This blog article today is primarily in response to articles by fiduciary securities advisers like this one:
First a disclosure: I sell life insurance for long term savings. There. I said it. (Whew! It’s like “coming out of the closet”!)
The author of the article is an investment adviser. While I did not look up this person's credentials, it is safe to assume that she is a Series 65 Investment Adviser - A fiduciary securities adviser. Fiduciary securities advisers are, unfortunately, usually not experts on advanced uses of life insurance policies.
Let’s get right to the heart of the matter: Borrowing against your life insurance policy for retirement cash flow.
There are many numbers to balance here:
Current Cash Values
Anticipated earnings / Costs of Insurance (netted out together)
Amount to borrow
Interest on the borrowed amount
Whole Life or Indexed Universal Life:
The best advantage for Whole Life policies, even with lower single-digit returns, is that they are generally very predictable and reliable year over year. The very popular IUL or Indexed Universal Life policies may have indexed interest to credit (subject to a cap due to stock market options purchased by the insurance company), but there may be some years that the underlying index returns ZERO percent. (Your policy may have a loss only because of the costs of insurance for the given year being offset with 0% gains.)
Now, let’s assume that you have $1,000,000 in cash values in your policy and you are age 65. And you would like to take a loan AGAINST the value of your policy. Let’s also assume that your policy nets about 5% per year after costs of insurance. (This rate is just for illustration purposes.)
How much of a loan should we take out? That depends on how long you think you need to take money from this account. Let’s assume a 4% loan distribution, or $40,000 so this money can be expected to last longer than 20 years.
Cash Value Growth: $1,000,000 earning 5% growth after cost of insurance expenses = $1,050,000
Loan Amount and Interest: $40,000 charging 5% loan interest (to keep the math the same) = $2,000 loan interest charge.
So, here’s how year 1 looks:
$1,000,000 x 5% growth (including costs of insurance) = $1,050,000
Loan amount + interest: $40,000 loan charging 5% = $2,000 loan cost.
$1,050,000 - $2,000 = $1,048,000.
Notice that the original $1,000,000 continues to grow even though you took out a loan AGAINST the cash values! Only the loan interest will affect the growth of the policy.
Let’s look at year 2:
$1,100,400 - $2,000 = $1,098,400.
Assuming that the original loan is still charging another 5% on that $40,000 = $2,000.
$1,048,000 x 5% = $52,400 in earnings = $1,100,400.
Let’s assume the same 5% interest growth.
We have $1,048,000… and we will NOT be paying back the loan on the policy.
Let’s take out another $40,000 loan for retirement income cash flow:
$1,098,400 - $2,000 loan interest = $1,096,400.
That original balance will continue to grow, so the $40,000 isn't what impacts the growth of the policy - only the tiny amount of loan interest (as shown in this amateur example).
You see, the MAGIC of using life insurance in retirement is the uninterrupted compounding during retirement! Your retirement income asset continues to grow while you only “pennies on the dollar” for your loan interest – as long as you are taking out reasonable sized loans against the policy.
It’s unfortunate, but the author of that article simply doesn’t understand the nature and advantage of responsible collateralization of a life insurance policy.
Now, let’s talk about two other facets listed in the article:
1. “The loan balance is subtracted from the death benefit”.
Yes, it is. Why? Because the loan is secured by the cash values while you’re alive and repaid by the death benefit when you pass. If you are realizing (enjoying) your capital, then the listed beneficiaries don’t need it. You might as well enjoy it!
2. “When faced with a budget crunch such as a job loss, health care expenses, or college tuition, life insurance premiums are often the first item to cut. Suddenly, the “forced saving” mechanism thought to be helpful becomes a burden. That rosy cash value projection turns to dust.”
Maybe… maybe not. It depends on how large of a policy.
Laid off: If there’s an issue with a job loss, and it’s a UL or Universal Life policy, it’s possible to not pay premiums for a time and let the costs of insurance be paid from the current cash values. If there’s sufficient cash values, you could borrow against it to pay off other debts to preserve your credit scores and not have ruined credit. (Many employers do a credit check prior to extending an offer of employment.)
Health care expenses, many policies have living benefit riders that may be accessed for the insured for critical or chronic illness purposes. Also, if the insured becomes disabled for at least six months, the insurance company could continue to make payments (including cash deposits) into your contract if you have Disability Waiver of Premium!
College tuition: Borrow against the policy so the money continues to grow and you can pay JUST THE LOAN INTEREST OUT OF POCKET – rather than sacrificing the entire balance and losing more compounding in the policy. Note that life insurance balances do NOT count against the student on the FAFSA for Free Application for Federal Student Aid forms. (Or better yet - BE THE STUDENT LOAN LENDER to your children and let THEM pay the loan interest on your policy for their education! Having some "skin in the game" might help them pay better attention, choose a more appropriate degree, and get a lesson on finance at the same time!)
There are other factors to be considered in terms of policy structure - such as the size of the death benefit. If the death benefit is too large, then the costs of insurance will surely erode much of any gains the policy can earn. Not every policy can work the way I've outlined it here, but there are too many variables to simply give ideas on how to check for yourself.
There are MANY advantages to owning permanent life insurance as a strategic asset. Do you know how to leverage it? Or do you just see it as an “expense”?
To determine what's possible with YOUR policy, you can contact your insurance company and have them run an "in-force illustration" with varying factors that you want and take a look as to how the policy would perform for you.
Just because they may be a "Fiduciary Securities Adviser" does NOT mean that they are an expert in all things related to insurance strategies.