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 get a free copy by downloading it by going to www.retireontime.com. My name is Mike Decker. I'm the author of the book, but I'm also a licensed financial adviser, insurance agent, and tax professional, which means when it comes to financial topics, we can talk about it all. Now that said, please remember this is just a show.
Everything you hear should be considered informational as in not financial advice. If you want financial advice, you can contact our team by going to www.yourwealthanalysis.com and request Your Wealth Analysis. With me in the studio today is my cohost colleague, mister David Franson. David, thanks for being here.
Yep. Thank you. Glad to be here.
David's gonna read your questions, and I will do my best to answer them. You can always submit your questions anytime during the week by texting them to (913) 363-1234. Again, that's (913) 363-1234, or you can email them to heyMike@howtoretireontime.com.
Let's begin. Hey, Mike. What's better? Caps, like on a buffered ETF, or participation, like on a structured note? We're we're deep in the weeds here. We've just wandered into like waist high.
Yeah. Someone's You're
have to explain this.
Someone's getting our so when you download our book, How to Retire On Time, which you can do it, retireontime.com right now. Yes. But we go through twenty some days of additional trainings in addition to the book. Okay. It's an expansive series of just incredible preparation for everyone that's gonna be retiring.
I'm willing to guess this person just got there's one email specifically that talks about this stuff. Mhmm. Okay. So great question. Let me explain to everyone who has no idea what a captive spread and participation means.
Rephrase it, please.
So you have a couple of products that are indexed. An indexed product basically means that you participate in growth based on the index on the upside, but you have no downside risk.
Alright.
Okay. So let me say that again. You put some money, and let's say a hundred thousand dollars into a product. If the S and P, for example, or the Nasdaq, or whatever index it's associated with, increases in value, you make money. But if it decreases in value, you do not lose money.
Okay. And there's like a backstop there.
Yep. Alright. Here are some examples of indexed products. Buffered ETFs, structured notes, fixed indexed annuities, indexed universal life insurance. Those are the most popular ones that I see.
Alright.
So let's talk about the buffered ETFs and the structured notes. Here's how they work. Buffered ETFs operate typically off of a cap. That means that if you put money in there, you will make up to a certain amount of money, but nothing above.
You run into the cap.
Yep. You max out. So right now, as of today's recording, a max buffer, which means you've got no downside risk, you can go up to 7%. So if the S and P makes 6%, you make 6%.
Mhmm.
If the S and P makes 12%, you make 7%, because there's a cap at 7%. If the S and P goes down 20%, you didn't lose money, but you didn't make money.
Yeah.
And then there's maybe like, I don't know, 0.5, zero point seven expense ratio fees. Okay, that's low. For what they're doing, I think it's reasonable. Okay. And every buffered ETFs can have different fees associated with it. But what they're doing, and this is pretty complicated, so I apologize. Let me know if I've David, if if I've lost you. Okay?
Yeah. If you go off the rails, I'll
steer you back. For all the regulators listening in right now, I am gonna explain this as simple as I can. Please note this is an oversimplified explanation. It's not exactly how it works. I'm just trying to to teach people right now the gist. Mhmm. Is that fair for everyone listening in? We good with that? Yep. So we don't dive into quantum phys No.
I'm just kidding. Okay. So what they basically do is they are buying an option, or they're selling an option contract. So they're selling the idea that after 7%, someone else can buy it, and then enjoy the profits. So here's an example.
They've Buffered ETF will sell a contract that basically says to this other entity, hey. If the S and P goes above 7%, we'll sell it to you at that 7% price, but then you can turn around and sell it yourself at a higher price. So like, let's say the S and P goes up 15%.
Okay.
They have the right to then buy it at that 7% growth price, turnaround same day, and then sell it at the 15% growth. They made 8% profit. So they're buying the right to exercise this contract, knowing that it might happen, it might not. I think it's like 66% of the time the S and P has double digit returns, something like that. Over 50% of the years, the S and P has double digit returns.
So it sounds like a good calculated risk then.
Yeah. So it's beneficial to the person buying this contract. They're saying, I'm willing to pay some money for it, because typically, I'll make money. Every now and then I won't. That's fine.
I'll let it expire. But so you've got the buffered ETF who's like, yeah, we just want the first seven percent. The other person who's sharing in this saying, yep, we want the excess. We're gonna pay for it. But on both sides of the trade, they're being compensated appropriately for the risk that they're taking.
Okay.
So do you see how there's two ends to it? Yeah. And then what they'll do is they'll then turn around, and they'll buy an option contract, saying if the S and P goes down, if it loses money, they have the right then to basically reset, and I'm oversimplifying this, but just go to zero, and someone else takes the losses. Mhmm. Why would someone do that?
Because the markets crash every seven to eight years. Usually, it's up. So they're making money usually knowing they're gonna take a hit every now and then, but they're being compensated appropriately for the risk that they're taking. Makes sense. And these contracts will vary in value, in price, okay?
But that's what's going on. So you've got really three entities here. They're all playing a game. They're all playing it and saying, I'm willing to take a certain risk. But for the average person, it's you just gotta know back on the institutional side that the things happening behind closed doors or whatever, they know what they're doing.
They're okay with the risks they're taking. It's not magic. It's just the retail investor who wants a buffered ETF is saying, I just want consistency with protection. Right. And they then go in and make these mechanics work for you, it's easier for you, but but fair for them.
Sure. Now it's one of the problems is you might say, well, a 7% buffer well, most of the time, the markets do really, really well, so I should get close to 7% regardless. No. This is not how it works. On average, if you look back since February, a buffered ETF, for example, and this is there's some back tested data here because they weren't really available until around 2018, but a buffered ETF would give you around five and a half percent average return because some years are zero, some years there's 2%.
So you're you're not getting around the 7%. You're getting around a five and a half percent return.
Okay.
You with me so far? Yep. K. Yeah. Yeah, this is great This is great radio.
Yes, professor, keep going.
So then you've got structured notes. They're built a little bit differently in that, what they'll do is they'll take, let's say you put a hundred thousand into something. They're gonna take, let's say 95% of all of that, and put it into a fixed product like a note, a banking note. And let's say that note's at 5.2%.
Okay.
So after one year time, that 95% or 95,000 becomes a hundred thousand.
Okay. Okay.
No risk. Yeah. And then what they do is they then have the 5% of the 5,000 remaining, and they're buying option contracts. They're buying the right to basically buy it at a low price and then sell at a higher price. They're buying options. They're buying calls.
Is this an insurance company that does a structured note or somebody else? Banks. Oh,
bank institutions. Okay. Yeah. Fixed index news are for the insurance side. Structured notes are on the institutional, like the security side.
Okay. Okay.
Yeah. So what they'll do then is they're gonna say, alright. So if the index goes up, you're gonna participate based on that option contract. So maybe you get fifty, sixty, 70 percent participation. So if the S and P goes up, let's say 10%, you got, let's say six or 7% on the growth.
The S and P goes up 20%, maybe you got around 14% of the growth. They're not meant to make you rich. They're just meant to give you growth potential, but have reasonable protection. Sure. The caveat though is the structured notes are going to have more fees.
Okay.
So you're gonna pay probably 3% in fees regardless of the outcome.
And why do they have more fees than other things? Is there a good explanation?
So so let's we'll have to bring in fixed indexed annuities to answer the question.
Oh, okay.
You could get 70% participation rate of the S and P, so as in if the S and P goes up 10%, you get 7%.
Okay.
So you get 70% of whatever happens. On the upside, none of the downside. But you pay two or 3% fees, You could take that same model and put it into an insurance product called a fixed index annuity as long as you don't turn on income or buy these riders, but instead of 70% of the upside, you're gonna have like 50% of the upside. So do you see how there's no quote unquote fee, but there's an opportunity cost?
Oh, okay.
Because they're making money off of your money. I can't officially say that, but let's let's call it as it is.
Yeah. Sure.
There's so many ways you could skin the cat, but these are all indexed products. And then the last one we didn't talk about are spreads. Spreads are more on the fixed index annuity side, not structured notes, not buffer ETFs, but they're worth mentioning, and that's where you get everything after a certain point. So let's say there's a 3% spread, you're gonna get everything after 3%. So if the markets go up 10%, you don't get the first three percent, you got everything after that, so you'd get 7%.
Okay. So these are different ways that you can structure and index products. It's extremely complicated from the option contracts, and the mechanisms underneath it that are making these things possible. It's not magic. It's not some secret market. It's just very advanced structuring of products. Right. Now, based on my experience and my research, which is better?
Oh, yeah. I was just gonna say, let's do we answer the question? Participation rates. Okay.
A reasonable participation rate, because it's uncapped Oh, right. Is typically, in my opinion, better if it is associated in equities. Yeah. So if it's associated with the S and P 500, you wanna be uncapped because the S and P is it's volatile, has some great great years, has some terrible years, but you wanna not be capped in those situations. If it's like a bond fund situation, first off, I'd be concerned about it because bond funds are subject to all sorts of additional issues.
But a bond fund can be a little bit more boring. Maybe the cap is more appropriate for that situation. So there's some nuance. But generally speaking, if you want the simple answer, I would typically prefer a participation rate because you're uncapped.
That makes sense. If there's a hard cap, you're guaranteed, like, I'm not going above that. Yeah. I'm limited. I'm being held back.
You know, it's like you wanna be somewhere between Babe Ruth who swings for the fences, and Ichiro who just tries get on first. Yeah. Yeah.
So I see what you did there, you Seattle guy. Yeah. Yeah? Yeah. Now I'm a Kansas City guy. Okay. Okay. Good. But, yeah, my We have adopted you.
Yeah. Well, I'm still sleepless in Seattle. I don't know. Alright. Yeah. Anyway, but that does that answer the question?
I think it does. Yeah.
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