The Best “Boring” Money Can Buy
By Tom Wall
What if your clients could get bond-like returns over time, but without taxation or volatility? Would that allow them to take more risk elsewhere with other volatile asset classes? Would it help them minimize taxation of their portfolio over time? Through one of the financial services industry’s best-kept secrets, your clients may be able to do exactly this.
By the grace of Congress, permanent life insurance enjoys three uncommon income tax advantages.
- The first is the death benefit, which is generally payable income-tax free to beneficiaries.
Beneficiaries will almost always receive far more in death benefits than has been paid in policy premiums. This “inevitable gain” of life insurance is not taxed, meaning one can multiply their assets by many times and not owe the IRS a dime.
- The second is FIFO (first-in, first-out) accounting, meaning you can get your cost basis back first before recognizing gains.
Cash values always grow tax-deferred, but what’s uncommon is that in a non-MEC life insurance contract, one can withdraw up to their cost basis (the sum of all premiums paid) before having to recognize gains. This is often discounted by clients, but most other investment vehicles require one to recognize gains each year, or at least withdraw (and pay taxes on) gains before getting basis back.
- Third, policy loans provide unlimited tax-free access to cash values.
Policy loans can be taken from a non-MEC contract without taxation. This can allow someone to access cash values above cost basis and still not pay any income taxes. Congress allows this because interest-bearing loans will indeed be paid back at some point, either while alive, or when subtracted from eventual death benefits. This is the unique provision that can allow one to get back many times their contribution without owing any taxes.
But tax-advantages are only half the story. Through the whole life insurance contract, one is guaranteed cash value growth each year that is enhanced by dividends. With dividends, one participates in the investment performance of the company. A return of mortality and expense charges is part of the dividend as well, but over time these are far less significant than the investment component. Thus, the term “participating” whole life insurance means that one can enjoy the upside potential of the company’s investments, but be guaranteed their cash value will rise regardless of that performance.
Below you can see the general investment account of a major mutual today. Highly rated long-term corporate bonds and mortgages make up most of the account, with cash and loans to policy owners also combining to make about three quarters of the account allocated toward fixed income. In my last post, I described how bonds may suffer due to a rising interest rate environment, but large insurers are insulated from interest rate risk because they don’t need to sell their bonds. Bonds purchased by major insurers are to back up liabilities (death benefits) promised decades down the road. While interest rate changes would impact the mark-to-market value of the bonds in the general investment account, holding them to maturity allows the company to continue to collect the coupon payments (interest) on the bonds before eventually receiving all their principal back. Only the wealthiest individual investors can take a similar approach, but generally without the favorable tax wrapper that whole life insurance provides. Add the earnings of other subsidiary businesses (“Common & Preferred Stocks”) to the modern mutual portfolio, and you essentially are looking at a diversified income fund that operates for the long-term upside benefit of policy owners while providing reserves for contractually guaranteed benefits.
Thus, the general investment account of a major mutual insurer acts much like a bond ladder, with changes in interest rates positively correlated with the portfolio average rate. Put differently, as interest rates rise, the fixed-income portion of the portfolio will average in those higher rates and bring the income up. This will lead to a higher dividend interest rate over time, as it has in the past. Conversely, a declining interest rate environment (like we’ve seen for the last four decades) will lead to lowering the portfolio average, and a declining dividend rate. In the chart below, you can see how one of the biggest mutual insurer’s dividend performance reacted to changes in the interest rate environment for corporate bonds. The correlation is extremely strong, with a bit of a lag as one would expect.
Going forward, interest rates are going to stay low or rise over time. While rates can certainly go lower or slightly negative in the short-term, there is a limit to how low they can go, and they’ve never been lower than they are today. Via whole life insurance, one can obtain annual performance that is roughly the rolling average of the long end of the yield curve, but with nearly complete access through loans, and no concern with volatility due to guaranteed cash value increases. The traditional tradeoff of long-term yields and liquidity doesn’t apply to a mature whole life contract. The economics of this are demonstrated effectively in the chart below of gross dividend interest rates of a sample major mutual insurer compared to indexes over the last several decades.
One could have indeed gotten bond-like returns, but without any of the volatility or taxes. And that’s the holy grail that the smartest minds on Wall Street are looking to figure out – better risk-adjusted returns. If we can obtain similar returns with reduced risk, then we’ve done a better job for our clients. And if those clients were ok with that original risk level, then perhaps the reduced risk of participating whole life insurance can increase their comfort with taking greater risk on other investments.
This is truly the golden age of whole life insurance, with today being the best environment in 80 years relative to alternatives like bonds and cash. In the 80’s and 90’s, stockbrokers cold called clients to pitch them on stock tips and investment ideas. Modern investing no longer looks like that, but investors today are struggling with how to allocate the conservative portion of their portfolio considering low rates. Instead of reaching for more risk, as many are today, there is an opportunity to diversify into an asset that historically has demonstrated positive out-performance in persistently low or rising interest rate environments. You could proactively reach out and instead of offering stock tips like the brokers of the past, you could offer “bond tips,” adding value to an underserved and riskier-than-ever portion of their portfolio.
In short, we all need “safe stuff” in our portfolio. We need boring, predictable assets so we can take appropriate risks with the rest of our money to grow wealth and fight inflation over time. Whole life insurance, particularly in today’s all-time low interest rate environment, just may be the best “boring” money can buy. Be the hero for your clients and let them in on the best kept secret in the business.
- Tom Wall
