When I think about life insurance, the three words that come to mind are:
Life insurance is one of the most misunderstood financial products by consumers.
Life insurance is one of the most mis-sold financial products by insurance agents.
Life insurance is one of the most mismanaged asset by wealth managers & financial advisors.
The combination of these three M’s ultimately gives a very valuable product a tarnished reputation causing many to underestimate the importance of life insurance in a holistic financial plan.
There are many types of life insurance, with many different features and benefits, but to the consumer they all appear similar.
When people think about life insurance, they may think about the “group life” coverage they had from work. For example, your employer might offer life insurance as an employee benefit. Typically, this is a multiple of your salary. For example, if you passed away while employed, you might be eligible for 3x your base salary as a death benefit to your family. After you leave your employer, this coverage generally goes away.
The reality is there are two major types of life insurance: Temporary Insurance and Permanent Insurance.
Within the categories of temporary and permanent, there are many different policy designs, features, benefits, and methods of funding.
Let’s face it, anything that pays a salesperson a commission has the chance of being misrepresented and life insurance is no different.
It doesn’t take much to become a life insurance agent. For most states, it’s a matter of taking a few online classes then passing a multiple-choice exam.
Although there are suitability standards which agents are held to, there is no fiduciary duty for an insurance only licensed agent unless they carry additional licenses or designations such as a Certified Financial Planner™ or Investment Advisor defined by the Investment Advisers Act of 1940.
The primary difference between a suitability standard and a fiduciary standard is that the suitability standard states an agent must ensure a product is suitable for the client while a fiduciary standard is a legal obligation that the product must be in the best interest of the client and the fiduciary must put the client’s interest ahead of their own.
In simple terms, someone who is only held to a suitability standard can put their own interest (i.e., earning a commission) ahead of the interest of the client, while a fiduciary must always put the client’s interest ahead of their own.
This has led to what we call the wild west of life insurance sales. People are getting solicited life insurance whether they need it, understand it, or can properly afford to fund it. In many cases, the policies sold are not designed to truly maximize the benefits to the client because of a lack of education to the agent, which we will cover later in this article.
This has led to a lot of unrealistic projections of what these policies are and what they are not. Ultimately, a good product gets a bad rap due to some bad actors’ selling it the wrong way.
While many wealth managers or investment professionals may be fiduciaries, many don’t have the training and expertise to properly manage life insurance as a true asset of the client.
They tend to focus on stocks, bonds, mutual funds, and ETFs while failing to help maximize the cash value and estate liquidity that a well-designed & properly managed life insurance policy can bring.
Most wealth advisors to ultra-high net worth understand that life insurance planning is critical to an estate, just look at the Silicon Valley Billionaire who purchased the largest life insurance policy ever. I am sure this person’s family office values life insurance as an asset class to make an investment this large:
But most wealth management firms neglect life insurance. If you own a policy, I am sure it is collecting dust in your safe. It isn’t reviewed and analyzed each year as it should be. The cash value isn’t actively used to help meet your financial goals and objectives like it could be.
We have all heard of the importance of laying a strong foundation before you build a house. Life insurance can be part of that strong foundation to your overall financial plan.
There are 6 core reasons to own life insurance:
- Your family relies upon your income, and you don’t have the assets to support your family if you passed away
- You want to leave a legacy or inheritance to someone for quarters on the dollar in the most tax-efficient manner
- You want to build another source of tax-free income to supplement your retirement, ultimately lowering your tax bracket in retirement
- You want to preserve your assets in the event you become disabled or chronically ill, in need of expensive long-term home healthcare, assisted living, nursing home or hospice care
- You have a business that is reliant on you being a key team member
- You will have a liquidity issue to pay your estate & income taxes upon your death (high-end estate planning)
In fact, in 2021 Ernst & Young conducted a study analyzing five strategies, across three different starting ages: 25, 35 and 45. For each strategy, their Monte Carlo analysis generated 1,000 scenarios based on randomized input from a range of factors, such as interest rates, inflation rates, equity returns and bond returns. The five strategies were:
- an investment only approach (using stocks and bonds)
- a term life insurance + investment approach
- a permanent life insurance + investment approach
- a deferred annuity plus investment approach
- a permanent life insurance + deferred annuity + investment approach
What they found was that the permanent life insurance + investments strategies outperform investment-only and term life + investments strategies.
The permanent life insurance was able to provide a volatility hedge against years where the market was down.
For the rest of this article, I am going to share several comparisons of life insurance to real estate.
One concept I try and share with all my clients is that it is better to put our money in things that will become assets rather than liabilities. An asset is something you own, and it holds a value. A liability is something you owe to someone else.
Wouldn’t you rather put your money towards something that you own vs owing that money to someone else?
For many of us, one of our earliest financial milestones was when we were able to buy our first home.
We have heard throughout our lives that we want to become a homeowner because of the equity we can build within our home. While real estate hasn’t historically been the best performing investment (comparing to sectors of the stock market like small cap or large cap stocks) it’s something almost all of us own because we don’t want to pay someone else to rent their house or apartment. We want something to show for the money we pay.
That is the same concept of temporary insurance vs permanent insurance.
Temporary insurance is like renting an apartment from someone else.
When you rent an apartment:
- It is generally cheaper than becoming a homeowner
- You build no equity
- After your lease is up, you can’t live there any longer without signing a new lease (and they can raise the price on you)
When you buy temporary insurance (term insurance):
- A death benefit will pay tax-free to your family if you pass away during the stated term (i.e., 10 years, 15 years, 20 years, 30 years)
- You build no equity
- After your term is up, you have nothing to show for the money you put in
- At the end of the term, the cost to establish another term period of benefits is much higher due to mortality costs increasing (you are now older)
Just as there are good reasons to rent an apartment, there are good reasons to buy term insurance.
For example, maybe you have a young family, and you don’t have a lot of discretionary cash flow. A term insurance policy is a very low-cost way to secure a death benefit for a time when the kids are young. In the unfortunate event you were to prematurely pass away, you have the peace of mind to know this death benefit will provide your spouse or the children’s guardian a tax-free lump sum of money to be able to support their needs growing up.
The first term insurance policy I purchased was a $2,000,000 death benefit 20-year term life insurance policy. I purchased this policy when I was 32 (at the time we had our first daughter) and it only cost me $880 per year. For that $880, I have the peace of mind to know my wife would get $2,000,000 to raise our family in the event I pass away before I was age 52. I still have this term policy today and feel like it is more valuable than ever because I have had some serious health events over the past 8 years which could prevent me from being eligible to buy more insurance to protect my family.
There could be other reasons why temporary insurance makes sense. A few high-level planning scenarios which we use term insurance for are:
- A key employee at a business, to insure against a loss to the business if the key employee passed away
- In a divorce, to insure the spouse who is required to make child support or alimony payments for a period of time
- In a business deal or asset purchase paid through an installment sale, where we need to insure the life of the person making the payments
On the contrast, permanent insurance is like buying real estate.
When you buy your home:
- It is generally more expensive than renting
- You build equity while you are paying off your mortgage
- The market value of your home could appreciate, further increasing your equity
- After your mortgage is paid off, you can continue to live in the house payment free (other than maintenance, taxes & insurance)
- You could borrow tax-free against the equity in your home to make further investments or supplement cash needs that you may have
- You can sell your home and realize a value for your asset
When you buy permanent insurance:
- It is generally more expensive than temporary insurance because you are buying a permanent asset that stays on your balance sheet for life
- You build equity in your policy in the form of cash value, which you could borrow tax-free to make further investments or supplement cash needs that you may have
- The death benefit will pay tax-free to your family no matter when you pass away if you fund the policy properly
- You could accelerate the death benefit if you become disabled or chronically ill, such as a long-term care event
- You could cash in the policy and receive the cash value
- You could sell the policy to a third party
When it comes to permanent insurance, there are four primary types:
- Whole Life
- Guaranteed Universal Life (GUL)
- Indexed Universal Life (IUL)
- Variable Universal Life (VUL)
The basics of these four products are similar, but the mechanics, design, and risks are dramatically different.
For example, a whole life policy is generally going to be the highest annual premium per thousand dollars of death benefit. This doesn’t necessarily mean it is the highest cost though. The cost of insurance is not the same as the premium you pay, and that is something many people mix up.
With all these policy types, the premium you pay is going to be divided into the following:
- Cost of insurance (to buy the death benefit)
- Cash value (the money you can access tax-free while living)
- Administrative costs (to run the insurance company)
For example, if you compared a whole life policy to a guaranteed universal life (GUL) policy, you would probably find that the whole life premiums are higher, but so is the guaranteed cash value that accumulates in the policy. If your goal is to accumulate cash value to use later in life to generate tax-free income, the whole life product could be a better option than the GUL. If your goal is to secure a permanent death benefit at the lowest possible cost and you don’t care about cash value growth, the GUL could be a better option.
If you compared a whole life policy with an indexed universal life policy, you would find that the whole life premium is higher, but so is the guaranteed cash value and guaranteed death benefit. In contrast, the non-guaranteed (the upside potential) cash value and death benefit of the indexed universal life may outperform the non-guaranteed cash value and death benefit of the whole life policy if we see good stock market performance because the growth of the whole life “non-guaranteed” cash value and death benefit is driven by the performance of the insurance company through a dividend payment back to you as the policy owner while the growth of the indexed universal life “non-guaranteed” cash value and death benefit is driven by the performance of stock market indexes such as the S&P 500 index. The indexed universal life typically has a floor of zero, meaning that if the stock market goes down during a particular time segment such as one year, you simply earn a zero for that time segment, but you don’t lose any of your principal due to the market downturn. If the index returns a positive return during that time segment, your cash value is credited that rate of return up to a cap.
For example, as I write this article indexed universal life floors are zero and caps are around 8 percent - 10 percent.
This means if the S&P 500 index goes down by 15%, you simply earn a zero. If the S&P 500 index goes up by 15%, you earn 8% (assuming an 8% cap). That return is locked and you cannot lose it in the future due to market downturns.
A risk of both whole life and indexed universal life policies is that the dividend of a whole life company and the cap of an indexed universal life product can change each year. If we see interest rates fall, we could see these dividends or caps fall, which would lower the potential growth of your cash value or death benefit. If we see interest rates rise, we could see dividends and caps increase, ultimately increasing the earnings potential of these policies.
Variable universal life policies bring in a direct investment component to the insurance policy. A VUL policy is structured like an IUL policy, except the cash value is directly invested in the stock market in a VUL. This could expose you to more upside potential, but also subject your money to market downturns, exposing the policy to the risk that the policy could lapse or require additional unplanned premium payments to be paid in. As with anything invested in the stock market, there are no guarantees, and this type of policy does have the greatest amount of risk of any insurance.
With any of these policies, we have two core focuses:
- Death Benefit
- Cash Value
Section 7702 of the Internal Revenue Code defines whether a contract qualifies as a life insurance contract.
The significance of this section of the tax code is that it governs that the proceeds from a genuine life insurance contract are tax advantaged. These proceeds are both the death benefit paying out income tax free to your beneficiary (could be subject to estate taxes if not structured properly) and the cash value being accessible tax-free if you follow the rules.
Life insurance death benefit is actuarially calculated based on life expectancy. The life insurance company can pool many clients together, which helps them calculate what the “average” life expectancy of their policy owners will be. Of course, there is no telling what each individual person’s life expectancy will be as none of us know how long we will be alive.
Think about it, if we have a group of 100,000 females who are all age 40, we can reasonably estimate that they will live until age 83 on average, according to the 2019 Social Security Actuarial Life Tables. Of course, we don’t know which side of that average we will each be on.
Life insurance companies use this actuarial data to help the forecast how they can remain profitable while insuring our lives. If you pass away before life expectancy, you lose your life, but you earn a more favorable rate of return on your insurance death benefit.
If you live past life expectancy, you win at life, but you earn a less favorable return on your insurance death benefit, something that I am sure we would all be happy with!
If you think about life insurance death benefit as an investment portfolio, this chart plots out the asset class equivalent of the internal rate of return on your death benefit.
But what if you don’t want to have to wait until you are dead to benefit from your life insurance policy?
What most people (clients and many insurance agents) miss is that there are a lot of different ways to fund a life insurance policy that can have a major influence on how you build cash value in your policy. You can fund it with a single lump sum payment or premium payments that could be as short as two years or as long as lifetime pay options.
Longer premium payment commitments are generally associated with a larger death benefit.
The shorter the time you to pay premiums, the lower your death benefit, but the higher the internal rate of return on your cash value.
The problem with most life insurance policies is that they aren’t designed to optimize your specific goals and objectives. Instead, they are funded right down the middle, essentially forcing you to overpay for your death benefit and/or minimize the earnings capability of your cash value.
It’s like buying a Swiss army knife. It works ok for a lot of things but doesn’t particularly excel in any one thing.
Policy design is critical.
If you want to maximize the cash value in your policy so that you can use it in the future, you should be paying the maximum premium allowable under section 7702 of the internal revenue code while minimizing your death benefit. This allows you to stash the maximum amount of cash into the policy, while reducing the cost of insurance, which is based on the amount of death benefit above and beyond your cash value. By reducing death benefit, we reduce cost of insurance. By reducing cost of insurance, we allow more cash to grow.
If you are purely looking for the maximum return on investment (ROI) for your death benefit, you want to design a policy which requires you to pay the minimum premium set forth by the insurance company for the maximum death benefit.
Unfortunately, most insurance in the United States is designed right at that dotted line in the image above, whereas it is not maximizing the death benefit ROI or the cash accumulation ROI.
So, what can you do with your cash value?
The simple answer is just about anything. When you build up cash value in a life insurance policy, you have two different ways you can access it. You could cash in part of the cash value, which could be a taxable event (gain is taxable, but basis is not), or you could take a loan against your policy, which would provide you the funds tax free.
Most policies allow you to take a loan of up to 90% of your cash value. When you take a loan, the insurance company charges you an interest rate on the loan balance and reduces the death benefit by the loan amount if you were to pass away with an outstanding loan.
The unique thing about life insurance is although you have a loan on the policy, the entire amount of cash value still can grow (i.e., dividend from whole life or interest credits from indexed universal life). In many circumstances, the dividend or interest credits more than offset the interest rate on the loan balance, making it a powerful strategy to produce tax-free withdrawals.
You could use those tax-free withdrawals to supplement your retirement income, purchase real estate, or even invest in a market downturn.
As two examples, when I was purchasing my house in South Carolina, we had yet to sell our Ohio house. I needed to come up with the down payment for the SC home and had two options:
- I could sell a part of my investment portfolio, subjecting myself to 20% capital gains tax, 3.8% net investment income tax, and state income tax. This would force me to sell a lot more of my investments than I would have wanted to fund the house down payment and pay the taxes. In addition, once I sold those investments the money was no longer in the stock market earning for me.
- I could borrow from my life insurance policy, tax free. I was charged a 3% interest rate on the loan balance, which was offset by my earnings in the policy that year. I had the cash within 48 hours of requesting the loan and I owed no income tax! This was the route I went and when the Ohio house sold, I simply used part of the proceeds to pay back the insurance policy.
When the stock market crashed in April of 2020 due to the Covid pandemic, I wanted to take advantage of “buying the dip” but I didn’t have a lot of excess cash. I was able to use the cash value in my life insurance policy, via a loan, as dry power to buy deeply discounted stocks and funds. My theory was that the market won’t be down forever, and when it rebounds, I will have benefited from buying low and could sell, pay tax on the capital gain, then pay back my life insurance cash value. Of course, I had no idea the market would recover so quickly, and as soon as those gains became long-term capital gains, I sold off a part of the investment portfolio to pay off the loan against my cash value. This is an example of money in motion to help continue to build wealth.
Lastly, when it comes to paying your premium, you have options.
For our clients that are still working, you may have additional capacity to save after you do the basics such as funding your 401k or Roth. Life insurance can be a great place to accumulate savings in a tax-advantaged manner while providing your family the peace of mind of a leveraged-up death benefit if something were to happen to you. Again referencing back to the Ernst & Young study, they illustrated people saving 30% of their retirement savings into permanent life insurance and it proved a better outcome than a 100% investment only approach.
For our clients that have accumulated investable assets, sometimes we use a portion of your dividends or capital gains to pay an ongoing annual premium to properly fund a life insurance policy. In other cases, we may use the cash value of a life insurance policy as a bond alternative in your portfolio.
For retirees who have required minimum distributions the government requires them to withdrawal from their retirement accounts, we may use a portion of those RMDs to purchase a properly funded policy. In many cases we design these policies to be able to provide long-term care benefits in addition to a death benefit.
For our higher net worth clients (over $5m+), there is the opportunity to engage in a concept called premium financing. With this strategy, you pay a portion of the life insurance premium, and a bank loans you money to pay the remaining premium. This allows you to put a much higher amount of money into a life insurance policy early on because it is part your money and part the banks money. Assuming the rate of return on the cash value of the insurance policy is greater than the interest rate on the loan from the bank, you have a positive arbitrage and come out ahead. It is like taking a mortgage out from a bank to buy real estate. You are hoping the real estate grows at a greater rate than the money you have borrowed. At some point you could take proceeds out of the policy or from another asset you own to pay off the loan and have a big pile of cash value in a life insurance policy to provide tax-free income to yourself and a death benefit to your family upon your passing.
As you can see, there is a lot of sophistication that can be brought to a holistic plan utilizing life insurance. My hope is that we can continue to bring clarity and eliminate the 3 M’s of this product being misunderstood, mis-sold and mismanaged!
If you have an existing permanent life insurance policy, we can work with you to review it and ensure it is the optimal plan based on your goals and objectives.
If you have no insurance, there is a chance you have gaps in your overall wealth strategy, and we would be happy to help guide you through this incredibly important decision.
If you are an existing client of Alison Wealth Management, please click this link to schedule some time for us to meet.
If you are new to Alison Wealth Management, click here to schedule an introductory call.
Dave Alison, CFP®, EA, BPC