Are These Common Life Insurance Myths Keeping You From Maximizing Retirement Income?
A big part of my business is helping sophisticated real estate investors learn how they can put their money to work in two places at one time by leveraging the cash value of a maximum over-funded life insurance policy: The Double Play. One of the first things I often have to do when I’m talking to someone, is deal with one or more of these Five common misconceptions about life insurance.
Its probably an understatement to state that most people don’t fully understand how permanent life insurance policies work. But this is made worse when you consider many life-insurance agents don’t fully understand how permanent life insurance policy’s work. They use phrases like “take money out of the policy” or “why should I pay interest to borrow from myself”.
When I hear this, it tells me that they don’t truly understand how life insurance policies work. In the case above, for example, you don’t borrow “From” an insurance policy. You get a loan from the insurance company “secured by” your cash value. That’s a huge difference. Its their money they are loaning you, not yours! Again, that’s a huge difference. This is how you can put your money to work in two places at one time. [see the statutes]
I show my clients how they can literally put their money to work in two places at one time by taking advantage of policy loans. All private banking strategies like Infinite Banking, Bank on Yourself, 7702 Plans, etc. all rely on this key property of a permanent life insurance policy.
The cash value on the life insurance policy earns dividends/interest even while it is serving as collateral for loans that can be invested in real estate. It doesn’t take a financial rocket scientist to realize that this strategy can build wealth faster. Its The Double Play.
Even if you’re not a real estate investor, permanent life insurance stands on its own merits as a retirement planning tool. A Life Insurance Retirement Plan (LIRP) is a powerful means of generating tax-free income for retirement. A LIRP based on the Cash Value of an Indexed Universal Life Insurance policy can generate 2 to 3 times the income that a similar amount of money in a traditional retirement plan can A LIRP makes sense before you even consider the fact that you can use the cash value to accelerate your wealth building by leveraging the cash value.
These following five myths are the first “Buts” I hear from people who have negative opinions about life insurance or just don’t fully understand how it works. Many of these myths are perpetuated by unsophisticated personal finance gurus who do their audience a massive disservice by perpetuating these myths. They are much better at marketing themselves than they are at finance.
Myth 1: “Whole life insurance is a rip off!”
What does this even mean?
The most common thing that I hear is: Buy Term and Invest the Difference. The idea being that you should buy an inexpensive term policy to cover your life insurance needs and then save the difference between the premium for the term policy and the premium for the Whole Life policy. I have written several blog posts on this subject, but I’ll summarize the conclusions here.
Not all life insurance policies are the same
To see why this isn’t the best approach, we really need to understand a little Life Insurance 101. We need to understand how a permanent life insurance product works. The cash value of a permanent life insurance policy essentially represents the policy owner saving up the death benefit over the life of the insured. The insurance company collects as little in premium as possible and makes a worst-case assumption about what they will earn on that savings. Its a fairly straightforward problem to solve for the premium necessary to reach the death benefit at some point in the future.
The real risk to the insurance company is mortality risk in the early years (bracket on left) when there is very little savings (cash value). So they cover that like all insurance companies do: they pool the risk. The set aside enough money into a pool to pay the expected claims. Its the same for all types of insurance. The risk is shared across all of the insureds, but benefits will only be paid to a few.
In the case of life insurance, this “pooling” essentially represents the cost of a 1-year term policy to cover the gap between the death benefit and the cash value. The two brackets in the graph illustrate the risk covered by the insurance company. The blue line represents the cash accumulation value.
The insurance company is “Buying Term and Investing the Difference” for you. This is a bit oversimplified, but it is the essence of what is going on under the hood. The advantage for the policy owner, is that the cash value in the policy is growing tax free. If you “invested the difference” yourself, that investment is occurring in a taxable environment. Additionally, the insurance company is making very conservative investments and the policy performance is guaranteed. Your “difference” is not guaranteed.
This simplified explanation is based on a Minimally-funded policy. This is one where the goal is maximum death benefit for the premium paid. At the far polar-opposite end of the spectrum, we have Maximum Over-funded Life Insurance. Here the goal is cash accumulation and the insurance company keeps the amount of additional life insurance benefit to an absolute minimum. Here is what the same graph looks like for a Maximum Over-funded policy design:
This policy design is for a 45 year old paying $100,000 per year of premium for only 10 years into a policy with an initial death benefit of about $2.5 Million. In this graph, you can see that the death benefit is held to an absolute minimum. After the 10th year, the death benefit is reduced in order to drive the cost out of the policy and to preserve the cash value. This minimizes the policy charges. The total cost of insurance in this policy is less than 0.25% of the cash value every year after the death benefit is reduced. This is a very efficient savings vehicle.
Its all about the income
The way to compare “investing the difference” with life insurance cash value is to look at the income generating capability of each account. The cash value of a life insurance policy, specifically a maximum over-funded indexed universal life (IUL), can generate tax-free retirement income at a rate of 7-8% of the cash value at the time of retirement.
This is comparable to the 4%-Rule used by financial advisors to estimate the maximum safe withdrawal rate from traditional retirement savings. The bottom line is that the cash value of a life insurance policy can generate 2 to 3 times the after-tax income of traditional retirement savings.
If you “invest the difference”, do you really think you can double or triple the growth on the cash value of a maximum over-funded policy? Its highly unlikely. Retirement income isn’t about how much you have saved, it is about how much income you can take from what you have. And the advantage goes to a LIRP for most people over age 40 who have already taken advantage of any company matching on their 401(k).
This graph is showing “Accumulation”. While the traditional savings does result in more accumulation by the time the client reaches age 65, accumulation is just a number on your account statement. It doesn’t pay bills. Income pays bills. The savings needs to be converted into income.
When the account values are converted into income that can be spent, the graph clearly shows the superiority of the life insurance retirement plan.
So how can the cash value generate so much more income?
The way that a life insurance retirement plan works is this: you borrow against the policy’s cash value to get tax free income. At the end of the year, when the interest is due, the insurance company, knowing that the collateral securing the loan also went up in value, loans you the money to pay themselves the interest and tacks it onto the loan balance. This continues year after year with the loan balance getting ever larger each year, but the loan balance is always secured by the offsetting increases in cash value. You have a compounding loan balance that is secured by the compounding cash value of the policy.
When the policy owner dies, the death benefit (which includes the small term payout plus ALL of the cash value) first satisfies all of the policy loans and then the balance is paid to the beneficiary.
The magic is that the cash value is not reduced as loans are taken. When you remove money from a brokerage account, it is no longer there and no longer appreciating in value. That is not the case with loans against the cash value. THIS is the reason why you can get so much more income from a Life Insurance Retirement Plan.
Since dollar for dollar, the Life Insurance Retirement Plan can generate more tax-free retirement income, the advantage goes to the life insurance. Myth: Busted.
Myth 2: “It takes forever to build up cash value”
As we showed in the graph of the Maximum over-funded policy above, a max funded policy is an entirely different animal from your typical minimally-funded policy. Instead of slowly growing the cash value over a lifetime of premium payments, the death benefit of this type of policy is held to an absolute minimum.
When a policy is designed for Minimum Non-MEC Death Benefit, the cash value to premium ratio should be about 85% assuming that the insured is in good health and doesn’t smoke.
While this 15% “load” may seem costly, keep in mind the income advantage from the previous example. A maximum overfunded life insurance policy is capable of generating more income despite the fees. But it has to be a properly-designed and funded policy.
Cash Value available immediately. Myth: Busted.
Myth 3: “The returns on life insurance are too low”
When I scan the industry, I see current dividend rates from roughly 4% to over 6%. The annualized interest crediting rate on an indexed universal life should average 6 to 7% given today’s interest rate climate and a look back at historical index returns. That’s a heck of a lot better than CD’s and bank rates!
One of the advantages of the cash value of a life insurance policy is the liquidity. A policy owner has access to their cash value via policy loans at any time. The cash value securing the loans is growing at long-term interest rates. Remember, insurance companies are matching up their liabilities with their investment decisions. They are in it for the long run.
And don’t forget that the cash value is in a tax-advantaged environment. If you are in a 25% tax bracket, for example, you would need to earn 8% in order to net 6% after paying income tax.
6-7% growth on the cash value in a principal-protected asset class. Myth: Busted.
Myth 4: “Why would I borrow money from myself?”
This is the hardest myth for most people to understand. Again, policy loans are loans that are secured by the cash value. The life insurance company is literally loaning you their money. Your money never leaves your account at the insurance company. You’re not borrowing from yourself. Period. You’re not paying interest to access your own money. Anyone who tells you different is wrong. Your money is still in cash value and busy earning dividends.
One of two things are going to happen:
- You pay back the loan plus interest due, or
- Two, you die and the loan is paid back from death benefit reducing the net amount of death benefit available to your beneficiary.
So let’s say that you only have $100,000 of cash value and you want to take a $100,000 policy loan. How will this work?
If you have cash value that is earning interest at 6%, for example, and you take a policy loan at 6%, then at the end of the year you owe the insurance company $6,000 in interest. How do you pay for that? Easy, the insurance company loans you the $6,000 because the $100,000 of cash value earned $6,000 during the year. Each year the interest on the policy loan is exactly collateralized by the cash value. This make the policy loan the equivalent of a tax-free distribution.
Not all insurance companies offer loans with rates that will equal the cash value. Is this important? You better believe it. If the loan rate was 8% and your cash value was growing at 6%, then your loan balance would essentially be consuming your cash value collateral. This highlights the need to work with an experienced, independent agent who can match the product to your needs.
You’re not borrowing from yourself. Myth: Busted.
Myth 5: The life insurance company keeps the cash value when I die
The cash value is literally part of the death benefit. It represents the policy owner saving up the death benefit over the insured’s natural life expectancy. The death benefit is the combination of the cash value and the additional risk covered by the life insurance company (shown by the black brackets in the “minimally-funded graph above).
In a case where the policy owner has outstanding policy loans, the loans are settled before the death benefit is paid to the beneficiary. If you are borrowing your own money, how can the insurance company keep it if you pass away?
You should also understand that the cash value belongs to the policy owner. So the policy owner has several options:
- Understanding that any policy loans must be paid back from the death benefit, the policy owner can spend the money themselves during their own life time via withdrawal or policy loan. Or,
- The policy owner can do nothing and the cash value will be transferred to their beneficiary tax-free. This is extremely valuable in cases where the estate would normally be subject to estate tax.
Life insurance is a very powerful financial product. There is much more to it than just a death benefit. The fact that the insurance company must make policy loans to the policy owners mandated by statute makes this one of the most unique financial products.
It is an absolute shame that life insurance receives such a bad rap and that these myths manage to persist. But that said, it is a very sophisticated financial product and it is very easy for an agent to unknowingly design a bad policy and worse, to tell a client something that simply isn’t accurate. I’ve heard agents use the phrase “take money out of the policy” when referring to policy loans. That is just not the case!
Be sure to download my FREE Report: “This Policy Design Mistake Can Cost You Thousands (or More!)“