I can’t believe it has been almost four years since my first “how financial institutions make money” post. Crazy how fast things go by so quickly. This initial post continues to be one of my most active even today and the primary path that people come to this post is through Google. It’s interesting that so many people are simply Googling (love that this is now a verb) the question: How do financial institutions make money? Honestly, I believe many people are pretty fed up with how things have been going financially and yet the Big Three (IRS, Wall Street, Banks) keep making money hand-over-fist.
For the most part, people are finally seeking to educate themselves first before just following another opinion. Opinions drive me crazy. I’m mean, I certainly like mine but who cares other than me, right? Mint Chocolate Chip is the BEST ice cream flavor of all time. No Kelly, says you, “_____ is the best ice cream flavor!” Who’s right? Who cares? Seriously, no matter what you say I still love Mint Chocolate Chip.
When it comes to the title of this blog “How financial institutions make money” there are no opinions. There’s only truth and the truth could care less about opinions. All of us must understand that there are four rules which are deeply cherished by the IRS, Wall Street and Banks. These rules allow all three to work together. They allow all three to ensure that they’re winning. They allow all three to redirect the risk of success entirely upon you. I thought we’d review these four rules today. You’ll find that they are extremely simple but they have huge implications. It’s interesting to me that even the Bible talks of a cord of three strands being unbreakable…these three (IRS, Wall Street and Banks – from now on referred to as “IWB”) are most certainly intertwined together and are so hard, if not impossible, to break.
Rule #1: They want and need your money
Now, before you pass this one off as too simple to carry any weight then please take a moment to think about the importance of this one (it’s #1 for a reason). This one does not require much explanation. All three, IWB, want our money and need our money in order to both operate and turn a profit.
Rule #2: They want and need your money on an ongoing basis
What would happen to Walmart, Coca Cola, Pepsi, McDonalds, Budweiser or any other company in the country if beginning today every customer only bought their product(s) one more time? That’s it. Just one more purchase. They would obviously have a HUGE day if every customer placed their order today but come tomorrow the alarms would be blaring. Nobody shows up again and these businesses are out of business very quickly. Think of all of the employees that would be unemployed or all the buildings that would be vacant or all the farmers who would have no one to sell their produce to…the results would be devastating and felt by all.
Is this example any different for the IWB? No. They must have your money and they must have it on an ongoing basis. If they don’t succeed at this very simple truth then they fail as well. Now, we could dig in real deep to show how, unlike the above mentioned companies, it is virtually impossible for them to fail. They can’t. They won’t. If they actually do fail then along comes Joe Taxpayer to bail them out so that they don’t fail. No matter what happens, they get our money on an ongoing basis.
So how do they accomplish Rule #2? They create financial products that we buy and that we “need”. Banks offer checking and savings accounts, CDs, money markets, loans, credit cards, etc. Wall Street offers financial investment accounts that we contribute to and hopefully grow and the IRS controls the tax implications and the rules behind all of it.
Rule #3: They want and need to hang on to your money for as long as they can
Does the bank like it when you withdraw your money? Of course they don’t. Keep in mind; their liabilities are their greatest assets. Your money on deposit with them is a liability to the bank – they owe you that money at a promised interest rate; however, they’re turning that money over and lending it to others at a higher rate. We must understand that there is a difference between liabilities and debt. Debt is no good and we must get rid of it but liabilities when managed properly can create a bunch of wealth for us just as they do for the banks. What happens if everyone goes to the bank the same day to withdraw their funds? It’s called a “run on the bank” and the bank would have to shut their doors or be faced with bankruptcy. They are never in a position to get everyone their deposits back on any given day because they don’t have it. They need our money, they need it on an ongoing basis and they need to hold on to it as long as possible.
The government is the worse with Rule #3. Why do they have so many rules when it comes to you using (whether you simply need it or just want it) your funds in your qualified plan accounts (IRAs, Roths, 401ks, etc.)? First, let’s make sure we get something very clear here – any funds in your government, qualified plans are not your funds. The government owns and controls that entire transaction. If it is truly your money then why are there so many rules around accessing the funds? Why do you have to wait until you’re 59 ½ to touch it without penalty? What if you choose to retire at age 50? If these accounts are truly in your best interest then why is there any penalty at all? Why are you required to take money out if you hit 70 ½ (Required Minimum Distribution)? What if it doesn’t fit your plan or it’s not in your best interest to access those funds at that point? The number of rules and regulations on these accounts are insane. You have NO control over them ultimately. Plus, the government can change the rules at any point to serve their financial needs. So, the IRS loves Rule #3. The banks love it as well. Wall Street makes a killing off of it too because they get to manage the money within these products. Think about it: you’re 35 years old with an IRA and you can’t touch it without penalty for 24 more years! Wall Street has a client for a LONG time!
They want to hang on to your money as long as they can and the rules and the product design allow them to do so.
Rule #4: They want and need to give your money back to you as slowly as possible
This one is similar to Rule #3 but it has a slight twist. They want to hold on to our money for as long as possible therefore they create rules to give it back to us as slowly as possible. If this isn’t the case then please explain the 10% tax penalty for withdrawing funds from a qualified plan retirement account prior to being 59 ½ years old. It’s your money (after all, you’re the one who made the deposits) so why are there so many rules and why are there penalties for you if you choose to access your funds? Answer: Rule #4. The government does not want you to be in a position of control because that takes away from their control so they create rules. These rules are based around them maintaining control so they limit your access. What’s shocking is that people continue to fund these accounts. Wall Street loves it because it creates a great deal of job security because they know you won’t access this money due to the rules and penalties so they have your money under management for many many years. The banks love it too because you’re not in a position to access capital for large capital purchases so they offer you a loan…and we know how much banks love that one.
These four rules are always at the center. When you begin to plan your trek up the mountain of retirement planning you can always find these four rules working against you…if you just pay attention.
Mt. Everest – descending is the most dangerous
Are there options? Are there ways to minimize the effect of these four and create a more effective plan up the mountain? Yes there are. Remember, for those who die climbing Mt. Everest, 70% of them die on the way down. The descent is the very most dangerous part of that journey. It’s no different financially. People are just climbing up without an understanding of how these rules affect them and more importantly, how they affect them on the way down. What do I mean by that statement? Well, if you have a large sum in your qualified retirement account, or that’s your plan at least, then please tell me the tax implications on that money during your retirement? You don’t know. No one does…it’s impossible because you’d have to literally know the future. You see, any financial professional can only plan one year at a time with those types of accounts because we don’t even know what taxes will be or what the distribution rules will be for next year. If you’re in this position then you can truly only plan one year at a time and that’s a very dangerous position to be in. The descent will most likely not work out in your favor. You must not only plan to effectively get up the mountain top but also to get back down to base camp alive (i.e. be financially independent through your life expectancy). With this knowledge your trek up the mountain may take a different path and while others are falling off you’re holding on just fine. That’s our expertise. That’s what we do for our clients.
There are solutions. There are answers to minimize the Four Rules’ overall negative effect on your plan; however, you have to be willing to learn. I don’t care what financial position you’re in, you must be willing to have a few discussions with a student-type mentality.
Kelly O’Connor – firstname.lastname@example.org