A popular retirement planning product, particularly for higher tax bracket individuals, is cash value life insurance. In addition to providing liquidity in the event of an unexpected death, the cash values represent additional lifetime protection. The funds can be used as a volatility buffer during down markets, plus they can be a source for tax-free retirement income. For the right retiree, cash value life insurance is a valuable retirement investment. The concern is how to determine the right solution and obtain the most appropriate life insurance product for each individual. In short, how do you evaluate which is the right policy to buy for your specific retirement planning needs?
Comparing life insurance policies can be challenging in part because of the unique design of the product itself. The risk element, i.e., mortality cost, can be thought of as the price a consumer pays for protection for a premature death, much as one looks at the premium associated with homeowner’s insurance as the price for an unexpected fire. A difference, however, between a life insurance policy and a homeowner’s policy is that a sizeable portion of the premium for a cash value life insurance policy is attributable to the reserve being built up in the policy. Unlike most forms of insurance, with life insurance the risk of dying is 100%. Everyone dies – it’s just not clear when that will happen, and that’s what the life insurance is for. With cash value life insurance specifically, the insurer overcharges for coverage in younger years so that the price will be manageable in later years. Otherwise, the premium for a thousand dollars of protection on a 100-year-old would be close to one thousand dollars.
The excess premium dollars being charged in the early years of a cash value policy’s existence are invested. How that money is invested significantly contributes to how the cash value of the policy will grow. Some policies, such as whole life insurance, charge a fixed premium, and they guarantee a minimum return on the invested dollars, represented as the policy’s cash values. Any excess earnings are paid to the policyowner as a tax-free dividend. Other designs, such as universal life, allow for flexible premiums, and then credit an interest rate to the cash value that is associated with the insurer’s investment experience. And yet others, such as variable life insurance, allow the policyowner to determine where the cash value should be invested. The purchaser controls the investing of cash values but also assumes the investment risk.
In addition to the design challenges with evaluating cash value life insurance products, consider the complexities associated with the fractured regulatory framework that oversees marketing of these products. Life insurance is primarily regulated through individual state law, but there is also a loose labyrinth of federal oversight. This has led to inconsistent and, frankly, overly optimistic claims by some insurance carriers as to how their products will perform. By its very nature, a cash value life insurance product is purchased to last for decades, and it is difficult to know how the policy will perform long-term. The trouble is that if, during the sales process, the purchaser is persuaded with a Pollyanna assurance of superior performance, it may take years before any problems are identified, and by then it may be too late to right the wrong.
A PROCESS FOR EVALUATION
These challenges associated with assessing a cash value life insurance product are not a reason to avoid the concept as a useful tool in retirement planning. We don’t avoid investing in stocks simply because their value will fluctuate over the long term; instead, we simply build volatility into the equation. And, to stack the odds in our favor, we do our homework on ways to maximize our return while minimizing our risk. Similarly, pre-purchase homework can also help individuals make a more informed decision about the right cash value life insurance policy to buy. Life insurance is very much a product that involves caveat emptor – let the buyer beware.
How can you become more aware of challenges and opportunities while making your purchasing decision? Below are some steps you can take to improve the odds of making a savvy choice. Taken together, they may help you weed out the hype and discover the winning strategy.
Step 1: Fit The Product To Your Profile
Cash value policies differ widely. Some have flexible premiums; some are fixed. Some offer a minimum guaranteed rate of return on cash values; others don’t. There is a myriad of riders available to further enhance the utility of the base product. All these variations are an attempt to offer features that will prove useful to the policyowner. So, the assessment process should begin with determining your profile and the needs you want the cash value life insurance policy to address. The factors are too many to itemize here, but examples include whether you need flexibility in premium outlays, are comfortable with accepting some additional risk in order to obtain a potentially higher return, and how likely (and when) you will access any cash values in the policy. For example, say you’re a high tax bracket pre-retiree who wants to supplement retirement income with a cash value life insurance policy. Some products are designed to automatically pay out a monthly income, making any internal adjustments to withdrawals and loans to maximize the efficiency of the policy. This product approach would require higher pre-retirement premium outlays. Other policy designs eschew these bells and whistles and instead focus on offering a level death benefit at the lowest possible guaranteed cost. One design isn’t better than the other; it’s just that they serve differing profiles.
As the purchaser, you need to have a plan in mind rather than be dazzled by a “gee whiz” concept that may or may not address your needs. For example, if you are risk averse and consequently want the insurance company to credit your cash values based on their consistent, but conservative investment philosophy, a whole life or traditional universal life policy may best fit your profile. If, instead, you want the crediting of your cash values to be more reflective of the stock market, while still maintaining some level of guarantees, an indexed universal life may better suit your needs. Finally, if you want permanent life insurance coverage, but also want to control how your account values are invested, a variable product would be best. The product should fit you, not the other way around.
This assessment should factor in what specific needs you want addressed in your retirement plan. Life insurance primarily provides a death benefit, and the cash values offer the possibility of supplementing retirement income. However, many modern policies have additional features, including coverage for long-term care and chronic illness. Some have riders that can be added to waive the premium in the event of a disability. Perhaps not a Swiss army knife, but modern-day cash value life insurance policies can address a myriad of retirement risks. There’s no free lunch for these added coverages; your product evaluation should involve paying for what you want, but not for features you’ll never use.
Sound like a challenge? Step 2 should help you in the process.
Step 2: Involve An Advisor
While it is popular to cut out the middleman in order to save costs, this strategy may be counterproductive when purchasing cash value life insurance. A review of many of the promotional materials online suggests that some of the information is dubious at best and fraudulent at worst. There are certainly helpful online tools and literature, but this product is not a commodity, and does not lend itself to easy comparisons. A professional advisor can help you sort through your options, apply for the right product, and help with the underwriting process.
Beyond helping with your purchase, there are two more reasons to seek out professional help: ongoing monitoring and future-plan execution. Because of the long ownership period associated with life insurance, monitoring is crucial. Life insurance policies have many moving parts, and a skilled eye is often needed to leverage these opportunities and avoid pitfalls. Further, ongoing scrutinization of the actual insurer is sometimes required, and an advisor may be needed to assure the carrier fulfills its duties. The other reason to involve an advisor is that help is typically needed to execute the plan once you retire. For example, if you’ve owned and paid for a cash value policy for 20 years, and now want to utilize the values to supplement retirement income, there are several steps that need to be taken with the policy. The death benefit option may need to be changed, withdrawals to tax basis would need to be requested, a switch from withdrawals to loans will eventually be required, and the retirement income flow may need to be shut off sometime in the future to avoid lapsing the policy. While the insurer’s service department may be able to help you with some of these steps, it would be helpful to have a trusted advisor overseeing the process.
In choosing an appropriate advisor, you should vet the individual or firm the same as you would any financial professional. What are the advisor’s credentials and experience? Do any red flags appear when checking with the applicable state’s insurance database and with FINRA’s BrokerCheck? And, important to the process, will the individual and/or firm be available when it comes time for you to execute your plan? It doesn’t do much good to have your insurance advisor retire the same time you do.
Bottom line: find someone or some firm who will serve as an ongoing insurance advisor, not merely as a purchasing agent.
Step 3: Question Policy Illustrations
Cash value life insurance is often proposed through the use of policy or sales illustrations. These are a handy way to demonstrate how the policy will work under a given set of assumptions. Traditionally, these illustrations also served as a kind of approximate price tag – “you pay X, and you’ll receive something close to Y in the future.” Similar to a fuel economy disclosure for an automobile, they helped provide a way to estimate a range of likely outcomes. This has changed.
Policy illustrations can no longer be relied on as an indicator or estimator of the future. Part of the reason for this statement is that this century’s market volatility has made it difficult for insurers to determine their likely investment returns. If carriers don’t know what they’ll earn, they can’t realistically show you an estimate of what they’ll credit to your policy values. There is another reason policy illustrations have lost their predictive value: the rules that govern illustrations vary by product type. Because of how life insurance is regulated, a whole life illustration showing a 5% dividend scale is very different from a variable universal life illustration showing a 5% return on cash valuesKayaker6, which is in turn, different from a 5% assumed rate for an indexed universal life illustration. Any attempt to compare illustrations across policy types would be the equivalent of comparing apples to oranges.
Exacerbating the challenge with illustrations is the overly enthusiastic and under-disclosed presentations made by some insurers. While traditionally the bulk of life insurance sales were generated by a staid collection of large mutual insurance companies, the life insurance industry has more recently fractured into a wildly diverse collection of carriers. This trend has accelerated with the recent acquisitions of insurance companies by private equity firms. Different companies with differing stakeholders are vying for your business. With this increase in competition, some outliers in the industry have been generating illustrations that are simply unrealistic. They take past returns and project them forward as though these numbers are a conservative example of how well the policy will perform. These illustrations sometimes involve scores of pages with disclaimers reminiscent of a software package’s Terms of Service (TOS) agreement.
Different from a TOS, however, you can learn from these illustrations, and they offer you options in what and how you purchase. By carefully reviewing a policy illustration, you can improve your understanding of how the proposed solution might fit your situation. First, don’t ignore the part of the illustration that shows results using guaranteed values. While this may present a worst-case scenario, it can help you understand how much risk there is in the policy solution presented – especially since illustrations present current assumptions as their baseline proposal. Next, where possible, ask for the same illustration to be shown using at a lower assumed rate. With some forms of universal life, as little as a one percent drop in the assumed rate can cause the policy to lapse decades earlier than it would when based on current assumptions. Finally, if the policy being considered is a flexible premium product, ask to look at an illustration based on a higher and lower premium. This can help you determine how stable or volatile returns might be based on premium inflows.
In general, use policy illustrations to better understand the solution being proposed. The illustration is a product guide, not a comparison tool.
Step 4: Avoid Borrowing To Pay Premiums
Because of the historically low interest rates we’ve recently experienced, so-called “financed life insurance” solutions have been aggressively marketed. For most consumers, this involves taking on risk that cannot be justified. Life insurance is usually purchased to lessen risk, not leverage it. There are certainly situations where structured premium borrowing techniques can work. Generally, however, these are reserved for affluent purchasers who can reasonably expect to make more return on their own investments than what the insurer can credit towards the policy. This use of financing is a far cry from illustrations that imply a consumer can pay premiums for their policy by leveraging the spread between the policy’s borrowing rate and internal crediting rate. Further, borrowing to pay premiums only makes sense when the borrower can absorb any losses caused by a down market, and has an exit plan for eventually extinguishing the loan.
Step 5: Build Your Insurance Plan Into Your Retirement Plan
Some insurance coverages can succeed with a “get it then forget it” approach. Not so with cash value life insurance. The policy’s premium outlays and cash value drawdowns are part of a dynamic management process. At some point, you’ll want to determine if you should utilize the policy’s cash values to supplement your retirement plan, and that will only work if the product is monitored and, sometimes, tweaked. An example is creating retirement income by withdrawing cash values from age 62 to age 70 so as to delay filing for Social Security. This requires a targeted withdrawal strategy accompanied by a shut of withdrawals at age 70. Another example is increasing your retirement cash flow by using the equity in your policy to stop paying premiums when you retire. The payment of premiums from internal values requires ongoing management. To fulfill these planning objectives, you should build in target dates for possible policy changes – premium reductions, cash value withdrawals, etc. Further, you should consider in advance which retirement risks your policy can help you address. For example, you might use cash values to pay the income tax on a Roth IRA conversion, or exercise a chronic illness rider if you experience a long-term care event. The cash value insurance policy shouldn’t sit in the safety deposit box waiting for you to die. It should be utilized in creating and executing your retirement plan.
Detractors of using cash value life insurance as a retirement planning tool are doing a disservice to many future retirees. There are clearly challenges in how these products are marketed, but this should not take away from the fact that there is a value to the use of this tax-advantaged strategy. As with any retirement planning approach, it is important to carefully review the details of the proposed solution. With life insurance in particular, this review generally calls for the involvement of an advisor and a thorough, even skeptical, review of any illustrations. Likewise, to accomplish the goals of the purchase, the policy should be part of the overall retirement plan. Simply stated, despite the nonsense that sometimes occurs, cash value life insurance in retirement planning makes sense.