By Boyce F. Lowery, CLU, ChFC
If you’re generally familiar with the world of personal finance and the various strategies available in the marketplace, you are probably aware that life insurance isn’t just used to protect against the financial consequences of premature death. It can also be used very effectively as a cash accumulation and tax advantaged financial tool.
For the truly informed consumer, a “properly designed” life insurance is a very popular choice because it can provide income-tax-free cash flow in future years while eliminating market risk. With income tax rates likely to increase in future years, having tax free cash flow could become even more valuable down the road.
So, what are a couple of options available for those looking to use life insurance as an accumulation vehicle?
For Those Who Want a Conservative Approach
If you are wishing to be conservative with some portion of your funds and want to use life insurance as part of that strategy, you can have guaranteed minimum growth rates on your cash and non-guaranteed returns on cash that could provide internal rates of return from 3% to 5% over time. This conservative approach uses whole life insurance (not fixed indexed universal life). Using whole life insurance allows funds to be available for an important market volatility buffer down the road when your equity-based or other assets that are subject to market risks are down in value. When you need money and your market-based assets are down in value, you can access cash from your insurance policy instead of the market to protect from eventually running out of money during retirement. The risk of having to take withdrawals from an investment account during a down market is called sequence of returns risk and is especially dangerous at the beginning of retirement. Having a source of cash with guaranteed returns and no market risk can be a great planning and hedging strategy to mitigate sequence of returns risk. Though not the purpose of this article, it has been mathematically proven that having a whole life policy as a volatility buffer can lead to higher overall returns for a consumer during their retirement years.
Looking for Potentially Higher Returns?
For those that want potentially higher returns than a whole life insurance policy offers, there is a different option. You can get the tax-free cash flow available from an insurance policy with greater potential for returns through the use of fixed indexed universal life. If you’re the kind of person who wants low risk, potentially high returns, no income tax on asset gains, and protection from creditors, then this may be the strategy for you. You get the benefit of knowing that your family would be financially secure if something happens to you and the peace of mind that comes from knowing that this portion of your money is not tied to the whims of the market.
As financial advisors, how do we help clients like this who are looking for low risk and potentially higher returns? Let me explain how that’s possible in today’s economic environment of extremely low interest rates and highly volatile markets.
For qualified clients, we incorporate a specially designed and specific type of fixed indexed universal life insurance policy into the mix. It can’t be just any fixed indexed UL product and it can’t be an “off-the-shelf” design. It must be customized to the client’s unique needs and, more importantly, it has to be from the right insurance company. You may ask how a life insurance product could possibly provide one with low risk, potentially high returns, and tax advantages? Let’s see.
How Insurance Companies Invest
First, some background information. The latest information we have on the average asset allocation for the general accounts across all U.S. life insurers is as follows:
Bonds – 68.9%
Mortgages – 11.9%
Policy Loans – 2.9%
Stocks – 2.2%
Cash and Equivalents – 1.7%
Derivatives – 1.3%
Short Term Investments – 0.7%
Real Estate – 0.5%
Other – 4.8%
Non-Invested – 5.1%
As evidenced by the above information, life insurance companies are generally heavily invested in bonds. So, let’s take a look at current bond yields available for insurance companies who are putting new money in investment-grade paper:
Aaa Corporate bond yield 2.37%
Baa Corporate bond yield 3.47%
10 Year U.S. Treasury Note 0.79%
30 Year U.S. Treasury Note 1.63%
As you can see, things aren’t looking very lucrative from a yield perspective in the bond market right now. Yes, bond yields are paltry by historic standards, yet life insurance companies still heavily invest in bonds because they are conservative and liquid. Life insurance companies have to have liquid reserves available to meet cash needs that arise from policy owner claims, withdrawals of cash from policies, and policy loans.
Of course, not all of a given life insurance company’s general account assets was invested at these low rates. A good portion of a life insurance company’s portfolio was invested at somewhat higher rates years ago, so the overall yield of a life insurance company’s general account might presently be in the 4% to 5% range, by way of example.
How the Right Life Insurance Product Can Provide High Yields
Now that we know life insurance companies invest very conservatively and they are doing so in a very-low-interest-rate environment, how can they possibly credit policies with interest rates in a given year at a 5%, 10%, or even a 20% (or higher) rate? Let me provide you with a broad overview.
The type of life insurance policy is the starting place. To have an opportunity for high-interest-rate crediting, with no market risk, you have to be using an indexed universal life plan. With such policies, the interest rate is tied to an underlying index. Some companies have more than one index from which to choose and allow diversification across their index options.
A life insurance company that offers indexed universal life will take a portion of their portfolio yield to cover some of the insurance company’s overhead expenses and profits and will use the remainder of the yield for their index options budget. The options budget is used to purchase options on various indices for the sole benefit of policy owners. If the underlying index does well over time (usually over a 12-month segment measured at the beginning of the segment and then again at the end of the segment), the insurance company will then pay interest to the client equal to the increase of the index, but usually subject to a cap. Some index options actually provide for a multiple of the index gain in percentage terms, such as 150% of the index gain and with no cap on the upside.
Most, but not all, life insurance companies use the S&P 500 Index as one of the index options on which they purchase options. Those options they purchase then allow the insurance company to provide the client a floor interest rate (typically 0%, but sometimes a little higher) for all policy years in addition to all of the upside if the underlying index does well, but again usually subject to a cap.
Where to Find the Greatest Potential Return Without Market Risk
Because low interest rates bring down portfolio yields for life insurance companies, they have a relatively small options budget with which to purchase options. That being the case, where can clients get the most upside potential without taking on market risk?
The most competitive life insurance companies in today’s environment have index options that are volatility controlled, meaning the cost of those options is much less expensive because of the very low volatility of the underlying index, relatively speaking. This lower-volatility/lower-cost option means there can be far greater upside opportunity for clients, which can lead to potentially much higher interest rate credits. For instance, in 2019, there were interest rate credits that exceeded 25% for indexed universal life policies with the right company and the right index options chosen. That’s quite the return, given that there was no market risk to the principal for the policy owner.
Because the S&P 500 Index has been so volatile, option costs on that index are very expensive. With life insurance companies having relatively low yields on their general account assets, that also limits how much cash is available for them to spend on option purchases on the various indices. Having one’s interest rate tied to the S&P 500 Index inside an indexed universal life policy may not be the best place to be at present time because of the high option prices and limited funds for those options which drives down the potential for higher interest rate credits. Insurance companies do generally allow policy owners to switch their index allocation at specified times inside the policy contract. However, many life insurance companies only have index options priced off the S&P 500 Index.
One particular company not only has multiple indices from which to choose, it will actually allow policy owners to lock in their gains during a given policy year for specific index options. This can be a huge benefit in certain circumstances.
How We Can Help
Everyone’s situation is different and you need a knowledgeable professional to determine what plan design is best for your specific needs. We are independent advisors who continually search the marketplace to find the best value for each client based on their unique circumstances and their objectives. If you already own an indexed universal life contract, we can help you determine what steps you should take to enhance your returns. If you don’t have a properly designed indexed universal life plan or whole life plan and want to learn more, we’d be happy to provide you that information. Simply call us at 888-827-0146.
Boyce Lowery is a 40-year veteran and established expert in the insurance industry. As the managing partner of Suncrest Advisors, he, his partner, and their associates all aim to provide financial security and peace of mind to business owners, executives and professionals, and high net-worth individuals across the United States. Along with more than four decades of experience, Boyce is a Chartered Life Underwriter® (the premier designation for insurance professionals signifying specialized knowledge in life insurance and estate planning) and a Chartered Financial Consultant® (known as the advanced financial planning designation). To learn more, visit https://suncrestadvisors.com/ or connect with Boyce on LinkedIn.