Saving for anything can be difficult. It takes dedication, persistence, and consistency. On top of that, it is challenging to determine the best place to keep your money that will yield the highest return. You hear and see countless advice on the best savings vehicles. How is it possible to understand what is real and what is a fallacy?
One question savers often ask is, “what can I do about low-interest rates?” Many savers have funds that for one reason or another, placing it in the markets would be unsuitable. Maybe they’re saving for a home, an emergency fund, or maybe they just don’t feel comfortable investing in the market at the moment. The markets have been on a tremendous run and some savers are starting to ask themselves “should I take some of the profits and make them safe and if so, where can I place the money and still earn some interest?”
So, what do investors do if they want to keep their money safe but still maximize their return?
A lot of financial advice online states you should seek banking products to keep your money safe.
Some gurus suggest high yield checking accounts. Banks or credit unions may have you jump through hoops for promotional interest rates, however; if you don’t make 33 debit card purchases, have a bunch of direct deposits or your account balance falls below a certain threshold, not only could you lose the rate you could get dinged with a fee.
Banks want to make people think they can earn interest on their accounts without having to worry. Bankers want you to believe the only place you can get safe products is with their savings checking, CDs and more. The brokers want you to believe the only place you can receive returns is with securities, which ironically are not secure.
Another option financial experts suggest to their clients is a short-term annuity. You have probably heard a financial expert preaching about annuities. A short-term fixed annuity can be a viable alternative to bank products. Typically, fixed annuities will pay higher interest rates, give consumers the ability to withdraw a portion of their money each year penalty-free, and have the benefit of being tax-deferred.
The negative is the penalty for surrendering (closing) the contract early is typically higher in a fixed annuity than a CD or similar bank product. Also, the IRS treats annuities like retirement accounts and there is a 10% penalty on the interest for withdrawing before you turn 59 1/2.
For someone saving for short-term goals, this penalty may need to be factored into the expected return.
Let me preface this by saying that this might not be the right direction for your financial plan, but I would like you to give it some thought. As we know, savings accounts yield minimal to no interest, banking products can leave you feeling trapped, and annuities have high penalties for early withdrawal.
Many savers want to keep their money safe but still make a positive return. That’s where I came up with this unique idea. Today I’m going to share with you a hack to ditch the banks and get your savings back on track.
What you don’t hear is financial gurus mentioning is something called a Modified Endowment Contract or a MEC. Essentially, a MEC is a life insurance policy that has been intentionally overfunded for using the fixed account as a savings vehicle.
The advantage to using a MEC is that a return of premium rider (deposits), or a waiver of surrender charge rider can be added to the contract so that the money can be more liquid than even a short-term annuity or CD. Generally, the rates on a MEC are competitive, if not better than, checking, money market, CDs or fixed annuities, and the enhanced liquidity facilitates taking advantage of rising rates or other savings alternatives.
The other option is to link the interest to an external index such as the S&P 500 or Dow, so if the index goes up for the year you may make money and if the market goes down you don’t lose money. Indexing is not to replace investing. It’s for people that want to keep their money safe but want to attempt to earn higher interest.
Let’s say the index goes up 13% for the contract year, you may make 13%. However, there can be caps on the percentage you make, or the contract may limit returns in other ways. Some policies cap the interest at 14%. So, if the market goes up 15% you are missing out on a percentage point. You must also factor in the insurance costs.
Index insurance contracts are not investments that, depending on the contract, may offer a guaranteed annual interest rate and earnings potential that is linked to participation in the growth, if any, of a stock market index. Such contracts have substantial variation in terms, costs of guarantees and features, and may cap participation or returns in significant ways. Any guarantees are backed by the financial strength of the insurance company.
What type of interest rate is possible?
Economist Roger Ibbotson and his team at Zebra Capital management recently did a study on Fixed Indexed Annuities, utilizing similar interest earning methods to Indexed Modified Endowment contracts and found that uncapped fixed annuities or FIAs would have performed better than bonds on an annualized basis if they had been around for the past 90 years.
There are many benefits to MECs but there are some drawbacks. It’s important to point out some of the downfalls of a MEC as well.
- There, of course, is the cost of insurance. However, the benefits can outweigh the costs. As I see it 3% minus 1% is still 2%, which is a better return than you would be receiving from your savings account.
- If you choose to take a distribution before you reach 59 1/2 there is a penalty on interest. If the interest grows for a few years tax-deferred. Then when you pay the penalty you may come out ahead, because you have been earning interest on money that would have been paid to the IRS each year.
- You may not receive 100% of market gains. True, and I never said it would, but you will get more market upside than bank products or doing nothing. See study
- Lastly, this is not backed by FDIC insurance. Claims are backed by the paying ability of the insurance company. Big insurers were never the embarrassment to the extent banks were in this country requiring billion dollar bailouts. I won’t name names but you know who I am talking about! Still you will want to work with highly rated companies.
Who might benefit from a M.E.C?
For an example let’s say you are looking to purchase a home. This may be a good opportunity to build capital for the down payment on your new home with little risk.
Maybe you sold a home and have the proceeds, your not ready to invest and you might not be planning on purchasing a home for a few years out.
Maybe you have some rainy-day money in CD’s and your looking for a higher interest rate, or for the tax deferral to save some money in taxes.
Anyone looking for opportunity and safety on the same dollars that is aware of , and comfortable with some of the drawbacks could benefit.
As highlighted above, there are some downfalls to using this method. It’s important to keep in mind that this is not a get rich quick strategy. If used correctly, it could potentially take you from earning 1% interest to 2.5% interest including insurance fees. Despite the negatives of a MEC, you may be able to earn a little extra interest on your money for minimal risk.
Talk to your advisor and see if a MEC may fit into your plan. It may be the saving vehicle you have been looking for or it may be something you should steer clear of. Remember, not every financial product is a good fit for every financial plan. Determine what will work for you and help you reach your financial goals.
Some Words of caution
Some advisors and savers are confusing short-term fixed annuities with a guaranteed interest rate with annuities that offer an income account value that may grow at a declared rate. It is very important that potential savers ask if their full account value will be available at the end of the term. If possible ask for an illustration.
Additionally, some annuities offer a declared rate in the first year than in year two they may allow lowering the rate. Always ask how long the interest rate will last.