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Welcome to How to Retire on Time, a show that answers your retirement questions. Say goodbye to the oversimplified advice you've heard hundreds of times. This show is about getting into the nitty-gritty so you can make better decisions as you prepare for retirement. Text your questions to 913-363-1234 and we'll feature them on the show. Don't forget to grab a copy of the book, How to Retire on Time, or check out our resources by going to www.retireontime.com.
Welcome to how to retire on time, a show that answers your questions about all things retirement, including income taxes, Social Security, health care, and more. This show is an extension of the book, How to Retire on Time, which you can grab today on Amazon, or you can go to www.howtoretireontime.com. My name is Mike Decker. I'm the author of the book, How to Retire on Time, but I'm also a licensed financial advisor, insurance agent, and tax professional, which means when it comes to financial topics, we can pretty much talk about it all. Now that said, please remember this is just a show.
Mike:Everything you hear should be considered informational, as in not financial advice. If you want personalized financial advice, then request your wealth analysis from my team today by going to www.yourwealthanalysis.com. With me in the studio today is my, esteemed colleague, mister David Fransen. David, thanks for being here. Yes.
Mike:Thank you for having me here. David's gonna be reading your questions, and I'm gonna do my best to answer them. You can send your questions in right now or anytime during the week. Just save this number, (913) 363-1234. Text them in, (913) 363-1234, or you can email them to heymike@howtoretireontime.com.
Mike:Let's begin.
David:Hey, Mike. Can you explain the difference between an index, indexing, and an indexed investment?
Mike:This is a very insightful question. Whoever is sending this is very inquisitive. Mhmm. And the reason why I wanna point that out is many times we just take something at face value and actually do not understand the interworkings of a financial instrument. So just by way of example, then we'll get to the indexing side of things.
Mike:A money market account. When you think of a money market account, what what do
David:you really think of? Checking account, low yield, not much of return.
Mike:Yeah. So a money market account is actually a very sophisticated, basically, ETF. The financial plumbing, what happens underneath the surface is insane. They're actually rather complex to run, but it's not like someone's just saying, Yeah, you put money in this thing and we'll just give you a random rate. They're moving investments around.
Mike:They're moving securities around like treasuries. Like there's a lot going on to get you that rate. So it might be easy for the consumer just to say, hey, I'll put some money in, you know, in this ticker, this money market fund. Yeah. And you get about this rate and think, oh, that's easy.
Mike:But no, it's actually quite complex. Yeah. If you really wanna dive into financial plumbing, look at how the reverse repurchase agreements, repos, you're looking at the Fed, you're looking at I mean, that investment banks, how money actually works is, like, complex. So whoever's asking this question is starting to pick up on the the reality that maybe things aren't as simple as they would suggest. Sure.
Mike:So let's talk about this starting with an index. What is an index? An index is a defined group of typically securities. So you're looking at stocks or bonds that are compiled together and constantly traded or held for an extended period of time, allowing you to basically put a little bit of money in and get exposure to a lot of different investments. Are you with me so far?
David:Yeah. Yeah. Absolutely. So how does that how would that compare to, like, you know, you look in, like, a book and there's an index in the back. Right?
David:So you can orders the book mentioned this. So the book has indexed, like, all the words in the book, right, or keywords or glossary or something. Right? Is that an apt analogy or is that totally off base?
Mike:Yeah. The index is really the list of everything you need to know. Uh-huh. So an index in securities is a list of all of the different securities within this one fund.
David:So, you
Mike:know, I I appreciate the the, question because what is actually in the fund is a very important thing, just like in the index of a book or whatever. You kind of know what's going on and where to find it. The index like, we'll use SPY. SPY VOO, it's the S and P five hundred.
David:Okay.
Mike:It's the 500 and some stocks that Standard and Poor's has deemed appropriate for this index. Mhmm. And then how much is weighted? So you've got Nvidia, Microsoft, Apple. They're more heavily weighted in there.
Mike:There's a bunch of them that have a small portion, but it's you need to understand the index or the list of all the securities in there.
David:Okay.
Mike:Now when we look at indexes, it's basically just a group of security stocks or bonds. So sometimes it's an equities or a stock fund. Sometimes it's a bond fund, the trading bonds. Sometimes it's a little bit of both. But you need to understand what's in the index, know what you're buying.
David:Okay.
Mike:Why does this matter? And they the reason I think it matters is because there are more indexes out there than there are actual securities to buy.
David:That's interesting.
Mike:Yeah. So when people say, oh, I bought a lot of indexes or index funds like ETFs, when you actually look at it, there's oftentimes they're buying the same securities over and over and over again, not really diversifying more than one of the indexes.
David:So the same security could show up in a few different indexes.
Mike:See, if you buy SPY and you buy it via o, you're basically buying the same thing.
David:Oh, yeah.
Mike:So are you really diversifying? Not really Mhmm. In that situation. Understanding the index or the list of securities within a fund is important for a number of reasons. And we could have do a whole show on just that, but we'll continue on.
Mike:Mhmm. Indexing is a form of passive investment where you're buying a certain fund and holding it for an extended period of time. Why would you do that? You wanna buy something and try not pay capital gains. So let's say it's a non retirement account.
Mike:Yeah. You received income from your employer. You've paid income taxes on it, and you don't really need to spend it. You've got enough in your emergency savings. So you put it in the market.
Mike:You buy an ETF, and you plan to hold that ETF for twenty years. That would be like indexing. You're buying and holding.
David:Okay.
Mike:So do you see the difference in index is different than indexing, which is kind of the verb of buying an ETF?
David:Oh, right.
Mike:Or sometimes a mutual fund. Now where the question becomes complicated is the indexed investments. Oh. K? Plot twist.
Mike:There are other more sophisticated investments that don't actually buy the index. They buy and give you money or performance based on the index.
David:So give us a real world example then.
Mike:Yeah. Well, actually, before I do that, I I do wanna point out that when you buy an ETF, SPY, you're not actually buying the S and P. You're putting money with a manager who's going to basically try and mimic that. So if you look at, let's say, the top five to 10 ETFs around the S and P 500, some of them may have higher fees. Some of them may have lower fees.
Mike:Some of them may try to have a competitive edge and maybe make a few investment decisions to maybe outpace the S and P slightly. So you're buying actual managers to try and perform at the same rate of an index. So indexing isn't necessarily buying all the indexes. There's some variance with fees. That's why people hound on fees so much.
Mike:Mhmm. If you want the S and P performance and you can get that with low fees, then do that instead of pay a lot of money and a lot of fees for basically something else that could have been done just buying the index. That was a bit complicated. The reason why I bring that up is when you buy an ETF, you're not actually buying the index. You're putting money with the fund manager to buy and mimic that performance is because indexed products aren't actually buying the index.
Mike:In the eighties, you had indexed CDs. They came out in the eighties. They're still around. They're just not as popular anymore. But the indexed CD basically says if the market would go up, you would be credited some money.
Mike:Your money would grow. The markets were to go down, you wouldn't lose anything. It's an indexed product from a bank. Okay. Then you've also got structured notes, which kind of do the same thing, a longer duration or hold time, maybe it's three, four years.
Mike:But if the markets increase in value, you are credited or given growth. If the markets go backwards, maybe you had a protected structured note, so it couldn't lose anything, but you've got some upside. You've got no downside risk. Are you with me so far?
David:Mhmm.
Mike:Those have been around since the eighties. Alright. Yeah. In the nineties, you had something come out called an a fixed indexed annuity. It used to be called an equity indexed annuity.
Mike:Now they call it FIAs or fixed indexed annuities. And the idea behind that is if you're not using it for income, k, you can put money with an insurance company and basically mimic the same simulation of an equity indexed CD from a bank or a structured note from a financial institution. It's the same thing, just from a different company.
David:Okay.
Mike:Slightly different wrapper. But again, the idea is if the index it is associated with this increases in value, you participate with the upside. And if the markets go down, assuming that you chose a product that has a % protection, then you don't go backwards. And every year, you can reset it every two years. You know?
Mike:Hey. The markets went down. Alright. You got zero. Reset.
Mike:Let's keep going. You're not recovering from the market drop. You just reset and and keep going. In I believe it was 2018, the securities industry then came out with buffered ETFs. Buffered ETFs are, again, another way that you can have a % protection of your money, but have upside potential.
Mike:Can you see a theme with this? Indexed products are sophisticated mechanisms to where you have to give up your money for a period of time. It's illiquid, whether it's a % illiquid or partially illiquid, depends on the product. It's associated with an index, and if that index increases in value, your money grows. Uh-huh.
Mike:If it goes backwards, you don't lose anything.
David:Right.
Mike:So people use these products to especially with our reservoir strategy, the idea that you should have some of your money principal protected. So if the markets go down, you could draw income from principal protected accounts while your other accounts have a chance to recover using equity index CDs or index CDs using structured notes, buffered ETFs, fixed index annuities. It's basically a way that you assume you got the right products, but you may be able to get more upside potential than you would a fixed product like a CD or a Treasury on its own. Uh-huh. You see the difference there?
David:Okay. So, Mike, how do these things, like, actually work?
Mike:Yeah. It seems like magic, doesn't it? Who thought of this? So this that's what I wanna know.
David:Who thought of all this? Who's sitting there and, like I I couldn't even conjure up any of this in my best day.
Mike:It's how do you use the tools available to you? Mhmm. Think about cooking. What what do you cook? Barbecue.
Mike:How did it first start? Well, you put meat next to the fire, and then you realize we put some salt on the meat. Maybe it turns a little bit better. Then you put some other dry rubs on there. I mean, things evolve over time.
Mike:You just have to understand the ingredients for you. Basically, here's how they work. This is admittedly very complex, so doing this over the airwaves might be a bit much. So stay with me here, but there's no such thing as a perfect investment product or strategy. Doesn't exist.
Mike:So when you see the spectrum of risk versus reward versus growth potential versus protection, right, all the things we want, you've got your fixed products, which have, in my opinion, the lower growth potential. You know what you're gonna get. Then you've got your fixed indexed products, which have more growth potential and a % protection, assuming you chose the right ones. But they're not gonna make you rich because the assets that would be in the market in theory have more growth potential. So I don't want to come off with anyone thinking, oh, well, I can have all the upside potential and none of the downside.
Mike:Nope. Not at all. Not how this works. Mhmm. So with that kind of disclaimer, here's roughly how they work.
Mike:Let's say you've got a hundred thousand dollars that you wanna put into a fixed index or an index product that has protection. So you want your money to grow better than a CD rate. You're okay with some risk. It might not grow, but you're hoping that it would, but you do not wanna go backwards. And you give it to a bank insurance company or a financial institution.
Mike:Here's what they would probably do, and this is how all of them basically work. They're gonna say, okay. What's the going rate of a, basically, a fixed income, like a bond or a CD that we can put most of the money in? And let's say the bank comes back and says, you know, you got $20,000,000 you wanna place with us. We'll give you a 5.3% rate.
Mike:Right? Because they might get a better rate because they're an institution. It's a larger amount of money, whatever it is. So we have 5.3% that we can get. That means we'll take your hundred thousand dollars and we'll put $95,000 of it, 95% of it, in this fixed interest account, whether it's a note, whether it's a CD, whatever it is, that is fixed at 5.3%.
Mike:Ninety five thousand dollars at a 5.3 rate means it's going to be around a hundred thousand dollars in twelve months.
David:Okay. So do
Mike:you see how now your principal is protected?
David:Oh.
Mike:So 95,000 becomes a hundred thousand, so there's really no risk at that point to the institution. Oh. So if that's the case, then they can take the extra $5,000 and go buy option contracts based on that index. So if the index increases in value, they can exercise them. And if they exercise them, they make money, you make money, everyone's happy.
Mike:Uh-huh. And if they don't, if the index doesn't make money and you don't make money, they just let them expire. They don't touch them. You're back at a hundred thousand, and you rinse and repeat. Now it's very common for someone to say, well, that's easy.
Mike:I can just do that on my own. Mhmm. Maybe. Uh-huh. But the option contracts that you would get through a buffered ETF, a structured note, or a fixed index annuity are far greater, all things being equal, than what you can get as a retail investor on your own.
Mike:Mhmm. Because to get the good contracts, you need around $20,000,000 to place. And most people don't have $20,000,000
David:No.
Mike:Casually to put into a fixed indexed or an indexed or a structured product like this. Right. So there is that urge of, oh, I have to do it on my own, so I'm gonna do it on my own. But if you're really looking at cash growth potential, where is the money able to go to have the best growth potential? That's not saying all of these products are made equal.
Mike:They're not. Some of them have uncompetitive rates. Some of them have more competitive rates. The the devil's in the details. But overall, if you're looking to grow your money with protection and you're okay saying, I don't need it to grow necessarily every year.
Mike:I just want over a longer term period of time, more growth potential than what a CD or a treasury or a typical corporate bond would do. Maybe this is an option as a part of your portfolio. We don't believe in extremes, but these are investments and products. This is what it is. This is how it works.
Mike:It's basically an index is a list of securities. Indexing is buying an index and holding it, and index products are typically structured products that participate with the upside, but protect you in in one way or the other from the downside. That's all the time we've got for the show today. If you enjoyed the show, consider subscribing to it wherever you get your podcast. Just search for how to retire on time.
Mike:Discover if your portfolio is built to weather flat market cycles or if you're missing tax minimization opportunities that you may not even know exist. Explore strategies that may be able to help you lower your overall risk while potentially increasing your overall growth and lifestyle flexibility. This is not your ordinary financial analysis. Learn more about Your Wealth Analysis and what it could do for you regardless of your age, asset, or target retirement date. Go to www.yourwealthanalysis.com today to learn more and get started.