I wanted to spend some time discussing how Cash Value Life Insurance is utilized for retirement and wealth creation as a follow-up to the piece on Cash Value Life Insurance as an Asset Class. As long as you don’t break the very significant regulations, there isn’t much monitoring when it comes to what you can and cannot fairly recommend in the financial services sector.
Financial counsel is frequently motivated by someone’s need to pay a mortgage, pay down a credit card debt, afford a vacation, etc. much as a real estate agent who suddenly transforms into a financial and business consultant in order to persuade a client to accept a 10% price reduction on their selling price in order to seal the transaction. Sadly, nobody seems to care for the most part. Problems don’t start to appear until a sacred cow is killed. You’ll truly enrage some individuals if you invest a 65-year-entire old’s portfolio entirely in midcap stocks, distribute that sale among many funds to avoid the sales load breakpoint, and do it all only a few days before the dividend payment deadline.
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).
Nestled in the deeper understanding of cash value life insurance product–sitting right next to a finer understanding of personal finance–is the design and use of cash value life insurance not primarily for death benefit purposes, but for a multitude of financial reasons to touch a much broader array of situations. 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).
The Key is Paid-Up Additions or Overfunding
You should use extreme caution when using cash value life insurance as an asset. There is a big difference between incidental cash value and planned cash value, even though all plans are designed to give cash value —that part is rather straightforward. Knowing what you’re dealing with and what you need to look at is crucial since cash value life insurance might take one of two different forms.
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 what the commissions paid to the agent/broker are based on, but this doesn’t necessarily mean you’ll get 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 minimize the death benefit to either the TAMARA 7-Pay Death Benefit or the DEFFRA Guideline Death Benefit, you’ll have to go with the higher of the two, as being below the other will either violate the Modified Endowment Contract test or the test of life insurance. Keeping the death benefit down to these levels will ensure the lowest internal expenses.
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
Therefore, the original query was: Can cash value life insurance be used to fund retirement or build wealth? Many investment salespeople have made the argument that it is, at most, a complementary tool. However, if properly constructed, you should have little issue obtaining a cash value life insurance policy that will give you an annual income after retirement that is 2.5–3 times your expenditure. While there is no assurance and specific circumstances will differ, the product’s steadiness makes speculating far less erratic than trying to navigate 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.
The process is really much simpler than most people realize. But, like all things, it’s a good idea to compare offers as the life settlement market is going to depend entirely on what an individual company feels it can make off 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). There are taxable implications to a life settlement, basically anything you receive in cash beyond your taxable basis will be taxable 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 point out that asking about selling a policy when you apply for insurance is not something insurance firms do just so you know you have the opportunity to do so in the future. STOLI, or Stranger Originated (or Owned) Life Insurance, will be reduced by this action. If you don’t have life insurance but someone approaches you about applying so they may buy the policy from you, this is known as STOLI. STOLI is the acquisition of cash value life insurance for the sole purpose of selling it to a third party.
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 Is Effective
Yes, cash value life insurance serves as a tool for retirement and wealth building. But when looking for your own strategy, caution should be exercised, just like with anything else. There are a lot of untrained and/or dishonest insurance agents out there. They also have the benefit of having a little bit more life insurance knowledge than you have. If planned out correctly, it can be a great tool for retirement purposes, and design is crucial. If you have any additional questions about using cash value life insurance as a retirement or wealth accumulation vehicle for your financial plan, we’d be happy to answer questions.