“A bank is a place that will lend you money if you can prove that you don’t need it.”
Two weeks ago we asked the question, “Should you borrow against your life insurance policy?” Today, we continue the topic by looking at the advantages and disadvantages of borrowing against a life insurance policy. The Advantages of Borrowing Against Life Insurance
It’s simple and relatively quick. There’s NO QUALIFICATION process, no need to fill out an application, have your income or credit checked, nor brace yourself for high fees and taxes (in most situations, see below exceptions.) You’ll have your loan in 5-10 business days for most companies, and occasionally they have faster options.
It’s flexible. You can borrow about 95% of the cash value amount of your whole life policy from most mutual insurance companies. And when you borrow against your insurance policy, you can design your own repayment schedule, modify it as needed, or even continue down the path of life without repaying it if your circumstances require. In contrast, most types of non-insurance loans have strict repayment schedules that may or may not work well for you.
It’s cheaper than you think. Life insurance policy loans are running in the 4 – 8% range right now. But that does not equate to a bank loan for the same amount. This is because you’re borrowing against an account that likely has an internal rate of return of 4-5%, depending on your age. And since you are borrowing against your cash value, not borrowing the cash value itself, your cash value continues to grow and earn dividends, which offsets the interest on the policy loan.
It’s (probably) not a taxable event. Although there are exceptions, typically the IRS will never know that you borrowed the money. Like taking a second mortgage or line of credit against a rental property, a policy loan is not considered “income” in most situations.
“Most people do not become rich because they fear the power of leverage.”
One of the advantages of a Whole Life Insurance policy is the ability to borrow against your cash value, though the concept is widely misunderstood, even by insurance agents! In this post, we’ll explore exactly what it means to take a loan against your insurance policy, and we’ll look at some good reasons – and bad reasons – to borrow against your policy.
Do You Borrow Your Cash Value, or Borrow Against It?
A common misunderstanding is that people think they are actually borrowing the cash value itself, but actually, they are taking a loan against it. Your cash value is the collateral that the life insurance company lends against. So the real choice you have is to either reduce (or liquidate) your cash value, or borrow against it.
The cash value is your savings to take as you wish, but we recommend that you borrow against it rather than deplete it. Why? Just like with a house or other piece of real estate, it is usually more advantageous to keep the asset long-term and borrow against it (for example, with a mortgage) than lose the asset.
Just as with a rental home, properly structured whole life insurance policies allow you to retain the asset for future use. Real estate investors may borrow against and pay off mortgages several times against a long-term rental, and you have the ability to do the same with your cash value policy.
Just like real estate, cash value policies allow you to have a C.L.U.E., which stands for
Control – you control the asset, not your employer or the government.
Liquidity – it can be liquidated if desired, with no penalties and minimal taxes.
Use – different from a retirement account, the money can be used as you please, including used as collateral.
Equity – the asset grows over time and your net worth increases.
Good Reasons to Borrow Against Your Life Insurance Policy
Perhaps the most common reason people borrow money is in reaction to a cash flow crunch, perhaps caused by illness, divorce, or a temporary period of unemployment, But there are many good, strategic reasons why you might want to borrow against your whole life policy, even if you are not having a financial emergency.
Real integrity is doing the right thing, knowing that nobody’s going to know whether you did it or not. -Oprah Winfrey
Last week, our blog post was about common Money Mistakes that even smart people make. This week we would like to discuss in detail another common financial mistake:
Getting advice from someone motivated to make a sale rather than provide the best advice.
There has been a raging debate amongst financial professionals since the 2010 Frank-Dodd bill authorized the SEC to adopt a fiduciary standard, which means “the best interest of the client” versus the current suitability standard, which only means “appropriateness of investment.” Due to much lobbying and intense opinions on the matter, no change in standard has yet to commence, though we may see such a change in 2013.
Here’s what the fiduciary vs. suitability standard debate means and why it matters:
The Suitability Standard
People who advise and sell investments are held to one of two standards, based on their registration. Those registered as an agent or broker might be referred to as a “Stockbroker,” a “Registered Representative” or even a “Financial Planner.” Broker-dealers and associated persons are regulated under the Securities Exchange Act of 1934 and are held to a suitability standard that requires them to make recommendations that are appropriate for a client’s risk tolerance, investment objectives, time horizon and financial status.
In other words, a stockbroker can’t put Grandma’s nest egg in volatile tech stocks, but they can consider their own commissions, preferences, and company expectations. Notably, brokers and financial reps are often trained to sell the company’s managed funds, which charge fees and tend to underperform the market as a whole, or the indices the funds are mimicking.
According to a March 30, 2013 article in the Seattle Times, two-thirds of managers failed to beat the market in 2012. In 2011, 84% underperformed the market. An objective advisor who is paid for their advice would hopefully advise an investor a different direction, explaining the long-term impact of the fees, perhaps even questioning if the associated risks of such a fund are necessary or desirable.
The problem with the suitability standard? It puts investors at risk and tolerates conflicts of interest.
“Health Savings Accounts (HSAs) are IRAs on steroids.”
– Paul Zane Pilzer, economist, author, entrepreneur, professor.
This month, we continue to explore health and wealth. Last week, we examined FSAs (or Flexible Spending Accounts/Arrangements), a tax-slashing employee benefit that most employees neglect. But there exists an even more powerful tool to wage the war against both taxes and high healthcare costs: Health Savings Accounts (HSAs).
If you could save hundreds, even thousands of dollars on taxes, while budgeting for health care costs, increasing health care choices, and limiting out of pocket medical expenses, would you? If so, an HSA, or Health Savings Account, may be for you. HSAs are an underutilized, yet beautifully designed financial instrument available to many Americans. What are they, and how do you tap the benefits of this alternative investment?
Approved by Congress in late 2003, HSAs are part of the new breed of Consumer Driven Health Plans – plans that, like FSAs, put more control (and responsibility) in the hands of consumers. Such health plans have risen steadily in recent years, with HSA accounts doubling between January 2008 to January 2012, going from 6.1 million to 13.5. For a speedy overview of Consumer Driven Health Plans, watch this video:
How they work: HSAs are savings or investment accounts where tax-free funds can be stored for current or future health care expenses. In 2013, contribution limits are $3,250 for individuals and $6,450 for families, with an additional $1,000 “catch up” allowed for those over 55.
“Triple Tax Free” benefits: Like a traditional IRA, contributions are tax free, reducing federal income taxes as well as other taxes. However, taxes are not simply deferred until later, when accounts (and taxes) are likely to have grown. Unused funds grow tax-free in an HSA, then, distributions are also tax-free when withdrawn for qualified expenses!
“Slow and steady wins the race.”
Aesop, The Hare and the Tortoise
We suggested in our last post that investors might benefit from boycotting Wall Street, as there seems little to protect consumers from risky schemes when even the rating agencies dish out credit ratings with no accountability.
But if stocks are risky, the price of gold difficult to predict, and with banks representing dismal returns at best and instability at worst, then where, pray tell, can money be saved or invested?
“Suppose there was a financial instrument… so solid it could survive the Great Depression intact; that earned untaxed interest at a competitive rate; that could be borrowed against at will regardless of credit conditions; and that could be used by individuals as well as major corporations and banks as a safe harbor during economic turmoil?”
The financial instrument Girouard is speaking of is dividend paying Whole Life Insurance, which is re-gaining favor amongst investors tired of roller coaster returns. And for anyone intent on insulating themselves against Wall Street excesses, the providers of choice of whole life are mutual insurance companies.
Mutual insurance companies stand in contrast to stock insurance companies, which have shareholders and quarterly reports to worry about. The modern equivalent of certain European trade guilds of the 1600s, whose members pooled money to help each other’s families in times of sickness or death, mutual companies operate for the benefit of their members, or policyholders.
Mutual insurance companies are mutually owned by policyholders, and the companies are legally bound to return all profits to policy owners in the form of dividends.
The flagship product of mutual insurance companies has long been permanent or whole life insurance with a cash value component. Many of us have parents and grandparents that relied on this type of policy for large and small emergencies, but times do change. Written off by younger investors seduced by the stock market adrenaline rush in the 80’s and 90’s, whole life insurance came to be viewed as an antiquated financial instrument of a previous generation – or worse – what uninformed investors bought before guru’s like Suze Orman and Dave Ramsey convinced them to “buy term and invest the difference.”
With the stock market’s wake-up call of 2008, some investors abandoned typical financial “plans” relying on stock market returns and headed for safer hills. By the end of 2008, two of the larger mutual insurance companies, Guardian Life and New York Life, were experiencing double-digit growth in sales of individual life policies.
Mutual Insurance vs. Stock Insurance Companies
While mutual companies were booming, publicly traded insurance companies were melting down with the rest of the economy, As Forbes magazine reported in “Mutual Respect”:
“With their survival on the line, publicly traded insurers are scrambling for cash by cutting dividends and issuing new shares (diluting existing investors), begging regulators for a relaxation of capital requirements and lobbying Washington for a cut of the $700 billion Wall Street bailout.”
Some stock insurance companies lost half or more of their value, meanwhile, mutually owned insurers didn’t ask for a dime. Their values held, or even improved. Some even announced near-record dividends to policyholders, such as Guardian Life, who paid its policyholders a healthy 7.3% dividend in 2009. By 2011, Guardian’s dividends paid to policyholders had grown to $795 million – an amount greater than the entire TARP bailout.
Update: Chart below shows Guardian’s dividend payouts to policyholders rose again in 2012:
Perhaps one lesson to be learned is this: The more an insurance company looks and acts like a stock, the less it can be expected to provide the benefits of solvency, stability, and consistent returns traditionally provided by insurance companies. As one mutual bank says in it’s ads, “We’re Main Street. Not Wall Street.”
However, buyers must ask some questions (or read some websites) to determine what companies are Main Street and which are Wall Street. The “mutual” moniker is no guarantee of a mutual company, nor has it ever been used only for mutual companies.
Similarly, just because a company has partially demutualized doesn’t mean that it is unstable. Still, how a company is structured and where its loyalties lie is something to consider when choosing a company. In a diatribe against demutualization Rich Franzen points out the conflicts of interest experienced by stock insurance companies:
“When a mutuality writes a permanent insurance policy, it is not simply a legal contract. It is also a solemn commitment to be there 50 years from now. Corporations do not think in terms of 50 years. Or 5 years. They think in terms of 3 months — this quarter. How did we do this quarter? “OMG, we need to lay some people off to make the quarterly report look less bad!” This is no way to run a life insurance company….”
The Long Term View
As John Schlifske, Chairman and Chief Executive Officer of Northwestern Mutual explains, “Think of the fable of the tortoise and the hare. We want to be the tortoise, grinding it out year after year, doing things we know are sustainable.”
More than just talk, companies such as Northwestern Mutual and Guardian Life have survived and thrived through the Civil War, the Great Depression, and the World Wars, paying dividends to policy owners for more than 140 consecutive years. When the stock market, investment banks, even Fanny and Freddie were reeling, most mutual insurance companies didn’t even flinch.
Northwestern Mutual’s dividends paid to policy owners before, during, and after the sub-prime crisis were as follows:
Mutual insurance companies may never boast double digit returns or garner the media attention lavished on high tech IPO’s, but these are exactly the kinds of Tortoises you want to be riding when the stock market rabbits are running in the wrong direction.
How can a mutual whole life policy help you build sustainable wealth, reduce taxes, and have more financial options? We thought you’d never ask! Partner for Prosperity’s own Kim D. H. Butler has written a powerful little book that will let you in on how the wealthy utilize whole life insurance throughout their entire life. It’s called Live Your Life Insurance, and it’s available on Amazon as a paperback or Kindle eBook.
“Adopt the pace of nature: her secret is patience.”
– Ralph Waldo Emerson
Permanent life insurance is a descriptive term for policies designed to remain in force for the entire life of the insured. Most permanent life insurance policies (such as whole life, variable life or universal life) also feature a cash value account, and this unique combination of a lifetime insurance benefit and tax-deferred accumulation can be a very valuable asset in a comprehensive financial program.
However, maximizing the benefits from permanent life insurance requires some thoughtful planning and on-going management. It is a long-term financial product, one designed to deliver greater returns later in its lifetime. Therefore, permanent insurance must be maintained to ensure that it is, indeed, “permanent.”
The Challenge of Funding Permanent Life Insurance
A significant practical challenge with permanent life insurance policy is simply continuing to pay the premiums. In a June 9, 2012, Wall Street Journal article, Leslie Scism notes that “Many buyers underestimate how difficult it can be to pay the premiums year after year, and they end up canceling their policy before they break even.” To prove the point, she quotes a December 2011 study from the Society of Actuaries that “20% of whole life policies are terminated in the first three years, and 39% within the first 10.”
While the article provides no details on why policies are terminated, the point remains valid: In order to fully realize the benefits, a permanent life policy must remain in force.
Building “Equity” with Permanent Insurance
Although the comparison isn’t perfect, buying a permanent life insurance policy is analogous to taking out a mortgage, in that an amortized payment (the monthly mortgage or insurance premium) secures the ownership of a much larger asset (the real estate or the insurance death benefit). Eventually, the house is paid off, or the insurance benefit is paid to the beneficiary.
In both mortgages and permanent life insurance, early payments are proportionally weighted toward expenses, and only later tip toward accumulation (home equity and cash value). In the case of a permanent insurance policy, it may take 15-20 years for cash values to exceed total premiums paid, depending on dividends* paid or investment returns on the cash value.
And not unlike long term real estate values, which (until recent years) tend to appreciate over time, the value of the death benefit of a whole life policy also increases over the years. In this way, continued premium payments not only keep the policy in force, but a portion of the continued payments is eventually recaptured.
When deciding on the length of a mortgage, most consumers understand that longer mortgages mean lower payments, but also slower accumulation of equity. The prevailing standard is 30 years for a personal residence, though most mortgage lenders offer shorter and longer terms, allowing borrowers to tailor mortgages to personal preferences.
With permanent life insurance, the prevailing period of premium payments is the lifetime of the insured (hence, the term “whole life”). But consumers should be aware that, just like mortgages, other time periods are available for funding a permanent life insurance plan. Among the possibilities:
Single-premium life insurance. It is possible to obtain a permanent life insurance benefit and pay just one premium. Compared to a standard whole life policy with annual premiums, the single-payment amount will be significantly higher. But the cash value accumulation will also accrue more rapidly – in some policies, cash value may exceed the initial premium in the policy’s second or third year.
The cash values in single-premium policies are subject to slightly different tax treatment compared to most permanent life policies**, and depending on individual circumstances, this may be a disadvantage. However, individuals with substantial liquid assets may find it desirable to secure a permanent life insurance benefit through a simple one-time asset transfer.
10-pay and 20-pay life insurance. Instead of planning to pay premiums for a lifetime, most life insurance companies offer policies that can be paid-up in shorter periods, such as 10 or 20 years. As with a mortgage, a shorter payment term means a larger outlay, but “equity” (or, cash value accumulation) accelerates as well. An illustration of projected values for a 10-pay policy will typically show cash values not only exceeding premiums paid at the end of the 10-year period, but often providing a rate of return comparable to other conservative, guaranteed investment choices.
Unscheduled paid-up additions. This feature allows a policyholder to make irregular additional deposits to the policy, increasing both cash values and the total insurance benefit. Similar to extra principal payments that retire a mortgage early, unscheduled paid-up additions can be used to pay up a life insurance policy ahead of schedule.***
A Life-Long Strategy for Keeping Life Insurance
For some people, one of the best ways to meet present needs for life insurance and maximize the long-term value of life insurance may be to purchase a large term insurance policy with generous conversion privileges. This strategy works well for consumers who have high needs for insurance earlier in life accompanied by limited cash flow (for instance, when children are living at home).
The conversion provision allows the policyholder to convert some or all of the existing term insurance to a permanent policy (or policies) at a later date (or dates) without requiring new underwriting. Depending on the terms of conversion, this switch to permanent coverage could occur all at once, or in several transactions over time, using one or more of the options listed above.
For those with a long-range financial vision, this strategy of buying term then converting is a cost-effective way to obtain a life insurance benefit now, and retain the option to maximize its value at a later date.
*Dividends are not guaranteed, and are declared annually by the insurance company’s board of directors. **A Modified Endowment Contract (MEC) is a type of life insurance contract that is subject to first-in-first-out (FIFO) ordinary income tax treatment, similar to distributions from an annuity. The distribution is also subject to a 10% tax penalty on the gain portion of the policy if the owner is under age 59 1/2. The death benefit is generally income tax free. ***(Note: The IRS has strict guidelines on the tax treatment of cash values. Paying up a policy too fast might mean forfeiture of the tax advantages of cash values. Expert assistance is essential when using paid-up additions to shorten the period of payments.)
IS YOUR LIFE INSURANCE PROGRAM BUILT TO LAST?
If you are looking for permanent solutions, now is the best time to connect with your financial professionals and weigh your options. Call Partners for Prosperity Inc. or your own Prosperity Economics advisor today to identify the ideal strategy for keeping your life insurance permanent.
This website is provided for informational purposes only. The information contained herein should not be construed as the provision of personalized investment advice. Information contained herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security or investment. Investing involves the risk of loss and investors should be prepared to bear potential losses. Past performance may not be indicative of future results and may have been impacted by events and economic conditions that will not prevail in the future.
Yes, send my FREE Prosperity Accelerator Pack including:
Financial Planning Has Failed Ebook
Kim Butler’s 7 Principles of Prosperity™️ Audio, Video, and Summary