#2 | Life Insurance for Accumulation

It’s no surprise that high income earners will look to reduce tax incidence in the face of rising tax rates. It shouldn’t be a surprise, then, that life insurance would suddenly garner new attention thanks to its tax advantaged status. But I have to admit, I’ve been surprised at the sheer volume of calls I’ve received since January from guys who usually sell death benefit protection for estate planning but are now looking at accumulation products.  More shocking still is the fact that these producers are being approached by potential clients looking to squirrel away assets in life insurance. This raises a host of questions that I think are well worth exploring.

I’ve noticed a healthy dose of skepticism from producers in the estate planning market when it comes to using life insurance for accumulation. I’m sure part of it is the fact that they’re not entirely familiar with accumulation products, but the primary issue is likely the abject failure of life insurance to deliver on its promises in the past. As usual, the problem is really a two headed beast – promises and delivery. Producers promised more than could be reasonably delivered and delivery, in some cases, was worse than could be reasonably expected.

Fortunately, the tax play for accumulating assets in life insurance doesn’t directly involve performance. It’s a very simple trade – taxes for policy charges. Anyone buying life insurance in this guise is simply betting that their taxes would have been greater than the policy charges. Performance in particular is a secondary concern. Skeptical producers should focus on managing expectations by showing very low return hurdles. I use 4% net rates on VUL as a baseline assumption. Why? Well, I don’t really care what equities have or haven’t done in the past. I’m not using an illustration to show returns, I’m using it to show the tradeoff between taxes and policy charges. All I care about is the efficiency of the trade.

If you’ve picked the right product and designed it correctly, you should be able to get something near a 3.5% IRR on policy distributions using only a 4% net investment yield assumption (not including investment expenses). I’d consider 50bps of drag to be a pretty efficient trade. Drag also decreases when policy performance increases. In other words, the trade is pretty good even under a pretty low return assumption. So what’s the catch? Well, there’s a few.

First, carriers will give you a litany of reasons to sell an expensive product for accumulation. One of the biggest reasons is commission, which comes straight out of policy charges to the tune of about $2.5 for every $1 of commission. Other reasons include riders, fund selection, loan charges, insurer financial strength and a few others. Before you pick a product based on one of these, recognize that any additional cost dilutes the fundamental trade for the product even if it yields tangible benefits.

Second, policies sold for accumulation require meticulous administration during the distribution phase or, in other words, when the agent has retired. The income stream needs to be adjusted to reflect actual policy performance, assets need to be managed to reduce volatility and the policy itself may need to be adjusted (face decreases, switches from Option 1 to Option 2, etc) in order to maintain efficiency. The policy will almost certainly fail to deliver on the originally estimated performance without proper administration.

Third, I’ve drawn a pretty careful distinction between selling accumulation on the virtues of the taxes vs. charges tradeoff and selling accumulation on the basis of illustrated performance. The former is about relative performance (taxable investments vs. non-taxable investments in a life insurance policy) and the latter is about absolute performance (6%, 8%, whatever). The problem with showing an illustration is that it inevitably creates expectations about absolute performance when, in reality, the decision to buy life insurance for accumulation should only be based on relative performance. That was our problem in the 2000’s – producers sold VUL at 12% and clients dumped the policies when equities dropped. That’s a completely irrational decision that likely has more to do with the fact that clients confused the illustrated rate of return with the policy itself. The only way to get clients to stick with the policy is to remove any specific performance expectation and replace it with a relative performance expectation. Failing to do so will undoubtedly leave you with unhappy clients.

So, in short, life insurance can be effectively sold for accumulation as long as the design is right, product selection revolves around policy charges, someone carefully administers it and the client enters the deal without expectations about how the separate account assets will perform.

You might have noticed that I haven’t referenced any product other than VUL in this article so far. There’s a reason. The only way to sell a pure trade between taxes and policy charges is by having roughly the same assets in the life insurance policy as would have existed outside of the policy. Variable UL is the only life insurance product that allows a direct comparison of a taxable portfolio to assets in a life insurance policy. Switching from a taxable portfolio to a Whole Life policy does trade taxes for charges but on a completely different return profile. Performance in any general account product is not comparable to investible assets in the real world. There’s a legitimate sale for general account accumulation products, but recognize that the focus necessarily moves from a pure taxes vs. charges trade to a much more complex asset transfer that offers a completely different risk/return profile. The sale becomes two parts – transferring assets to another risk profile and then the tax advantages of the product. The best of all worlds, in my opinion, is a VUL product that offers general account investment options with both fixed and Indexed crediting methodologies in addition to the traditional separate account funds. AXA and PacLife both offer products with lean charges and several general account options.

Finally, I do believe that focusing on selling life insurance for accumulation invites regulatory and tax scrutiny that we’d probably rather avoid. Indexed UL marketing materials are particularly edgy in both their references to life insurance as an investment and the tax advantages of using life insurance for accumulation. It wouldn’t take an IRS agent long to figure out pretty quickly that the CYA fine-print language about life insurance being “used primarily for death benefit protection” is completely out of line with the way the products are being marketed and sold. Tax shelters have a long history of being squelched once they get to be too popular. The more the industry focuses on accumulation sales, the more we risk our tax advantaged status. It’s up to us to police ourselves before things get out of hand. But the opportunity is clear – we have a unique and incredible opportunity to provide income tax planning solutions to clients at minimal cost.