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In my first days in the industry, at the bright young age of 20, I was taught to present cash value life products with two great benefits: the first being a measure of protection for the family, the second being a source of cash. “Mr. Smith, you pay the premium and have protection for the family, but look at all this cash available to help you with your retirement when you get there. You can even access the money on a tax-preferenced basis!”  Now, after several decades of experience, I’ve discovered that life products used for these purposes are both a severely overpriced term insurance contract and a very underperforming investment.

Using some numerical engineering, we can easily determine the true cost ramifications of an insurance policy by dissecting the following illustration. Suppose we are using a product that is illustrating an 8% return and, at the beginning of year five, we have $50,000 in illustrated cash value and also deposit another $10,000 in premiums. Absent any costs at the end of the year, we would be illustrating $64,800 ($50k + $10k + an 8% return). If the illustration projects our end of year value to be $60,210, it is quite apparent then that our costs are $3,590 for “protection” for that year. (The $64,800 we should have had less the $60,210 the illustration suggests we will have.) If we compare the cost of protection in that year to a term insurance cost, chances are likely the term insurance would be considerably less.    

Surely no one in our industry should consider life insurance — even variable life products — a good investment unless also taking into account the tax advantages that can be derived from a properly structured contract. Frankly speaking, the insurance “protection” costs will far outweigh any advisory fee or similar costs associated with mainstream investment options. And generally speaking, we should not be considering cash value products a good monetary value as a protection vehicle either, unless the protection needed goes into the post-retirement upper ages, such as in the case of estate planning needs or pension maximization strategies.

See also: Adding Values to the Boomer Estate Plan

My suggestion to younger clients is that there should not be a need for life insurance as a protection vehicle (absent the estate or pension scenarios) in retirement. If the couple saves adequately for their retirement, there should be enough for just one of them should the other pass early in retirement. Thus, the need for life insurance as a protection vehicle gets reduced to a pre-retirement time-frame — or perhaps just until the kids get past college. If you analyze the true protection costs of a cash value contract for, say, 30 years and compare that to the cost of a 30-year term contract, chances are extremely high the term insurance would cost less. Of course, there are other factors that a “numerical engineer” should take into account, such as the future surrender value of the cash value contract compared to the future value of the excess premium invested in mainstream investments, etc. The point, however, is that we have a duty to the client to do a thorough job of analyzing the true contractual costs. 

Suppose I were to suggest that you could make an investment of $100,000 into a vehicle that had mutual funds choices, and that, each year, you could take the yield out without being taxed. The caveat? You would be required to pay a $50 annual fee. Also, in this scenario, your family stands to gain $101,000 if you passed away. Would that proposition be attractive to you?

Now consider this scenario. You acquire a $101,000 life insurance policy with a $100,000 deposit. The annual earnings less the true costs of the $1,000 “at risk” (the amount the insurance company is at risk over and above your deposit) could be obtained through tax-free life insurance zero net cost loans. Would that also be attractive? It should be, because it is the same thing. When comparing the $50 cost in this example to the tax implications of an 8% gain on $100,000, the difference is proportionally staggering, especially when compounding that year over year.  

The problem with my question however, is that since TAMRA, TEFRA and DEFRA legislation came to be in the 1980s, we cannot have that any more. You cannot immediately deposit $100,000 into a $101,000 policy.  You can, however, work your way into that scenario over time.

Since there is apparent value once you would arrive at that point, the obvious question then becomes, “What does it cost you to get there?” Keep in mind when we look to obtain our goal in this scenario, we are really trying to minimize the amount at risk, or the insurance element, as much as the regulations will allow us to, in order to minimize the erosion to our return from insurance costs. For many, the alternative erosion comes in the form of income taxes, capital gains taxes or a combination of the two. So it then comes down to a choice of tax erosion or erosion of insurance costs.

In our office we’ve created a spreadsheet to help analyze the true annual insurance costs. Once costs are determined, we then compare those costs to the erosion to an investment that would come from paying income taxes on the assumed gains, using various tax rates. Utilizing a level death benefit product and putting as much inside the contract as the regulations allow, we find with consistency that the insurance costs erosion annually tends to level out, and then decline as the cash value grows and the amount at risk shrinks. The tax erosion, on the other hand, will grow continually as a taxable account value grows. Using a spreadsheet to illustrate an 8% return and a 28% tax rate, it is quite common for the tax costs to start exceeding the insurance costs within the first 4–6 years. The spread between the two gets wider each and every year.  

The easy question I ask my client who has a good amount of long-term investment funds in a taxable account is, “Would you prefer erosion to your earnings as a result of paying taxes, or as a result of paying the insurance company and having a benefit for your family should something unexpected happen?”

My philosophy is that the tax benefits of life insurance as an investment are only bested by a Roth IRA or Roth 401k. I also believe that, for a life contract to be efficient, it is essential to determine its purpose. If it is for protection, we should be acquiring the least expensive product we can that meets our protection objectives and timeline. This usually means term insurance. If it is for tax-advantaged investment purposes, we should be looking to minimize the protection benefit of the contract as quickly as we can, to get erosion to the overall yield by insurance costs to its lowest level, and thereby maximize the return net of all costs. In other words, we should be depositing every dime we can as allowed by the regulations, and as quickly as we can. Gone should be the days of advisors trying to sell it both ways, as protection and an investment. This approach delivers both overpriced insurance and inefficient investing.