Following up on the Cash Value Life Insurance as an Asset Class post, I wanted to spend some time talking about how Cash Value Life Insurance get's used for retirement and wealth accumulation.
Believe it or not, there's not a lot oversight when it comes to the financial services industry when it comes to what you can and cannot reasonably recommend as long as you don't violate the really big rules. Like a real estate agent who suddenly turns into a financial and business adviser in order to convince a client to take a 10% haircut on their selling price because he or she wants to close the deal, financial advice can often be driven by someone's need to pay a mortgage, pay down a credit card debt, afford a vacation, etc. And for the most part, sadly, no one cares. It's not until someone kills a sacred cow that problems begin to arise. Put a 65 year old's entire portfolio into midcap stocks, spread that sale around into different funds so as to avoid the sales load breakpoint, and do it all a few days before the dividend date and you'll really upset some people. Those are concrete examples of big no-no's any compliance officer should be more than capable of thwarting. These examples are a violation of suitability. On the topic of cash value life insurance, and its place as a retirement vehicle, the question is one of suitability. Is it suitable?
I've declared this before, and I've even elaborated a bit, today we'll drill into exactly what this means, we'll even use a very concrete example where someone has seriously violated suitability by virtue of extremely poor design and execution. This is a somewhat nuance topic that might take a little time to understand, but like all tougher pursuits in life, it's well worth the effort to understand. This is what separates the whole and universal life insurance Dave Ramsey talks about, and what I talk about. But first, we have to lay down a few foundational understandings.
Here comes a rather crazy statement: not all life insurance is bought for the same purpose. While most would assume life insurance is a relatively straight forward purchase based on death benefit coverage compared to the relative premium cost, this assumption would be false (and sadly it's an assumption made by a lot of life agents). Nestled in the deeper understanding of cash value life insurance product–sitting right next to a finer understanding of personal finance–is the design and use of cash value life insurance not primarily for death benefit purposes, but for a multitude of financial reasons to touch a much broader array of situations.
This is an important point to make because there's a serious differentiation that needs to be made. A lot of life agents with a rudimentary understanding of cash value life insurance misapply the product when wealth accumulation and retirement planning are a bigger piece of the puzzle (sometimes intentionally).
When using cash value life insurance as an asset, you want to be very careful about where your money goes. All policies are developed to provide cash value–that part is pretty simple–but there is a huge difference between incidental cash value, and intended cash value. Cash value life insurance takes shape in two different forms, and so it'll be important to know what you're dealing with and what you need to look at.
Whole life insurance is the original form of cash value life insurance. Whole life insurance has undergone some pretty significant changes over the past 30 years, so it's important to note that the stuff your mom and dad bought when you were in diapers is very different. The key to leveraging the cash in cash value life insurance is in over-funding the policy; in a whole life policy this is done through a Paid-up Additions rider (PUA). PUA's grow faster cash wise than the base whole life premium, so more PUA's means more cash for you. What you're doing is placing more cash into the policy than you need to and the life insurance company is rewarding you with more cash for doing so. You can always get a breakdown of where the money you place into a policy goes, you should always look at this, and look to maximize the amount of your outlay going into PUA's.
Universal Life insurance is a newer form of cash value life insurance introduced around the late 70's/early 80's. Universal Life insurance doesn't have a base premium as it's a term insurance-like product that comes with an additional account for your cash value. You can sometimes get a breakdown of the expenses of the Universal Life policy you are reviewing, but this has become increasingly more difficult to obtain. There is, however, a surrogate you can use in place of the base premium you can review with Whole Life insurance, the target premium. Target premium is the calculated premium required to keep the policy in force based off the current interest and expense assumptions on the policy. The target premium is also what the commissions paid to the agent/broker are based on, but this doesn't necessarily mean you'll get the best deal from the policy with the lower target premium. The best way to approach a purely cash focused Universal Life policy is to minimize the death benefit to either the TAMARA 7-Pay Death Benefit or the DEFFRA Guideline Death Benefit, you'll have to go with the higher of the two, as being below the other will either violate the Modified Endowment Contract test or the test of life insurance. Keeping the death benefit down to these levels will ensure the lowest internal expenses. Also, Universal Life insurance allows for a choice between the test used to qualify the contract for life insurance. The two tests that exist are Cash Value Accumulation Test (CVAT) and Guideline Premium Test (GPT). GPT is the test of choice for maximizing cash in your cash value life insurance.
So the initial question was does cash value life insurance work as a retirement vehicle or wealth accumulation tool? A lot of investment salesmen have attempted to suggest it's merely a supplemental tool at best. But if designed correctly, you should have little trouble getting a cash value life insurance policy to supply you with 2.5-3 times your outlay as annual income during retirement. Of course, this isn't a guaranteed thing, and individual situations will vary, but the stability of the product makes the guessing a lot less sporadic than trying to tackle the stock market (regardless of your trading volume). If you have other retirement assets, you can exhaust those first, and leverage the cash accumulation and death benefit of the life policy to provide more income by delaying distributions, and/or replacing assets when you die. Or you could sell the life policy.
The secondary market for life insurance–also known as the life settlement market–has admittedly shrunk in recent years, but that doesn't mean it's not available and not a worthwhile endeavor. Permanent cash value life insurance is a coveted asset and there are financial intermediaries that would jump at the opportunity to pay your premiums if they can be the beneficiary of the policy. What you're typically looking at is a buy out from the Life Settlement Company that is equal to some number between your cash surrender value and your death benefit (usually closer the the cash value than the death benefit, but depending on your health, you may be able to secure more cash as the less likely you are to live long term the more money you can reasonably expect in the buy out). For those who have a moral affliction to this sort of thing, you might want to skip on down to the next heading, as we're talking about leveraging the fact that you're going to die one day for money.
The process is really much simpler than most people realize. But, like all things, it's a good idea to compare offers as the life settlement market is going to depend entirely on what an individual company feels it can make off your life policy (i.e. how long they feel comfortable paying premiums keeping in mind the money they are going to pay you, before they receive the death benefit). There are taxable implications to a life settlement, basically anything you receive in cash beyond your taxable basis will be taxable as income in the year it is received.
Also keep in mind that there is a huge difference between a life settlement and something known as a viatical settlement, which is essentially selling a life policy when you are terminally or chronically ill. Though they are somewhat similar in nature, life settlements do not require you to be unhealthy to sell the policy.
I should also note that simply knowing this is an option in the future is not the reason insurance companies ask about selling a policy for which you apply. This is a measure to curb STOLI or Stranger Originated (or owned) Life Insurance. STOLI is the purchase of cash value life insurance for no other reason than to sell it to a third party (i.e. you don't have life insurance, but someone approaches you about applying so they can buy the policy from you).
If you don't like the idea of selling your life insurance policy, there's always donating it to charity. It won't help you with the money in your pocket, but it can help significantly reduce your tax burden for several years to come. This reduction in taxable income could seriously help you keep more of other assets by not needing to withdraw additional funds to cover taxes. It can also free up other assets you otherwise had earmarked for charitable causes.
Lastly we'll bring up reverse mortgages. Once a last resort for the financially destitute, now reverse mortgages are more common place around people with money than those without. The only problem for many people is the whole giving up your house to repay the loan when you die. With life insurance in force you have two options, use the death benefit to pay the bank back (or to buy it back as they try to sell it, everyone knows banks are terribly impatient about home sales and don't usually have the patience to find the highest bidder) or you could simply let the kids (or whomever) walk with the cash (we never really liked the house anyway).
Yes, cash value life insurance is a retirement and wealth accumulation vehicle. But like everything else out there, prudence should be employed when seeking out your own plan. There are many inexperienced and/or unscrupulous insurance agents roaming the earth. They have the added advantage of knowing just a little bit more about life insurance than you do. If planned out correctly, it can be a great tool for retirement purposes, and design is crucial. If you have any additional questions about using cash value life insurance as a retirement or wealth accumulation vehicle for your financial plan, we'd be happy to answer questions.
Brandon launched the Insurance Pro Blog in July of 2011 as a project to de-mystify the life insurance industry. Brandon was born in Northern New England, and he currently calls VT home. He attended Syracuse University and graduated with a triple major in Economics, Public Administration, and Political Science.