One of the questions we get about how we structured MAP is why we use cash value life insurance. Wouldn’t it be better to advise members of the middle class to buy less expensive term insurance and put together a portfolio of zero coupon bonds.
We believe our solution is better for our demographic. Here’s why.
What the Critics Say About Whole Life Insurance
Many critics of whole life insurance argue that it should not be used as an investment vehicle. These advisors recommend the purchase of term insurance and investing the difference between the cost of
This advice assumes the rate of return in an investment account will outperform the guarantees associated with cash value whole life. This may be true for a disciplined,
It would be fairer to compare the future accumulation of guaranteed cash value with the payout from a zero-coupon bond of similar credit-rating. A zero-coupon bond provides a guaranteed payout at maturity. For example, a 30-year zero-coupon bond with a yield of 4% and a par value of $5,000 can be purchased for $1,542. The bond will mature in 30 years for the par value of $5,000, provided the issuer doesn’t default on the debt obligation.
A very highly-rated insurance company and a very highly-rated municipal bond issuer will have
Replicating Cash Value with a Bond Portfolio
Suppose a bond portfolio can be assembled to replicate the expected payout of a whole life policy at a pre-determined date. This would be a fair
Assume John is 35 years old and purchases a $250 000 whole life policy, with an annual premium of $4,576. His accumulated cash value at age 65 is expected to be $226,404, assuming 75% of the current dividend scale is paid out in the future. This assumption reflects the anticipation of lower dividend payments over the next few years resulting from the historical low-interest rate environment.
Assume Kate wants to purchase a comparable amount of term life insurance coverage, and replicate John’s cash value by purchasing bonds each year, in small increments, maturing when John turns 65. Kate’s budget is $4,576 per year, which is the same as John’s.
We assume the yield on a 30-year AAA-rated municipal bond is 4.0%:
In the first year, Kate is able to purchase $13,000 in 30-year zero-coupon municipal bonds for $4,008.14. This price doesn’t include any
At the end of twenty years, Kate’s term policy has expired and she will need to purchase a new policy. Fortunately, she hasn’t developed any health conditions so she’s able to purchase a 10-year level term policy, with comparable coverage to John’s whole life policy. The new term policy will cost her an annual premium of $1,679.36. Kate now has less money left over to purchase bonds. John is now 55, so Kate needs to purchase 10-year zero coupon municipal bonds, which offer a lower yield than 30-year bonds. She is only able to purchase $3,000 worth of bonds for $2,254.83, assuming a yield of 2.90% on the bonds. With the remaining $2,321.17 left in her budget, she pays her annual term premium of $1,679.36 and puts the rest in her savings account.
By the time John reaches age 65, Kate has purchased 200 bonds with a face value of $1,000 each. Her total bond payout of $200,000 is
The cash value in John’s whole life policy has grown to $226,404. His original principal of $137,280 is tax-free. John can withdraw his principal first, thereby deferring his tax liability into the future. Assuming Johns ordinary income tax rate is 20%, his after-tax balance is equal to $208,579.20.
John’s cash value is about the same as Kate’s.
Cash Value Advantages are Often Over-Looked
Whole life insurance is easy to implement. Once purchased, it becomes fairly routine to maintain. Premiums are paid every month and the cash value grows on a guaranteed basis. The advancement of data analytics in the industry has lead to new accelerated underwriting platforms designed to rapidly speed up the underwriting process, making it less invasive for most applicants.
Whole life is much less intimidating and less costly for a consumer to manage than a traditional retirement portfolio. There are no asset requirements or AUM-based fees going to advisors. There are no unexpected surrender charges.
Participating policies provide potential dividend payments from the insurer, which can be automatically converted into paid-up additions on the policy. Paid-up additions increase both the cash value and the death benefit on the policy without any action required by the owner of the policy. The amount of the dividend may vary depending on company earnings, but many highly rated mutual insurance companies have a very long history of paying dividends. Strong dividend performance can boost the rate of return on the policy.
Cash value is liquid and can be accessed via a withdrawal of the gain, a partial withdrawal of the basis, or a policy loan. The bonds described earlier generally need to be sold in order to convert them to cash. The bonds may incur a market value adjustment based on prevailing bond rates. This is a hidden risk in the municipal bond market.
Interest Rate Risk
The cash value is guaranteed, while only the future dividend is subject to the risk of changing interest rates. Bonds purchased in the future will be subject to the current yields offered at the time, which could be higher or lower than the yields offered today. Similarly, liquidating a bond may result in a gain or a loss depending on prevailing interest rates. Gains may be subject to capital gains taxes.
Cash value accumulations are tax-deferred. Withdrawals can be made from the policy up to the cost basis without incurring any tax liability. After the cost basis is withdrawn, the gains can be accessed and are taxed as ordinary income. Cash value policies also provide tax-free loans, if the loans are paid back on time.
Municipal bonds do offer unique tax advantages that other bonds such as corporate bonds do not. However, there are many exceptions to the tax qualifying status of municipal bonds. Typically, only local municipal bonds receive the
Cash Value Whole Life is a Better Choice
Both zero coupon bonds and cash value life insurance are viable options for implementing MAP. On balance, we concluded that using cash value life insurance over a long time-horizon is a better choice due to its simplicity and ease of implementation.
It can be difficult to quantify the value of peace of mind. MAP works best for those who are willing to sacrifice the possibility of higher expected returns from the stock market, for a steady increase in cash value. It is an alternative that reduces irrational investor behavior and creates a glide path to retirement with much less uncertainty and decision making post-implementation.