Bob Birdsell shows you how by coupling the power of leverage with competitive growth, an exit strategy, and tax advantages you may improve overall yield on an executive’s account by as much as 30% to 40%.

*This article is reprinted with permission from the February 2015 issue of PSX: The Exchange for People Strategy, an eMagazine that brings you cutting edge views and perspectives on all things related to people strategy.*

Let’s first look at the dictionary definition for leverage. According to Dictionary.com, when used as a noun, leverage means: “the use of a small initial investment, credit, or borrowed funds to gain a very high return in relation to one’s investment, to control a much larger investment, or to reduce one’s own risk.” When used as a verb, leverage means: “to use (something valuable) to achieve a desired result.”

Now if we look at leverage from a personal level, the most common use involves the purchases of a home. Americans are typically required to “put down” 10% to 30% of the purchase price and borrow the balance. Margin accounts with an investment firm are also an illustration of the individual use of leverage. The use of leverage in business is widespread, especially with Private Equity and Hedge Funds, where leverage (the debt to equity ratio) can be 20 to 1 or higher.

The purpose of this article is not to debate the merits or hazards of leverage but rather to explore whether leverage can be used to enhance an executive’s retirement income opportunities without exposing him/her to significant risk.

This assessment will be divided into two parts and presented in articles over two months. In this article we introduce the concept of using leverage to enhance an executive’s retirement income. In next month’s article we will provide details, point-by-point analysis, and the specifics of the concept.

Let us begin with a few simple assumptions. First, we will assume that a 50 year old executive desires to enhance his/her retirement income opportunities but is not interested in exposing his/her assets or income to a high degree of risk. Second, this executive has the means to set aside approximately $40,000 a year for at least 5 years.

After examining many investment options, our executive decides to invest in a hedged index investment account from an insurance company that is tied to the S&P 500. The rationale for this strategy involves a desire to receive a return tied to the S&P 500 but to not necessarily be in the market and faced potentially with significant downside fluctuations. Research reveals that the average returns of the S&P over any 10 year period going back 28 years have been 8% to 10% and even higher when the several down years are subtracted from the average 10 year returns. The value of the account (disregarding taxes) is at the end of five years $253,436. (Charts can be found in the original PSX eMagazine article accessible here.)

The projections used above have no leverage component and simply represent the accruing values in an account over a 5 year period if a return of 8% is achieved on an annual contribution of $40,000. If with leverage from third party bank loans we add an additional contribution of $40,000, but reduce returns to 5% to cover the cost of the loan (see below). At the end of the 5th year, ADDITIONAL investment income on the account is $32,806. (A detailed chart for this can be found in the original PSX eMagazine article accessible here.)

The cost of this loan is assumed to be the mid-term AFR (Applicable Federal Rate) rate and over the 5 year period is assumed to be 3% (current mid-term AFR rate is 1.9%). The net earnings credited to the additional contribution, therefore, is 5% (8% minus the 3% cost of loan). Collateral for the loan is secured by the executive’s personal contributions to and assets in the investment account.

By adding $32,806 to the executive’s account at the end of 5 years, you effectively increased the rate of return from 8% to approximately 11.5%. Another way of describing the results shown above is, “when you can earn more than the cost of the borrowing, you win!” In the example cited above the risk spread is 5% (earnings is 8% and cost of borrowing is 3%, therefore the arbitrage is 5%). By adding $32,806 to the executive’s account at the end of 5 years, you effectively increased the rate of return from 8% to approximately 11.5%. Since the loan is secured from the assets accruing in the investment account it requires no further collateral.

A simple explanation of this concept may be nothing more than to acknowledge “The Power of Leverage.” You may be asking, “I can see how leverage does create more potential income but at what cost and what risk? Furthermore, what is the Exit Strategy and does this provide Competitive Growth with Safety? And finally, are there any Tax Advantages?” Let us address each of these issues.

First, what is the cost? The cost involves securing the loan from a third party and paying the mid-term AFR rate on the loan and then investing the proceeds in the same manner as the original amount contributed by the executive. Arguably, there should be no direct cost to the executive since the proceeds will be invested in a hedged index contract which tracks the S&P 500 and the returns are expected to exceed the cost of the borrowings.

The second question relates to risk, and here is where we depart from the conventional investment practice. Although it is easily documented that over almost any 10 year period the S&P 500 will perform well, there are periods within each of these 10 year cycles when the index falls short of expectations. How then can this investment strategy eliminate this risk issue? One way is to purchase a hedge on the index. Such a hedge will protect the account values in a down market but also limit the upside yield in an up market. Such hedge products often provide the guarantee of a 0% net return in a down market but then limit the up side to, for example, 13%. The question then becomes, is the cost of the hedge (both from the perspective of “limited” upside potential and direct acquisition costs) worth the guarantee? This becomes an issue each executive considering such a strategy must resolve based on his/her personal risk tolerance.

The third element involves an exit strategy which will allow the participant to exit without a loss. This can be accomplished at virtually any point during the accumulation period, even after the cost of the hedge is taken into consideration. In other words, the executive is able to exit the investment at almost any point and recover 100% of his/her principle assuming the hedge is purchased.

The next consideration involves “Competitive Growth with Safety.” We have already discussed the safety issue which is addressed via the hedge which protects against losses and provides an exit strategy. Determining if the growth is “competitive” is a matter of personal opinion. The investment strategy presented in this article introduces the concept of leverage with hedge which removes the risks normally associated with leverage. However, the hedge will limit upside return potential, while eliminating downside risk. One way to determine if the growth potential is “competitive” is to ask this question, “Would you be happy with the S&P 500 returns if all the negative years could be removed?” If the answer is yes, then the second question is, “Would you still be happy if the cost of securing no negative returns limits the upside potential to (for example) 13%? In other words, in exchange for a guarantee that your principle would never be subject to market decline, you will limit the potential investment growth to no more than 13%.

The final question on “Tax Advantages” will be covered in detail in next month’s article. Suffice it to say, there are significant tax advantages involved in this strategy.

As I’m sure you know, when it comes to the most complex issues, “the Devil is in the Details.” The specific details on how to best use this leveraging concept will be reviewed in next month’s article. So until then, “Happy Leveraging!”◘◘◘ Bob can be reached at Robert.Birdsell@grahall.com