Today we are going to be discussing life insurance and the first question I will ask you is, “Do you have life insurance as an asset class in your portfolio?”
If you are questioning what I mean by this then you’re in luck because we are going to dive into what it means to have life insurance as an asset class.
It’s interesting to me how little people really know about life insurance.
Other Uses for Life Insurance
Most people when they think of life insurance they think about its use to protect families, pensions, liabilities and business.
But there are other uses such as banking, retirement, tax reduction, long term care and portfolio diversification that is not often considered when thinking about life insurance.
I think one of the limitations people have about life insurance is its complexity but its also the negativity that surrounds these plans.
We are going to discuss all of this and more, but before we do I want to say a couple of things.
- To get the most from this, I would encourage you to set aside any biases you may have based on things you have heard and tune in to why I do this in my personal planning.
- I wouldn’t be putting thousands of dollars each month into these plans if I felt they didn’t work or make sense.
Now, I have shared my personal story before in other podcasts so I wont repeat myself but I will say that when I started out in the financial business in 1993, I started by selling life insurance and absolutely hated it.
I spent a couple of years learning the insurance business but I jumped to investments as soon as I could and got away from life insurance all together for a period of time.
I think I moved away from it because I didn’t like my experience with how it was being packaged and sold to people. That problem still exists today.
But as I got more and more involved in financial planning, I realized that there was a need for it and I began incorporating life insurance back into my practice but not in the same manner as before.
Rethinking the topic of life insurance
Fast forward 20 years to today after thinking and rethinking the topic of life insurance, I have come to the conclusion that when it is used and designed properly, it is an effective tool and has a multitude of practical applications.
My goal is to share these proper designs and purposes with you so you can you understand why these programs can prove to be a welcome addition to many portfolios and financial plans.
The key here is removing everything you have heard about life insurance and setting those thoughts aside so to not cloud what we are discussing. This will allow you to take in what I will share with you over the next few minutes and hopefully formulate a different perspective about how these plans work.
Due to time limitations I will focus on the most common design of life insurance I use called a Specially Designed Life Insurance Contract. Basically this is a high cash value, dividend paying whole life insurance policy.
Whole life insurance
Now, you may be asking why I use whole life when there is so much negativity about these plans and many newer forms of insurance available. And my response to that is this.
Most of what you hear or read about whole life insurance are repeated thoughts and opinions from one person to another. It is a comment or belief that is passed from one person to another with little if any basis for the opinion. Generalizations and misleading comparisons are made without much testing or vetting.
Keep in mind that life insurance has been around since 100 BC. That’s a long time. The only financial instruments that are older than this are real estate, gold, silver and bonds. The first stock wasn’t used until the 1600’s, 1500 years after life insurance.
The first point I will make that I feel is important is that life insurance can be considered property and what that means is that it can be owned. If the contract is funded for a specified period, the policy owner has no future payment obligations and the death benefit, along with its cash values, are owned by the policy owner.
All other forms of life insurance such as universal life, indexed life and variable life are all perpetual payment designs. The payments never end whether the policy owner makes the payment or the premiums are deducted from the cash value of the contract.
The primary advantage to these plans regardless of their design is the tax-free death benefit, tax-free growth and if handled properly, tax free access to cash.
Now, you may be asking about term insurance since it is the most commonly compared product to whole life. I own millions of dollars in term insurance but this form of insurance fits more into the category of auto or homeowner insurance and specifically covers your family if a death occurs. We are not discussing insurance coverage here. What we are discussing is whole life insurance as an asset class and how the unique features of a whole life policy can make it a perfect addition to a financial plan.
SDLI as a bank alternative
Now, a common use of these policies (which we will refer to as SDLI) is to take advantage of its high yields and tax-free growth as a bank alternative. I have explained this extensively in other podcasts so I won’t drill down too deep here but the basis for this idea is due to low yielding bank rates.
A challenge savers face is the necessity for holding cash in low yielding saving accounts. As savers, the need to hold cash in a savings account is important to have access to funds when needed. The trade off for this access is little to no growth on the assets.
Though viewed mostly as a longer-term financial vehicle, a well-designed SDLIC can rival a bank savings account due to high, early cash values. Here are few things to think about:
With historically low interest rates, banks have little incentive to offer much of a return on a deposit account. While bank accounts offer a safe place to store cash, yields are low and are taxable.
In contrast, SDLIC offers access to the account surrender value through policy loans or withdrawals. The earnings are in line with bond yields at 3-4% and have favorable tax treatment by the IRS. In addition, they offer an enhanced death benefit and long term care benefits.
There are no perfect situations. A SDLIC does have a couple drawbacks:
- There are premium (deposit) requirements for 5-7 years depending on the design.
- Policies have some cash restrictions in the early years that decrease over time allowing more access each year that passes. (In year one, they allow 65-80% access depending on the design)
Though a SDLIC does have some early restriction on access, if you do not need all of your money in the early years of contributing to a policy, this can offer more growth and benefits than using a bank account over time.
A proper design of these plans will offer access to cash when you need it in order to make big-ticket purchases that you would otherwise rely on a bank to lend you money.
Bank loans and SDLIC
Often time’s people become accustom to relying on bank loans to make automobile purchases, education needs, home improvements, weddings, etc. It has become second nature for people to take on these loans when cash reserves or cash flow is inadequate to fund the need.
- When using a SDLIC, the policy design and loan provisions allow policy owners to take policy loans from the policy. These loans are provided by the insurance company issuing the policy and are not a withdrawal of policy cash values. (The policy value and death benefit are used as collateral for the loan.)
- Payments to repay the loan are optional (though we recommend you have a pay back method) and your money remains in the policy with uninterrupted compounding tax-free growth.
- Therefore, when a loan is taken, the insurance company lends you money with interest (typically around 5%) and your cash remains in the policy accumulating with interest and dividends (3-4%).
- When you borrow money from a bank, you are paying interest back to the bank with no method to recapture the cost of borrowing the money and you have a required fixed payment due each month.
- When you store money in a savings account and then withdrawal money to make your purchase, the money withdrawn is then gone and no longer working for you.
- When you store money in a bank account (as we have already discussed) you have >1% in taxable earnings.
In both instances, whether you use a SDLIC or a bank loan, you have interest charges, which is a cost for borrowing money. However, there are significant differences that you should take time to understand. When you borrow money from a bank, you are spending money you do not have. There is nothing supporting the loan other than your signed contract with no method to recover the interest paid.
If you are storing money in a bank account to make these purchases then you are dealing with all of the problem we have already mentioned. You have little in earnings and when money is withdrawn from the account, that money is gone and is not working for you.
An SDLIC has money stored and earning 3-4%. When money is needed you are borrowing money from the insurance company with your policy as collateral. The loan is charged around 5% for the amount borrowed. Meanwhile your policy cash values remain in the policy earning interest.
Now, before you assume you are paying 1% on the loan, you have to understand that this is not about interest rates. It is about how the policy is designed and the net benefit to the policy owner.
A policy has $100,000 in cash value and the policy owner takes a loan to make a purchase of $30,000. The $100,000 @4% earns $4,000 and the $30,000 @5% is $1,500. The earnings recapture the cost of the loan and the net gain is $2,500.
This is why creating your own “banking system” using a SDLIC can help you build long term wealth on money you would otherwise spend or pay interest to a bank.
When it comes to portfolio design and asset allocation, using specially designed life insurance in your portfolio offers built in tax advantages while offering bond like returns.
The challenge investors have is the scarcity of available options. The choices are to either settle with a low yielding savings account or enter the high volatility of the stock market. Yes, there are fixed income options such as bonds and alike, but these are the most at risk asset class considering the reduction in interest rates over the last three decades that contributed to the bull run of bonds has settled in at all time lows.
What drove bonds higher was declining interest rates. Now, interest rates are near zero with nowhere to go but up, leaving bonds susceptible to loss. So, finding an alternative is important to help replace bonds as a way to balance the risk of stocks.
A couple of things to think about when it comes to savings and investments:
- The goal of asset allocation is to spread risk amongst asset classes. Most people do not fully understand what this is. They see diversification as a quantity of holdings rather than quantity of assets. There is a difference. Having five US stock funds is equal to one asset. You may have quantity but you do not have diversification.
- For example: Bonds and fixed income securities are an asset class. Cash is an asset class. US stocks are an asset class and International stocks are another asset class. The list goes on…
- Since interest rates are at historic lows and bonds are at risk of losing value if rates rise, finding an alternative for this asset class is important to help properly diversify a portfolio.
For these reasons, we believe using a SDLIC can be an effective replacement for the use of bonds and other fixed income options due to its ability to benefit from a rising interest rate environment.
The biggest misrepresentations of whole life insurance come from Wall Street and financial entertainers. They will often make the mistake of comparing a policy to a stock market driven asset. They will claim, “You can earn more in the market”. While this could be true of the market, it is not a fair comparison of products. A whole life policy is a bank or bond alternative, not a stock market alternative. Making that comparison is not truthful and is their attempt to undermine the benefits of using whole life insurance. SDLIC is not a perfect program but should not to be compared to a volatile long-term growth asset. A SDLIC is a consistent return program and low volatility asset.
SDLIC is not right for everyone
Now, I always want to make sure there is no confusion with what I am saying. These are complex concepts and expectations are critical when looking at this and all other types of programs available. While SDLIC can be ‘The Swiss Army Knife” of your financial planning due to its high cash values, accessibility to cash, death benefit, long term care benefits and tax favorable treatment, it is just a piece of a much bigger picture.
I don’t think SDLIC is an investment and don’t want you to walk away from this conversation thinking that it is. It is an alternative to a bond with comparable earnings potential. There is a difference. Any and all investments are speculation. A life insurance policy is not.
Another point here is that, SDLIC is not right for everyone. If you need access to all of your money in the early years and have historically not been good with money then this is probably not the best option for you. This would be true with investing as well. If you’re not a good saver and carry debt then you really need to be tuned into your cash flow problems before trying to save money.
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