Life insurance, the ultimate family planning tool, should be a core element of almost every family's financial plan; a large infusion of cash just when your family needs it. Being a fan of life insurance and investing, I'm always skeptical of schemes that combine life insurance protection with savings, especially saving for retirement. Death and retirement seem like opposite ends of a pole, how can one help the other? How does spending help saving? I’
ve also learned to look twice when dealing with financial sales people. Their commissions are steep and have to be paid by someone. So logically, it will be the investment product you buy.
There are thousands of life insurance companies in the US and in foreign companies that do business in the US. If you were to compile a list of all available policies, add in all policies issued over the past fifty years and include policies being developed today, you could have one monstrous database with tens of thousands of different life insurance plans. To simplify this discussion, I’ll focus on three major types of life insurance policies:
Term Life (TL): A policy issued for a fixed period of time with no cash value building within the policy. The death benefit is paid if the insured dies during the period of time the policy is in force. If the insured outlives the policy term, they receive nothing.
Whole Life (WL): A policy where the policy term lasts the entire life of insured or until some fixed age (say 100) where insured is guaranteed to be paid face value of policy. If they die it’s paid as a death benefit. If they live, it’s a return of cash value. Either is guaranteed as long as the policy premiums are paid. Paid premium invested in the policy is paid back at a predetermined rate of return; usually a very conservative 2-3%. The return is projected to the penny for the life of the policy and is written as a policy illustration.
The two previous plans have fixed benefits and fixed payments. The third plan gets a little more complicated:
Universal Life (UL) or Variable Universal Life(VUL) : The naming difference is due to the underlying investments. UL is based on some conservative guaranteed investment, similar to a savings account or a money market; your return is guaranteed to never be negative, but the return rate will fluctuate with market interest rates.
VUL is similar but premium dollars are invested in a type of mutual fund called a
subaccount. The
subaccount could be any type of investment: money markets, bonds, stocks, and foreign stocks; any type of investment that is deemed suitable by the SEC and is available as a mutual fund. Your returns could be positive or negative based on the underlying investment and your principle is not guaranteed.
Both policies have a variable premium and variable benefits. This is the way it works:Your agent/broker will give you a range of payments from minimum to maximum. Let's say that your minimum is $30.00/month your maximum is $120.00/month and your midpoint payment is $65.00/month for an insurance policy with a death benefit of $50000. You select a payment; let's say $40.00/monthEvery time you make a payment that money will go into the account that pays interest or into a
subaccount which is invested. Every month, your insurance company will withdraw the expense of insuring you for $50,000 from that account (I’ll talk more about the expense later). The balance will grow if principle with interest is greater than the insurance expense or if your
subaccount has a positive return and the return outpaces the insurance cost.Here is the tricky part: Every year that goes by, you become older. Therefore the cost of insuring you goes up. In the first years that’s not a big difference, but after 10 or 20 years it will add up. So every year the company will withdraw a bigger amount of money from that account to keep you insured. Remember that the balance will grow with interest which may go up or down based on market rate, or in your
subaccount depending of the rate of investment return. So the more you pay on the earlier years, the less you will have to pay in the later years. In some cases -if you’re funded well early- the insurance company will ask you to stop payments temporarily; the opposite is also true, if you funded very lightly or your
subaccounts lose money, the insurance company will require you to raise your payments or you will lose the policy. Depending on your overall rate of return, you could end up with a substantial amount of money OR a life policy which needs extra money to stay in force OR a useless life policy which crashed and burned because you were unwilling or unable to pay additional premiums to keep the death benefit in force.
The sales pitches typically discuss the positive rate of return and the substantial amount of cash built within the policy. This money can grow tax deferred and can be borrowed tax free. Another golden nugget for your retirement; tax free money you can spend in your twilight years and life insurance that lasts a lifetime.
Sounds great in theory, but there are several sticking points in reality. For one thing, the expenses I talked about earlier. To pay agent commissions, show the insurance company a profit and pay investment fees on
subaccounts each payment has certain charges subtracted:
· Sales load: Typically 6%
· Investment fees on
subaccounts: Typically 2% per year; a drag in the investment returns.
· Cost of life insurance for face value of policy: Actuarial charge based on policyholders’ age at time of payment. Sex and other rating factors (smoker/non-smoker, health, occupational or lifestyle factors) are also factored in.
And depending on the insurer, you may not be getting a very good price on the basic insurance protection either. Most policies are quoted and sold at standard rating or will only offer preferred rating for policies with face values of above a certain amount, say $150K.
And while the borrowing scheme may seem like an easy enough way to turn investment gains into tax-free payouts, there are complications there too, the largest being that if the policy lapses after you've been borrowing money from it throughout retirement, you will pay taxes on the borrowed money as taxable income not capital gains like a mutual fund.
All in all, I don't think these policies are worth the trouble. That said, I suppose you could make a case for one if someone were already maxing out tax-advantaged alternatives like 401(k)s, IRAs and the like OR if a business was paying for it OR you have money coming out of every space in your house and can’t fit it anywhere else. I don't think it's a very compelling case.
But I suppose someone who really wanted to use (or sell) one of these policies could come up with a rational. But I doubt that even the biggest proponents of investing through life insurance would suggest that you do so before you had contributed all you can to all available tax-deferred investments. After all, it makes no sense to give up the lucrative up-front tax breaks that a 401(k) and traditional IRA offer (or the more straightforward tax-free withdrawals of a Roth IRA) in favor of an insurance strategy that's a lot more expensive and fraught with potential complications.
My advice for the 80% of Americans who don’t own an individual insurance policy? Buy a substantial Term policy; $500K or 5 to 10 times your annual income does nicely for most people. Then maximize your 401K, IRA or other investments you make. Have more money than you can invest tax deferred? Lots of investment opportunities in the world: tax advantaged mutual funds, real estate, business ventures the list goes on. Or just take a nice vacation with your cash. Just think twice before buying the ‘lifetime protection’ policy.
