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Most Americans still buy their life insurance and insurance annuities through a financial professional, and for good reason. Both insurance vehicles typically have numerous intangibles and investment elements associated with them that pertain to a person’s overall life goals and financial situation. In regard to life insurance, one might wonder if one is really getting a reliable insurance product that one can count on to deliver. Is a person better off with a large lump settlement or with numerous “bells and whistles” that may come with different “fine print?” Is someone better off buying a variable policy or structuring term insurance with a side investment program?
THE PARADOXICAL FINANCIAL INSTRUMENT
Life insurance is a very peculiar product. The insured pays cash for a benefit he hopes to never use. Unlike most other products, ones ability to get it is inversely proportional to how plainly obvious it is that one really needs it. Very wealthy people who can afford to pay premiums the most need insurance the least (with the exception of certain estate planning tax avoidance-related benefits) because they are largely self-insurable, and poor people who can least afford insurance premiums need the benefits the most. As people get older, they slow down, see more instances of underinsured people who become destitute, and become more conscious of different causes of death and their own mortality. At the same time, the annual cost of initiating an insurance policy escalates dramatically each succeeding year beginning when one is in ones late 40’s. Lastly, a financial instrument whose death benefit can be calculated with some precision from actuarial tables would seem to be far removed from stock and bond market fluctuations, yet investment performance over the long run in financial markets is central towards building permanent life insurance cash values or hedging fixed term life death benefits against the ravages of inflation.
Three very basic questions are: How much insurance do you need? Secondly, do you need term or permanent insurance? Lastly, how can you maximize the investment side of an insurance policy?
HOW MUCH INSURANCE DO YOU NEED?
Determining the right amount of life insurance often involves achieving a balance between two very different objectives: alleviating the chance of financial distress, and achieving financial empowerment.
A major advantage of life insurance is that upon death it creates an immediate estate that is tax free to a beneficiary. The death benefit is also free of probate delays and most other problems involved in passing along wealth. From a minimalist, purely insurance-oriented viewpoint, one might ask, given all the assets already available to a beneficiary, how much additional insurance is necessary to help the beneficiary avoid destitution? What is the minimal amount of insurance necessary to help one sleep reasonably well at night and make reasonably comfortable premium payments given ones current income level?
The financial empowerment objective involves less fear of a downside and is more altruistic and ego-driven. If a beneficiary receives a certain level of assets, how much more might he or she or it (if it is a charitable organization) be able to accomplish? What are the tax and other cost implications of using life insurance as an estate planning vehicle compared to other methods of passing on wealth? How might ones heirs think better of their benefactor or how might ones legacy otherwise be improved by passing on a certain level of assets?
TWO BASIC APPROACHES: TERM AND PERMANENT INSURANCE
A term policy typically involves a fixed death benefit which requires a fixed premium payment every year for a fixed time period, such as ten or twenty years. After the term of the life insurance expires, one is back to zero insurance. There are no residual benefits or values left over.
The good news about term insurance is that it is the cheapest and simplest form of insurance available. The bad news is that people in their fifties who get term insurance can typically only go out twenty years with some kind of reasonably affordable, fixed, annual premium payments. People who live past the time when their term insurance expires when they are in their seventies are usually insurable thereafter. The annual premiums for folks in their 70’s who want to start a policy are prohibitive. That is the way it goes in insurance; when it becomes really obvious that someone needs insurance to help a beneficiary because of his age, estate planning needs, deteriorating health, or some other actuarial factor, the premiums become unaffordable.
Enter “permanent” or “whole” life insurance, which means that one is able to keep a policy in force ones whole life so long as one keeps up the premium payments or maintains enough cash value within the policy as a cash reserve for automatic payments. With a permanent or whole life policy, one makes payments that cover not only an insurance benefit, but also build up what is called a cash value or investment value. Hence, permanent insurance is typically a hybridized animal that marries an insurance feature to an investment porfolio component.
A good short quiz to help you understand better whether your needs are geared towards permanent or term insurance can be found at a Midland National Life Insurance web site. Midland, incidentally, is an A+ rated company, and is one of the companies that I have worked with.
As one might expect, in the real world there are some gray zones in making a decision between using term and permanent insurance.
For starters, the decision is not necessarily either-or. An individual can get a term policy and later convert to permanent insurance. So long as the conversion takes place within the time period of the term coverage, and the death benefit is not increased, a term policy holder can convert without requalifying or taking a new physical exam. His premium payments will rise based on his new age at the time he converts to permanent insurance.
One might also consider replicating major elements of a permanent life policy by combining term insurance with a Roth IRA or some other tax-deferred vehicle. Hopefully, if one chooses this approach, the value of the Roth IRA will be large enough by the time ones term insurance expires so that one feels adequately self-insured. Hopefully one can also maintain the same savings and investment discipline that one otherwise would have put into making single premium payments on a permanent policy. In choosing between the two approaches, one might also consider differences involving the ability to take out policy loans and avoid taxes.
THE INVESTMENT COMPONENT OF INSURANCE VEHICLES
Permanent life insurance is typically broken down further into two additional categories: universal and variable life insurance.
Universal life insurance usually invests in fixed income instruments and hence is considered much more conservative than variable insurance. In running hypothetical examples for clients on my computer, the program usually assumes something close to a seventy year trailing historic bond real rate of return of around 2-3%. The rate of return assumptions in the computer software would probably change if we get more inflation.
Variable life insurance policies typically involve a menu of equity mutual funds as well as bond funds. The client selects from a menu to create and rebalance his portfolio much like running a 401K plan. Hypothetical programs typically assume rates of return around 3 or 4% above bonds. They typically suggest that a client can make smaller premium payments compared to universal life insurance plans and enjoy a faster portfolio value build up. However, there is a big catch here. Nothing is guaranteed. Variable insurance is riskier because stocks tend to be riskier than bonds. If the stock market underperforms the bond market, or the investor makes poor menu choices, the policy holder is stuck with the consequences. It can always turn out that in retrospect, a universal policy was the better way to go.
A WORD ABOUT INSURANCE ANNUITIES
The term “insurance annuity” originates from a vehicle offered by insurance companies that guarantees individuals a source of income for the rest of their lives. An annuity can be either a fixed amount of money received monthly, or a fixed number of shares of a mutual fund that fluctuate with the market. A person can buy an annuity with either an up front payment of funds, or one can accumulate funds over time by adding after tax dollars into a tax deferred vehicle called an “insurance annuity” and make an “annuitization” decision later.
The term “insurance annuity” usually means a tax deferred vehicle that is in the accumulation phase that is managed much like a 401K plan. After a period of accumulating funds, no one is ever forced to actually “annuitize.” One can choose to pass ones annuity on to an heir (and suffer some major tax consequences), or withdraw funds and pay income taxes on the gains just like the way one would withdraw money from an IRA.
Insurance annuities usually make sense for individuals who have already stuffed their Roth IRAs and 401K plans to their annual limits and need an additional tax-deferred vehicle to stash additional savings..
A Roth IRA can be superior to an insurance annuity because it allows tax free growth as opposed to tax deferred growth. After a certain age, a person can withdraw his funds from a Roth IRA without paying any taxes, whereas a person who withdraws funds from an insurance annuity must pay income taxes on the gains. Also, a Roth IRA offers the additional flexibility of being able to invest in individual stocks and bonds as opposed to being restricted to a limited menu of mutual funds, which is usually the case with insurance annuities and 401K plans
A 401K plan can be superior to an insurance annuity because it allows a person to make pre-tax contributions from his salary. An insurance annuity only accepts after tax contributions.
An insurance annuity can be superior to a Roth IRA and 401K plan for a risk averse investor. Most annuities offer some kind of downside protection guarantee. Some insurance annuities guarantee that the investor will always get his principal back even if the market crashes. Some have guaranteed minimum rates of return that step up over various time periods.
Insurance annuity guarantees raise an important issue. In my papers “A Bear Case Overview” and “Amidst Bullish Hoopla: A `Behind the Curtain’ Look at Fed Desperation and Intervention Wizardry” I discuss the underlying nature of America’s bubble stock and bond markets. I talk about how certain major money center banks such as JP Morgan Chase and Citigroup may be overexposed to growing Third World debt, burgeoning unregulated derivatives, and other time bombs. Every so often one reads about insurance companies that make bad bets and go bankrupt. There are a lot of financial firms that cultivate the appearance of being rock solid and being too big to fail that could possibly turn into Enrons if America experiences a serious and prolonged economic downturn. They are typically run by management teams who are more interested in looting their companies with exorbitantly high salaries, stock options, and other perks in the short run and think they can walk away with a nice nest egg even if their companies crash in a few years, therefore they are willing to promise consumers much more than they can realistically deliver in the long run in order to rapidly grow their businesses in the short run at any price. I would be leery of insurance annuities guarantees that sound too good to be true.
Variable life insurance policies and insurance annuities typically offer a menu of mutual funds that the investor can allocate to try to maximize investment growth, much like managing a 401K plan. In fact, the investment issues are usually identical to managing a 401K plan.
The problem with most mutual fund menus offered by most 401K plans and insurance companies is that they tend to be analogous to the proverbial generals who are always most proficient at fighting the last war, and relatively clueless about handling new wars.
As one might expect, by the end of the 1960’s, most mutual fund menus were geared towards the 1960’s environment of a general bull market in stocks and not the decade ahead. By the end of the 1970’s, mutual fund menus were geared towards the stagflationary 1970’s environment of a falling or sideways general stock market and rising commodity prices and not the decade ahead. By the end of the 1980’s, most mutual fund menus were geared towards the 1980’s environment of a rising general stock market. However, this time there was an anomaly, and investors who navigated by the rear view mirror image of the trailing ten years had dumb luck on their side. The general stock market kept going up through the 1990’s. The market was buoyed by an unusual confluence of factors such as growing household participation in the market, post cold war optimism and the “peace dividend,” the increasing tide of Baby Boomer funds available for investment, the excitement of the internet and telecom revolutions, and the increasing latitude for massive financial reporting fraud. As I explain in my papers “A Bear Case Overview” and “Amidst Bullish Hoopla: A `Behind the Curtain’ Look at Fed Desperation and Intervention Wizardry” we also saw continued reckless deficit government spending, brazen government and Fed interventions, and some of the most aggressive credit expansion and monetary creation policies in history. Given the issues addressed in my papers, and the way the markets and economy have been slipping since 2000, I think that an investor would be very unwise to invest according to the rear view mirror image of the 1992-2000 bull market. I see a repeat of the stagflationary environment of the 1970’s which favored commodities and foreign investments, only this time I think that both the magnitude of the domestic economic crisis and the level of inflation will be much worse.
WHERE DO WE GO FROM HERE?
If you already own insurance products, you might consider alternative insurance providers who are better equipped for handling the challenges ahead. A next step might be to arrange a 1035 exchange. Such an exchange allows one to exchange the value of ones current holdings in an insurance vehicle into a comparable vehicle carried by a difference insurance company with superior menu choices. Needless to say, we want menu choices that look through the front windshield rather than stay fixated on the rear view mirror.
Flag carried by the 3rd Maryland Regiment at the Battle of Cowpens, S. Carolina, 1781
William Fox. Sometimes
William Fox offers viewpoints that are not necessarily his own to provide