Insurance Is Not Triple Tax-Free
There is an investment account that gives you a tax deduction when you contribute, grows tax-free, and then comes out tax-free. It isn’t a universal life insurance policy. It’s a health savings account. Mr. Andrew likes to pretend that contributions to a UL policy are tax-free. It takes a huge mental leap to buy into his logic. He suggests that because you can deduct your home equity interest, taking out a bigger home equity loan to put the money into a UL policy is like putting tax-free money into the policy. That’s like saying I can buy a boat tax-free if I borrow from my home to do so. That’s like saying if I borrowed money from my home to put into a Roth IRA it’s a tax-free contribution. It’s silly logic, but that’s how it works to him. In reality, you buy life insurance contracts with after-tax money, just like boats and Roth IRAs. It does grow tax-free and upon withdrawal, your basis is tax free. You can borrow from the policy tax-free, and the death benefit is income tax-free. But the contributions ARE NOT tax-free, no matter how much Mr. Andrew wishes they were. This further demonstrates why it’s almost surely an awful idea to pull money out of your 401K (paying penalties and taxes) in order to put it into an account whose tax benefits are really no better and whose costs are likely much higher.
The Early Years Of A Life Insurance Policy
Structuring a life insurance policy as an investment isn’t that complicated. You’re basically trying to get the benefits of life insurance (tax-free growth, tax-free loans, tax-free death benefit) without the downsides of life insurance (primarily high costs but also ongoing required premium payments.) You overfund the policy, basically paying for the whole policy as soon as you can without it becoming a modified endowment contract (because then the loans you’re planning to use for retirement income aren’t tax-free). You choose as low a death benefit as possible in order to maximize the cash value. But even with doing these things, you still have a few years at the beginning of the policy when your returns absolutely suck. To make matters worse, if you want out, you’ll likely be paying a significant surrender charge. It’s hilarious to me that Mr. Andrew preaches liquidity, then advocates for this as an investment. I suppose you could consider it liquid later on when the cash value has grown (if by liquid you mean you can get your money within a few business days). But it sure isn’t liquid in any sense of the word in the first few years. I agree with Mr. Andrew that an investment is best judged over the time period it is intended for, and over very long time periods a well-structured life insurance contract bought at today’s rates is likely to have low, but positive returns (2-5%). But it seems an awfully big sacrifice to have such crappy early returns just to get okay returns later. It would be one thing if it would provide 15% returns if you held on long enough, but that just isn’t the way it works.
Bank On Yourself – esque
This strategy isn’t all that different from the Bank On Yourself concept I’ve discussed before. The BOY folks seem to prefer using whole life policies whereas the Missed Fortune folks like Universal life. A UL policy can be funded a little faster, but UL policies don’t offer non-direct recognition on loans from the policy, an essential part of the BOY concept. The main concept is the same – earn tax-free returns similar to fixed income investments and take out tax-free loans as needed, whether to buy a car or pay for golf as retiree.
Borrowing from your life insurance policy cash value is tax-free, but it isn’t interest free. In fact, you usually pay interest of 4-8% when borrowing from your own money. It isn’t a huge deal with a non-direct recognition policy, since the dividend rate is usually pretty similar to the loan rate, but with a universal life policy or a direct recognition WL policy, borrowing from your policy may really cost you.
Current Expected Returns On Universal Life
I asked an insurance agent, Larry Keller, to provide me a quote for a UL contract for a 30 year old male. Since Mr. Andrew always makes the assumption that the UL “side-fund” is going to grow at 7.75%, I was curious to see what I could really expect it to grow at given today’s low interest rate environment. Looking at the illustration was disappointing to say the least. There are actually two illustrations, one with the guaranteed scale and one using the current dividend scale.
The Guaranteed Scale
The policy shows you put in $25K a year for four years for this policy with a $1 Million death benefit. The guaranteed minimum dividend (not your return) is 2.5% per year. After one year, you have $17,530 if you surrender it. After four years, you have $88,036 (remember you’ve put in $100K at this point.) In fact, the surrender value never actually gets to $100K, and due to the increasing costs of the insurance you must pay each year, the policy lapses at year 43 (unless you add cash to it.) So, in fact, there is no guaranteed permanent death benefit with this policy and it never actually guarantees you a positive return, no matter how long you hold it. Not much of a guarantee, is it?
The Non-Guaranteed Scale
Let’s look at the scale using their current projections (which are almost surely to fall given our current interest rate environment.) Again, you put in $25K a year for four years for this $1M policy. Assuming the current dividend rate of 4.95% AND the current insurance charges, your net surrender value after one year is $18,074. After four years it is $93,824. After 10 years it would be $119,265, a return of 2.09%. After 20 years, it would be $175,531, an annualized return of 3.08%. After 30 years it would be $258,457 for a return of 3.38%. After a full 40 years (you’re now 70 years old), this $100K you invested would now be worth $369,021, giving you an annualized return over 4 decades of 3.45%. At least on the non-guaranteed scale you get to keep your $1 Million in life insurance, instead of losing it at Age 73. In fact, starting about age 72 it actually starts increasing, and if you die at your age expectancy of 83, and never borrowed from the policy, your heirs would get $1.587M. The return on that would be 5.51%.
There are four things you can learn from this exercise. First, if you’re trying to arbitrage between your mortgage rate and the return on these policies, you’d better have a very cheap mortgage. Even using my 2.75% mortgage (1.7% or so after-tax), you’re only making 0.39% a year on this arbitrage, for the first ten years, and that’s assuming it performs no worse than illustrated, which it is almost surely going to do. Second, that 2.09-3.45% number looks an awful lot like inflation. The real, after-inflation, return is going to pretty darn close to zero. I don’t know how you feel about inflation, but I’m not really into locking my money up for decades and then not actually making any money on it. Third, that 2.09-3.45% number is very different from the dividend rate of 4.95%. WITH PERMANENT LIFE INSURANCE THE DIVIDEND RATE IS NOT YOUR RATE OF RETURN. Last the return on the death benefit is higher than the return on the cash surrender value. That’s why life insurance is much better used for money you plan to leave behind than for money you plan to spend in retirement. Surprise, surprise, life insurance is actually life insurance, not an “alternative retirement plan.”
I’m not the first to criticize Douglas Andrews “Missed Fortune” ideas. You can find other critiques here, here, and here. It isn’t that the whole philosophy is flat-out wrong. But there are a lot of bad assumptions and half-truths so that when you add them all up, “this dog don’t hunt.” Avoiding retirement plans causes most people to have less after-tax money in the end. Withdrawing from them early is also generally a mistake, especially if you’re paying significant taxes and penalties. Buying real estate with nothing down is a mistake that not only increases the risk of foreclosure, but also raises the costs of your mortgage. Universal life policies as an investment are likely to have long-term returns of no more than 2-3.5% going forward, and quite possibly may have negative returns, especially for shorter time periods. Arbitraging a low mortgage rate for a possibly slightly higher return on a universal life policy not only increases your financial risks, but is unlikely to make any kind of a significant positive difference in your personal finances. In summary, if you follow Douglas Andrew’s ill-conceived financial plan, the only people likely to end up wealthy due to your efforts are your lender and your life insurance agent.
What do you think? Have you read the book? Are you a Missed Fortune believer? Do you like keeping zero equity in your home or buying universal life policies as an investment? Fire off below in the comments section! As always, keep the discussion focused on ideas, rather than individuals.