Lately, I’ve been doing quite a bit of speaking on the subject of cash value life insurance as a savings vehicle and a source of retirement income. Without going into detail here, let’s highlight a few of the reasons that properly structured cash value life insurance may be the best available way to save money, build wealth, and create substantial, reliable, and tax-free retirement income.
- No contribution limits
- Tax-Deferred Growth
- Growth rates that can average as much as 8% or more over time, and may be as high as 15-17% in any given year
- Complete safety/protection from downside market risk
- Tax-free (lifetime) income
- More Income potential per dollar of accumulated cash than any other product or account type
- Low fees
- Lower cost of college (in many/most cases)
- Additional benefits in the event of certain major health events, disability, and long-term care
- Protection from creditors, probate, and other asset attacks
But with a basket of deliverable benefits like that, the concern I hear voiced most often is, ‘it sounds too good to be true.’ It’s a fair concern. After all, nothing in life is truly free of risk. So let’s look at what I consider to be the 8 potential risks of cash value life insurance.
- The insurance carrier could go out of business. While very rare – it has happened. However, most insurance companies are well over 100 years old. That means they’ve weathered every financial calamity thrown their way over a very long period of time. Why?
- Because insurance company reserve requirements are much higher than even banks – because they are very conservatively managed companies.
- Because regulatory protections create a safety net for policy-owners (that works in a similar way to FDIC insurance on bank savings).
The net result is that very few policy-owners – over all of history – have lost money on an insurance contract.
- The internal ‘costs’ of the policy could increase. All cash value insurance products have internal costs – the costs you pay the insurance company for the benefits they deliver. These costs are generally not guaranteed forever. An increase in those internal costs could affect the performance of your policy.
The primary cost component however is the cost of the life insurance death benefit itself. The good news is that for most insurance companies, the internal cost of insurance has NEVER gone up in their history. Why? Because as life expectancies grow, it becomes less expensive for an insurance carrier to provide the death benefit.
In other words, while the risk exists – it is very low. We see the best evidence of this when we ‘shop’ our life insurance policy from time to time – and often find we can buy the same coverage cheaper than we could say, five years ago. In fact, life insurance may be the only thing we own that actually goes down in price over time.
- Policy Performance could be lower than projected. There are a few different ways earnings are credited to a cash value life insurance policy. Whole life offers a fixed, guaranteed interest rate plus the potential of a dividend bonus based on the carrier’s performance. Indexed Universal Life credits earnings to the policy base on the performance of an equity index – like the S&P 500 for example (without any downside risk). IUL’s also offer a fixed interest rate that is generally slightly lower than the guaranteed fixed rate on a Whole Life policy.
All this is to say that while most Whole Life policies may have performed historically in the 6-7% range (including dividends); and most IUL’s have performed in the 7-8% range historically. However, a sustained period of poor economic performance could mean that crediting rates hover near the minimums rather than the historical averages.
Some nay-sayers will argue this means the policy could lose value. If credited earnings are zero, and the cost of the core insurance component is taken out of the cash account – the policy could go down in value, however this is not a ‘loss’ – rather an expense. To call it a ‘loss’ would be like saying an account that earned zero actually lost money because the account owner also paid a $1,000 life insurance premium on a term policy.
- Negative Arbitrage. (This discussion does not apply to Whole Life – but rather to Indexed Universal Life only). Benefit number 5 from the list above suggests that there is more income potential per dollar of cash in a cash value life insurance policy than in any other kind of investment. That’s because a cash value insurance policy has two accounts – a cash account, and a life insurance account.
When you start taking income from your policy, that income is usually structured as a series of ‘advances’ against the insurance account – meaning the cash account is never touched (and it eventually becomes part of the tax-free death benefit). As such, one account is going down in value (the insurance account) and one account is growing in value (the cash account).
Since the cash account usually grows at a much faster rate than the insurance account declines – a cash value life insurance policy will typically yield much more income than any other type of account with the same amount of cash in it.
That’s because a single account investment goes down in value when money is withdrawn, and up in value when earnings are credited on the undistributed balance. Generally however, they go down over time on a net basis.
The two account feature of cash value life insurance creates an opportunity for the policy owner to benefit from arbitrage – interest earned at a higher rate on the (larger) cash account – offset in part by interest charged on ‘advances’ from the (smaller) life insurance account at a lower rate.
But just as arbitrage can be positive (earn 7% on the cash account – while paying 5% on insurance account advances); arbitrage can also be negative (earn zero on the cash account while paying 5% on the insurance account advances). So while it’s true that negative arbitrage is a risk – it is known, and most policies offer several ‘levers’ that can prevent negative arbitrage from dramatically impacting the policy as a whole.
While a bit more complex a subject – a properly structured Indexed Universal Life policy – sold, monitored, and adjusted by an experienced agent, is a very safe instrument.
- Running out of Income. Some will point to the fact that after turning ‘income’ on in a cash value life policy, there is no guarantee that the income will last as long as you do. Once again, there is an element of truth – but the whole truth is more reassuring than concerning.
Most competent agents will ‘illustrate’ income using a conservative growth rate (6-7%); and structure income so it lasts to age 100. Assuming the policy performs to the illustration variables, income will run out only for those who live past age 100.
Some carriers offer features that will actually guarantee lifetime income. This option makes a life insurance policy perform like its guaranteed lifetime income cousin – the annuity – but typically at a much better rate of income.
Closely monitoring policy performance over time gives the policy owner the ability to make adjustments to prevent this outcome. Many policy owners will take a bit less income than the policy could generate as an additional ‘hedge.’ Any way you look at it, the risk of running out of money is minimal as long as you realize this is a living, breathing vehicle that does require a few moments of attention on an annual basis.
- Tax Explosion. All cash value life insurance policies used for retirement income need to remain ‘in force’ until death. Why? Because if they are cancelled prior to death, the cumulative income taken out of them becomes taxable. If you’ve taken $500,000 of income out over 20 years, the prospect of a tax bill on $500,000 is not a fun thing to contemplate.
While a possibility, there are three ways to prevent this potentially disastrous outcome.
- Don’t take money out at a rate that risks the policy either imploding or that would require an infusion of capital to keep it alive. As in the discussion on the previous point – reducing the amount of income to below what the policy illustration may allow, creates an effective hedge.
- Choose a policy with an ‘over-loan’ feature that will protect against this possibility (most have them).
- Convert the policy to a reduced – paid-up policy. No further income will be possible, but the policy will remain permanent without further funding, thus eliminating the possibility of an implosion. A nominal death benefit will also be locked in.
- Illustrations are Illusions. While this isn’t really a risk – critics will often point to the fact that insurance illustrations are out of date the minute the agent hits the print button. Completely true. However, they’re also designed to project performance under a certain – and reasonable – set of assumptions. Most illustrations will show the outcome under various ‘stress’ situations. And while agents have some discretion to illustrate aggressively versus conservatively – the best agents will be realistic and conservative in their use of illustrations.
Why not just dispense with the illustration and avoid the criticism? Because the industry believes they are important tools that both disclose and inform. No Wall Street plan – or broker – will ever provide an illustration or projection of future values, making them both unaccountable and unhelpful.
Insurance illustrations serve a purpose – better agents will tell you they are assumption-based projections – and knowing both the assumptions and the performance range is the best way to inform consumers.
- High Fees/Costs. Cash value life insurance often gets painted with the brush of high cost. Seems logical. After all, a life insurance policy is the only kind of savings and growth vehicle that comes with a death benefit – so it must be more expensive than a Wall Street account, 401k, or others – right?
Wrong. Flat wrong. When a life insurance policy is structured by a competent agent – to produce the maximum wealth and retirement income for you – it is, by definition, structured to generate the least possible cost and commission for the agent and insurance company.
In fact, studies show that over a lifetime, cash value life insurance is usually less than ½ the cost of a comparable Wall Street account – sometimes less than 1/10th the cost – yes – even including that big huge death benefit. If someone takes you down this path – make sure they prove their point, because they can’t.
So there you have it. If we just look at the long list of benefits – they can seem too good to be true. When we disclose, assess, and discuss the risks – they reveal that they’re not too good to be true – they are not 100% risk free – but that on the whole – they’re usually way better than the typical Wall Street junk most of us put most of our money in, most of the time.
