Investors are pouring money into an old investment: life insurance. That’s right. Life insurance can be an investment. Before interest rates were deregulated a few decades ago, life insurance and passbook savings accounts at the local bank were a major vehicle for saving and investing for many people. It became less popular after money market funds and other high-yielding alternatives became available.
After more than 10 years of low interest rates and poor stock market returns, however, investors have been putting more investment money into life insurance attracted by safety of principal and guaranteed income.
I’m talking about permanent or cash value life insurance. These are policies that combine the life insurance benefit with a cash value account.
The traditional version is whole life insurance. The insurer pays an annual dividend that is credited to the cash value account. Dividends generally have a guaranteed minimum rate. The earnings of the cash value account are tax deferred. The insurer determines the amount of the annual dividend, based on its investment experience and expenses.
Another form of permanent insurance is universal life, including variable universal life. The income credited to the cash value account can be pegged to investments selected by the policy owner or some investment benchmark, among other things. Universal life has the potential for both higher and lower returns than whole life. UL also allows the owner to change the death benefit, and premium payments are flexible within a range of minimum and maximum amounts. The insurance under UL is based on renewal term insurance, and costs generally are more transparent than for whole life.
Permanent vs. Term Life
Permanent life is different from term life. A term life policy lasts for a stated period of years. The insured has the coverage for that period as long as the premiums are paid. After the term, the policy ends, and the policy owner doesn’t receive anything. There is no cash value or surrender value. Term life is to cover a specific need that is likely to end at a point in time. Term life is ideal for ensuring there is money to pay a mortgage or provide children with college education, to give two examples of obligations that end at a point in time.
Permanent life provides for a continuing need, such as estate taxes or buying out the estate of a deceased co-owner of a business. Permanent life also can be used to provide a legacy for heirs.
Many people now are using permanent life as both life insurance and their source of safe investments.
There are several advantages of permanent life as an investment. The investment is safe as long as the insurer is financially solvent, and many of them have been around for over 100 years and invest more safely than banks. The dividend yields on cash value accounts are higher than bond yields these days and in the past have increased steadily in many policies. The minimum guaranteed dividend exceeds 10-year treasury yields in most policies. With variable universal life, you choose how the cash value account is invested from among funds offered by the insurer. You can do some of your stock investing through the cash value account.
At some point, the cash value account can provide two advantages.
The annual premiums can be paid from the dividends and the cash value. The insured can stop making premium payments, yet the policy will stay in force. This is sometimes called a vanishing premium policy.
Another advantage is the cash value account can be a source of cash, often tax free. Permanent policies generally allow loans from the cash value, and the loans are tax free. The loan might not have to be repaid. The outstanding loan balance and accumulated interest will reduce the life insurance benefit paid to the beneficiary.
You don’t have to take a loan to access cash. When you take a distribution from the cash value account, you withdraw your principal contributions first, and that is tax free. You pay income taxes only on withdrawals of the dividends and income.
Of course, when an estate or heirs receive a life insurance benefit that is free of income taxes.
Some people encourage the use of only permanent life insurance for investing and spending. Their strategy is to buy a whole life insurance policy, build up the cash value as much as possible, and use policy loans when you need money. Your savings compound tax-deferred, and you withdraw it tax-free as needed. You can see some details on web sites such as www.bankonyourself.com.
There are tricks and disadvantages in using permanent life insurance as a saving and investment vehicle.
You shouldn’t buy permanent life insurance as an investment unless you already need the life insurance. Otherwise, you’ll pay a lot of money for insurance you don’t need. The insurance need also should be permanent. Term life insurance is much cheaper than permanent life, though it is difficult to separate the costs of a permanent life policy.
There are a lot of costs in permanent life policies. The broker or agent often receives half or more of the first-year’s premiums as commission. Other amounts are subtracted from premiums before earnings are credited to the cash value account, and it is difficult to identify these costs and compare them between policies, especially in whole life.
Cashing Out of Cash Value
Because of the costs, it can take a long time for the cash value account to build to the point when you can take loans or distributions. Most insurance experts estimate you need to wait at least 20 years before it’s safe to begin loans or withdrawals from whole life. Unfortunately, few permanent policies stay active that long. About 20% are terminated in the first three years and 30% in the first 10 years, according to the Society of Actuaries. Advocates of investing solely through whole life insurance say you need a policy with guaranteed dividend increases and other key features, and even then you have to wait years before beginning distributions and loans.
There are strict tax rules about taking loans and withdrawals from the cash value account. Make the wrong move and your loan will be taxable.
Another disadvantage is that many insurers have been steadily reducing the dividends paid on cash value accounts as interest rates and market returns decline. On universal life policies, the income reductions have been especially steep.
Many financial planners can tell stories of people coming to them with old universal life policies that were supposed to stay in effect for life without any new premiums being paid after 10 years or so. Earnings from the cash value account were supposed to be high enough to pay the insurance premiums and increase the cash value. But earnings declined, so the cash value accounts were tapped to pay premiums. Eventually the cash value account was exhausted and the insured was faced with an option of adding thousands of dollars to the policy to keep it in force or letting the policy lapse with no cash value or other benefits.
To earn the benefits of permanent life insurance and avoid the traps, consider these steps.
? Buy permanent life insurance only when you need or want the insurance benefits. The insurance is too expensive to buy only for the investment advantages.
? Maximize your other tax-deferred and tax-free opportunities, such as 401(k) deferrals, IRA contributions, and even deferred annuities.
? Be confident you’ll be able to pay the life insurance premiums indefinitely.
? Don’t plan on tapping the cash value account for a number of years.
? Ask agents or brokers about ?blended policies.? These are policies that more cleanly break out term life and permanent life, which results in lower costs and a faster build up of cash value. Agents earn lower commissions on these policies.
? Don’t put much faith in the policy illustrations. These are projections of future cash value and life insurance benefits based on assumptions about investment earnings and other factors. The assumptions usually are optimistic. Agents also are required to show a pessimistic illustration. You need to be prepared for a range of different results and determine if the policy would provide benefits and be affordable under many of the possibilities.
? Use cash value insurance as substitutes for your bond or fixed income investment allocation. Stocks and other risky investments for which you seek higher returns generally should be owned in taxable accounts where they qualify for the long-term capital gains tax break and losses can be deductible or offset gains.
? Look for low-cost policies. The Consumer Federation of America offers to evaluate policies for a fee at www.evaluatelifeinsurance.org and generally favors universal life policies offered by TIAA-CREF. Others, such as insurance advisor Peter Katt, recommend using policies from mutual insurers. Policyholders, not shareholders, own them. The largest mutuals are Guardian Life, Massachusetts Mutual, New York Life, and Northwestern Mutual Life.
RW August 2012