Many people know that life insurance can provide protection from the financial risk of early death. Fewer people realize that life insurance can simultaneously be an excellent investment. A life insurance policy can accrue a very large cash value and can actually earn money. Life insurance will usually outperform the risk-free rate and has tax advantages as well. Some investors find permanent life insurance an excellent way to accrue a lot of value with little risk.
As with any investment, the cash value can be harvested and withdrawn through partial surrenders, loans can be taken against it, and the policy can throw off regular cash flow through dividends.
Permanent Forms Of Insurance Have A Cash Surrender Value
Every permanent form of life insurance carries a cash value. This generally will increase over time if the policy is funded as it has been illustrated. Whole life insurance is guaranteed to perform at least as well as the minimums that are stated, but universal life insurance has a much wider variance in performance. Permanent forms of life insurance with cash value include whole life insurance, universal life, and variable universal life policies.
Term insurance does not have a cash value, and “permanent term” which is usually a renewing term to age 100 or older, also does not contain any cash surrender value. Term life insurance is not investable because it has no surrender value.
The cash value can be accessed at any time, and for any reason. Many high net worth individuals invest in permanent life insurance solely for the cash value benefit.
Cash Value Provides A Rate Of Return
Cash value is not merely a stagnant store of money. The cash value of every life insurance policy is meant to provide a positive rate of return for the owner over time. This return on investment is achieved through different means for each type of life insurance product. This is how each policy grows in value.
Whole Life Insurance
Guaranteed Growth
Whole life insurance cash value increases through payments made into the policy. A portion of every premium payment goes into the cash-value account, which is a savings repository within the policy. The cash value in a policy is then guaranteed to grow at some minimum rate, stated when the policy is issued in the initial illustration. This minimum rate usually will provide a positive rate of return for the policy owner over time, meaning that the cash value at some point will be worth more than the total amount of premiums paid into the policy. Dividends reinvested into the policy can speed this growth up.
All cash value growth within a life insurance policy is tax-deferred, making this more and more advantageous as people pay higher income tax rates. The compounding tax-deferred growth within a life insurance policy can make the true after-tax return pretty attractive compared to other investments, especially taking into account how stable (secure and not volatile) a whole life insurance policy is.
Whole life insurance is considered an extremely safe investment because life insurance companies are mandated to meet certain reserve requirements by law. This means that their financial structure lends to them being some of the most financially sound companies in the history of United States corporations. For evidence, many of the large life insurance companies have not only been in business since the 1800s, but they have made dividend payments for over a hundred consecutive years (even during the great depression years).
Dividends
In addition to the guaranteed rate of growth, as stated above the component that really hastens the growth of the cash value account investment is dividend payments from the life insurance company to the policy owner or reinvested into the policy. Typically, the dividend amount will increase as the policy ages and as the cash value grows. Larger death benefit policies are paid higher dividends as well. Dividends are paid at the end of the year after the company has calculated its financial results. Dividend payments are improved through a lower experienced death rate than expected, higher company sales, and the general interest rate environment.
Whole life policy owners have three options when it comes to using their dividend payments. The payments can be used to:
- Be paid directly to the owner of the policy as a check.
- Reduce premiums (when the dividend becomes larger than the premium the excess can be paid to the owner or used to purchase additional insurance).
- Purchase additional paid-up insurance, increasing the death benefit and the size of future dividend payments.
All three of these options increase the rate of return experienced by the policy owner. The effects of each of these options and the reasons policy owners choose each option are as follows:
Direct Payment Of Dividend To Owner
A dividend payment received as a check is direct income for the owner. This income is considered taxable by the IRS, and this is not the most efficient use for dividend payments as far as achieving the highest long-term rate of growth. However, this is not always the goal of every life insurance policy used for investment purposes. Taking a direct payment also allows owners to get cashflow back from their investment.
Some life insurance owners fund life insurance policies with the intent that the policy will provide the payments to supplement their retirement income. By taking the dividends as cash, the owner can get a payout every year for the rest of his/her life. No one would invest in life insurance solely for the cash dividend payment, but the dividend income payments coupled with the death benefit paid when a death claim is filed is an attractive combination.
Policy owners can even make withdrawals from the cash value late in the policy’s life and still have enough value to keep the policy in force for the entire life of the insured. A withdrawal is a partial surrender and it will reduce the death benefit dollar for dollar permanently. Owners can also access their policy value by loans. Loans also reduce the death benefit, but not if they are paid back.
Using Dividends To Reduce Premiums
When using dividend payments to reduce premiums, the amount of money that the policy owner pays into the policy is reduced. Even though the owner is paying less and less money over time as the dividend payments grow, the cash value is still guaranteed to grow by at least the illustrated minimums. After enough time, the dividend payment may be able to pay the entire policy premium all by itself. At this point, the life insurance policy will continue to accrue cash value without any more money being paid in.
After many years, the policy value will increase substantially. When dividend payments are larger than the premium payment, the excess can be used to either purchase paid-up insurance or can be paid out directly to the owner. Purchasing paid-up insurance in turn increases the dividend payments even further in future years so it has a compounding effect. Don’t forget that the whole time life insurance coverage is also in place protecting beneficiaries and increasing the size of the estate paid to the next generations. Using dividends to reduce premiums means that the total amount paid into the policy is quite significantly less than the death benefit.
Using Dividends To Purchase Additional Paid-Up Life Insurance
Using dividends to purchase paid-up insurance is the way to get the largest policy value and the most growth on your investment. Paid-up insurance adds to the death benefit of the policy, without adding any additional premium due each year. Additional paid-up insurance also leads to higher dividend payouts in subsequent years. Each year the dividend payment grows and the insurance coverage and cash value will grows with it in a compounding way. The cash value, growing tax-deferred the whole time, can be withdrawn from the policy with the cost basis withdrawn first (so there are no taxes on gains). There are clear advantages to owning a whole life insurance policy for a long time as an investment.
The bottom line is that through cash value guarantees and dividend payments, a whole life insurance policy can be a great investment. It benefits the owner during his lifetime with the positive internal rate of return and tax advantages and it benefits the beneficiaries after the insured person dies by providing a large death benefit payout.
Universal Life Insurance
Universal life insurance pays a guaranteed minimum rate of return (2% by law) or higher when prevailing interest rates are higher. The interest rate is determined through a published formula usually tied to other rates such as LIBOR. Each month a cost of insurance charges comes from the cash value. The universal life policy allows flexible premium funding which is unlike a whole life insurance policy.
The way to generate a positive rate of return with a universal life insurance policy is to fund the policy really well. It must be funded significantly over the price of the insurance in the early years. The excess continues to accrue in the cash-value account, which is then paid the current interest rate. This value also accrues completely tax-deferred, which increases the true rate of return. The higher the tax bracket of the owner, the higher the true net rate of return provided by the policy. Eventually, with enough cash value, the policy can become self-sustaining and can continue to grow without further payments being made. This both keeps the life insurance in force and provides a source of savings for the owner.
Universal life insurance enjoys the same tax advantages as a whole life insurance policy. All growth is completely tax-deferred and withdrawals are taken FIFO, meaning the entire amount that was paid into the policy can be withdrawn tax-free. Loans can also be taken tax-free and used as a source of income. It is unwise to take money from a universal life insurance policy because the cost of insurance rises so much in the later years of the insured person’s life. Universal life insurance also typically has high surrender charges so they should not be surrendered in the period with charges unless it is necessary.
Variable Life Insurance Is the Most Risk and Most Possible Return
Variable universal life insurance works similarly to universal life insurance in that the premium payment structure is flexible. As long as the cost of insurance charges is covered, it does not matter if a person is paying into the policy or not. Any excess premium payment over the cost of insurance is deposited into the cash value account that gets invested into the market.
Cash Value Invested Into Variable Sub Account Funds
The cash value account in a variable universal life insurance contract does not always carry any guaranteed rate of return unless it is put into a money market account. The cash value account is invested into funds effectively the same as mutual funds, called sub-accounts. Each sub-account is managed by a professional fund manager and invests in different securities according to the investment objective for each. For instance, some may focus on high-yield bonds, or mid-cap equities, or utilities. Other sub-accounts may be funds whose performance is tied to indexes such as the S&P 500. The client has full control over which subaccount to invest in and can make trades similar to mutual fund trades in a brokerage account. The gain is not taxed when traded, as long as the money stays within the policy.
The cash value then fluctuates daily according to the market performance of each subaccount. The more money that is invested into the cash value account over the cost of insurance, the more money is available to invest. This means that the best performing policies are those which are well funded from the start and have time to grow.
The value grows tax-deferred just like other forms of life insurance, even though it is invested in the market. The death benefit of course provides protection for beneficiaries the entire time, and withdrawals are taxed FIFO (gains last). Loans are available as they are in other forms of permanent life insurance.
If the investments within a variable life insurance policy are performing highly, the returns on this type of life insurance will rival investment accounts in performance. Because these are tax-deferred as well, the net return can become even higher. The fees tend to be higher within this type of policy so only purchase this as an investment if you need the life insurance coverage.
The risks are that investments perform poorly. The cost of insurance within a universal life insurance policy and a variable universal life insurance rises over time. If the investments perform poorly on top of this, clients can end up spending a lot of money on a variable universal life insurance and it will be a poor investment. Sometimes these policies become difficult to keep in force until death because the cost of insurance is so high. The worst-case scenario for a policy owner is to pay a lot of money into the policy for years, and then have the policy lapse with no value. Just like with investment accounts, sound investing strategies with the diversification of risk are required to give a policy the highest chance of performing well over time.
Life Insurance Is An Investment For Owners And Beneficiaries Sake
No matter the form of life insurance used, life insurance is a great way to pass on money tax-free to the next generation. Even if the policy does not provide extra money for the owner, it will provide a wonderful benefit to the beneficiaries. The tax-deferred earnings in life insurance provide an advantage over traditional investment vehicles even if the rate of return is slightly lower.
Life insurance is a great way to diversify an investment portfolio and whole life insurance is an attractive alternative to other forms of fixed-income investment, even without considering the death benefit provided.
