Life Insurance Loans are the one thing just about every agent who has cash value life insurance in their quiver can tell you about. And why? Because they're TAX FREE! But wait, there's more…
Unfortunately, however, we're not about to tell you about what you get if you call within the next 15 minutes. No, instead we're about to let you down somewhat hard. The more to this story is the ugly side of life insurance policy loans. To be clear, this isn't some tirade against them as I've been known for some other slick life insurance trick. Nor is it a suggestion that you not use them. We simply need to set some ground rules to keep you all honest and out of trouble.
Unfortunately, Indexed Universal Life might be the biggest offender here. Not because of the product, but the agents and lack of good judgment practiced by some company sales forces (don't hate the player, hate the game). You see, these otherwise upstanding individuals who don't cheat on their taxes, always come to a complete stop at a stop sign, and never tell anyone else your secrets do have mortgages to pay and children to put through college. So sometimes they might have to stretch the truth just a tiny little bit in order to make their product or idea look better than everyone else.
The best way to stretch the truth is to talk about indexed crediting rates from years long since gone when the stock market was a booming and then illustrating loans with variable interest rates at current market conditions (one of these things is not like the other) oops. Now, this wouldn't be so bad if we know where the guarantees sit. For example, I may be showing you a current interest rate assumed at 5.9%, but the guaranteed maximum loan interest rate is 6% so we're not far enough off to be hugely worried. Alternatively if there is no cap, or if I'm more than 100 basis points aways from that cap, more caution is necessary.
If you're looking at distributions it makes sense to look at both indexed loans (the IUL equivalent of a Non-direct Recognition loan), and fixed loans. Most fixed loans are wash or near wash loans, so their impact is minor. Let's keep in mind that portions of the policy moved to fixed buckets to support the fixed loans will represent a tiny portion of the policy for several years.
Now, I know the push back. “But the indexing cap is like 14%, why give that up just because I'm worried about a year or two where I don't get credited?” Well, you might be right. Here's the problem though, distribution time means we're headed into that period of the policy the whole life hacks always warned us about. The steeply increasing Cost of Insurance period. Now, we know the true impact of this is over hyped by some, but it's does exist. Fixed loans ensure against the problem of compounding a bad crediting year and increasing COI.
It used to be simple. Whole life was withdrawal to basis and universal life was loans only if it had a wash loan provision. But then someone had to invent this indexed loan business and confuse the hell out of everyone. Again, the Non-direct Recognition feature to indexed loans makes it tempting to suggest loans only. But there is a potential for a pretty dramatic negative spread between the loan interest rate and the credited interest rate. Perhaps we could save the withdrawal to basis for a rainy day?
For contracts that allow interest payment in arrears, we could also start with a loan, but then wipe it out with a withdrawal to basis if we have a bad crediting year. This won't completely wipe out the problem of zero crediting years, as it's not a trigger we can pull and infinite number of times, but it is a good card to have in your bag of tricks just in case. So, if you're going the indexed route, probably best to remain loans only until you need to surrender in a bad year. There are a bunch of ways to attack this. We'll be happy to discuss in further detail if you reach out to us.
The thing I fear the most is the over zealous approach to policy loans at times. Insurance is supposed to be about safety and reliability. We don't have super gains because we're not subject to super risk. And you don't need that risk to get to the top of the mountain. The mutual fund industry is looking really foolish right now as it reneges on the age old 5% withdrawal. Even worse is it's inability to land on new number (anyone is going to look bad so they might as well just pick one out of a hat, I'm still not convinced that's not what they did the last time).
We really don't want to go down that same road. We don't need that reputation. Life insurance loans will do just fine without the added hype.
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.