Enrich Your Future 23: Seeing Through the Frame: Making Better Investment Decisions

Andrew Stotz 00:01
Andrew, fellow risk takers, this is your worst podcast host Andrew Stotz from a Stotz Academy, continuing my discussion with Larry swedroe, who for three decades was the head of Research at Buckingham wealth partners. You can learn more about his story in episode 645, now Larry stands out because he bridges both the academic research world and practical investing. Today we're diving into a chapter from his recent book, enrich your future, the keys to successful investing. And specifically we're talking about chapter 23 framing the problem. Larry. Take it away.

Larry Swedroe 00:33
Yeah, it's a part of the field of behavioral finance explores how we as human beings are subject to biases and mistakes in all kinds of ways that we're almost certainly not aware of. And Wall Street has learned to take advantage it by how they frame our problem. And I was reading a book on US on the subject, and they use this example to show how a question or a problem is presented, and could lead you to give the answer the questioner wants you to give. So the question you're faced with, in this case, is you're the commanding officer of 600 troops and you're surrounded by the enemy. After you call your lieutenants around, you decide carefully analyze the situation. You analyze it, and you decide you have two choices. Alternative, a is to fight it out until the reinforcements arrive. You estimate that you'll have 200 troops out of the 600 who are going to survive if you do that. Okay? Alternative B is you decide to try to sneak out in the middle of the night, and if you do that, you estimate there's a 1/3 chance everyone will make it out. Okay? So then they ask you, which alternative you would choose. Now, they then ask another group of people the same exact question from a mathematical perspective. They just changed the framing to read it this way is in the first case, alternative a, instead of saying 200 will survive, you say 400 will die if you choose to fight it out wait for the reinforcements. And alternative B is that there's a two thirds chance that everyone will die. If you go, turns out, in the first case, everyone chooses to try to save the 200 and there, you know, and the other case, they don't do that right, because it's framing it they're going to die. So it's a different framing, and a simpler example that I like is one on they use this in supermarkets, in shoppers. So I asked you the question, Andrew, you're presented with the question there on the table are two kinds of chopped meat that you would use to make for hamburgers. One of them says 90% fat free, and the other says 10% fat. Which one tastes better? Well, we know it's exactly the same thing. But depending on how you frame the question, right, you get different answers, right? And you know, so the same thing has happened. So what does this all have to do with investing? In my view, the best example is annuities. How they're presented is a guaranteed income, and depending on the features, we're guaranteed to at least get your money back and stuff. They guarantee you some return of an index, right? But they never tell you all the hidden parts, because you would never buy it if they describe the negatives in there, like the hidden expenses, and you're getting a return of an index. Now, for example, the S p5 100 last year went up 23% but they an investment in an S p5 100 index fund went up 25% now how did that happen? Well, the fund paid 2% dividends, that doesn't show up in a price only index, and so they're cheating you out of that 2% that's a cost that you don't see. And there's all kinds of things we describe in. Book, have these hidden expenses, chew up all of the benefits, and there's virtually no one who should buy any of these annuities that are higher expense. There are annuities that can make sense. For example, in the US Vanguard has a no commission annuity, and there's no extra hidden fees, and you do get the mortality credits that are inherent and annuity. So that might make sense for somebody, but all of the products that are sold by the typical insurance company and Wall Street firms are laden with all kinds of, you know, glitzy features that they're selling you. In each case, you're paying an excessive fee to get that benefit, but they're framing it and you're getting this benefit without telling you that the costs far exceed the mathematical odds of your getting that benefit.

Andrew Stotz 05:55
And a question for you is, for a person that's never heard of annuity or doesn't know much about it, if you were to think about the general concept of an annuity, and maybe use that Vanguard one as an example of kind of a base case. What is an annuity?

Larry Swedroe 06:09
Yeah, the best way to think about it is the original annuity was actually called the tan team French word, and it was a great idea, except it had a moral problem. So in the like 1600s I think was the beginning of the tontines, say 10 people would get together and they'd each put, you know, $1,000 worth of whatever the currency was, into a pot, and the last person alive would take all the proceeds now the other people wouldn't need it, because they'd be dead, right? And so you would get a big return on your investment. You can invest it in, say, in French government bonds in the meantime, and then the last person alive would get all of the proceeds. Okay? The problem was, in those days, someone figured out, well, I could just hire somebody and execute, okay, that's a moral problem. That's a big moral problem. So the way you get around that and the US is you have to have, at least the laws were then written. You have to have a vested interest in that life. You can't just make an investment in somebody's now that's changed, but so what happens is the insurance company is going to issue a contract, and let's say it takes somebody that age 65 they know the average life expectancy today for a 65 year old person with a certain, you know, health traits is say 20 years. Yup. Okay. Now they know with certainty, or as close to certainty as they can get, that maybe 3% of them will die next year, and, you know, 5% will live to 100 about 85 and they come up with

Andrew Stotz 08:06
this great statistics on this. I mean, it's very clear

Larry Swedroe 08:09
we have great now, of course, science changes, right? And you can have plagues that kill off lots of people and die early, and the insurance companies win, or you get drug companies inventing with govi and solving diabetes and you know, obesity and people might live longer, and so that can change,

Andrew Stotz 08:32
but the insurance companies can adjust for that.

Larry Swedroe 08:35
Can adjust, right? So what happens is the people who die early are basically subsidizing the people who live longer, and you get what are called these mortality credits if you do live long, because they know they're not going to have to pay out the full amount for the next year, because, say, 1/10 of them will die next year, so they could pay out more on the back end, because some well, okay, and those mortality credits, once you get to about 875, which they don't tell you this, almost nobody generally should buy an annuity when they're in their 60s, or, You know, early 70s, maybe. But the mortality credits, once you get to age 75 become large enough to offset the insurance companies cost the capital, their cost to originate and market the products, and then it becomes a worthwhile investment. I bought an annuity for my mother in law at the last age you're allowed to at age 85 at a time when interest rates were close to zero and she was getting near double digit returns because of the mortality credits. In her case, she happened to live 11 years, and it turned out to be a great investment. She had died early. I would have been a bad investment, but she went in. Needed the money. So an annuity is buying what I would use the words longevity insurance, and you shouldn't care if you die early and say, Oh my God, no, you don't need it, right? And take it with you. A little less,

Andrew Stotz 10:14
maybe you literally can't take it with you. Yeah.

Larry Swedroe 10:18
The purpose is to protect your lifestyle, not worried about your children, and

Andrew Stotz 10:23
you don't. I mean, ultimately, the ultimate annuity is if you amass enough money that you can earn income, or, let's say, earn return on your money and draw down your money, and you're creating an annuity. In that case, you don't need to buy an annuity. In that case, correct?

Larry Swedroe 10:43
You could create an annuity, if you will, by buying in the US treasury inflation protected securities, which gives you the inflation protection lock in a guaranteed return, but you don't get the benefit of the mortality credits. And that could be a big benefit, especially once you get to age 80 or even more. Now, recently in the US, a company called Stone Ridge created a product which technically is not an annuity, but it acts like one or very close to it. It's not an annuity because it doesn't guarantee to pay out for life, but it pays out as close as you could get to a guarantee to pay out to age 100 if lots of people live longer than expected, maybe it'll pay out to age 99 but you I would recommend not buying it until age 80, because until age 80, it's not an annuity. They're just paying you, like the yield on tips, and so that's a big benefit. It's the only annuity that gives you true inflation protection. The US, all the products, except this one, have a cap if they have any inflation protection, typically of no more than 3% a year. And that's not good. Just ask people in places like Thailand or Argentina or Brazil, especially when you're talking about hedging the risk of longevity for maybe 20 or 30 years. So I would never buy an annuity that didn't give me full inflation protection.

Andrew Stotz 12:25
And this is called Life x funds. Life

Larry Swedroe 12:28
X, L, I, F, E, x. It's available in a mutual fund form, and I think they're not in an ETF

12:37
form as well. Yeah, I think, I think I'm seeing it, it,

Larry Swedroe 12:41
you could buy it as a product, and it pays out like the annuity, but you don't get any mortality credits until age 80. And the reason is, it doesn't annuitize until age 80. You because you have the right to cancel, which is nice, because a lot of people say, what if I need my money back and I need whatever the reason? So they say, Fine, we're giving you the right to cancel up until age 80. Once you turn 80, it automatically annuity. So my point is, Why buy it? Just wait till age 79 you know. And then you could buy it.

Andrew Stotz 13:18
And does a reverse mortgage help in this case too. Like, for instance, if people have got their money in their house, their asset rich but cash poor, let's say they have a $500,000 valued house, they do a reverse mortgage and basically receive income from that. Well, they

Larry Swedroe 13:36
won't be receiving income. They'd be receiving cash flow and depleting its negative income, but cash flow, and then it gets repaid when the person dies and stuff. So that could be a very good mechanism for people who are, let's say, living in California, and you're not, house hasn't burned down with the fires, and these people tend to be wealthy, but cash poor, because the house may be worth $4 million but they have no financial assets. So this is a way to create the financial assets you I think you can typically borrow something like 60% of the value of the house, and you create an annuity out of that, and you're charged the spread, of course, because you're borrowing and you're not getting mortality credits. But that's a really good way for people, for example, who maybe I'll use the term die with dignity, don't want to go to a nursing home, stay in my home, and that'll give them enough money to last maybe five or 10 years, and they can have a much more comfortable life, and you can never get kicked out of the house. Yeah,

Andrew Stotz 14:50
the last thing I wanted to talk about, about the annuities, just for a second to kind of understand it from a big picture perspective, from a big picture perspective. You're giving money. So there's, you're giving money to an insurance company, and a portion of that money, they're investing with the objective that they're going to earn a certain return over time that's going to be able to fund, you know, what they've got to pay out over time and and the question that I have is that, you know, these insurance companies are limited as to what they can invest in by, you know, regulators and others. It's not like they're putting 100% of that money in equity. So already you could say, you can assume that an insurance company's return is going to be, yeah, I don't know, somewhere between, you know, 3% and 7% or, I don't know what, what is the breakdown in the US on what they can actually get.

Larry Swedroe 15:41
Yeah, so the insurance companies are playing a game that they could basically invest in relatively safe investments, let's say investment grade bonds that have low historical default losses and pretty good recovery rates and the net return might be 2% over treasuries, so they're guaranteeing you the Treasury rate, say, and they're earning that spread, and of course, they're making a bet that their annuity tables are right, and of course they're going to charge you fees to cover their cost of capital and marketing expenses. But so it's another thing I would never invest in an annuity unless the company were rated at least double A, preferably triple A, because you're making a long term bet. And the US there are insurance pools. Each state has a guarantee. So if you stay within the state guarantee, the state guarantees that if the insurance company goes bankrupt, the pool will take over. And what the state does is, let's say XYZ insurance company is issued an annuity to your mom and they go bankrupt. Okay, let's say you live in New Jersey, and there are 100 other insurers the state goes to the other 99 and says, you're taking over this policy and you're going to make the payments. And they know that's a cost of doing business there. So that's a good protection. None has ever defaulted as long as you stayed within the state limits. So that might mean you wanted to buy a $3 million worth of annuities, and the state limit was 300,000 you might have to go buy 10 different annuities to stay within that limit, which I'd certainly recommend you do. Yeah. And

Andrew Stotz 17:37
so when I think about annuities, the first thing I always think about is, okay if I invest my money over the next 20 or 30 years, and I was just to do all equity, let's just imagine for a moment, and I'm young, and I'm just going to, you know, go 30 years all equity, ultimately I'm going to be able to earn a return higher, just naturally, than any insurance company is going to be able to because they're limited by the regulator.

Larry Swedroe 18:06
The key word you left out is you have a higher expected but not guaranteed return. Your left tail risk is significant. You could end up losing a huge percentage of just ask. Let's say you were a young Japanese investor in 1990 and looking at the prior 2530 years with spectacular returns in the Japanese economy, it's taking over the world, all right? And the next 30 years, it had no returns before inflation, right? So you would have been clearly better off just buying Japanese yen.

Andrew Stotz 18:43
A Japanese insurance company would also assuming that it's investing in Japan, as you're assuming that I, as an individual, would be adjusting in Japan, they're faced with the same situation, right? That they can't, you know, they can only allocate so much to stocks because of the regulator.

Larry Swedroe 19:00
They may not even be allowed to invest in any equities. They typically have to be. They have capital rules. They might be allowed, let's make something up, but it might be like 70% has to be in government or investment grade bonds, and you could have a small allocation to real estate or things like that. And I don't know if you're allowed equities at all, or whether the insurance company would even want to take the risk of investing in equities, because if the equities do poorly, they've got to guarantee they have to pay

19:36
out. Yeah,

Andrew Stotz 19:37
so it's an interesting one. I know in Asia and in Thailand, it's really a hard sell by these institutions. And you know what you've talked about? You know, we've talked about the framing and we've talked about this, but we also need to just highlight that the commissions related to this are, can be enormous, and the, let's say, all the fees bundled. Up. That's what people really need to be very careful about. Yep,

Larry Swedroe 20:03
they're going to tell you, you get an index return. When we talked about part of that problem, you're not getting the dividends. You're getting principal protection. They offer, in many cases, a minimum guaranteed return might be like 3% or something like that. They offer it in the US anyway, tax deferred growth. So that's like a nice thing, the income options that guarantee you at least get a return of some principal and some Death Benefit Guarantee, and that's what they sell, and they never tell you about, except in the fine print of 30 pages of all the things that you really should know but nobody reads.

Andrew Stotz 20:49
Yeah, so that, and I would say, CFA, the CFA Institute, after the 2008 crisis, came up with a publication that was the 10 investor rights basically that individual investors should exercise. And one of those rights was you have a right to understand the fees that you're being charged. And therefore that means you also have the right to continue to ask for them, to explain them in language that you can understand. And

Larry Swedroe 21:22
to me, it should be simple. The law should be written a consumer protection that the language must be readable by a sixth grader, or something the equivalent in plain, simple English, you know. And then you can have the footnotes that go into greater detail. Now, the expenses are 2.3% fees. There's a 5% commission. There is this, there is that, one sentence, very simple. There's a guaranteed death benefit, but that cost you, here's the it lowers the annuity payment by 2% and you know, something very simple, 10 little points so you could read it and make a decision. But that's not how they're sold. At least I've never seen one sold that way. Yeah,

Andrew Stotz 22:10
and that's where I teach in my ethics and finance class, I teach my students that you could be in ethical violation just by bad language. Yeah,

Larry Swedroe 22:21
it's ethical malfeasance, yeah,

Andrew Stotz 22:23
well, that's a great discussion, and I want to thank you again for that. Larry, it's always fun to talk about and dig into these things, and I'm looking forward to next chapter, which is, why do smart people do dumb things

Larry Swedroe 22:41
again and again, yeah,

Andrew Stotz 22:43
over and over, yeah, we should add that in, over and over. So for listeners out there who want to keep up with all that Larry's doing, follow him on X Twitter and Larry swedro, and also you can find him on LinkedIn. This is your worst podcast host, Andrew Stotz, saying, I'll see you on the upside. You.