Frank Mbanusi

We all have 6 potential resources to support ourselves, our families, our businesses, and our charities:

• Our time
• Our talent
• Our treasure
• Other people’s time
• Other people’s talent
• Other people’s treasure

Most people only use their time and talent to make a living. Some people use their treasure to save for their future. Employers use other people’s time and talent to operate their business (they “leverage” other people’s time and talent). Wealthy people use other people’s money (OPM) to build wealth (they “leverage” other people’s treasure). Why do wealthy people use OPM? Wealthy people understand the difference between “velocity of money” and “wealth momentum”.

• Velocity = speed of money (rate of return)
• Momentum = mass TIMES velocity
• Wealth Momentum = amount OF money TIMES return ON money
• Wealth momentum, by definition, can be exponentially greater than velocity of money—it simply requires more money. Wealthy people increase their wealth momentum by adding OPM to their money.

Wealthy people understand there is a cost to use OPM and there is a cost to NOT use OPM. The cost to use OPM is known as “employment cost” (cost to employ money, which would include the interest rate and payment). The cost to NOT use OPM is known as “lost opportunity cost” (growth/income they could have earned on another asset). If employment cost is less than the opportunity, they borrow. If they can borrow at 3% and can earn 8%, they borrow. This is known as “positive arbitrage”. If employment cost is more than the opportunity, they do not borrow. If they can borrow at 10% and can earn 8%, they do not borrow. This is known as “negative arbitrage”.

In the context of speed, wealthy people understand, like aviators, that to increase their speed, they must increase their “thrust” AND decrease their “drag”. To decrease financial “drag”, wealthy people minimize expenses, taxes AND the lost opportunity costs related to expenses, taxes and spending their own money. To increase financial “thrust”, wealthy people use OPM if they can earn positive arbitrage.

Here is a simple story to illustrate why wealthy people use OPM: A farmer owned an apple orchard and had a contract to sell boxes of apples to Walmart at $5 per box. Once he sells all his apples, his neighbor (who does not have a contract with
Walmart) offers to sell him boxes of apples at $3 per box that he can then sell for $5 per box. How many boxes of apples do you think the farmer would like to buy from his neighbor? As many as he can! Wealthy people view OPM the same way: if
they can “buy” a dollar for 3 cents and then “sell” the same dollar for 5 cents, they want to “buy” as many dollars as they can.

Simply put, wealthy people increase their wealth momentum by:

• Borrowing to BUILD
• Borrowing to BUY
• Borrowing to BEQUEATH

Specifically, wealthy people increase their wealth momentum with the following tax-efficient system:

• Wealthy people BORROW tax free to BUILD tax-deferred businesses (their company stock is tax deferred).
• Wealthy people BORROW tax free from their businesses, or against their tax-deferred company stock, to support their lifestyle and to BUY tax-deferred assets. The following is the first paragraph of the proposed Billionaire Income Tax by Senator Ron Wyden on October 27, 2021: “Working Americans like nurses and firefighters pay taxes with every paycheck, while billionaires defer paying taxes for decades, if not indefinitely. The tax code’s preferences for capital income over wage income fuel the concentration of dynastic wealth among the nation’s billionaires. The wealthiest few who avoid taxes by indefinitely holding assets are also able to borrow against those assets to fund their lifestyles. This means they opt out of paying taxes and instead pay only low interest rates on loans from Wall Street banks. As a result, middle-class families who earn their incomes from wages and salaries may face higher average tax rates than billionaires.”
• Wealthy people BORROW tax free against tax-deferred assets to BUY more tax-deferred assets
• Wealthy people BORROW tax free to BUY tax-free life insurance. Wealthy people don’t buy life insurance because they NEED it—they buy it because they WANT it. They want life insurance cash value so they can borrow against it tax free to finance their lifestyle and BUY more tax-deferred assets. They BEQUEATH the life insurance death benefit so their family can use the life insurance company’s money to pay off loans that may be due at death. In other words, they use OPM to pay off OPM! Using the death benefit to pay off required loans at death has the additional benefit of not forcing heirs to sell assets at an inopportune time. Wealthy institutions (banks and publicly traded companies) often use cash value life insurance as their primary source of liquid reserves. Do an internet search on “bank owned life insurance BOLI” and “corporate owned life insurance COLI”. Many of the largest banks in America have more cash value life insurance as part of their Tier 1 capital (their liquid reserves) than any other asset. Since customer deposit
• accounts at banks are “accounts payable” to the bank, the bank is technically borrowing from their customers to BUY life insurance.
• Wealthy people BORROW tax free against their tax-free life insurance cash value to BUY more tax-deferred businesses or assets. Walt Disney used a loan against his life insurance to start Disneyland. JC Penney used a loan against his life insurance to finance his stores. Ray Kroc used a loan against his life insurance to finance McDonald’s. Doris Christopher used a loan against her life insurance to start Pampered Chef.
• Wealthy people BORROW tax free against their tax-free life insurance to BUY more tax-free life insurance (until they reach their family’s and employees’ insurability limits). This strategy is called “stacking”.
• Interestingly, the Wall Street Journal published an article entitled “Buy, Borrow, Die: How Rich Americans Live Off Their Paper Wealth”, with a subtitle of “Banks say the wealthy are borrowing more than ever, using low-interest loans backed by their
• investments”.
• In short, wealthy people use OPM to buy and build businesses, buy assets, buy life insurance, support their lifestyle, and pay taxes (if they have any).
• If you conclude that wealthy people are “playing chess” while the masses are “playing checkers” you are correct. Checkers and chess are played on the same game board, but they use different pieces, rules, and strategies. If you are going to win the game, you first must know what game you are playing. We all play on the same game board of money. The good news is that we get to CHOOSE which game we are playing. Forbes published an article entitled “How Ordinary Americans Can Also Buy, Borrow, And Die Without Paying Taxes” that discusses how and why the rich do it and how “ordinary” people can do it. There are some good ideas in the article, and we offer additional strategies that are available to everyone.
• We encourage individuals and businesses (of any income or net worth) to choose financial chess over checkers, and we educate our clients on the financial chess pieces, rules, and strategies. One of the financial chess pieces wealthy people and institutions use is cash value life insurance, and one of the financial chess strategies is to fund their policies with OPM. We have clients funding as little as $100 per month who can implement the same strategy as wealthy people. We
• have other clients who are funding millions of their own dollars AND millions of OPM into their life insurance policies.
• Like most things, there is good, bad, and ugly cash value life insurance, so it is important to make sure of the following:
• Choose the right life insurance company. Use A-rated companies if possible.

• Choose the right life insurance product type. Most wealthy people use either whole life or indexed life for traditional products and use variable life for their private placement (non-traditional) product.
• Choose the right life insurance product that fits your purpose. Companies can have multiple products of the same type that are designed for different purposes (accumulation versus death benefit). Wealthy people choose products that have expense reimbursement bonuses to reduce the financial “drag” of expenses. Expense reimbursement bonuses are offered by companies that “profit share” with their customers. These bonuses are called “dividends” with whole life and “indexed crediting bonuses” with indexed life. The US tax court, in their decision on the taxation of life insurance dividends, said dividends were “a return of overcharged premium”, which sounds a lot like “expense reimbursement”.
• Choose the right index strategy (if using indexed life). Using historical data, this is the biggest difference between indexed life products.
• Design the product to be both effective and efficient. There are too many variables to discuss here but may include options like death benefit type and riders.
• Fund the product optimally. Choose how much of your own money you want to use and when. Choose how much of OPM you want to use and when.
• Use the product optimally. Choose which liquidity option you want—withdrawal or loan. Most wealthy people choose participating loans (or lines of credit) to reduce the “drag” of lost opportunity cost of withdrawals.
• Own the product properly. For most people, owning the policy in their name is appropriate. For others, it may be appropriate to own the policy in a corporate entity. And for others, it may be appropriate to own it in a trust.

Cash value life insurance (if structured, funded and used like wealthy people do) offers the following investment attributes that make it the Swiss Army Knife of assets:

• Liquid (like a checking or savings account). Can have checkbook access through line of credit.
• Loans against the account value that are easy, low cost, and have good terms (like a HELOC). This reduces the “drag” of lost opportunity cost of withdrawals. This increases the “thrust” of potential positive arbitrage.
• No market risk (like a CD).
• No net cost through expense reimbursement (better long term than a no-load mutual fund). This reduces the “drag” of expenses AND the lost opportunity cost of expenses.
• Potential for double digit annual returns, with or without leverage (like a stock market index fund).
• Tax-free growth, income, and death benefit (like a Roth IRA). This reduces the “drag” of taxes AND the lost opportunity cost of taxes.

For businesses, cash value life insurance can be used as an alternative to bank checking and savings for liquid reserves.
Ironically, many banks use cash value life insurance for a significant portion of their liquid reserves. Here are some of the
benefits for employers and employees when a company uses cash value life insurance as part of their liquid reserves:

• Employer benefits:
  • Liquidity with checkbook access
  • No market risk
  • Potential for double-digit rate of return
  • Fund buy-sell agreement
  • Fund key person insurance
  • Fund non-qualified deferred compensation plan
  • Attract and retain key employees
  • Significant tax-free income from life insurance
  • Increased business valuation from tax-free income. This could be 6x to 10x multiple of tax-free income (EBITA) from life insurance vs 1x multiple for cash reserves at bank
  • Asset protection of liquid reserves (lawsuits, bankruptcy) through secured line of credit
  • Tax deduction for some of the cost of employee life insurance
  • Tax deduction for employee supplemental retirement income
• Employee benefits:
  • Significant and permanent death benefit for heirs or charities (10x to 30x salary)
  • Supplemental retirement income benefit
  • Lifetime access to death benefit for long term care, terminal illness and critical illness
  • Option to purchase cash value in the future
  • One of our clients calls these benefits “sticky golden handcuffs” since they can reduce the chance of an employee leaving

Finally, for more sophisticated investors, we recommend private placement life insurance (PPLI), since it provides a low cost, tax-free “wrapper” around many of their currently taxable and tax-deferred investments (without having to change their current investments or advisors). For example, if a client has $5 million of “tax exposed” assets and is in a 30% tax bracket, the question is: “Would you rather “partner” with the IRS and pay them 30% of your gains, or would you rather “partner” with a life insurance company who charges you an average of 2% per year, but provides your family $15 million of tax-free death benefit that should more than reimburse those charges?”. Interestingly, many money managers prefer PPLI because it removes tax sensitivity from their trades. For our clients who already have traditional life insurance and do not want more death benefit or
who are not insurable, they can assign the current death benefit to the private placement life insurance company in exchange for the same death benefit. With this strategy, there is no underwriting or additional cost of insurance, and the “tax exposed” assets can still become tax free. Like anything else, PPLI is a game with its own pieces, and has rules and strategies that must be followed to win. Continuing the game theme, Tony Robbins recommends PPLI in his book “Money – Master the Game” in chapter 5.5 entitled “Secrets of the Ultrawealthy (That You Can Use Too!)”.
In conclusion, we have covered a lot of what you could do in your pursuit of increased wealth momentum, but the important question is “What should you do and how should you do it?”. “Could” is based on knowledge. “Should” is based on wisdom.

What is indexed universal life insurance?

• IUL is also known as equity indexed universal life (EIUL)
• IUL is a type of permanent life insurance policy (i.e. not term insurance) that provides both a death benefit to named beneficiaries and living benefits to the policy owner in the form of policy (or cash) values
• What is unique to IUL is the growth of the policy values is linked to the positive performance of one or more securities or market indexes, like the S&P 500 Index, while NOT exposing the policy values to the downside risks of the markets
  • Whereas variable universal life (VUL), which also has policy values linked to securities, has both unlimited downside and upside exposure to the linked markets, IUL provides downside protection from market risks (in the form of a guaranteed minimum annual return) in exchange for a capped upside of any positive annual market returns
  • IUL policies combine the long-term growth potential of equity or other markets with the security of a traditional life insurance contract

Many people who “drink Wall Street Kool-Aid” are surprised that life-insurance-company-based products are a significant part of the net worth of some of the savviest and wealthiest institutions and individuals in the world:

• According to a New York Times (Charles Duhigg) article published in 2006, “Hedge funds, financial institutions like Credit Suisse and Deutsche Bank, and investors like Warren E. Buffett are spending billions to buy life insurance policies” on the secondary market
• According to government disclosures, Federal Reserve Chairman, Ben Bernanke, has the majority of his liquid net worth on deposit with life insurance companies (not deposited in banks or invested on Wall Street) – Medical Economics 6/19/2009
• The nation’s large banks invest immense sums of their Tier 1 capital reserves (a bank’s most important asset and a key measure of its strength) into permanent life insurance underwritten by major life insurance companies – Medical Economics 6/19/2009
  • As of the date of the article, Bank of America, JP Morgan, Wells Fargo, US Bancorp and Bank of New York Mellon had more of their Tier 1 capital reserves in permanent life insurance than they did in bank premises fixed assets and real estate COMBINED
  • During the economic downturn of 2008-2009, Wells Fargo almost tripled its holdings in permanent life insurance

 So a good question might be: Why do they do that?

Well, after a brief analysis of the five key elements of any prudent asset, the answer should be clear.  These five elements are:

1. Liquidity
2. Safety
3. Expense
4. Return Potential
5. Tax Efficiency

Since no one asset is the best in each of these areas, it is important to know the pros and cons of each asset using these five elements as a guide.

The following bullet points are only meant to highlight some of the pros and cons and are not a comprehensive discussion.  In addition, any reference to specific financial products is not a recommendation to buy or sell these products.

Liquidity

• Though IUL is designed to be held long term (at least 10 years), it offers significant liquidity
  • Of all other long-term, tax-favored assets (i.e. IRAs, 401(k) plans, annuities) it provides the most liquidity without a tax penalty
  • IUL is the only long-term, tax-favored asset used as collateral for a bank loan
    • Using an annuity or retirement plan as loan collateral, even if allowed by the bank, will trigger a taxable event
    • Due to IUL liquidity, banks will even lend money for the purpose of purchasing IUL, using the policy values as primary collateral
  • It is not uncommon to have access to 100% of your principle within a few years
    • Some IUL policies have a provision for 100% liquidity from the beginning of the policy
  • IUL liquidity provisions include either withdrawals from the policy values or loans from the insurance company using the policy values as collateral
  • According to a Medical Economics article on 6/19/2009:
    • John McCain used the liquidity of his large life insurance policy to initially finance his campaign
    • Doris Christopher used the liquidity of her life insurance policy to launch Pampered Chef—that she eventually sold to Warren Buffet for $900 million
    • J.C. Penney used the liquidity of his large life insurance policy to begin resuscitating his retail stores after the crash of 1929

Safety

• An IUL policy that is properly structured and funded with a highly-rated insurance company should be one of the safest assets to hold in a portfolio
  • IUL is sold by some of the largest and highest-rated insurance companies in the world
    • Unlike banks, life insurance companies do not use excessive leverage
    • If a bank has $1 million on deposit, it can lend out up to $10 million
      • This “excessive” leverage is a reason many banks are failing
    • If a life insurance company has $1 million on deposit, it can lend out no more than $920,000, meaning life insurance companies are 100% reserve-based lenders, making them stable institutions in down economies
    • According to the Medical Economics article, during the Great Depression, when more than 10,000 banks failed, 99.9% of consumers’ savings in life insurance remained safe with legal reserve life insurance companies
  • IUL, since it is a life insurance CONTRACT, contractually guarantees that though the policies values are linked to various markets, there is a guaranteed minimum return in case of negative markets
    • In addition, all positive interest that is credited to policy values is protected from future market losses
  • In many states, life insurance policy values are protected from creditors (lawsuit, bankruptcy) by state law
  • There are two main risks of losing money in an IUL:
    • Not properly funding the policy
    • This risk can be mitigated with proper structuring (i.e. minimum death benefit per $ of premium) and source funding (i.e. using assets, instead of cash flow, to fund the policy)
    • Cancelling the policy in the early years
    • This risk can be mitigated with proper planning and ongoing policy servicing

Expense

• There are six (6) main expenses associated with IUL:
  • Cost of insurance (also known as mortality charges)
    • Monthly expense to pay for death benefit
  • Premium expense (also known as premium tax)
    • One-time percentage (usually 5%) of each paid premium which is paid by the insurance company to the government
  • Policy expense (also known as monthly expense)
    • Monthly expense to cover insurance company expenses
  • Cap-rate enhancement expense
    • Expense to purchase more market-index upside
  • Loan interest
    • Subtracted from policy values if not paid in cash
  • Surrender charge
    • Possible back-end expense charged if policy is cancelled before a certain year (usually 10-15 years)
    • Many IUL companies offer policy riders that waive the surrender charge
    • From an expense perspective, since IUL is “front-loaded” and typically has a surrender charge, it usually does not make sense to purchase IUL as part of your short-term portfolio (i.e. less than 10 years)
      • Purchasing IUL requires a long-term approach—much like the mindset you take when deciding to purchase a home versus rent a home (i.e. short-term pain for long-term gain)
    • Due to the number of possible expenses of IUL, it has the reputation with some people of being      “expensive”, but in and of itself, IUL is neither expensive nor inexpensive—it depends on the policy structure, funding and utilization
    • A properly funded, structured and utilized IUL can have a relatively low expense ratio compared to many other assets; conversely, due to non-cash-value-correlated expenses of IUL, not funding IUL properly, or cancelling it in the early years, can lead to a high expense ratio
      • To minimize the expense ratio of IUL, you should purchase as little death benefit as possible (see Internal Revenue Code (IRC) §7702) for each premium dollar paid—that way, more money is retained in your policy values
      • The expense ratio of a policy can be projected/calculated using the difference between the illustrated (gross) rate and the internal (net) rate of return (IRR)
      • For example if the gross illustrated rate of the IUL contract is 8% and the net long-term IRR is 7.6% then only .4% is lost to policy costs (or about 5% of the total return)—which compares favorably to mutual funds and other managed portfolios
      • With most mutual funds, the annual expenses that have to be subtracted from the gross return include fund fees, management fees and taxes
      • For example, if you owned Fidelity Magellan Fund (FMAGX), according to Yahoo! Finance, the annual fee paid to the fund is 0.59%
      • The management fee paid to your advisor could be around 1% (less or more depending on how much you invest)
      • Since the fund has a turnover rate of 102%, that means that most of your gains in the fund would be taxed at short-term capital gain rates (i.e. your marginal tax bracket) and have to be paid each year
      • Therefore, if the fund grossed 8% (its current 10-year return is less than 1%), then the net after-tax return would only be 3.82%–which means you would lose 52% of “your” return to the fund, your advisor and the IRS:
        • 0.59% to the fund
        • 1% to your advisor
        • 2.59% to the IRS, assuming a 35% marginal federal tax bracket (not including potential state income tax) and taxed at short-term capital gain tax rate (due to high turnover rate of the fund)
      • Therefore, with the expenses and taxes associated with the Fidelity Magellan Fund, using the assumptions above, the fund would have to average almost 16% per year to net what an IUL would net with an illustrated return of 8% and an IRR of 7.6%
      • So, in this example, would you rather pay 5% of your long-term return to have death benefit throughout the term of the policy (and downside protection from the markets) or would you rather pay over 50% of your return to have no death benefit (and no downside protection from the markets)?
      • Again, the expense of an asset is always relative to what you are comparing it to
    • Rate of Return Potential
    • IUL policy values are linked to various market indexes that allow your policy values to grow up to maximum annual cap rates
    • Using long-term historical performances of market indexes, most policies will illustrate future policy value growth based on historical averages of 7%-9%, depending on the index and cap rate
    • There are several ways to potentially increase the long-term IRR (net return) of IUL policy values:
    • Purchase IUL from companies that have higher participation caps
      • Some companies have annual cap rates as high as 20% on their index strategies
    • Purchase IUL using premium loans (also known as premium financing)
      • This strategy alone can significantly increase the long-term IRR of IUL
    • Use fixed participating loans when accessing the policy values
      • These are loans where you pay a fixed rate to the insurance company but you still have the upside of the market indexes for your policy values
      • One company offers a fixed participating loan that is contractually guaranteed to be 5.3% for the life of the policy
      • Use fixed participating loans during your “accumulating” years to purchase appreciating assets like real estate and other investments
        • This allows you to have the potential to experience a double positive arbitrage (the difference between what you pay in interest versus what you gain through rate of return)
          • You can earn the difference between the loan rate and the IUL index crediting rate, PLUS…
          • You can earn the difference between the loan rate and the return on the appreciating asset
    • Sell the policy on the secondary market
      • During your retirement, if you decide you no longer want or need your policy, you could sell the death benefit (i.e. contract) for more than the policy value
      • This would obviously be in your best interest but may not be in the best interest of your beneficiaries
      • The secondary life insurance market is what was referenced to earlier that hedge funds, banks and investors like Warren Buffet are involved in
      • When a policy on a senior citizen is sold/purchased on the secondary market, it is known as a “senior life settlement”
      • In the right situation, it can be a win/win for both the seller and buyer since the seller (you) is getting significantly more than the policy values, while the buyer is purchasing your death benefit at a deep discount
    • Tax Efficiency
    • IUL can be one of the most tax-favored assets under the Internal Revenue Code (see your tax advisor for specifics regarding your situation)
      • A properly structured, properly funded and properly utilized IUL (see IRC §101 and IRC §7702) has similar, but arguably better, tax benefits than Roth IRAs (see IRC §408A and IRC §7701)
        • Premiums are paid with after-tax dollars
        • Policy value growth is tax deferred
        • Policy value profit can be accessed tax free via withdrawals and/or policy loans (that can be paid back via the death benefit at policy maturity)
        • Policy death benefits (usually significantly more than policy values) can be received tax free by beneficiaries
      • The two main advantages of IUL over Roth IRAs are:
        • You can put significantly more money into IUL than a Roth IRA
        • IUL has significantly more early liquidity (i.e. penalty-free withdrawals/loans) than a Roth IRA
      • However, if a policy is “cashed in”, any profit in the policy would be taxable at your federal marginal tax bracket
        • This tax can be mitigated if the policy values are rolled directly to another qualifying permanent life insurance policy (see IRC §1035)
        • This is similar to doing a real estate tax-free exchange (see IRC §1031)
        • This tax-free exchange option is important since there is a high probability that future insurance policies will have more desirable features, and policy owners may want to “upgrade” their contracts without having to pay a “tax toll”
    • Therefore, since properly structured, properly funded and properly utilized IUL:
    • Is more liquid than most assets…
    • Is one of the safest assets…
    • Is relatively inexpensive…
    • Has historically-based, above-average return potential, and…
    • Is one of the most tax-efficient assets…
    • IUL is at the top of my list as a foundational part of a long-term portfolio.

Qualified plans are any kind of employer-sponsored retirement plan or individual retirement plan. The most common employer-sponsored retirement plan is a 401(k). Both 401(k)s and IRAs are wrappers for different kinds of assets. Mutual funds tend to be the most common asset held in qualified plans. This post looks at five elements of qualified plans: liquidity, safety, expenses, rate of return, and tax efficiency.

Liquidity

As long as you remain with your employer, 401(k) plans are usually not liquid. However, in many cases, you can borrow up to $50,000 from your plan. Yet borrowing comes with strict repayment terms. On the other hand, IRAs are completely liquid. When you withdraw money, though, you will be taxed immediately, and if you’re under 59 ½ years old you’ll have to pay a 10% penalty.

Safety

The safety of qualified plans is not very high. With 401(k) plans, you don’t have unlimited access to any asset you want. The plan administrator decides which assets will be available to employees. IRA plans may be safer than 401(k) plans, but it depends on the type of assets that you choose.

Expenses

In general, 401(k) plans tend to be expensive. The plan administrator decides which funds will be available, and they’re not always the least expensive funds. You also have to pay administrative fees for 401(k) plans. Most people don’t know what the fees are because they’re typically hidden in the fine print. The expenses for IRAs tend to be lower—there aren’t any administrative fees if the plan is self-directed. However, the expenses of the assets themselves will still be present.

Rate of Return

The rate of return for 401(k) plans depends on the underlying assets that your employer makes available. Yet, since many employers provide employee matching the rate of return can be high. Employers who offer employee matching will usually match 2-6% of your funds. The average tends to be around 3%. There is no employee matching with an IRA plan, so the rate of return depends on the underlying assets in the account. Therefore, the rate can vary wildly from plan to plan.

Tax Efficiency

The tax efficiency depends on whether you have a Roth 401(k) or IRA or you have a regular 401(k) or IRA. When you withdraw money from regular plans, you pay ordinary income taxes. When you withdraw money from a Roth plan, though, you don’t have to pay taxes. With both plans, your money will grow tax-free. Many people find Roth plans attractive since they expect taxes to increase in the future. However, if you earn more than $200,000 you’re ineligible to participate in a Roth IRA. IUL plans are a popular alternative for investors who make more than $200,000.

Mutual funds are a popular asset that many investors hold. Investopedia defines a mutual fund as “an investment vehicle made up of a pool of funds collected from many investors for the purpose of investing in securities such as stocks, bonds, money market instruments and similar assets” (Investopedia). This post will take a close look at mutual funds and examine their liquidity, safety, expenses, rate of return, and tax efficiency.

Liquidity

When it comes to liquidity, mutual funds usually get a good rating. If you want to access the money in the fund, you can do so without any penalties or extra taxes. However, the degree of liquidity depends on the type of funds you own. There are three different classes of mutual funds, and each class has different fees associated with it. To learn more about each class, have a look at this article.

Safety

If mutual funds received a rating for safety, the rating would not be very high. The success and failure of mutual funds depend on the performance of the market. When the market is up, so is the mutual fund. But when the market is down, so is the mutual fund. If safety is your biggest concern when it comes to your assets, then you should seriously consider how comfortable you are facing the risks of the market.

Expenses

With mutual funds, there are two fees that immediately stand out: the fund management fee, or administrative fee, and the fee associated with using a financial advisor. Management fees can vary from low to high. However, Morningstar reports that the average management fee for a mutual fund is 1.25%. A 1.25% management fee is actually similar to the management fees of other assets out there. Many people need the assistance of a financial advisor to help them manage the fund, and that adds another 1 or 2 percent to the expenses.

Rate Of Return

Since mutual funds are tied to the market, their rate of return can vary significantly. Mutual funds have the potential to grow over time, but, as I detailed in a previous post on stocks, many investors fall prey to their emotions. They either get worried and sell too soon or chase top rated mutual funds with the hope of making more money.

DALBAR is an organization that analyzes the behavior of investors. Each year the organization releases a report that details the performance of the market in relation to individual investors.  Over the last 30 years, the S&P has averaged 10.35%, but the typical investor has only averaged 3.66%. And while the bond market has averaged 6.73%, the typical bond investor has only averaged 0.59%. People actually tend to do worse with bond funds than with stocks.

Tax Efficiency

Since you’re taxed when the fund manager sells individual assets, you can end up paying a lot of taxes on a mutual fund. Each year you’ll receive a 1099 form for the fund. If any assets were sold in less than a year, they’ll be considered ordinary income, and you’ll have to pay the expensive taxes associated with that. On the other hand, assets held for more than a year will be taxed as capital gains. If you use a mutual fund manager like the majority of people, you have no control over when the manager buys or sells assets. One strategy to avoid excessive taxes is to invest in an index fund that has low turnover rates rather than an actively managed fund.