Here's something you wouldn't expect to find written around here: Whole life insurance (at it's core) kind of sucks. Sure everything is guaranteed, and to some people and in some applications those guarantees are vitally important. But the thing that drives whole life insurance to the level that makes it an attractive cash accumulation tool for us is what insurance company refer to as the ability to participate in the sharing of divisible surplus, aka dividends.
To be somewhat bold, non-participating whole life insurance is horrendously boring, and probably not worth your time (unless your in your 60's or older and just looking for $5-10k for final expense costs when you die, and if you think that's all it's going to cost, you might want to think again).
The key element that takes Whole Life insurance to the next level is the payment of dividends (participating whole life insurance). Dividends not only supply your policy with loads of extra cash above and beyond the guaranteed cash the insurance company promises you'll have if you pay your premiums, but they also give you the ability to continue to earn money on your money even when you've taken the money out to spend it.
Earlier in the week we declared PUA's the magic behind Cash Value life insurance. If PUA's are the magic, dividends are the mana that grant them their magic.
Dividends are paid in cash every year the insurance company from which you hold your policy declares a dividend. And all of the whole life players have been paying dividends on their participating whole life policies for around 100 year or more (and in some cases, many more) The cash can go towards a few different options, here are the most common ones:
A lot of stock brokers (and even a lot of insurance agents) take the literal definition of a dividend paid on an insurance contract and apply it incorrectly (most of the time in an intentionally disingenuous fashion). Dividends are considered a return of premium, and it's not uncommon to see the before-mentioned types curl up their faces like they just took a shot of tequila and exclaim something to the effect of, “The only reason they pay dividends is because they charged you too much to begin with!”
Don't buy the pitch to dissuade. The categorization of a dividend as a refund of premium is an extremely tax advantageous feature that frankly is a little legislative miracle I, and several others who really understand what is going on, still can't believe the insurance industry was able to sell congress on. Every dollar you pay into your insurance contract is considered part of your taxable basis, so every dollar paid out as a dividend refunds that, unless of course it goes into PUA's at which point it's a wash. The important thing to note is, if you start taking dividends as cash from the policy, you have zero taxable consequences on those dividends until the entire basis has been refunded and only then you'd incur a taxable liability on future dividends paid as cash (but please note, not if you switched back to purchasing PUA's or paying base premium). And even if you've pulled your entire basis out of the policy, insurance companies will continue to pay you a dividend, same as if you hadn't (refund of premium and then some, a lot of “and then some” in most cases).
If there's one thing that the general public, the investment folks (I think they prefer financial adviser…whatever that is), and even insurance agents tend not to understand about life insurance policies, it's how policy loans work. Mechanically what's taking place is the following: the the insurance company lends money to you with the understanding that the cash in your policy is pledged collateral for the loan in case you don't pay it back. Notice one very important piece of information about all this. Your money stays in the policy and continues to grow. This means you can use your money, without loosing the wealth building dividends that continue to increase your cash value. Think taking money out of the bank but still being paid interest on it.
It's this feature that powers the concepts of Life Economic Acceleration Process (LEAP) and Infinite Banking et. al. Now, there are two ways an insurance company might pay dividends so it's important to understand the difference between the two. And it's an important feature that gets glossed over way too easy. We'll revisit it very frequently, but the chief thing to keep in mind is that you can still earn money on your money, even when your using (spending) your money. There is no other financial tool available that provides this benefit with the same guarantees offered up by participating whole life insurance.
Non-direct recognition means the insurance company does not take loan status on a policy into consideration when it pays a dividend. It's the original form of dividend payment and it ruled the day up until the 80's when The Guardian Life Insurance Company of America pioneered a new process called Direct Recognition. Because dividends are not adjusted when a loan is outstanding Non-direct recognition (or NDR) is the preferred feature among the LEAPsters and Infinite Bankers.
In the 1970's and 80's America experienced some significantly high interest rates. Rates that brought us to new highs in the world of yields on various savings vehicles. And while people spread-sheeted yields on various savings vehicles (yes they did it back then too, only in a different way since GUI personal computers weren't a hit yet) one product that appeared to lag behind others from a declared rate point of view was participating whole life insurance. Whole life insurance was lagging by a few 100 bps behind other choices like bonds and CD's, and the reason was in part NDR. It still worked just as beautifully, but a lot of people were pulling money out of their policies to take advantage of a 100 bp or so increase in a CD (for example). To combat this, insurance companies did two things:
These days direct recognition tends to enjoy a slightly less attractive impression when compared to NDR. However, some companies use it to increase dividends (instead of reduce them) when a policy loan is outstanding (the reason for this goes beyond the scope of this article, but if you don't think you're life will be complete without knowing why, you can aways shoot us an email, and we'll give you the answer. Still, if you are looking into Infinite Banking et. al. we strongly encourage you to approach Direct Recognition with caution. Guardian (and maybe Penn Mutual) is the only company we'd be comfortable giving a greenlight on regarding this.
And there you have it. Whole dividends in 1600 words or less.
Brandon launched the Insurance Pro Blog in July of 2011 as a project to de-mystify the life insurance industry. A specialist in the design and application of life insurance cash accumulation features, Brandon is one of the foremost authorities on the subject of coordinating life insurance cash values in a financial plan.