The purpose of this article is to discuss a common interest rate arbitrage mistake that newbies make. Both newbie policy owners (and agents!) tend to get excited when they realize that the expected growth rate on the cash value of an index universal life is higher than the policy loan rate. This can lead to some dangerous financial decisions. I am going to show you the common mistake people make and where you should really be looking for arbitrage. I will also show an easier way to take advantage of interest rate arbitrage while keeping your premium outlay to a minimum.
What Is Interest Rate Arbitrage
Let me start by explaining interest rate arbitrage. Interest rate arbitrage occurs when you can borrow money at a lower rate than you can invest it. If you could borrow as much money as you wanted at 4%, for example, and you knew you could safely invest it and earn 6%, how much would you want to borrow?
All of it!
Right? An indexed universal life insurance policy creates a unique opportunity to create interest rate arbitrage. Because the cash value should earn a premium over the typical debt market rate of return, it is possible to get a policy loan at a lower interest rate than the cash value is earning.
But unfortunately, some people get carried away with the possibilities that this offers before they understand the entire business model.
Where should you look for interest rate arbitrage?
Before I discuss the mistakes that people make, I want to explain where you should be looking for interest rate arbitrage when you are doing The Double Play. You should look for interest rate arbitrage outside of the policy, not inside of it. Let me explain.
The Double Play is very simple. Understand that if you can put your money into an asset that is growing at 6%, and you can borrow against that asset at 4%, and use those borrowed funds to invest in real estate or any other assets growing at 10%, then whatever you make on that outside investment, is over and above what you are earning on your cash value. You are literally putting your money to work in two places at one time and earning a higher total return. If you don’t like my numbers, plug in your own reasonable numbers. It works even when the borrowing rate and earning rate are the same.
Now in an IUL, there may be years where the cash value doesn’t earn any interest crediting and there may be years where it earns interest crediting up to the cap. Some people get fixated on the fact that they could be paying 4% loan interest at the same time that the cash value earned zero. In their minds, they are going backwards. Negative interest rate arbitrage.
This is not the right way to look at it. You need to think about it from a business perspective. Regardless of whether your cash value earns interest crediting one year or not, you have a source of funds that is secured by it. Whatever you earn with that borrowed money creates value outside of the insurance policy’s cash value.
Businesses don’t invest in projects that don’t have a positive net present value. Likewise, given a choice between projects, they will choose the project with the highest net present value. The bottom line is that you don’t borrow money unless you know that you can invest it and earn enough to cover the cost of interest and still make a reasonable profit.
The Double Play = Cash Value + (investment return – loan interest)*(1-tax rate)
If you look closely at this formula, and realize that the cash value will either be the cash value or the cash value plus one year’s worth of interest, you can see that the impact of a year of 0% interest crediting is minimal. The following table provides and example with numbers:
This example assumes that we are looking at the second year performance. Since interest would be credited after the end of the first year, the performance of the outside investment will be exactly the same in Year 1 whether the policy is credited with interest or not.
On the left side of the table where the cash value was credited with 5% interest, the client is able to borrow $90,100. On the right side of the table where the policy did not earn any interest, the client is only able to borrow $85,000. The difference in the amount that can be borrowed is only $5,100. So what we are concerned with is the difference in returns on that additional $5,100 only.
And after making 10% on that $5,100, The $510 is reduced by taxes and interest leaving the total difference in performance at only $153 dollars.
I know what you’re thinking: “But Tom! The cash value didn’t earn anything!” You have to keep in mind that if there are flat years of crediting, those years are likely to be followed up by returns near the cap. I’ll address this further in the next section.
Cash Value Volatility
For those concerned with the perceived negative interest rate arbitrage, because the cash value is earning interest in some years and not earning interest in other years, just be aware that the Cash Value should be treated like any other retirement assets. For example, when you are investing in the stock market, you know or at least hope that it will return 9% annualized returns over a long period of time. But, you know that it could be down by as much as 40% in any given year (such as 2006), yet millions of people still invest in it.
The cash value is the same. There will be years of 0% interest crediting and there will be years of 10% plus. And just as with investments in the market, you just have to have faith that the money will be there when you need to retire. And since life insurance cash value is principal protected, it is a safer bet than most retirement planning assets that can lose value.
Once people realize that the interest crediting rate on an indexed universal life is typically greater than the loan interest rate, they start to look at arbitrage inside the policy. If the cash value is growing at 6% for example, and the loan rate is 4%, the cash value growth exceeds the loan by 2%. People think that they can build wealth by borrowing against the policy to pay the policies on premium.
Understand that the loan balance is growing and compounding when you do this. The loan is not your money. The loan and the capitalized interest, is a liability against the policy’s cash value which is securing the loan. As a result, all you are really doing is capturing the very tiny sliver between the cash value and the loan balance.
This example is based upon a Premium Financing example where the interest is being capitalized. Since both the cash value and the loan balance are both growing and compounding over time, the policy owner only captures the sliver created by the spread between the two. This spread exists in the theoretical world of “expected” returns, but in the real world the loan balance may exceed the cash value in the early years. This is very risky and the reason that you should not attempt this.
A better way to do it
If you truly want to take advantage of the arbitrage, use the arbitrage between the fixed simple interest and compounding interest on the cash value. If you instead pay the interest each year, your interest payments will remain level. They will only fluctuate by the changes in the interest rate. However, the cash value will be growing at a compounding rate.
The advantage of this is that every year the interest expense is fixed, but the gap between the loan balance and the cash value will be growing with every passing year.
So, for example, normally I would say that if you had $250,000 of savings, you should design a policy with $50,000 annual premiums for 5 years. This is the optimal way to get a lump sum of money into a policy. This is addressed in detail in my eBook: Don’t Make This Policy Design Mistake (Available in my online store for $5.99). This book addresses why you NEVER want to make a lump sum premium payment.
I’m going to show you another, more sophisticated way to deploy a lump sum of savings. To properly take advantage of the arbitrage, you could design a policy around ~ $150,000 a year premium. Then at the end of the year, you take a loan for about $125,000, throw in an extra ~$25,000, and now you have your second year premium. You are financing most of the second year premium. You could repeat this for as many years as you can afford the interest.
This spreadsheet shows an example closely matching what I’ve described. By the end of the 5th year, the policy owner has financed $550,023 of premium which is costing $22,001 per year to finance. As long as the policy owner keeps paying the interest, they can keep earning an ever greater spread between the cash value and the loan balance. At some point in time, the policy owner could stop making interest payments and finance the interest instead. At this point they could enjoy tax-free income created by putting the insurance company’s money to work for them!
Be mindful that the insurance company is financing the bulk of the premiums with loans against cash value purchased with loans from them. If you were to utilize a strategy like this, it would be crucial that you have the financial ability to afford the interest on the loans.
The beauty of this approach is that instead of capturing only a narrow sliver of the spread between the cash value and the loan balance, you are capturing a much wider spread between the fixed loan balance and the ever growing and compounding cash value. This gap will get larger with every passing year.
Understand that in this example, the loan balance is fixed. In the previous example the loan balance is compounding.
Because the interest crediting rate on an indexed universal life will likely exceed the loan interest rate on a policy loan secured by the cash value of an indexed universal life, many people incorrectly think that they are losing money if they have a loan payment while being interested crediting is zero. The interest rate arbitrage that you should be looking at is on the outside of the policy. Whether or not the cash value earns interest crediting in any given year is immaterial. You can still take a loan against it and you can still put that loan to work in the investment of your choice. The interest should be treated as simply the cost of capital.
Many newbie policy owners and even agents, mistakenly think that they can finance future premiums by taking loans against the first premium auto life insurance policy this is extremely risky and does not really create much additional value. The only value created is the narrow sliver of equity that exists between the cash value and the loan balance.If you want to attempt this properly, keep in mind that you should pay the interest on the policy loan. this creates an arbitrage between simple interest on the loan balance and compounding interest on the cash value securing the loan. Thus, with every passing year, and ever widening gap of equity is created.