Can Cash Value Life Insurance Be A Substantial Retirement Vehicle?
Following up on the Cash Value Life Insurance as an Asset Class post, I wanted to spend some time talking about how Cash Value Life Insurance get’s used for retirement and wealth accumulation.
Believe it or not, there’s not a lot oversight when it comes to the financial services industry when it comes to what you can and cannot reasonably recommend as long as you don’t violate the really big rules. Like a real estate agent who suddenly turns into a financial and business adviser in order to convince a client to take a 10% haircut on their selling price because he or she wants to close the deal, financial advice can often be driven by someone’s need to pay a mortgage, pay down a credit card debt, afford a vacation, etc.
And for the most part, sadly, no one cares. It’s not until someone kills a sacred cow that problems begin to arise. Put a 65 year old’s entire portfolio into midcap stocks, spread that sale around into different funds so as to avoid the sales load breakpoint, and do it all a few days before the dividend date and you’ll really upset some people.
Those are concrete examples of big no-no’s any compliance officer should be more than capable of thwarting. These examples are a violation of suitability. On the topic of cash value life insurance, and its place as a retirement vehicle, the question is one of suitability. Is it suitable?
Design Is EVERYTHING When It Comes To Cash Value Life Insurance
I’ve declared this before, and I’ve even elaborated a bit, today we’ll drill into exactly what this means, we’ll even use a very concrete example where someone has seriously violated suitability by virtue of extremely poor design and execution. This is a somewhat nuance topic that might take a little time to understand, but like all tougher pursuits in life, it’s well worth the effort to understand.
This is what separates the whole and universal life insurance Dave Ramsey talks about, and what I talk about. But first, we have to lay down a few foundational understandings.
Purpose is Different with Cash Value Life Insurance
Here comes a rather crazy statement: not all life insurance is bought for the same purpose. While most would assume life insurance is a relatively straight forward purchase based on death benefit coverage compared to the relative premium cost, this assumption would be false (and sadly it’s an assumption made by a lot of life agents).
The design and application of cash value life insurance for a variety of financial reasons to touch a far broader range of scenarios is nestled in a deeper grasp of cash value life insurance product-sitting right next to a finer understanding of personal finance.
This is an important point to make because there’s a serious differentiation that needs to be made. A lot of life agents with a rudimentary understanding of cash value life insurance misapply the product when wealth accumulation and retirement planning are a bigger piece of the puzzle (sometimes intentionally).
Paid-Up Additions or Over Funding is Key
When using cash value life insurance as an asset, you want to be very careful about where your money goes. All policies are developed to provide cash value–that part is pretty simple–but there is a huge difference between incidental cash value, and intended cash value. Cash value life insurance takes shape in two different forms, and so it’ll be important to know what you’re dealing with and what you need to look at.
Whole Life Insurance
Whole life insurance is the original form of cash value life insurance. Whole life insurance has undergone some pretty significant changes over the past 30 years, so it’s important to note that the stuff your mom and dad bought when you were in diapers is very different. The key to leveraging the cash in cash value life insurance is in over-funding the policy; in a whole life policy this is done through a Paid-up Additions rider (PUA).
PUA’s grow faster cash wise than the base whole life premium, so more PUA’s means more cash for you. What you’re doing is placing more cash into the policy than you need to and the life insurance company is rewarding you with more cash for doing so. You can always get a breakdown of where the money you place into a policy goes, you should always look at this, and look to maximize the amount of your outlay going into PUA’s.
Universal Life Insurance
Universal Life insurance is a newer form of cash value life insurance introduced around the late 70’s/early 80’s. Universal Life insurance doesn’t have a base premium as it’s a term insurance-like product that comes with an additional account for your cash value. You can sometimes get a breakdown of the expenses of the Universal Life policy you are reviewing, but this has become increasingly more difficult to obtain. There is, however, a surrogate you can use in place of the base premium you can review with Whole Life insurance, the target premium. Target premium is the calculated premium required to keep the policy in force based off the current interest and expense assumptions on the policy.
The target premium is also the basis for the commissions paid to the agent/broker, but this does not guarantee that you will obtain the best deal from the policy with the lower target premium. The best way to approach a purely cash-focused Universal Life policy is to limit the death benefit to either the TAMARA 7-Pay Death Benefit or the DEFFRA Guideline Death Benefit. You must choose the higher of the two, as anything less will violate either the Modified Endowment Contract test or the life insurance test. Keeping the death benefit at these levels ensures that internal expenses are kept to a minimum.
Also, Universal Life insurance allows for a choice between the test used to qualify the contract for life insurance. The two tests that exist are Cash Value Accumulation Test (CVAT) and Guideline Premium Test (GPT). GPT is the test of choice for maximizing cash in your cash value life insurance.
Cash Value Life Insurance For Retirement
So the initial question was does cash value life insurance work as a retirement vehicle or wealth accumulation tool? A lot of investment salesmen have attempted to suggest it’s merely a supplemental tool at best. But if designed correctly, you should have little trouble getting a cash value life insurance policy to supply you with 2.5-3 times your outlay as annual income during retirement. Of course, this isn’t a guaranteed thing, and individual situations will vary, but the stability of the product makes the guessing a lot less sporadic than trying to tackle the stock market (regardless of your trading volume). If you have other retirement assets, you can exhaust those first, and leverage the cash accumulation and death benefit of the life policy to provide more income by delaying distributions, and/or replacing assets when you die. Or you could sell the life policy.
Selling Your Cash Value Life Insurance Policy?
The secondary market for life insurance–also known as the life settlement market–has admittedly shrunk in recent years, but that doesn’t mean it’s not available and not a worthwhile endeavor. Permanent cash value life insurance is a coveted asset and there are financial intermediaries that would jump at the opportunity to pay your premiums if they can be the beneficiary of the policy. What you’re typically looking at is a buy out from the Life Settlement Company that is equal to some number between your cash surrender value and your death benefit (usually closer the the cash value than the death benefit, but depending on your health, you may be able to secure more cash as the less likely you are to live long term the more money you can reasonably expect in the buy out). For those who have a moral affliction to this sort of thing, you might want to skip on down to the next heading, as we’re talking about leveraging the fact that you’re going to die one day for money.
Most people underestimate how simple the process is. However, as with anything, it’s a good idea to compare offers because the life settlement market is entirely dependent on what an individual firm believes it can make from your life policy (i.e. how long they feel comfortable paying premiums keeping in mind the money they are going to pay you, before they receive the death benefit). A life settlement has tax ramifications; generally, anything you get in cash above your taxable base is taxed as income in the year it is received.
Also keep in mind that there is a huge difference between a life settlement and something known as a viatical settlement, which is essentially selling a life policy when you are terminally or chronically ill. Though they are somewhat similar in nature, life settlements do not require you to be unhealthy to sell the policy.
I should also note that simply knowing this is an option in the future is not the reason insurance companies ask about selling a policy for which you apply. This is a measure to curb STOLI or Stranger Originated (or owned) Life Insurance. STOLI is the purchase of cash value life insurance for no other reason than to sell it to a third party (i.e. you don’t have life insurance, but someone approaches you about applying so they can buy the policy from you).
Giving Away Your Cash Value Life Insurance Policy
If you don’t like the idea of selling your life insurance policy, there’s always donating it to charity. It won’t help you with the money in your pocket, but it can help significantly reduce your tax burden for several years to come. This reduction in taxable income could seriously help you keep more of other assets by not needing to withdraw additional funds to cover taxes. It can also free up other assets you otherwise had earmarked for charitable causes.
Your House And Cash Value Life Insurance
Lastly we’ll bring up reverse mortgages. Once a last resort for the financially destitute, now reverse mortgages are more common place around people with money than those without. The only problem for many people is the whole giving up your house to repay the loan when you die. With life insurance in force you have two options, use the death benefit to pay the bank back (or to buy it back as they try to sell it, everyone knows banks are terribly impatient about home sales and don’t usually have the patience to find the highest bidder) or you could simply let the kids (or whomever) walk with the cash (we never really liked the house anyway).
It Does Work
Yes, cash value life insurance can be used for retirement and asset accumulation. However, as with anything else, caution should be exercised when looking for your own plan. There are a lot of unskilled and/or dishonest insurance agents out there. They also have the advantage of knowing a little more about life insurance than you do. It can be a terrific tool for retirement if properly planned, and design is critical. We’d be pleased to address any additional questions you have about using cash value life insurance as a retirement or wealth accumulation vehicle in your financial plan.