Last year in 2017, apart from the Bitcoin question, another most frequently asked questions was "should you use life insurance as an investment". Even though investing through a life insurance policy doesn't have a good reputation among fee-only financial planners in general, I believe there is neither a bad investment vehicle by default nor a good investment product or methodology for everyone. It is to understand the pros and cons of all your options and then make an informed decision based on your specific situation. Hope this blog could help when you are approached by an insurance agent next time. Today's post is the first of two parts and covers the Participating Whole Life Insurance and the Current Assumption Universal Life Insurance.
In general, life insurance falls into two categories: term life insurance and permanent life insurance. For term life insurance, you are paying for the death benefit, period. For permanent life insurance, in addition to paying for the death benefit, you are also investing some money through the insurance company with additional cost.
The selling point of using permanent life insurance as an investment is that you don't have to pay income taxes on the money you earn from the policy or the money you loan out from the policy. The latter is usually not available in other types of investment vehicle besides real estate. In other words, you don't have to pay income tax when you borrow your own money out of your insurance policy. Tax is a very important consideration in investing. People tend to save taxes as much as they can. However, you should never let the tax tail wag the investment dog. Instead, you need to focus on how much money you could get after taxes rather than the tax itself. No one could predict the future. But to have some reasonable expectations, you at least need to have some basic understandings about how the insurance company is going to invest your money first. Let's go through some popular types of permanent life insurance that are being sold as investments.
1. Participating Whole Life Insurance
This is a type of permanent life insurance that pays so-called dividends. Are the dividends generated from the additional money you give the insurance company to invest? Not really. With this type of policy, after paying all the policy charges, the value of the money left in your policy will be guaranteed to increase at a very low rate. The dividends are actually coming out of the profits of the insurance company. When an insurance agent tells you the policy pays 6% dividends, it does not mean that you will earn 6% from your money. It means that the insurance company will pay out 6% of their profits to all policyholders having the same type of policy. How much will you get? You won't know until you receive the dividends.
The next question is where the insurance company's profits come from? Without a doubt, they come from the insurance premiums. Some of them may be generated from the excess interests they earn by investing your money. Most of them come from policy charges that policyholders pay. Not surprisingly, the internal policy charges on this type of policy are notoriously the highest and the most non-transparent among permanent life insurance. In other words, from an investment perspective, you are giving your money to the insurance company and hoping they could share with you a decent percentage of the profit they earn from you and other customers. Another way of proving this point is the IRS treats the dividends from a Participating Whole Life Insurance as "return of premium" instead of taxable gain as long as they do not exceed your total paid premium amount.
In my opinion, a participating whole life insurance policy rarely makes sense to me unless you need both life insurance and an account that requires you to save money at the same time. It could be beneficial in certain cases, but for most regular investors, you have better options.
2. Current Assumption Universal Life Insurance
This type of policy is relatively straightforward. The premium will cover the policy charges first, and these costs are relatively more transparent and probably the lowest among permanent life insurances. The rest of your money will be added to the insurance company's general investment account. The money is usually invested conservatively in a diversified fixed income portfolio consisting of bonds and mortgage-backed securities. The insurance company will declare an interest rate every year and credit the interests to your account based on the overall performance of the portfolio. The credit rate fluctuates over time and differs between insurance companies. As of 2017, the rate is usually between 4% - 5%. Considering the current economic environment with historically low-interest rate, it is a very attractive return as a standalone investment, especially after taxes.
I have two concerns about this. Firstly, you are buying insurance, so you need to pay policy charges first. Even though the total policy charges of this type of policy is a lot lower than a whole life policy, 4% rate of return still won't be enough to make it a great investment compared to other alternatives. Secondly, neither current policy charges nor current declared credit interest rate is guaranteed. The insurance company does have a cap on fees and a guaranteed minimum interest rate, but generally, the insurance company has the discretion to charge you more or give you less without obtaining your approval. It is possible that they charge you less or give you more if they would like to, which I have seen it happened before. The point is they have the control, not you. Regarding investing, I am a firm believer in the capital market and the concept of focusing on what you can control, which you could learn more it here. I certainly do not like an investment when someone else has discretionary control on both the costs and the returns. I bet that the insurance company will never lose before you.
In my opinion, a current assumption universal life policy is much more transparent than a whole life policy from both the cost and return perspectives. However, it does not worth the risk of losing so much control to invest in a conservative portfolio through an insurance company.
Next week, I will cover one of the most popular and probably also the most overly sold type of life insurance policy on the market: Indexed Universal Life Insurance (IUL). I will also share with you some key takeaways to help you decide whether you should invest through a life insurance product in general. Stay tuned!