Journal of Financial Planning; July 2011
Peter C. Katt, CFP®, LIC, is a fee-only life insurance adviser and sole proprietor of Katt & Company in Kalamazoo, Michigan. His website is www.peterkatt.com.
Thinking of life insurance as an investment can cause some financial advisers to curse the subject and reject it out of hand. If you are one of those advisers, you can throw down this magazine or bear with me and give the matter thoughtful consideration.
Example 1: Cash Values and Wealth Transfer
John, 42, is a very healthy, successful businessman with a wife and two children. He has a net worth of $7 million. He is a commodity trader, and his income fluctuates between a minimal amount to $1 million a year. He has a defined-benefit pension plan with $1 million life insurance in it. He contacted me recently to discuss a systematic investment/wealth-transfer plan that would give him the flexibility of tapping into it in retirement or using it as additional inheritance for his children. Of significant importance to John is that this investment not be subject to creditors. It was obvious to me he had been talking with life insurance agents and that the investment in question was life insurance.
John asked me to analyze it for him. He wanted to consider an annual investment budget between $50,000 and $100,000, and we settled on $100,000 for the purpose of my analysis. He wanted to limit this to fixed-income investments because he takes a lot of risk in his business. Following is my report to John.
“You requested that I review your potential purchase of life insurance for the dual purposes of possible tax-free withdrawal of cash values and estate wealth transfer. To follow are my comments and observations:
- For the purpose of this report, the life insurance policy is low-expense Premier Mutual (PM) whole life. The dividend rate is 6 percent, which will change (fictional). PM has the highest possible financial strength ratings. I have analyzed policies for 30 years and believe PM’s values have consistently been the highest. I am assuming that you will pay premiums of $100,000 to age 65, then zero premiums. The initial death benefit ($3.5 million) is the minimum amount to avoid MEC status on such a policy. This is the secret to this design—using minimum death benefits so it enhances the cash values and long-term death benefits.
- You are entertaining the options of owning such a policy personally or having it owned by an irrevocable life insurance trust (ILIT). If it is owned personally, you will have easy access to cash values to supplement retirement, etc. If it is owned by an ILIT, you will have a difficult time getting access to cash values.
- I spoke with an attorney that you may hire. He believes cash values are out of reach of creditors in Illinois even if you own the policy. If the policy is in an ILIT, he also believes the cash values and proceeds are not in reach of creditors. He will verify these positions.
- The illustration I presented showed premiums of $100,000 for 23 years to age 65, then tax-free withdrawals of $230,000 for 10 years from 66 to 75. That is, you fund the policy with premiums of $2.3 million to age 65 and then withdraw the same amount during the next 10 years. At age 75, based on the current 6 percent dividend, the remaining cash values are $4,084,528 and the death benefits are $5,962,028. If you own the policy personally, after withdrawing your cost basis, and depending on the estate tax, you would probably gift the remaining policy into an ILIT. Your life expectancy is age 86.
Taking into account $100,000 premiums paid in over 23 years, annual withdrawals of $230,000 for 10 years, and death benefits of $8,266,847 at age 86, the overall IRR is 5.39 percent, which is entirely income- and estate-tax free. This amount will change as the dividend rate changes. If the overall dividend rate is higher, the IRR is likely to be higher and vice versa. If this strategy is followed and the policy is gifted to an ILIT at age 75, the gift value would be approximately $4,084,528 (the cash value). If a gift of the policy is done, the policy will be in your estate for three years. The proceeds at life expectancy of age 86 would be estate-tax free. - If the policy is initially acquired by an ILIT, the premiums of $100,000 are gifts. They would be offset by your annual exclusions and absorbed by Karen and your estate-tax credits. Under this plan you are using the life insurance policy solely as a wealth-transfer asset. If you gift $100,000 to age 65, without any withdrawal of cash values, the illustrated death benefits at 86, based on a 6 percent dividend, are $14,523,935, which is a premiums-to-death-benefits IRR of 5.54 percent. This is income- and estate-tax free.
- Obviously, if we continue to have low fixed-income rates, PM’s dividend will have to fall and actual policy values will fall, but PM’s IRRs will continue to be strong versus conventional savings/investing outside of the life insurance policy. Conversely, if we experience a significant rise in fixed-income rates on a sustained basis, PM’s dividend rate will likely track the rising rates. In this sense this program is inflation protected.
- If you use such a life insurance policy for the dual purposes of retirement income and estate wealth transfer by owning it personally before gifting to an ILIT at 75, the relationship of the 6 percent illustrated dividend rate to overall IRR of 5.39 percent is 90 percent, and it is 92 percent if the policy is used solely for wealth transfer with the 5.54 percent yield. Generally, this translates to understanding the value of this life insurance asset in an inflationary environment. That is, if the average PM dividend rate is 7.5 percent during your lifetime, your yields should be 6.75 percent to 6.93 percent depending on how the policy is used.”
John’s situation is somewhat on the cusp of using life insurance for retirement income plus inheritance because he doesn’t really need the life insurance protection while he raises his family because of his $7 million net worth. In John’s case, life insurance was an interesting option for two reasons. First, the estate wealth transfer aspect—he is funding an ultimate transfer of $14,523,935 at his life expectancy, assuming he doesn’t need income from the policy during his lifetime (based on the current 6 percent dividend rate). The other reason is his desire to keep this asset out of the reach of creditors while continuing to own it for his overall financial security. For John’s specific purposes this life insurance is an excellent investment option.
Example 2: Family Protection
The other use of life insurance as an investment is when permanent insurance is part of needed family protection life insurance. Let’s consider an example. Tom, 41, is a physician. His wife doesn’t work outside the home. They have three young children. Tom and I agreed that after taking into account his invested assets he needs a total of $2.5 million coverage on his life for family protection. He is already insured with a $1 million term policy, so he needs an additional $1.5 million. All of this could be term insurance, but Tom is also able to save/invest an additional $7,700 a year long-term after taking into account the tax-advantaged plans he is already using.
We discussed using a PM life insurance policy for Tom. In this case I figured out that the minimum amount of life insurance that could be purchased with $7,700 is $325,000. So Tom purchased an additional $1,175,000 of 25-year term and a low-expense PM policy for $325,000 with $7,700 premiums. The plan is for Tom to fund the PM policy to age 65 and then withdraw $19,982 for 10 years in his retirement, income-tax free. At 75, cash values are illustrated to be $476,759 and death benefits are $660,000. Tom will likely then let the policy continue to his death. At life expectancy the death benefits are approximately $1 million. The availability of this amount of permanent death benefit will allow Tom to spend more of his nest egg in retirement and still leave an inheritance for his children. The overall income-tax-free IRR for this life insurance planning is 5.5 percent, based on a 6 percent dividend rate. This planning is not appropriate for clients who have little interest in leaving an inheritance to their children.
I believe advisers who are adamantly against considering life insurance as an investment focus on clients who should truly be using only term, and expand that opposition to all clients. In my view, John and Tom are both well served using permanent life insurance as part of their overall financial planning.