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.
How Do I Get Them?
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:
- Paid-Up Additions: the cash paid purchases PUA's and we know we like these things.
- Paid in Cash: The owner of the policy can choose simply to collect the dividend as cash and do with it whatever he or she wishes.
- Pay Loan: If there is an outstanding loan on the policy the dividends paid will go towards the loan. If the dividends paid completely payoff the loan, the owner of the policy will then need to decide what happens to the rest of the dividends using any of the other options available.
- Purchase One Year Term: Often times the owner has the option to use dividends to purchase a guaranteed issue One Year Term insurance policy with the dividends, this is a move to increase death benefit, which has several applications that go beyond the scope of this post, but we'll be talking about in the very near future.
- Reduce/pay premium: This means the dividend will pay for all or part of the required premium required to keep the policy in force. As is the case with paying a loan. If the dividends paid exceed the premium (and this will almost always happen with a policy if kept long enough) the owner must decide which option the rest of the money will go towards.
- Accumulate at interest: This means the dividends are paid in cash, and kept in a side account that earns interest paid by the insurance company. You can look up what the insurance company is paying, it's typically referred to as the reserve rate. Since the money is no longer in the policy, interest paid on these accounts is taxable in the year it is earned.
Refund of Over-Payments (e.g. Extremely High Premium)?
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).
“LEAP” Into Awesomeness: How policy Loans work, and Why Dividends Matter with Respect to This
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: The Original Method
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.
Direct Recognition: How to Deal with those Whiny People
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:
- Universal Life came along and stripped away all of the guarantees whole life insurance offered in the name of offering a better interest rate. Dividends were also removed in favor a term product that came with a savings account with an interest rate that killed savings accounts in comparison (sign up for life insurance, and get a free savings account!).
- Direct recognition was created. Instead of paying the same dividend rate on all policies regardless of loan status on the policy, direct recognition was the answer to preventing money from leaving the contracts. If you left the money in, you got a much more competitive interest rate, and if you removed it, the insurance company “penalized” you by reducing the dividend paid on the portion of the policy that was pledged as loan collateral.
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.