I've written twice before about Variable Universal Life (VUL) insurance policies and how they can be used as another retirement account. The first time, I was extremely negative about them. The second time, cautiously optimistic. This time, I'm neutral. While this could work for the right person with the right financial situation and the right policy, I won't be buying one any time soon.
First, by way of disclosure, the main firm using these for physicians right now is Larson Financial, the largest physician-specific financial advisory firm in the country, who I've written about before. Larson has hired me in the past for some consulting work and we've worked on some joint projects over the years. I have occasionally referred readers to them for hourly financial planning. They've also purchased advertising on this site. Obviously, my financial incentive/conflict of interest in this regard is to treat them with kid gloves. I've had readers who love Larson and readers who hate them. I don't know that they're any more polarizing than other firms, they just have more physician clients than the others so I hear more about them, for better or worse. The only beefs I've really ever had with them are their AUM fees are relatively high (although not higher than industry average/standard levels and no higher than some other advertisers I have listed) and, in the past, have used VULs more than I think they probably should have.
Other than those two issues, I think they're fine to use, but there is no perfect financial advisor. Larson Financial has certainly taken a lot of flak (including from me) in the past for using VULs, and over the last 2-3 years has made some excellent changes in how they sell VULs, such that those who buy them should be much happier with their purchase than some purchasers have been in the past. As a result, they also sell a lot fewer VULs. They tell me that, from a financial perspective, they don't really care one way or the other, since in the long run they make more off of AUM fees than off VUL commissions on the same amount of money. But they feel they have certain clients where this option is a no-brainer so they feel compelled to continue to offer it to those clients out of a fiduciary duty, despite the poor reputation of VULs. At any rate, it is impossible to separate a discussion of VULs as physician retirement accounts from a discussion of Larson financial.
Tom Martin, CFP®, CPWA®, AIF®, a partner at Larson Financial who has guest posted here previously, promised readers years ago a more complete discussion of VUL policies. Unfortunately, due to compliance issues, it borders on impossible for a licensed advisor to comment on a post like this, much less write it. The little rules are kind of stupid sometimes, such as the fact that you can't call an insurance policy an investment, even though we all know that's why it is being bought. So I'll be doing the writing today and all opinions here are mine, in case that isn't obvious once you read them (which I think it will be.)
Biased Against Cash Value Life Insurance
As a general rule, I don't like cash value life insurance for three reasons.
First, it is complex. There are a lot of moving parts and assumptions and monstrously long prospectuses and disclosures. As a general rule, complexity favors the issuer and the salesman of a financial product, not the buyer. VULs are among the most complex of insurance products. I have spent a ridiculous amount of time wrapping my head around how these policies in general and this policy in particular is likely to perform. Even this post about it is 3-5 times longer than my typical post.
Second, I'm not a big fan of mixing insurance and investing. As a general rule, you end up with inferior insurance and investments. What are the odds that the company has combined the best possible insurance with the best possible investments? Not good.
Third, cash value life insurance is generally sold with ridiculously large commissions. A commission, once paid, never comes back to you. To make matters worse, someone paid by commissions has a serious conflict of interest to recommend the product which pays the highest commission (and as much of it as you will buy), which often is the worst product for you. As a general rule, avoiding paying commissions on financial products whenever possible is a good idea.
The Premise Behind VUL
One of the reasons I dislike whole life insurance is that you're tying your money up for decades at a relatively low rate of return. Now, there are a few reasons to buy it, (ask yourself these 12 questions before doing so) most of which revolve around wanting a life-long death benefit. If I'm going to tie my money up for 50-80 years, I want a decent rate of return for doing so. With whole life, your cash value is invested with the rest of the insurance company's investments, which are mostly bonds, thus the low rates of return. With VUL, your cash value is invested in the equivalent of stock mutual funds, and thus theoretically, should have higher returns in the long run. Assuming you can get the same mutual funds inside a VUL that you would use outside a VUL, the question comes down to whether the additional insurance costs can be made smaller than the tax costs over the long run for you personally.
Two Very Large Caveats
Before we get any further, it is important to bear two things in mind. First, this discussion is comparing a VUL to a taxable account. If you have not maxed out all your other available retirement accounts (401(k), profit-sharing, individual 401(k), Defined Benefit/Cash Value Plan, Backdoor Roth IRAs, 403(b), 457, HSA etc) AND want to invest MORE for retirement, then you don't need to read any further. The VUL is NOT going to beat these types of accounts given their special tax treatment. In fact, I would argue you should also have a significant non-qualified/taxable account as a cushion before considering VUL, especially if you give any significant sums to charity.
The second caveat is that the VUL had better have the best possible investing choices for you. If it isn't full of low-cost passive funds such as those from Vanguard, DFA, iShares etc, then I wouldn't bother looking at it. Even if a VUL structure works for you, over 6 decades it isn't going to be able to overcome poor investment options. Larson has gotten insurance companies to put DFA funds into the VULs they sell, which are the same funds they put their clients' qualified and non-qualified money into.
Larson has been working with FINRA to make a calculator/spreadsheet demonstrating the benefits of VUL. It took a long, long time to be approved but finally was earlier this winter. I don't have access to the calculator (so I can't give it to you) but they've sent me its output using some reasonable assumptions and that's what I've illustrated here showing how a VUL could be beneficial to the right person.
In this illustration, we're using the “Nationwide YourLife® Accumulation VUL” a loaded VUL Larson uses frequently with its clients. They also occasionally use a non-loaded TIAA-CREF product if a client wants to break even sooner, but feel this one has better characteristics in the long-run. There are two things worth noting in the prospectus. The first is that there are tons of investing options in the subaccounts, including low-cost index funds and DFA passive funds. The second is a rider that is very important towards the end of the distribution phase due to a problem universal life insurance policies have due to the variability of their returns- the Overloan Lapse Protection Rider. This is what keeps the policy from imploding if you borrow too much and market performance sucks. Here is the wording from the prospectus:
A policy owner is able to prevent the policy from Lapsing due to Indebtedness by invoking the Overloan Lapse Protection Rider, which provides a guaranteed paid-up insurance benefit. The Rider is designed to enable the policy owner of a policy with a substantially depleted Cash Value, due to Indebtedness, to potentially avoid the negative tax consequences associated with Lapsing the policy.
The policy owner is eligible to invoke the Rider upon meeting the following conditions:
• Indebtedness reaches a certain percentage of the policy's Cash Value (the percentage will range from 84% to 99% based upon the life insurance qualification test and the Insured's Attained Age); • The Insured is Attained Age 75 or older; • The policy is currently In Force and has been In Force for at least 15 years; • The policy's Cash Value is at least $100,000; and • All amounts available for partial surrender not subject to federal income tax have been taken.
The first time the policy's Indebtedness reaches the percentage that makes the policy eligible for the Rider, Nationwide will notify the policy owner of the policy's eligibility to invoke the Rider. The letter will also describe the Rider, its cost, and its guaranteed benefits. The Rider may be invoked at any time, provided that the above conditions are met.
The Overloan Lapse Protection Rider Charge is a one-time charge deducted at the time the Rider is invoked, and is assessed against the Cash Value allocated to the Sub-Accounts and the fixed investment options. The charge is intended to cover the administrative costs and to compensate Nationwide for the risks associated with the Rider's guaranteed paid-up death benefit. The charge is the product of the policy's Cash Value and an age-based factor ranging from 0.15% to 15.70% as shown in the Policy Data Pages. If the Cash Value less Indebtedness is insufficient to satisfy the charge, the Rider cannot be invoked without repaying enough Indebtedness to cover the charge.
There is a lot of legalese there, but it is a key part of the concept so I thought it was important to include. Basically if you've borrowed a ton of money against the policy, and then the market tanks, rather than having the policy implode on you (making all gains distributed to you fully taxable) you can pay a charge (hopefully just from the remaining cash value) and walk away from the thing, although there is potential that you would have to bring money to the table to do so.
We assume a 7.5% nominal return on the investments, whether inside a taxable account or a VUL, and a 2% dividend yield. So the entire investment is essentially in stocks. We assume they are both funded with $72,000 per year from age 36 until age 65 (30 years). This buys a $4 Million death benefit. So in an effort to make things comparable, $2,555 per year is taken from the taxable side and used to purchase term life insurance for the first 20 years. I asked them to illustrate it without that expense, but FINRA wouldn't let them. If you did, it would definitely push the break-even point out a bit. Just for fun, I ran 20 years of $2,555 a year contributions at 7.5% per year for a total of 60 years, the same length of time as this illustration. It grows to $2 Million-not insignificant, like any small expense compounded for 6 decades.
Then starting at age 66 and for the next 30 years (or as long as the money lasts) you pull $520,596 out of the account (7-8%) each year, theoretically spending all of it before you die. Your capital gains/dividend rate is 20% + 3.8% PPACA tax, so you're in the top bracket. It also assumes a 6% state tax rate. It also assumes you are not paying any kind of asset management fee in the taxable account (FINRA wouldn't let them use that assumption in the calculator either, although in that case, it would make the VUL look dramatically better because it is far better to pay a single commission, even a large one, than 60 years of 1% AUM fees.) So, with these assumptions, how does the VUL stack up?
This is fairly complex, so let me go over it slowly. Let's start on the left. The yellow line is the taxable account value. The red line is the taxable account value after the assumed tax rates have been applied to it. The green shaded area is the cash value of the VUL. As you can see, the after-tax taxable account breaks even with the VUL cash value after 24 years. The pre-tax taxable account is still well ahead of the VUL cash value at retirement (66). You end up with ~10% more in taxable than you do in the VUL after 30 years. Of course, the government wants a chunk of that, and if you sold the entire thing at age 66, you would get less cash out of the taxable account than you would out of the VUL, but not much less.
In the distribution phase it gets more interesting. The breakeven point for the pre-tax account is at about age 70, and then the taxable account runs out of money 8 years before the VUL. The difference between how much can be pulled out and spent from the VUL versus the taxable account is about $4 Million ($11.3M versus $15.6M, all nominal of course.)
The chart on the right illustrates the death benefit. If everything works out well and you live to be 96, there is no death benefit. If you die early on when you may have an insurance need, you get plenty of money from either the VUL or the term policy, although likely more from the VUL. When you die, of course, you get the death benefit, not the cash value. If you die in between when the term policy ends and retirement (or even a little after) your decision to invest in cash value life insurance is going to turn out pretty well.
This is the other output from the calculator/spreadsheet. It mostly demonstrates costs. By showing a time period of 60 years, it makes the massive commission cost look really tiny. Essentially, in the beginning the insurance costs (especially the commission during those first ten years) are dramatically higher than the tax costs in the taxable account. Then, as the accounts grow the tax drag gets larger until it eventually eclipses the cost of the insurance (which goes down a bit once the commission is fully paid). That breaks even about 13 years into the policy. Then, when you start selling and withdrawing at age 66, the tax costs go up dramatically. One interesting aspect of this chart is the way the insurance costs rise from age 76 to 91, then fall precipitously. They rise because the insurance component on the elderly is really expensive- that cost is NOT fixed throughout the life of the policy, it rises and at an increasing rate. The insurance costs fall after age 91 because you are decreasing the face value of the policy as the cash value falls due to withdrawals.
Below the chart, it lists the assumed costs. As you can see, the costs on the taxable account are almost all taxes. The costs on the VUL are almost all insurance costs. The surrender charge list is a reminder that this sort of a thing is a terrible idea if you aren't going to keep it your entire life.
Why Might VUL Work For You?
So, what is it that makes the insurance policy work so well in this illustration. There are a few factors at work.
First, the VUL includes a death benefit. That gives it a $2,555 advantage (the cost of the same amount of term insurance) each year for the first twenty years, the time at which even a small difference has a long time to compound.
Second, the VUL is not taxed as it grows. A 2% yield taxed at nearly 30% basically knocks 0.6% a year off the return of the taxable account. So the taxable account isn't growing as quickly as it would in a tax-protected account.
Third, when you withdraw money from a VUL, the first thing that comes out is the premiums you've paid. That comes out tax-free AND interest-free. That lowers the death benefit, of course, but you're not buying this thing for the death benefit. Basically, your first 4+ years of withdrawals are a return of your premiums paid, so you don't have to borrow that money. After that, you have to start paying interest on the money taken out of the VUL, since you're borrowing it (technically from the insurance company with the cash value as collateral), not withdrawing it. But that 4+ years gives the VUL a big boost in the distribution phase. Meanwhile, the assumption in the illustration is that you're withdrawing evenly from the taxable account, paying 29.8% on all gains. It was simply too complex to model an extremely tax-efficient strategy in the taxable account, but we'll discuss that a little later.
The Bottom Line
If you're in the highest tax bracket both now and later, you've bought a GOOD VUL packed with good investments, you're committed to holding it your entire life, you will have no trouble making the premiums, this is money you plan to completely spend in retirement, you cannot invest in an extremely tax-efficient manner in a taxable account, and neither the government nor the insurance company changes the rules significantly over the next 6-7 decades (or changes them to favor investing in a VUL over a taxable account), then this could work out very well for you. In fact, there's about $4 Million in slush there to make up for some of your assumptions being a little off.
But I'm Not Buying One
However, I'm still not going to buy a VUL for myself any time soon, despite having an income higher than most doctors for a number of reasons.
Too Many Bad Habits
Buying life insurance is a pain for me, so I try to do it as little as possible. While some schmuck actuary in Connecticut is trying to understand the difference between 5.10 and 5.11 and how much more dangerous climbing is if you do it more than 500 miles from home, I'm sweating bullets wondering how much more I'm going to pay for this policy than the idiot down the street who sits around watching TV all evening after work but hasn't yet been diagnosed with the diabetes he'll have soon. Combining insurance and investments usually isn't a good idea, but it's an especially bad idea if you can't get insurance or can only get it at a higher rate than other people.
Tons of Tax-Advantaged Accounts
I barely have a taxable account, and it is threatening to disappear all the time. In fact, it did from 2010 to 2015 before being resurrected. Where does my taxable account go? Four places- It goes into tax-protected accounts as more of them become available, it goes to charity in lieu of cash, it pays off debt, and it pays for Roth conversions at appropriate periods in my life. Many WCI readers are appropriately jealous of my available tax-protected space. This includes a partnership 401(k)/profit sharing plan, a defined benefit/cash balance plan, an individual 401(k) for WCI for me, an individual 401(k) for WCI for my wife, Backdoor Roth IRAs, an HSA, Roth IRAs for each of the kids, UGMAs for each of the kids, 529s for each of the kids. Not counting the kids money, I've got over $200K a year in tax-protected savings available to us if there is sufficient income to max it all out. At a 20% savings rate, that requires a million bucks a year in income just to max it out. At a million bucks of income, I would probably be giving close to $100K to charity each year. So, in order to want to start investing in a VUL, I would need to be saving something like $400K a year of a ~$650K net income. It just doesn't make sense for me. Not only would you need a huge income for this to work, but you also need to be plagued with career-long terrible retirement account options and a lack of desire to make large charitable donations.
Tom Martin argues that since some docs have a terribly low amount of tax-protected investment space (and I've met a few of you) that this can make sense at quite low income levels for the right doc. If you think that might be you, you'll have to run the numbers. Not my circus. Not my monkeys.
Not Interested In Long Commitments
I've already got three long commitments in my life, my marriage, my partnership, and my side business. I don't need any more. Buying a VUL is like getting married- til death do you part. If you decide you don't like this VUL at any point in the next 6 decades, you may be faced with an unsavory choice. I mean, you don't even break even (compared to investing in a taxable account) for two and a half decades. My financial life has changed a ton in the last 10 years. I have no idea how much it might change in the next 10, much less 50. Even the commitment to come up with $72K a year for the next 30 years is unpalatable to me. Minus our mortgage, savings, taxes, charity, and major expenditures, that's almost what my family lives on. I would hate to be in the situation where I felt like I was working longer than I wanted to in order to feed a ridiculous commitment to a life insurance policy. Sure, with universal life there are lots of ways you can decrease the premium due, but that obviously has consequences to the policy. The more of that you do, the more of the benefit for which you bought the policy in the first place goes away. In this particular case the minimum premium can be dropped as low as $17,592.
There is just a lot more flexibility with a taxable account. If I don't want to fund it this year, I don't have to. If I want to put in less, I can do that. If I want to put in more, I can do that. If an attractive investment comes up that no one had thought of when the policy was designed, or one that can't be put into a policy, I can invest in that. Think of all the financial innovations in the last 70 years. Now, imagine you were invested in a VUL that was packed with investments from 1950. No index funds. No ETFs. No DFA. No Vanguard. Now, consider all the investments that don't get put into VULs- P2P Loans, small business ventures, private equity, hedge funds, real estate etc. Flexibility has value.
A VUL can, however, be funded in much less time than 30 years. So I asked them to use the same assumptions, but only make payments for 10 years (same $72K a year payments and keep everything else the same.) This is how it looks:
As you can see, the concept can still work even without the 30 year commitment. Still a 10 year commitment, but that's more palatable.
I Can Invest Very Tax-Efficiently
When I look at that first chart, all I can think about are all the ways in which I could cut down on the tax burden. For example, you can select funds with a dividend yield of less than 2%. You can do tax-loss harvesting. You can move to a state without a state income tax. You can use your taxable account to pay for Roth conversions of tax-deferred money. You can use appreciated shares for gifts to charity. You can sell the highest tax basis shares first. You can spend from your retirement accounts instead and leave the highly appreciated shares to your heirs, who will be able to take advantage of the step-up in basis at death.
Plus, this is all illustrated at the maximum tax rates, including during retirement. How much taxable income can you have in retirement before you hit the maximum tax brackets? Well, in 2016 for a married couple filing jointly it's a taxable income of $467K. That's after all your deductions and it doesn't include any Roth IRA withdrawals. Even the 3.8% Obamacare tax doesn't kick in until you hit an adjusted gross income of $250K. We're basically living on $100K now and having a heck of a great time, essentially denying ourselves nothing that will make us any happier. Perhaps $200K if you throw in a new boat or car every year or two and some expensive vacations. What the heck am I going to do with the equivalent of a half million dollars in today's dollars in retirement? I'll be giving it away is what I'll be doing (and there are tons of tax-advantaged ways to do that), or else I've got to come up with a lot more expensive hobbies than what I'm doing now. Even if you can just get out of the top bracket into the second highest bracket, your capital gains/dividend rate drops to 15%. In fact, if you can get your taxable income down below $75K a year (very reasonable for many docs enjoying a comfortable retirement-remember that's after deductions and doesn't include Roth withdrawals) you don't pay capital gains taxes at all under current law.
Now, I've got to give Larson credit. I've seen lots of insurance agents produce terrible illustrations showing how awesome whole life is by assuming every dollar your taxable investments ever make are taxed at 50% every year. At least Larson is using appropriate assumptions. But those assumptions don't apply to me nor to the vast majority of physicians. If you think they apply to you, run some calculations on just how much retirement income you think you'll have. Bear in mind the minimum distribution at age 70 on even a $10 Million tax-deferred account is less than $400K.
So I asked Larson to go back to the drawing board and see how things look with a lower overall tax rate on the taxable account. They sent me tons of illustrations, but I'm only going to show you two.
This one keeps everything else the same as the initial example, except we lower the Federal income tax level from 20% to 15% on dividends and LTCGs, keep the 3.8% Medicare tax, and eliminate the 6% state tax. In essence, we've lowered the marginal tax rate from 29.8% to 18.8%.
As you can see, lowering the tax rate by 11% turns that $4 million of slush into a break-even scenario. The whole comparison here boils down to insurance costs versus tax costs. If you can get the tax costs lower, a taxable account can beat VUL. Just to illustrate that further, this example lowers the marginal tax by another 5% to 13.8% (yes, I know that 10% federal plus 3.8% medicare doesn't make any sense.)
In this case, you see that the taxable account dramatically outperforms the VUL the entire time, hitting age 95 with $3M more. Whether or not you can get your effective tax rate on your investments down to 13.8%, I'll leave to you to consider.
Risks of Change
Change happens, and it happens a lot over 6 or 7 decades. With that much time, risk of change is substantial. Government can change the rules about insurance and investing. Those changes could make your decision about VUL better or worse, but either way, it is out of your control. The insurance company can make changes too. Perhaps right now it has nice little DFA funds available in the VUL, but there is no reason they can't substitute them for some terrible loaded high ER actively managed fund next year. Perhaps they raise the cost of insurance, or the interest rate on borrowed money. There is also the risk of investment underperformance. If my taxable investments do worse than expected, I get less money and pay less in taxes. If my VUL investments do worse than expected, it's possible I may have to reduce my death benefit and/or contribute additional money to the policy (or invoke the rider.) The opposite is also true, of course, but there is risk there and I dislike risk outside of my control.
Are there people for whom a good VUL will work out better than a taxable account? Absolutely. But I'm probably going to continue to disagree with the Larson partners about the percentage of physicians for whom it is a good move. If you think it might be right for you, feel free to buy it. Perhaps you're a plastic surgeon making $1.5 Million a year with an $8 Million net worth, serious asset protection concerns (and living in a state where cash value life insurance gets good asset protection,) and only $100K a year of tax-advantaged space–I could be easily convinced this is a good move for you. But if you're a family practitioner making $180K, not maxing out your 401(k), still owe $200K in student loans, and don't have a taxable account, this might be one of the stupidest financial moves you could make. If you're like most docs, and somewhere in between those two extremes AND looking at having a major portion of your retirement savings in a taxable account, you might want to run the numbers and Larson's tool will help you to do that. Just remember that every calculator is “Garbage in, garbage out” so make sure your assumptions are as good as you can possibly make them.
What do you think? Do you own a VUL? Why or why not? If so, are you happy with it so far? How do you plan to spend from it? What were the main factors that made you decide to buy it? Would you consider buying one of these if your income went up or your tax-protected space went down dramatically? Why or why not?