ELITE ADVISOR BEST PRACTICES
Life Insurance as an Asset and a Hedge - Part Two
How savvy advisors are structuring and managing policies to their clients’ advantage
By Richard L. Harris
- Cash value life insurance has many uses as both a portfolio enhancement tool and a hedge against premature death.
- Variable Universal Life (VUL) offers a choice of separately managed equity and bond accounts managed by professional money managers.
- The performance of Equity Indexed Universal Life (EIUL) is based on the guaranteed minimum crediting rate and the performance of an underlying stock index, such as the S&P 500.
In Part One of this article series, we looked at the four unique features of life insurance that build cash value and that make it different from any other financial asset. Here we’ll look more closely at the mechanics of advanced policies and help you determine whether plain vanilla, variable universal life or equity indexed universal life policies make sense for your clients.
Policy amortization techniques
The first, the plain vanilla of the group, is one that accumulates value based on the performance of the insurance company’s general account. Periodically, the insurance company announces a change in crediting rates either up or down but can never go below the minimum guaranteed rate. That rate is applied to any accumulated value after paying expenses and mortality costs.
The second technique, called variable universal life (VUL), offers a choice of separately managed equity and bond accounts managed by professional money managers. The names of these separate accounts are often the same as the name of the mutual funds that the same managers oversee while using the same strategy. There is also a fixed account similar to what is offered in the plain vanilla UL. The accumulated values depend on the performance of the separate accounts chosen. Unlike with the plain vanilla UL, the accumulated value can go down because of investment performance. This product can be sold only by people with the appropriate securities licenses.
The third is called equity indexed universal life (EIUL). Currently, it is not considered a security, although many broker-dealers have assumed supervision of what products can be sold by their representatives. The performance is based on two factors: the guaranteed minimum crediting rate and the performance of a stock market index such as the S&P 500. The minimum rate, the maximum crediting rate and the multiplier of the index can all change at any time based on the economics at the time. (A full discussion of the workings of EIUL is beyond the scope of this article.) If the S&P is below the guaranteed minimum crediting rate, then the minimum crediting rate is applied to the accumulated value. This does not mean that the policy cannot go down in value! Anyone offering this product needs to make that clear to the potential purchaser. Mortality and expense charges come out regardless of the performance.
Regardless of the product, if properly funded (not a Modified Endowment Contract – MEC) the values can be accessed either by withdrawals or loans. In the case of whole life, the withdrawals would come from the paid-up additions, if that strategy were used. Whether loans or withdrawals are used to access the value of the paid-up additions, the guaranteed cash value can be accessed only by loans. In a UL policy, all of the cash surrender value can be accessed either way. However, to avoid income taxation, one should never withdraw more than the basis in the policy. After that, values should be accessed by loans. WARNING: If someone has taken out more than their basis by withdrawal and loans and the policy lapses, then the excess over basis is immediately subject to income tax. There’s nothing worse than phantom income—income that is taxable without the value to pay the taxes. You will not have a happy client. To avoid phantom income, the policy should be managed so that the insured will die with the policy in force. Because there is no income tax on the death benefit, there is no income tax on all the money that previously came out.
Now to hedging. When talking about hedging, it is important to discuss how different assets perform in relation to each other. In theory, bonds and stocks should not go up and down at the same time. However, in 2008, everything went down. The fact that someone dies has no relation to any financial market or other market. The death benefit is payable regardless of when someone dies as long as the policy is in force. This guarantees that there will be money for beneficiaries regardless of the value of any of the insured’s other assets.
Also, life insurance is a hedge against not living long enough. When someone gets married and has children, it is with the expectation (hope) that the parent will be able to support the children as long as the parent lives. However, if the parent dies before fulfilling these obligations, the death benefit from life insurance can support the family.
Finally, general account life insurance (whole life or plain vanilla UL) has some advantages as a savings vehicle. The general accounts of insurance companies are mostly invested in high-quality bonds. Because the insurance companies’ obligations are long term (not everyone dies or takes out their cash value at the same time), the insurance company can invest for the longer term. The rates of return that insurance companies earn on their general accounts are typically higher than those of a savings account. Most insurance companies use portfolio rates to determine the crediting rate. A portfolio is made up of assets acquired over time—some at higher interest rates and some at lower. Insurance companies using this method will always lag behind current interest rates—when rates go down as well as when they go up.
While a savings account does not have mortality and expense charges taken out as life insurance does, neither does it grow tax-free. And managing a policy properly can allow for money coming out without having to pay income taxes. A cash value policy with a strong insurance company is something to consider.