We’ve seen it all our lives; and the older one gets, the more transparent it becomes. Some people simply don’t know what they’re talking about. Here are a few examples:
- “Pay cash and you avoid paying interest.” You’ve heard that one. Whether good or bad, it sounds simple enough. It’s apparent plausibility even leads us to believe it without even bothering to examine it, let alone test it.
The truth: Everyone pays interest, including those who pay cash. How?
The money you use to pay cash is unavailable to lend to others which would allow you to earn interest. $40,000 cash paid for a car is $1,200 every year in lost interest (hypothetical 3% rate) that money could have earned. That’s $6,000 over five years. True cost of the car: $46,000.
Some people may not think “opportunity cost” is worth worrying about; but, I doubt they’re among the wealthy. Warren Buffet may disagree with them.
Whether it would have earned more than it would have saved on the car purchase is another discussion, of course; but, the blind statement that it’s always better to pay cash is an example of financial pornography. It sounds good, so it must be true in all cases when, in fact, it may or may not be true in any given case.
- “Investments should be compared on the basis of their average annual return.”Really?
Average annual (arithmetic) return is different from average annual compounded (geometric) returns. Geometric returns measure how well an investor would have done. You might find Understanding Investment Returns helpful.
- “Buy term insurance and invest the difference.” Really?
It sounds true because we want it to be true. The tv gurus tell us it’s cheaper. This one is usually advanced by some financial types who are usually selling something else: Other financial products – or gurus[2] selling CDs, DVDs, workbooks, seminars, etc.
Professional speakers know this basic axiom: If you tell people something they think they already know and perceive to be true, they will think you’re smart and follow your advice. Tell them something that flies in the face of their belief system, and it’s like getting someone to change religions. People tend to favor the advice that’s consistent with what they’ve always believed.
– Anonymous
Ask yourself: Why is term insurance so cheap?
First of all, you’re paying for “pure” protection; but, as you’ll see, the cost for pure protection is the same in a wide variety of policies. More significant, I think, are the statistics from a study conducted by LIMRA[3] indicates that death benefits are paid out for only 1% of retail term insurance policies. The other 99% are dropped without value.
There’s very little risk in a 3-year term if your life expectancy is higher. And, when you renew, the rates will be higher, too. It’s like an apartment lease.[4] When the lease is up you renew at higher rates – but most of us like owning our houses. We like the predictability of no increases and we know it can be paid off by us or a buyer.
This is a no-brainer for the insurance companies; and, unfortunately, too many who find chase “shiny things” – things that sound cheap and therefore good.
The ‘term is cheaper’ argument has been disproven in numerous analytical models, but ignored by mostly tv gurus trying to sell their CDs and DVDs. The reason is simple: Their argument generally ignores cash-value buildup which can be accessed tax-free and usually based on policy designs created decades ago.
Many will argue that if you invest the difference, you won’t need the insurance later and won’t have to renew. How many people actually did this – or do? And, what happened to those who bought that idea in 1988 only to see their retirement accounts blow-up the day they retired in 2009?
Ask 10 35-year olds who believe the ‘buy-term-invest-the-difference argument if they’re doing it; then ask ten 60-year-olds who did it if they’re glad they did. I’ve never met a 70-year-old who wished s/he’d followed that advice – ever. Not one.
This is a mantra that simply hasn’t worked since they began preaching it in the early 1970s – at least that’s when I first heard it.
What the schools don’t teach[5] and the public doesn’t know: There are only two ways to pay for life insurance:
- You can purchase off-the-shelf, retail, yearly renewable term life insurance and pay for it with after-tax income – a purchase of pure protection for a limited time; or
- you may rearrange assets to place investment funds with the insurance company, funds in excess of what is required for the yearly renewable term insurance.
So, what happens with the excess money that most people place with the company… money beyond what’s required for pure protection? The insurance company invests those extra funds on your behalf and earns a return that will not be subject to income tax. Sounds a little like a tax-deferred vehicle, doesn’t it?
The insurance company will then use a portion, or all, of this return to pay the annual mortality and expense charges required by your life insurance contract. You can choose to pay for life insurance with the pretax earnings on your investments inside the policy.[6] Oops! Now we’re not limited to a specific term. The policy can even become self-supporting!
Under the first method, retail term insurance, you would be paying for these same benefits with dollars that had been subject to taxation. Under the second, the inside buildup of excess dollars, above the cost of pure insurance, can be added-to with pre-tax buildup, grows tax-deferred, and, depending on the design, possibly be accessed later tax-free. Any purpose. No pre-59-1/2 penalties. No credit checks, no loan origination fees, no application process,and on-demand.
In essence, all insurance is term insurance. You pay for life insurance each year, whether you make the payment directly or have premium payments taken from earnings in the insurance company’s investment account (which you’re funding over and above the cost of pure insurance).
The question is how excess capital is treated and utilized once the cost of pure protection is covered. The uninitiated see it as a cost. Those who know understand it has uses as a financial vehicle for efficiently managing assets in excess of the insurance cost. Excess capital is managed in the insurance company’s general account in conservative investments (usually long-term bonds and mortgages) and the client receives tax-deferred treatment on those cash values.
One product, indexed universal life (IUL), in one form, marries the concepts of term insurance with an equity-indexed annuity. This allows the policy owner’s cash value to benefit from upside moves in the market while being protected against loss. How is that possible? The company uses a small portion of their investment account to buy options on an index, which they can exercise to take gains when available. This product is particularly popular with successful business owners.
- Receive market-like returns with no market risk.
- Never take a market loss
- Draw income in retirement tax-free
- Access to money at any age
- Provides a large income-tax-free lump sum payment to your family if you die prematurely
- Protected against judgments and lawsuits (in many states)
- Can give you an option to continue to make your savings contributions if you become disabled
- No 59-1/2 required minimum distributions
- Cost of insurance similar to pure term
Not bad. Your 401(k)s, IRAs nor the investments they hold – stocks, bonds, mutual funds, CDs, etc. – can do all that. If you can find something better, let me know. Many advisors, RIAs included, are now beginning to view IUL policies designed as financial tools not so much as substitutes for stocks in client portfolios, but for placement as part of a portfolios bond allocation. There are a number of reasons for this; but, the primary ones are:
- Safety – insurance company guarantees against loss – bonds won’t do that.
- Bond like returns – Despite the caps and floors, returns can be expected to look more like bond, rather than stock, returns – and likely even a little better – and with better tax treatment than is available even in tax-deferred vehicles.
- Advantages outlined in the previous list, including excess capital accumulation beyond what maturing bonds would likely provide.
- Business owners particularly like the fact that there are no funding limits other than those imposed by the insurance company and that prior year’s under-funding can be carried over, unlike traditional retirement plans.
Maybe the guru’s don’t get it; but the people in Congress sure do.
It’s an issue congress has re-visited on more than one occasion since 1985 with some wanting to tax the inside buildup received by those who hold permanent, participating policies designed as a financial tool rather than pure term protection.
Their argument is that even if a policy owner did surrender the policy during his or her lifetime and incurred ordinary income tax on the amount received in excess of the investment made, that policy owner has still received still reaped a substantial income tax benefit. This is because the tax basis in the policy includes a portion of the premium that had been used to pay the cost of life insurance for past periods. In other words, the cost of life insurance has become equivalent to a tax-deductible expense in these policies.
They’re arguing that comparable investment products are not tax-free or tax deferred.[7] Further, they argue that life insurance is not subject to significant limitations on the timing and amount of contributions (although greater limitations were imposed in 1988 under Modified Endowment rules) and that there are no required minimum distributions.[8]
Interesting; don’t you think? Politicians in Washington, D.C. are able to present the benefits of life insurance so forcefully, whereas the insurance industry itself seems unable to communicate these benefits to the public without confusion, usually coming from self-anointed gurus.
Will Congress change the rules? Probably. But, if history is any guide, people who bought policies with provisions Congress decided to change, required the changes going forward only. Policies already in force have generally been “grandfathered” so those policy owners would not be affected. The reason for this is simple: An insurance policy is a private contract between two parties and the law has been loath to interfere with lawful agreements between private parties. The lesson seems to be if you like it, you’d better do it before the politicians see it as a revenue source.
Should you start using life insurance as an investment vehicle? No. Even though advisors, as I stated earlier, are beginning to view some policies as part of an asset allocation, life insurance is still about life insurance – there must be a need for the death benefit – but, it does have some attractive tax and savings components that can help secure your life while you’re still alive, as indicated earlier. Policy design is something you should discuss with your financial/insurance advisor.
Unfortunately for the investing public, information isn’t education. And, financial entertainment seldom provides even good information. The investor is left on his own if not seeking qualified help.
Jim
——————
[1]See my report, Understanding Investment Returns.
[2] Not all gurus are financial pornographers. A few are actually qualified: They’ve taken the rigorous coursework, passed the exams, have respected credentials, are regulated, practicing professionals. One example is Ed Slott, the IRA guru you often see on public television. A few others I won’t mention, with nationwide radio programs, have never taken any academic courses, achieved any credentials, or worked with a single client. They’re also unregulated. But, they do have free speech.
[3] Life Insurance Marketing Research Association
[4] Term insurance has it’s uses, particularly for temporary protection needs, i.e., a need that isn’t permanent.
[5] If the schools did teach it, it would interesting to see who they’d pick to teach the class and what their qualifications would be.
[6]The New Investment Life Insurance Advisor, Ben G. Baldwin, McGraw-Hill, 2002.
[7] IRAs, 401(k)s, 403(b)s are account types, not investments. Investments placed in these accounts grow tax-deferred until withdrawn, then taxed at the then-current income tax rates. So, someone in the 28% bracket, for example, can figure that 28% of the account balance really belongs to Uncle Sam. This is not necessarily the case inside a life insurance contract.
[8] It’s worth noting that the government is not a party to the contract. The policy is a private contract between the owner and the insurance company, giving the owner greater control.
Become an IFG client! Don’t play phone-tag; schedule your 15-minute introductory phone call using this convenient scheduler!
Jim Lorenzen is a CERTIFIED FINANCIAL PLANNER® professional and An Accredited Investment Fiduciary® in his 21st year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located across the U.S.. He is also licensed for insurance as an independent agent under California license 0C00742. IFG helps specializes in crafting wealth design strategies around life goals by using a proven planning process coupled with a cost-conscious objective and non-conflicted risk management philosophy.
The Independent Financial Group does not provide legal or tax advice and nothing contained herein should be construed as securities or investment advice, nor an opinion regarding the appropriateness of any investment to the individual reader. The general information provided should not be acted upon without obtaining specific legal, tax, and investment advice from an appropriate licensed professional. Images used in this post are public domain stock images and do not represent any IFG affiliate or client.
