November 22, 2017

Variable Loan Options in Life Insurance Policies: Good or Bad?

Cash Value Life Insurance

For years, many advisors have sold life insurance to clients as an “investment” to help them build their wealth in a tax-favorable manner and receive it tax free via life insurance policy loans. This can work out as a terrific financial and estate planning tool when done right (especially when coupled with equity harvesting and the 1% CFA mortgage).  This newsletter is not about how to properly setup a policy as a wealth building tool and instead will focus on the more narrow topic of using Variable Loans when accessing cash from a policy in retirement.

Type of Life Insurance

This newsletter is also not meant to debate the different types of life insurance policies.  My personal preference for clients looking to build cash in a life policy in an Equity Indexed Life Insurance (EILI) policy.  I like EILI because the policies have a minimum guaranteed rate of return every year and peg the growth to the best measuring index (S&P 500).  As many of you know, I also like the EILI which credits 140% of what the S&P 500 returns each year (which will come into play in the following discussion).

Tax-Free Growth

As stated above, clients purchase “cash-value” life insurance on the theory that it will work out as a good long-term “investment.”  When this concept is initially introduced to a client it doesn’t make the most sense. How can a life insurance policy which has loads create more retirement income than simply putting money in a brokerage account?  The rather simple and short answer is that in a life insurance policy, as the cash in the policy grows, there are no annual taxes due on the growth of the assets (no dividend or short- or long-term capital gains taxes).

Policy Loans

When accessing cash from a life insurance policy, clients simply “borrow” money from the policy.  Loans are not treated as income and, therefore, you often hear the term “tax-free income” when referring to policy loans. This however is a real live loan where interest is charged on the borrowed money.   Policy loans and “wash loans” are not the easiest things to explain, so I’ll do it with an example.

Example

If you have $200,000 worth of cash-surrender value in a life policy, you could call the insurance company and request a “tax-free” loan from the policy. Let’s say that loan is $20,000.  The insurance company has to charge interest in the policy on the borrowed money.  If loan rate is 8%, then you are charged inside the policy 8% interest on the loan and that must be paid every year.  The cash in the policy is still growing but at what rate?  If the crediting rate on the cash in the life policy is only 6%, then there will be a shortfall on the interest owed and the cash value in the policy will start to go backwards.

If your policy has a wash loan, the interest charged on the loan would equal the growth rate on the cash in the policy. Therefore, the balance of cash in the policy will not have to be used to pay the interest on the loan. So, if the interest on the loan is 8%, the insurance company will credit 8% on the same amount of cash in the life policy; (it is a neutral transaction from the client’s point of view).  The life policy was charged 8% on the $10,000 loan, but the life policy also earned 8% on $10,000 in the policy to create this neutral situation.

Variable Loans

Many companies are using what are called “Variable Loans” to enhance the product and potential for larger tax-free loans.  How does a Variable Loan work?  The insurance company will still charge the client interest on the borrowed money at whatever the going rate is at the time.  Let’s say the rate is 6%.  Unlike a wash loan where the cash in the policy would be credited with a return of 6%, with a Variable Loan in any given year, the client has no idea what the investment return will be in the policy.

For example─if you purchased my favorite type of life insurance policy (EILI), the growth in the policy is pegged to the S&P 500.  If S&P 500 returns 10% in a year when there is a loan on the policy with an interest rate of 6%, the client has a positive arbitrage.

Conversely─if the S&P 500 goes negative (which in most EILI policies will earn a return of zero in that particular year), your policy is still charged with a loan where the rate is 6%. What that means is in the year when the S&P 500 underperforms the interest rate on the loan, the principal cash in the policy will have to be invaded to pay that interest.

Better Potential for Growth

The reason you should consider using a life insurance policy with the option of using a variable loan is because if borrowing rates and the S&P 500 perform as they have over the last many years, you will actually make money on the money borrowed form your life insurance policy.

How?   As stated above in the example, if the borrowing rate on a loan from your policy is 6% and the life policy which pegs the growth of the S&P 500 earns 10%, your have a 4% positive arbitrage on the cash in your policy.  In other words you are making money on the money borrowed from your policy.

Historically the S&P 500 has returned in excess of 2% more pre year than the borrowing rates used for loans.  Will that trend continue?  Most likely it will over the long-term although as you know: “past performance is no guarantee of future performance.”

Further Protection

I alluded to an EILI policy which credits 140% of what the S&P 500 returns every year.  I like this policy when discussing the Variable Loan issue, and I think with an illustration you’ll see why.

Assume the interest rate on a loan from a life insurance policy is 6%.  In most policies, if the S&P 500 returns say 4.5%. the client is going to go backwards by 1.5% in their policy due to the fact that the return is less than the interest rate (the client would have been better with wash loans).   If the client had a policy that credited 140% of what the S&P 500 returns, the client would have been credited with 6.3% in their policy and would have done slightly better than a wash loan.

Carrying that forward, what if the S&P 500 returned only 3%?  The client would be upside down 3% if the interest rate on the loan were 6% in a normal policy but only upside down by 1.8% in a policy that credits 140% of what the S&P 500 returns.

My point is simply that the 140% crediting policy allows for more security for the client and better growth for clients who think the S&P 500 is going to be flat for a period of time.

Even More Protection

Some of the new life insurance policies have free guaranteed no-lapse riders for clients who borrow money from the policy over the age of 65.  That means if you borrow money from your life insurance policy and you are over the age of 65, the policy can never lapse and the insurance company MUST keep your life insurance policy in place until death.  That is a very important protection feature.

Summary

Variable loans are a good option to have in policy. The more options the better.  Also if you want to protect yourself when purchasing cash value policies, it is recommended that you consider using an EILI policy that credits 140% of the S&P 500.  And finally, it is very important to use a policy with a no-lapse guarantee so you never have to worry about all the negative ramifications of having the policy lapse before death.

For information on the 140% crediting life policy, please contact our info@thewpi.org and you will be referred to your local CWPP™ advisor for help.