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When a Note Can Offer Principal Protection · How to Retire on Time

• 0:00
  Mike: Hi. Mike Decker, author of the book How to Retire on Time. Here's a question I was recently asked on my Retire on Time q and a. Check it out.
• 0:12
  David: They asked us to talk about structured notes. So we've talked about those here on the show before. So I found your approaches to many topics to be valuable. Yeah. So any...
• 0:23
  What what can you tell us about the the principal protection that's found in structured notes? K. So first off, let's explain the mechanics of all of this.
• 0:33
  Mike: Okay? Structured notes, buffered ETFs, and I have to include indexed annuities and indexed universal life insurance. They are all the same thing, basically, just slightly packaged with different mechanics. So if we were to distill it all down, what's going on? There's some mechanism of protection, and there's some mechanism of upside potential.
• 1:01
  K. Okay? So let's use a structured note since that's what's in question just for a moment. Structured notes might be something that would function as follows, and this is not every single one. I'm just saying here's an example of a simple explanation of how it might work.
• 1:18
  So, the ten year treasury is like 5.2% right now. Okay? Yeah. So what they're gonna do is they're gonna take your money, and they'll put, let's say a $100,000, and they're gonna say, okay, we are gonna put $95,000 in a ten year treasury that's going to pay 5.2% coupon rate.
• 1:40
  David: Okay.
• 1:41
  Mike: K? So they know next year, the money they put in there is gonna pay out 5.2%. So 5.2% of $95,000 gets you whole to a $100,000, roughly speaking. I'm glossing over the fact that, you know, rates can go up or down, and so, you know, if you sold early, you could lose money to the bond funds. The bond...
• 2:03
  Let... Just forget that for just a second. Okay? Okay. So now that's principal protected or there's a...
• 2:10
  An element that creates consistency and predictability on the structure of the product. Now note is a debt instrument. So maybe they don't do a ten year treasury of 5.2%. Maybe it's a one year note from an institutional bank. So there's some nuance with the note side of it.
• 2:27
  But basically, the baseline is it's covered. Then in this example, which is a simplified example, there's there is more nuance to it. Then you're going to take, let's say, 5%, $5,000, and you're going to buy as much as you can in option contracts for upside potential. So, when people make these claims of like, Oh, well, they're only going to give you 10% of the upside and keep the rest themselves, that's not totally true. Yes, they're probably going to make money off of you, whether it's through a fee, a spread, or something.
• 3:00
  Mhmm. But you can't take $5,000 and get complete upside potential of a $100... $100,000 value. Like, they're giving you as much as the option budget would allow, and option contracts, especially for things like the S and P 500, are expensive. So maybe they give you seven, eight, nine, 10% of the upside, and they're gonna keep a little bit for themselves, whether it's through transactions built internally or some other way.
• 3:31
  David: Mhmm.
• 3:32
  Mike: They're giving you as much upside as they can for the structure, and so that might be a one year structured note. It might be a two or three year structured note. Therein lies more complexity. Because if you do a three year structured note, let's say, and these are the ones that have growth potential but no downside risk, FDIC insured, and not all of them are FDIC insured, by the way. Okay.
• 3:55
  Remember Lehman Brothers.
• 3:56
  David: Okay. I remember them.
• 3:57
  Mike: Those notes didn't do so well. I know. Because they're gone. Yeah. But you have now this idea where, okay, in three years you're gonna get, let's say, 30 or 40, whatever the cap is or the participation is, and it looks better.
• 4:12
  But if the markets crash in the second year and six month period of time, you have three years of no returns. So people want the growth of a structured note. They want to grow their portfolio without it going backwards. One year is a good, maybe two years in certain conditions, but three years, in conditions like today, I just be a little bit hesitant on it. Now that's one version of a structured note.
• 4:41
  Oh. There are many other versions of structured notes. Another one is the income structured note, where as long as certain parameters are met over a certain period of time, it's paying you out income. Oh. Okay.
• 4:55
  That works, but you need to understand that if certain conditions are not met, the income is gone. And for some of them, maybe it recovers and it starts paying out income again. We don't have guaranteed income. See, people confuse this with indexed annuities where those are guaranteed income, but a structured note is not guaranteed. It's just slightly higher income many times.
• 5:16
  Depends on your age and several other factors, but it could just stop pain as well.
• 5:20
  David: So you probably shouldn't count on that for your income in retirement.
• 5:24
  Mike: They're incredibly complicated. There are different levels, thresholds, and mechanisms in there. They're just packaged in all these different ways. So it's very important to understand what type of note it is, what's the historical behavior of it, what's the probability that one of these conditions are never met. Whenever someone says, oh, well this will never happen, it's pretty close to probably happening.
• 5:51
  I've just... I've seen that story over and over again. So there's no such thing as a perfect investment product or strategy. A buffered ETF is great for shorter term liquidity, and some reasonable growth potential and enjoying long term capital gains in your brokerage account, not your IRA or Roth because there's no capital gains issues with those. Mhmm.
• 6:11
  Structured notes might give you more income, but it's not guaranteed income, but it's just a little bit better as long as conditions are met. When conditions are not met, you need to have a backup plan. So we call reserves is your backup plan. And then you've got the index annuities which lock in every year because it's an insurance product. They can structure their version of a structured note slightly differently.
• 6:35
  In other words, this is an incredibly complex side of structured products that greed can take take advantage of. You wanna make sure that you're not getting an unsustainable product or a product with a high probability of it not working out. You wanna make sure that you're getting the right products for the right timelines, and all of that is contingent on your plan and the strategies you want to implement. So I have no problem with any of the tools that we've discussed so far, and we glossed over a lot of it. What I am concerned about is people going all in on one saying, well it'll be fine, and if it's not I'll just kind of figure it out.
• 7:16
  That's where your money then controls you. Because when it doesn't go well, and you have to figure it out, you're interrupting your lifestyle. So be cautious about it. Like I have no problem with let's just say arbitrarily a structured notes, pay 9% as long as markets are up. It's not that bad of a deal.
• 7:32
  Yeah. Maybe that replaced some of your bond fund components, and if it stops paying for a little bit of time, okay. But your your lifestyle is not dependent on it. Maybe you laddered out some CDs or MYGAs while you're trying to grow your assets in different ways. Like, there's so many ways you can combine these portfolios.
• 7:47
  But what I'm getting at is don't assume that what you want will happen. Hey. I wanna pause real quick and just say, if you're getting close to retirement, I wanna invite you to download my book, How to Retire On Time. It's free. Just go to retireontime.com, and you can download my book, get the audiobook, the workbook, and so much more, including six plus calculators to help you prepare to retire on time.
• 8:11
  Check it out. Retireontime.com. Alright. Let... Now let's get back to the show.
• 8:15
  So we've got some some other comments here. Tips are still bonds, so they're not alternative assets. Tips tips are bonds. I mean, alternative assets, there's there's a lot of definitions on that. They do behave differently than bonds.
• 8:29
  So my opinion on tips ladders is you might win or you might lose. Just depends on inflation. I don't understand though why you would buy bonds to hedge against inflation. The stock market is a better hedge in my opinion for inflation, not bonds. Mhmm.
• 8:47
  So if you want low risk short term hedge against inflation, then how does that work in your portfolio? We've used tips for certain clients with certain situations, but we haven't. I just don't wanna gloss over that tips are the best way to hedge against inflation. That's just not true. It's a way for a very specific situation for a very specific...
• 9:10
  It's a specific tool for a very specific mission. Mhmm. So I love them. Hate them. Yeah.
• 9:15
  It's just a tool in the toolbox. But I wouldn't say they're completely disconnected from they're they're disconnected from the stock market, but rates are gonna affect tips. See, tips are just a hedge against inflation. Mhmm. But there's still a coupon rate.
• 9:32
  The coupon rate is typically a little bit lower than other bonds as well. So are you okay getting a lower rate to hedge against potential inflation? Is inflation gonna go away? Is it not gonna go away? You can't bank on your political fear, and I'm not saying this person's scared of one political party or another.
• 9:50
  I'm not suggesting that inflation has been very real.
• 9:53
  David: Mhmm.
• 9:54
  Mike: But just because what has happened doesn't mean it's gonna continue to happen. So just be careful of overdoing it one way or the other. I had two people talk about tips. Think of it this way. Corporate bonds versus municipal bonds.
• 10:07
  Municipal bonds pay less because they can. Because they're able to give you money tax free or at least tax exempt, and there's nuance in that.
• 10:17
  David: Right.
• 10:17
  Mike: Tips can pay less because they have a risk of inflation. So if inflation goes, they they might pay more, but they're gonna pay less because you're hedging against a certain bet. So everything you get, you're gonna give up something. So just be careful with going too much into one way. The email I've got going out on Wednesday talks about inflation risk, and different lower risk asset classes, and a lot of the assumptions we make that aren't...
• 10:43
  The conclusions of the assumptions we're making aren't based on the historical evidence that's been provided. So we're making these these more fear based decisions, and that's not necessarily a bad thing. It's people trying to be proactive in solving the issues. That's all the time we've got for today's show. If you enjoyed the show, thanks for tuning the podcast.
• 11:03
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