Our blog, “Life Insurance – A Primer”, concluded that Accumulation Universal Life and Whole Life policies have characteristics that warrant their consideration as a complimentary asset class. An asset class is any category of investment that might be held in a liquid investment portfolio. For example, large and small company U.S. stocks, international stocks, bonds, etc. Life insurance is not an investment and would not be directly held in an investment portfolio but can be an important complement to the fixed income, or bond portion, of a balanced portfolio.
Let’s first look at bonds to better understand how.
A typical long-term portfolio has a 60 or 70 percent allocation to stocks with the balance in bonds. The bond allocation serves to dampen portfolio volatility. First, because bond returns are less volatile than stocks, and second, because their returns have very little (.02) correlation with large-cap U.S. equity returns. Bonds also generate taxable interest income.
A bond portfolio’s return is the combination of changes in its market value and the interest income. The market value of a bond portfolio rises and falls inversely with the direction of interest rate movements. (In 2022, the worst year ever for bonds, the most popular bond index was down 13%, due to the Fed’s dramatic increase in interest rates.) In the accumulation phase of a portfolio’s life cycle, the income is usually reinvested. In the late-stage phase, the income is often distributed. The historical return for bonds is between 4% and 6% since 1926. Let’s see how life insurance complements the valuable role played by bonds.
Let’s use whole life policies to illustrate the concept. In addition to providing an income tax free death benefit for life, the policies build cash reserves. After the first year or two, whole life policies have guaranteed cash surrender values which increase with each premium payment.
Mutual insurance companies are owned by policy holders whose whole life policies participate in company profits through tax free dividends. Dividends are not guaranteed and may be declared annually. Major long-standing mutuals have made uninterrupted dividend payments for more than 100 years. While there are as many as 12 ways to use dividends, they are commonly used to reduce premium payments but most often reinvested in the policy. This provides tax deferred compounding of the dividends and increases the death benefit. For the balance of this discussion, “cash values” will mean the sum of the guaranteed cash values and dividend accumulations.Unlike bond values, cash values never go down. They grow without taxation. You can think of these cash values as a tax favored pool of low-risk assets sitting in partnership next to your investment portfolio. Their value doesn’t change with movements in stock or bond markets or interest rates — a perfect non-correlated asset (combining non-correlated asset classes is at the heart of true portfolio diversification).
Cash values can be accounted for in an investment portfolio’s asset allocation.
Assume you want a 60/40 asset allocation for your $1,000,000 portfolio and have $100,000 of insurance cash values. Treating your cash values as a bond-like substitute, you can reduce your portfolio’s allocation to bonds to 34%, allowing for a greater allocation to equities, thereby increasing return potential without materially increasing the risk profile of the combined asset pool (the $340,000 bond allocation plus the $100,000 of cash values total $440,000, which is 40% of $1,100,000).
A whole life policy can supplement the retirement provided by your investment portfolio. The tax-free dividends can be paid in cash. Another option is to take periodic, or random cash value withdrawals. Withdrawals are tax free until their sum exceeds the sum of all premiums paid. Additional withdrawals are taxable as ordinary income.
Withdrawals reduce the death benefit but remember that dividend accumulations had increased the death benefit over the years (dividend distributions do not). With proper planning, a policy can be maintained at retirement with no out-of-pocket premium payments. This can delay taking money from your 401k or IRA until required by law, so they can continue to grow on a tax deferred basis.
The lifetime death benefit also creates flexibility in legacy planning. The death benefit can be paid to children and/or grandchildren, perhaps in a trust, giving you the luxury of using more of your portfolio for your own enjoyment in your retirement years. It can replace some or all the assets lost to state or federal estate taxes or to long term care expenses. It can further provide for a surviving spouse.
Unlike assets in a 401k plan which also grow on a tax deferred basis, a policy’s cash values can be accessed without restriction or penalty. The accessibility of cash values as a safety net is perhaps their most important role. Prior to retirement they should be held in reserve for emergencies. In the author’s long career, he has seen 12 family businesses saved by their cash values during recessions when business was bad, and bankers refused to provide loans. A recent experience with a substantial and very successful family business stands out. The company’s revenue was severely impacted during the pandemic. Its heretofore friendly banker became unfriendly when asked for a loan. The company turned to its $13 million of cash values to save the day. The loans have since been repaid. Cash values have helped families support college education expenses, provided when jobs were lost and helped with unexpected medical bills. In yet another instance, cash values have been used as a down payment for the purchase of a business, with the balance paid by the seller or bank financing.
Cash values can be accessed by terminating all or a portion of a policy, but that is usually not the best option. It would mean the loss of the death benefit, perhaps when needed the most, and when it may be difficult, if not impossible, to replace. The best option is to “be your own banker”.
The cash values can be borrowed from the policy, no questions asked, they belong to you. Insurance policy loans have unique features unlike traditional bank obligations. There is no repayment schedule and no due date. You repay them when, and how, one can — in whole or in part.
If you surrender the policy or die before repayment, the loan is deducted from the surrender or death benefit proceeds. The first year’s interest is deducted from the loan, so there is no out-of-pocket expense in year one. Thereafter, annual interest is paid in advance. If need be, the interest can be borrowed as well.
Of course, you could also access your investment portfolio to meet emergencies, but that might mean selling when markets are down or incurring taxes, depending on market conditions.
In summary, people buy permanent cash value life insurance for more than just the lifetime death benefit. They want the tax-free dividends, the safety (relative to stocks and bonds) of the tax deferred accumulations, a potential source of retirement income, and the opportunity to be their own banker. They also recognize the financial flexibility afforded by the death benefit post-retirement and its ability to provide a legacy to benefit children and/or grandchildren.
As noted above, whole life insurance is not an investment. Its rate of return at death is quite large, especially in the early years. It may provide lifetime cash on cash returns that are comparable to bond returns, if purchased early. Alternatively, it may simply provide a lifetime cash on cash break even. But stocks and bonds don’t provide a mortality benefit. As discussed above, its cash values make it a reasonable complement to a bond portfolio, but not a substitute.
Some refer to their policies as a mortality bond.
A word about risk. U.S. Treasury notes and bonds are backed by the U.S. Government’s taxing power. Corporate bonds are backed by the issuers. Rating agencies rate their credit worthiness.
Life insurance policies are backed by a company’s financial strength and claims paying ability. Fortunately, insurance companies are rated by multiple rating agencies. The ratings are readily available. Prudence would suggest that only highly rated companies with long term dividend histories should be considered for whole life policies.
Principal & Co-Founder
Baldwin & Clarke, LLP
