By Roccy DeFrancesco
The Wealth Preservation Institute
Whether you are an attorney, CPA/EA/accountant, life insurance agent or financial planner, a good working knowledge of life insurance is a must if you are giving any kind of estate or business planning advice to clients. Even if you are not giving advice to clients on this issue, the chances are significant that you have a cash-value policy and, therefore, this article should make for interesting reading.
Cash-value life insurance
For years, many advisors have sold life insurance to higher income clients as an investment to help them grow money in a tax-favorable manner and receive it tax free via life insurance policy loans. This article is not meant to debate the pros and cons of such a sale.
Type of life insurance
This article is also not meant to debate the different types of life insurance policies. My personal preference for clients looking to build cash in a life policy is an equity indexed life insurance (EILI) policy. I like EILI because the policies have a minimum guaranteed rate of return every year and peg the growth to the best measuring index (S&P 500). I also like the EILI that credits 140 percent of what the S&P 500 returns each year (which will come into play in the following discussion).
As stated above, advisors sell and clients purchase cash-value life insurance on the theory that it will work out as a good long-term investment. To the lay reader, this will make little sense. How can a life insurance policy that has many loads create more retirement income than simply putting money in a brokerage account? The short answer is that in a life insurance policy, as the cash in the policy grows, there are no annual taxes due on the growth of the assets (no dividend or short- or long-term capital gains taxes).
When accessing cash from a life insurance policy, clients simply "borrow" money from the policy. Loans are not treated as income and, therefore, you often hear the term "tax-free income" in reference to policy loans. This, however, is a real live loan in which interest is charged on the borrowed money. Policy loans and "wash loans" are not the easiest things to explain, so I'll do it with an example.
If a client has $200,000 worth of cash-surrender value in a life policy, the client could call the insurance company and request a "tax-free" loan from the policy. Let's say that loan is $10,000. The insurance company has to charge interest in the policy on the borrowed money. If loan rate is 8 percent, then the client's policy is charged 8 percent interest on the loan and that must be paid every year. The cash in the policy is still growing, but at what rate? If the crediting rate on the cash in the life policy is only 6 percent, then there will be a shortfall on the interest owed and the cash value in the policy could start to reverse.
If the client had a wash loan, the interest charged on the loan would equal the growth rate on the cash in the policy. Therefore, the balance of cash in the policy will not have to be used to pay the interest on the loan. So, if the interest on the loan is 8 percent, the insurance company will credit 8 percent on the same amount of cash in the life policy (it is a neutral transaction from the client's point of view). The life policy was charged 8 percent on the $10,000 loan, but the life policy also earned 8 percent on $10,000 in the policy to create this neutral situation.
Many companies are using what are called "variable loans" to enhance the product and potential for larger tax-free loans. How does a variable loan work? The insurance company will still charge the client interest on the borrowed money at whatever the going rate is at the time. Let's say the rate is 6 percent. Unlike a wash loan where the cash in the policy would be credited with a return of 6 percent, with a variable loan in any given year, the client has no idea what the investment return will be in the policy.
For example, if the client purchased my favorite type of life insurance policy (EILI), the growth in the policy is pegged to the S&P 500. If the S&P 500 returns 10 percent in a year when there is a loan on the policy with an interest rate of 6 percent, the client is actually making money on the money borrowed from the life insurance policy.
Conversely, if the S&P 500 goes negative (which in most EILI policies will earn a return of zero in that particular year), the client's policy is still charged with a loan for which the rate is 6 percent. What that means is in the year when the S&P 500 underperforms the interest rate on the loan, the principal cash in the policy will have to be invaded to pay that interest.
If a client has a variable loan in their policy in a time when the S&P goes really flat, the client could receive a call from the insurance company saying that there is not enough cash in the policy to pay the interest on the loan and that the client needs to come up with some cash or the policy will lapse (which would have very negative tax ramifications).
Scary? Honestly, most clients who buy policies with variable loans fail to understand them or don't even know the policy has such an option. They just looked at the illustration and amount that could be borrowed and trusted the agent when buying the policy.
What's scary is that the illustration software used by insurance companies that sell variable loan policies default the interest on the loans not to a wash loan but to the variable loan with a spread of anywhere between 1percent and 2 percent-plus. The rationale of the insurance companies is that over the long term, the S&P 500 has always outperformed borrowing rates by an average of 2 percent or more each year. That may be true over the long haul, but what if we have an environment similar to the 1980s when interest rates were not only above 10 percent, but were above 15 percent. What if the client happened to borrow from the policy at a time when the S&P 500 went flat for a three-, five- or seven-year period?
If you are selling these policies, make sure you fully disclose to your clients how variable loans work. I strongly recommend that you illustrate not only the default position of the software, which is the variable loan with a spread, but also a traditional wash loan. You'll be surprised at how much less a client can borrow from a life insurance policy when comparing the two. This is important because these policies allow the client to choose a wash loan or the variable loan option.
I alluded to an EILI policy that credits 140 percent of what the S&P 500 returns every year. I like this policy when discussing the variable loan issue, and I think the following illustration will demonstrate why.
Assume the interest rate on a loan from a life insurance policy is 6 percent. In most policies, if the S&P 500 returns, say, 4.5 percent, the client is going to go backwards by 1.5% in their policy due to the fact that the return is less than the interest rate (the client would have been better with wash loans). If the client had a policy that credited 140 percent of what the S&P 500 returns, the client would have been credited with 6.3 percent in their policy and would have done slightly better than with a wash loan.
Carrying that forward, what if the S&P 500 returned only 3 percent? The client would be upside-down 3 percent if the interest rate on the loan were 6 percent in a normal policy, but only upside-down by 1.8 percent in a policy that credits 140 percent of what the S&P 500 returns.
My point is simply that the 140 percent crediting policy allows for more security and better growth for clients who think the S&P 500 is going to be flat for a period of time. This same policy also has a feature (like some companies) so if the client borrows money over the age of 65, the policy has a free automatic "no-lapse" guarantee.
Wash loans are a good option to have in policy. The more options the better. It is vitally important for advisors to disclose whether they are illustrating a policy and loans with the variable loan feature so the client knows that, in order to obtain similar borrowing results, he/she will have to make money on the borrowed money in the policy. Finally, if you want to use a policy that will help hedge a client's risk, you should seek out and use the policy which credits 140 percent of what the S&P 500 returns every year.