#399 | The Simple Case for Permanent Life Insurance

Tap filling bucket water

I’ve noticed that some things have changed since I’ve gotten older. A few rogue gray hairs are sprouting up over my ears. My joints pop a little bit when I get out of bed in the morning. I feel nostalgic more often, especially when I think about moments from the early days of my kids’ lives. I’ve settled into certain routines that have been going strong for more than a decade. But one of the more interesting changes has been the increasing number of people both inside the industry and in the real world who ask me what I personally do for life insurance.

This really hit home for me a few months ago when I was skiing in Telluride with 9 friends of mine, a ski trip I’ve been doing for over 10 years. Everyone was milling around the kitchen one morning and I was sitting at the table – probably working on an article for The Life Product Review – when one of the guys asked me if I’d take a look at his life insurance policy. He’d recently been pitched on the idea of buying more permanent insurance and wanted me to take a look at his current policy and the proposal. That’s not particularly surprising. Every now and then a friend pings me for advice about life insurance and I’m happy to give my two cents.

What was surprising, however, was the fact that every single guy in the house ended up sitting around the table and peppering me with questions about life insurance for half an hour. Is Whole Life really a rip off like Dave Ramsey says? Shouldn’t I just buy term and invest the difference? Should I have life insurance on my kids? What about my wife? I have this in-force term policy, should I convert it? Wait, so this thing isn’t taxed as it grows and I can get the money out tax free? And I can buy a policy that lets me invest in the same kinds of funds I’m using in my brokerage account? Why hasn’t my financial advisor talked to me about this? How do I get a policy like that?

That table is a target rich environment. Every guy there easily qualifies as an accredited investor. Every one of them is highly accomplished in their own field. They’re smart, savvy guys who have deep understanding about lots of things related to finance. One guy, a Managing Director at an investment bank, casually dropped that he’s gotten into trading options. Another guy is snapping up beleaguered commercial real estate. Another one is financing affordable housing. But when it comes to life insurance, they know effectively nothing.

That’s obviously an indictment of the industry writ large, but it’s also an opportunity. They were interested. Interested enough to stop what they were doing that morning and sit around for half an hour to talk about life insurance. And it wasn’t just one conversation at a ski trip. I find myself having these conversations on a fairly regular basis and making a pretty straightforward pitch for life insurance that consistently delivers the same “ah ha” moment that I felt when it first dawned on me. It’s not complicated. It’s not particularly detailed. And it goes something like this:

Think about your discretionary savings as a cascading series of buckets. When one of them fills up, the remainder spills over into the next one. The first bucket is a 529 Plan for your kids because college is the most proximate thing you’re probably thinking about for savings. The second bucket is qualified money – such as a SEP IRA – where you get a current deduction but pay taxes on future distributions in retirements.. You’re limited to around $70k in that bucket per year.

After that, the money usually spills into a brokerage account. The power of the brokerage account is that it’s liquid and you can invest in whatever you want. The downside is that you get 1099s because you’re trading or the funds have turnover or they have taxable distributions. Either way, you’re getting tax friction every year and you probably pay for the additional tax in cash, which means you’re saving less because you’re paying tax on gains. It’s a really big jump from qualified plans to the brokerage account in terms of taxation.

Cash value life insurance slots above the brokerage account and below the qualified money and 529s. Life insurance obviously has a tax-free death benefit, but you don’t get a 1099 every year for the growth in the policy cash value. You only pay tax if you surrender the policy. Otherwise, you can borrow the money from the contract – often at zero net cost – and get your gains out tax free as long as the death benefit stays in force. If you can invest in the same sort of stuff that you’re doing in your brokerage account, then why wouldn’t you use life insurance?

These are really simple products. You pay a premium, policy charges are deducted and whatever is left over earns interest based on how you allocate your money across the available funds. If you have Vanguard in your brokerage account, you can get the insurance version of the fund in a Variable UL policy, usually at the same cost. The policy fees – excluding Cost of Insurance, which you’re already paying for in a separate Term policy – are 20bps or less over the long run. They’re generally really efficient.

The crazy thing is that the contribution limits for life insurance are incredibly high. You already have [for example] $2 million in Term insurance. If you switched that to a permanent life insurance policy, you’d be able to put in over $1 million in premiums that are totally flexible. You can decide how much and when you want to contribute as long as there’s enough to keep the policy in force. Ideally, you’d max out that contribution and only then have spillover into your taxable brokerage account. You’re already paying for life insurance coverage anyway, this just gives you the ability to have a third strategy for discretionary savings that isn’t taxed annually.

That’s it. Again, it’s a very simple story and there are a lot of things that I purposely don’t talk about. I don’t talk about the fact that life insurance could theoretically substitute for the 529 plan because both of them are tax free. I don’t talk about the fact that it may actually make more sense to pay tax now and put the difference in life insurance – a Roth, essentially – versus a traditional SEP IRA. Why not? Because those are well-known, credible, externally validated tax planning tools where the tax advantages are “free.” You don’t have to pay extra fees in order to get access to the tax advantages, but you do for life insurance. As a result, life insurance rightfully belongs below those buckets.

Despite the fact that I own quite a bit of Whole Life and have written extensively on the value of the product, I don’t usually bring it up right away because there’s no clear analogue for Whole Life in the investment world. If you go straight for Whole Life, the story takes a turn. It’s not nearly as simple as slotting the life insurance bucket for the same investment strategy between the qualified money and the brokerage account because the asset strategy has to be transformed into Whole Life. There is a real case to be made for Whole Life as a fixed income alternative, which is exactly how I use it, but that’s not the point of this particular conversation. Making Whole Life the centerpiece requires starting in a different place.

The same logic applies to fixed and indexed strategies that are prevalent within Variable UL and, of course, are available as stand-alone products. Imagine how distracting it would be if I started to explain how indexed crediting works and all of the jargon associated with that or even tried to talk about why a client would want a fixed interest strategy over a money market fund. That is not the point of this conversation. It’s a feature that, ultimately, has nothing to do with why someone would want life insurance. If someone is buying life insurance just because of the crediting strategy, then that’s a recipe for disappointment and disillusionment.

Finally, I don’t talk about life insurance for the death benefit for the simple reason that virtually everyone who is asking me about life insurance is asking me specifically about permanent life insurance. They’re already well aware of the fact that they need life insurance and they’ve already covered their risk with Term. The question isn’t “do I need life insurance?” The question is – “how do I best use life insurance?” If there is no need for life insurance, which is rare, then the story changes. The drag for buying life insurance increases because of the Cost of Insurance isn’t a common denominator. It may still make sense for someone to use the product, but it’s not a slam dunk. Life insurance is always about protection. That’s always where the conversation starts. But the incredible power and appeal of the product is that protection is not where the conversation ends.

The typical reaction to the story is that it’s a lightbulb moment. That’s not because I’m a great salesperson, otherwise I would have followed in the footsteps of my dad, my mom and my grandfather and been an insurance agent. The reason is that the story makes sense to people, especially people my age who are starting to seriously think about financial planning, because it lines up with their usual mental model for their own financial plan. They’re already using 529s and qualified plans. They’ve already been putting the excess into their brokerage account. They’ve already made the conscious decision to prioritize tax advantaged strategies over taxable strategies. The fact that they now see a new bucket – life insurance – to slot between the two makes total sense and operates on the same logic. As one of my friends said when we were talking about this last week, “why would I have anything in my brokerage account when I can use life insurance and buy the same funds?” Lightbulb.

Inevitably, however, the conversation turns to the perennial boogieman of life insurance – commissions and surrender charges. I think it’s worth pointing out, first and foremost, that those are optional and not actually core to the product itself. They’re a choice and you can choose not to have them. My friends can buy a product such as Nationwide Advisory VUL. On the ski trip, they were asking some pretty detailed questions about the policy charges, so I just pulled up the illustration software and they all looked over my shoulder as we walked through the charge breakdown for both Advisory VUL and Nationwide’s retail VUL product.

Advisory VUL works exactly how I had described it to them – premiums in, charges out, whatever is left over earns interest. Simple, easy, straightforward. Nothing to hide. Nothing to explain. Nothing to justify. If anything, they were mostly just annoyed that North Carolina charges a 2% state premium tax because that’s the biggest line-item charge besides the guaranteed level Term-like cost of the death benefit. And if that’s what someone is annoyed about, then you know they actually get it.

The retail product, however, requires a different explanation because the policy charge structure is so punitive relative to Advisory VUL. The power of Advisory VUL is that it’s a no-commitment sale. You can buy it and only fund it like Term or you can pump hundreds of thousands of dollars a year into it. The product isn’t biased. But in a retail product, there is an inherent bias. You can’t fund it like Term because it has high fixed charges related to heaped commissions. If you’re going to buy a retail product, you have to basically have to fully fund it. And if you don’t, then you could end up in a world of trouble with a collapsing product. It’s not the same sort of nice, clean story as Advisory VUL.

Advisory VUL breaks even – after excluding the cost of coverage – as soon as the investment return clears the amount of the premium tax, which is between 1% and 3%, depending on the state. By contrast, the retail product starts deep in the hole due to surrender charges and takes almost a decade to break even due to policy charges that cover heaped commissions. But, after that, the retail product actually smokes Advisory VUL if the advisor is charging anything more than 35bps or so in AUM. Taking commissions into account, the retail product is actually a better long-term performer than the advisory product.

And ultimately, isn’t that what advisors are in the business of doing – long-term financial planning? Isn’t the entire point of financial planning to get people who are in their mid-40s to make decisions that will benefit them in their mid-60s and beyond? Charging AUM in an advisory product rather than heaped commissions in a retail product is a way to make the decision for the person in their mid-40s easier because it reduces the friction at the point of sale. That is a real benefit because more people will buy the product. But which option would that person rather have chosen 20 years later? Heaped commissions, because it ultimately delivers better performance. So which one is the right approach? You could argue in favor of either. One is not necessarily and inherently better than the other*.

Early in my career, I relished the complexity and intricacies of life insurance product. I loved finding anomalies in pricing that could be exploited. I found all of the little quirks of product pricing to be deeply interesting. I thought that these sorts of things were what set products apart and made for a great story. But as I look at how I actually use life insurance and, therefore, how I talk to my friends about life insurance, I’ve come to a completely different conclusion – it just ain’t that complicated.

There are a few great use cases for life insurance that cover 95%+ of the market and can be solved with simple products that you can confidently explain and clients can intuitively understand for themselves. Anything beyond that is playing with fire. Our greatest opportunity doesn’t lie in edgy tax planning tactics, premium financing or esoteric crediting strategies. Our greatest opportunity is to tell simple stories about our incredibly powerful products that other financial advisors simply aren’t telling. The other question all of my friends asked: “Why in the world hasn’t my financial advisor told me about this?” Maybe it’s time to explain a few things to your financial advisor – or get a new one.

*The ideal solution for the consumer in terms of pure financial economics would be to pay no commissions at all, but then how would they know the story? That would be the best product that no one buys and, in the end, that may not the best product at all.