Less Filling, Greate Taste

"The debate over whether cash-value life insurance can provide significant investment potential is marked by misinformation and biased arguments from both sides. Our columnist looks at when cash-value life insurance can compete with other investment options."

Like "less filling" versus "great taste," the debate about whether cash-value life insurance has significant investment potential continues to rage. The combatants are familiar to us because they are the same ones who battle over term versus permanet (cash-value) life insurance. In one corner are CPA's financial planners, and the media who argue that cash-value life insurance is a poor investment. In the other corner are life insurance salespeople who argue that cash-value life insurance not only is a great investment idea, but is the sine qua non of a civilized society.

Like a good political debate, this dispute about whether cash-value life insurance is a good investment features few accurate and balanced arguments. Those who argue against life insurance as an investment frequently compare whole life (supported primarily by intermediate corporate bonds, held for their yields) with a perfectly timed strategy of blithely maneuvering amoung high-flying stock markets stretched across the globe. The reality is, if the non life insurance investment is going to be stocks, then the life insurance competitor should be allowed to be variable life where a similar investment strategy can be followed. Or the life insurance (universal or whole) investment should be compared with a similar investment strategy of holding corporate bonds for their yields.

An important issue critics of life insurance fail to note is the favorable tax treatment its cash values reveive. The cash-value buildup is tax-deferred (unlike the gains realized in a stock or bond fund) and cash value can be withdrawn on a first-in, first-out (FIFO) basis; that is, withdrawals are not included in income until they exceed the cumulative premiums paid (unlike the LIFO treatment of partial withdrawals from annuities where they are included in income on an interest-earned-first basis).

On the other hand, the proponents of using life insurance as an investment sometimes fail to moderate the potential buyer's expectations. Rather than being careful to present projected policy values that are reasonable, they too often make exaggerated future policy-value promises. This is a familiar problem and is common to all purchases of cash-value life insurance.

An additional issue that is not handled well by some who push life insurance as an investment is that excess income should first be allocated to tax-deductible investment opportunities, such as simplified employee pension plans (SEPs). If tax-deductible investment opportunities are available, they usually should be maximized before any life insurance investment is considered. However, some life insurance salespeople either do not make the effort to determine if such tax-deductible investments are available, or they argue that contributing after-tax income to life insurance is better that contributing before-tax income to a qualified plan.

Another distortion is that many salespeople hype life insurance as the ideal retirement-income investment by promising entirely tax-free retirement income via net-zero policy loans. "Interest-free" policy loans are questionable for three reasons:

Finally, some life insurance salespeople fail to discriminate between potential buyers who have an objective need for the death-benefit protection and those who are only buying life insurance because of the investment promises. When the policy's selling, administrative, and mortality costs are factored in, life insurance does not work as well. However, if the death-benefit protection is needed, then either the value of the protection being provided, over time, or the actual death benefits add to the new rate of return, making life insurance a reasonable investment possibility.

The ideal client for using cash-value life insurance as an adjunct to other investment vehicles is a high-income earner in his or her 30s or 40s. Typically, this type of client has sufficient cash flow to fund all availabe tax-deductible investment opportunities and still have investable funds available. Also, this client ganerally has an objective need for a significant amount of death-benefit protection in the event the client has the bad judgement to die before acuumulating significant invested assets to take care of his or her family.

Our client, Ted, is 40 years old and in excellent health. He is self-employed, earning $300,000 annually in a consulting business. He makes the maximum SEP contribution. Ted is married, with two children, 10 and 8. Taking into account his income-protection goals for his family in the event of his death, Ted needs slightly more than $1.5 million of life insurance. We agree that this need will probably decrease in the years ahead as his obligations decrease and his invested assests increase. Therefore, Ted decides to purchase $1 million of term, split nearly equally between 5-, 10-, and 15-year level policies. These policies will be owned by and payable to an irrevocable trust.

In addition, Ted decides to purchase a super-funded universal-life policy with annual premiums of $20,000. The minimum increasing death benefit these premiums will buy without causing the policy to be a modified endowment contract is approximately $625,000. The policy will be owned by and payable to his self-trusted revolcable trust. Although the policy could help in providing for educational costs from current cash flow. Therefore, he views this policy's investment role as providing for additional retirement income.

Table 1 shows the projected policy values, based on current pricing conditions (using an investment-yield assumption of 7.28 percent, which translates into about a 6.0-percent interest crediting rate).

TABLE 1 Projected Policy Values, Low Load, Universal Life
40-Year-Old Male Nonsmoker $626,805 Increasing Death Benefit Annual Premium: $20,000
Age	Premium	Cash Value	Death Benefit
45	$20,000	$ 112,086	$ 738,891
50	20,000	262,159	888,964
60	20,000	759,642	1,386,447
65	20,000	1,148,383	1,770,188

Based on current pricing conditions, Ted could begin withdrawing $100,000 annually at age 65. Withdrawals the first five years are considered a return on principal and not included in income. Withdrawals thereafter would be considered income. If Ted were in a 35-percent marginal income-tax bracket, his net retirement income from the super-funded policy would be $65,000 annually, beginning at age 70. (Note that none of the funds received from the policy are considered loans. At least for prospective planning purposes, I ignore the idea of interest-free loans.)

Based on current pricing contitions, this retirement income from the policy could continue to age 95 with substantial values still remaining in the policy. Table 2 shows the projected policy values during the period of time $100,000 is being withdrawn annually from the policy.

TABLE 2 Projected Policy Values, Low Load, Universal Life
40-Year-Old Male Nonsmoker $625,000 Increasing Death Benefit $100,000 Withdrawals Beginning at Age 65
Age	Withdrawal	Cash Value	Death Benefit
66	$100,000	$1,106,462	$1,733,267*
75	100,000	719,243	833,267
80	100,000	572,542	651,169
85	100,000	480,661	579,694
90	100,000	453,599	576,279
95	100,000	542,884	573,312
* Death benefit changed from Option B (increasing) to Option A (level).

At Ted's death, the policy's death benefit will be paid to his trust. The proceeds will not be paid to his trust. The proceeds will not be included in the trust's income. When the premium payments, withdrawals, taxes paid, and death proceeds are combined, the projected after-tax rate of return (ROR) is 5.9 percent if Ted dies at age 75, 5.7 percent if he dies at age 80, 5.9 percent if he dies at 85, or 6.0 percent if he dies at age 90.

Computing the actual ROR is not as important as computing the percentage of ROR to the investment yield that supports the policy, because the investment yields will fluctuate. As a percentage of the investment yield supporting the policy (7.28 percent for this example), the after-tax RORs are 80 per-cent if Ted dies at age 75, 79 percent if he dies at age 80, 80 percent if he dies at age 85, or 83 percent if he dies at age 90.

These are after-tax returns worthy of consideration, especially when the death benefits the policy provides are otherwise needed. If Ted had wanted to be more aggressive with this super-funded life insurance policy, he could have purchased a variable-life policy, investing the cash values in equity funds until retirement, the switching to a bod fund to better conserve his cas value. Again, we would expect the same after-tax ROR percentages to the underlying investment yeild.

Cash-value life insurance can compete with other investment possibilities as long as:

Reprinted with permission by the Financial Planning Association, Journal of Financial Planning, Volume 8, Number 1, January 1995.

Peter Katt, CFP, LIC, sole proprietor of Katt & Co., is a fee-only life insurance adviser located in Kalamazoo, Michigan (269.372.3497).