully aware of what you are doing and its consequences. Over the next several years, your real estate equity is going to Money Heaven and it’s not coming back.

Please also know that the biggest cost of hanging on to falling real estate is not just the loss of your current equity; it is the much bigger
opportunity costs
of losing wealth when you could have been protecting and growing your money elsewhere.

Why do people buy whole life insurance and annuities? Our faith in these products is so solid that the question seems almost silly. We buy them for protection, of course! If bonds are considered safer than stocks, then insurance and annuities are supposed to be even safer than bonds. The universal assumption is that, even in the rare event that the company goes under, these policies
always pay out
. These are the bedrock safety instruments that allow even the most anxious investors to sleep soundly at night. Like the old Prudential ad that calmly reassures us: you can always count on “The Rock.”

Where did this “rock solid” mentality come from? Like most of our ideas about money and investing, it came from the past. Today, people don’t worry too much about the safety of their money in banks, but before the Federal Deposit Insurance Corporation (FDIC) was established so that the government insured depositors’ money, banks were not always so safe. If you lived in New York or Chicago, you might have access to some very reputable financial institutions. But if you lived in more remote parts of the country, the pickings were slim. If you had a nest egg to protect, keeping it under your mattress or burying gold in your backyard may have seemed like a better option than risking it at the bank.

Enter whole life insurance and annuities. These could be bought from a national company with a solid reputation. An annuity could provide investors with the income they needed for the remainder of their lives. And with whole life insurance, the policyholder had reliable savings that could be borrowed against when necessary, not to mention the protection for his or her heirs. For many people, this made whole life insurance and annuities more attractive options than a savings account at a potentially less reliable local bank. Why take a risk when you could own a piece of The Rock?

But this long history of comfort that people have derived from owning whole life insurance and annuities has kept most of us from thinking about the deeper and riskier realities of these policies. That is because . . .

When you pay your premiums to an insurance or annuity company, they are not just stashing that cash under a mattress; these companies are
investing
it. Therefore, whether you know it or not,
you
are investing it. When you buy an annuity, whole life insurance, or long-term care insurance, you are buying exposure to the investments that these companies own.

What do these companies invest in? For many years, they invested primarily in long-term corporate bonds. One of the main reasons that insurance and annuity companies have the reputation for being so very safe is that traditionally they invested almost exclusively in safe, highly rated bonds. By pooling the policies of their clients into what is called a general account, insurance companies typically invest in a highly diversified portfolio of bonds, providing protection against default and related risks in the bond market.

In the past few decades, insurance companies have also begun investing in some stocks, and more recently they have been providing permanent financing to commercial real estate development, and even to some large-scale residential real estate projects.

If you have a whole life insurance policy, it is easy to think of it like car insurance—something you can count on if an unfortunate event occurs. But, really, your whole life insurance policy is an investment, with bonds making up the biggest piece of your company’s investment pie.

As a good example of this, we looked at the investment portfolio of Northwestern Mutual (see
Figure 7.1
). We chose Northwestern because it is such a highly rated and well-managed company. Interestingly, they invest in almost no government bonds due to their lower coupon rates. They prefer mostly long-term corporate bonds, which carry a higher risk and therefore offer higher yields, as can be seen in
Figure 7.2
.

Figure 7.1
Northwestern Mutual Mostly Invests in Bonds

Bonds make up the lion’s share of most insurance company investments.

Source
:
www.northwesternmutual.com
.

Figure 7.2
Northwestern Mutual’s Bond Portfolio

Government bonds are only a small proportion of Northwestern Mutual’s bond portfolio.

Source
:
www.northwesternmutual.com
.

Based on past performance, today’s conventional wisdom tells us these policies are rock solid and safe. The top insurance companies in the United States have high ratings based on their historical reliability and creditworthiness. Many of these companies have been in business since before the Great Depression, and they have weathered every recession, every market fall, and every inflationary period along the way. This certainly inspires the full and long-term confidence of investors who want to hold on to their policies for 20 or 30 years or more.

The insurance industry’s primary rating agency, A. M. Best, analyzes and grades insurance companies regarding their creditworthiness, debt, overall financial strength, and other factors. Like a report card, they rate each insurance company from A++ for those considered the most superior, to F for those in liquidation (see
Table 7.1
).

Table 7.1
A. M. Best Rating Scale for Overall Financial Strength

Source
:
www.ambest.com

As an additional way of spreading out and limiting risk, insurance companies may also use reinsurance. Many insurance companies also have very large reserves and are well capitalized, further adding to their strength. This type of strength is part of what A. M. Best is looking at when determining its insurance company ratings.

Adding to the overall sense of security, each state maintains a fund (funded primarily by an insurance policy premium tax) standing ready to cover insurance policyholders in the event that an individual insurance company happens to fail. And if necessary, even the federal government could potentially step in to bail out insurance companies, as it did with AIG.

With the support of seemingly rock solid credit ratings and the potential for government backup if necessary, it is understandable that insurance and annuities provide a deep sense of safety. Not surprisingly, that comes at a price. Here is a brief description of these policies and the relatively higher premiums you must pay in order to feel safe.

There are two general types of life insurance: term and whole life. Term life insurance provides your beneficiary a set payout amount in the event of your death if it occurs within a limited “term” of time. When that time period is up, your term policy ends. If you want to buy another one at that point, the new term policy will likely be at a higher premium because of your greater age. And if you have also developed a medical problem since you bought the first policy, you may not be able to buy another policy or you may have to pay a much higher price.

In the case of whole life insurance, you are buying a combination of what you would get with a term life insurance policy except that, rather than terminating, it lasts your “whole” life. In addition, whole life insurance acts as a forced savings account. Whole life insurance gives some people the peace of mind that comes from feeling that they are guaranteed coverage for life, and it provides a tax-free death benefit to the beneficiaries. It also often provides for the payment of a certain amount of money later, under certain conditions or at specific times. Most policies also usually allow loans to be made against the policy. A third type of insurance, called universal life, is a hybrid of both term and whole life.

Whole life insurance policies (and to a lesser extent, universal life) are significantly more expensive than term life insurance. You are paying for the feeling of safety of lifetime coverage, whether you need it or not, and the feeling of safety that you have a forced savings account (even though you could earn more by investing it on your own). Whole life insurance is much more of an investment than term life insurance and, accordingly, it costs more.

An annuity is a contract between you and an insurance company, in which you give them either a one-time or series of payments in exchange for a guarantee of periodic payments to you, beginning now or in the future. Annuities are popular in retirement plans because earnings are usually tax deferred. When withdrawals are later taken, the gains are taxed as ordinary income, not capital gains.

There are three types of annuities: fixed, indexed, and variable. In all three cases, the annuity is basically an investment in some type of asset (typically bonds, but also stocks), plus the addition of insurance that provides some minimum payout in the event that your investment falls below a set amount. A fixed annuity is essentially the purchase of a fixed-interest-rate bond with the addition of bond insurance, plus perhaps some life insurance. An indexed annuity pays based on changes in an index, such as the Standard & Poor’s 500, and provides insurance that earnings will not fall below some specified minimum, regardless of index performance. A variable annuity pays based on the performance of a variety of investment options, each with different levels of risk and return, similar to a variety of mutual funds. It also provides insurance that earnings will not fall below some specified minimum.