I was in Orlando at the Heckerling Conference when the January Issue of Trusts & Estates came out. Richard Harris came by to see me and made a comment on my piece in the magazine and let me know he had an article in the same issue that I might like to read. At my first opportunity I read it and then tracked him down and told him that I was upset by what he wrote. Why? Because I was in the process of writing essentially the same article and he beat me to it. Of course I had some fun with that but now I am relegated to commenting about his article which may actually be a bit easier than completing my own.
Richard is the Chair of the Insurance Advisory Board to Trusts & Estates and his article, Hedging Your Bets is subtitled; Using Life Insurance Assets to Stabilize an Investment Portfolio. I immediately understood what his point was going to be but I like his style and straight forward way of relating the subject matter, so it was a great read.
I have run into the following circumstance a number of times recently and given the changes in the estate tax law, I am sure you will hear a form of the following question a lot more often in the future; “We bought this policy in the trust to provide liquidity for estate taxes but given what our estate is valued at today and/or that we now have significant liquidity and given the recent changes in the tax law, do we really need it?” It’s important to remember that it is the rare client who is a fan of writing premium checks and in the off chance the policy owner has had an objective, third party analysis, he is likely already on the fence because it is probably been shown that the policy is lapsing at some point or at least under-performing original projections.
This is a perfectly sane train of thought but the best action plan may not be as clear as one thinks when it comes to keeping or bailing on a policy, depending on a number of factors.
Let’s start out with Richard’s first sentence. “Life Insurance is unique among types of insurance in that it insures against an event (death) that will occur as opposed to an event that may occur.” Life insurance hedges against the timing of death rather than whether or not it will happen. “That is, the timing of death is unrelated to the ups and downs of the economic market and helps to stabilize an individual’s portfolio of assets.” It does not go up or down with the Dow, it is not affected by housing starts, jobless numbers, monetary exchange rates, etc. If ones dies in another 2009 (bottom of the bear market), the death benefit will come in at full face amount and not discounted by 40%. In other words, life insurance has a risk which is not correlated with other investments. It is, in fact, a reason for the life settlement industry and why investment trusts will layer in life insurance among their investment holdings. Life insurance is a very strong diversification tool in a portfolio.
So, we’re talking about life insurance as an investment, right? Yes, but not as commonly understood.
Most commentary on “life insurance as an investment” is focused on the accumulation of cash value and the inherent tax advantages of a policy’s cash value. While I do not think such a strategy is inherently misguided, I am generally not a fan of such, in part due to the fact that very few policy owners understand the dynamics of such a transaction, the potential downsides and are too often misled regarding the internal rate of return realized under such a strategy.
Viewing a life insurance death benefit as an “investment” is another matter and is the focus of my comments.
This alternate view of life insurance is the reason I converted a term policy I owned on a former business partner (22 years my senior) to a permanent policy and the reason I procured a $1,000,000 policy on my parents which I own and pay for is the same rationale I share with my consulting clients regarding whether or not they should keep a life insurance policy they don’t “need”.
Here is a typical story. A trustee for a national trust company/bank comes up to me after an estate planning council meeting and says that she wants me to review her parent’s policies. Turns out they have three Universal Life policies from a respectable carrier; one on Mom, one on Dad and a survivor life policy. Dad is uninsurable and Mom is very healthy. Dad’s policy is very sound and will clearly pay a death benefit under any assumption of longevity but Mom’s policy and the survivor policy have what I deem to be a fifty-fifty chance of paying based on Mom’s life expectancy. This generates the afore mentioned comments; the estate isn’t large enough to be subject to estate taxes so do we need this policy?
Short answer; of course not.
The more realistic question is; should we maintain this policy? Answer; maybe. Let’s view this as the financial transaction it is and using empirical data, decide if it is a transaction, which if offered separate from a discussion about estate tax liquidity, one would want to take advantage of?
First we look at the remediation options for the existing policy to get it to persist for the desired duration under reasonable assumptions and then put that into context by comparing it to market alternatives. We then take the more attractive option and run the numbers. The bottom line in this instance is that the existing cash value and the proposed premiums (if any) will provide a 7.5% rate of return relative to death benefit at Mom’s fiftieth percentile life expectancy. If she lives for a shorter period, the IRR is higher and if she lives longer, the IRR is lower. This is a guaranteed, net after tax return with the only variable being the date of Mom’s death. A taxable equivalent under the lowest conceivable tax rates (federal and state combined capital gain rate in Michigan of 20%) would be 9.39%.
I would suggest that while one may be able to outperform this return, it is quite impossible at a commensurate risk which makes this an un-duplicable risk adjusted financial transaction. As good as this may be, a main point of Richard’s article with which I wholeheartedly agree is that the timing of Mom’s death has nothing to do with any other financial asset in the portfolio. As long as there is a financial ability to do so and there is a desire to manage assets as astutely as possible and, in this case, a goal of establishing a trust with assets to accomplish a specified purpose for the next generation or two, why would the family not pull the trigger? In other words, if this was a bona fide offer made utilizing any non-insurance vehicle, the reaction may be, “How much can we buy?”
Furthermore, for this family I created a scatter graph which plotted the estate investment holdings by class relative to risk and reward along with a single plot for showing the average risk and reward of the portfolio. I then layered in the life insurance, using risk commensurate with an AAA bond. My finding (in this particular estate) was that we could actually increase the return of the portfolio while reducing risk.
Here is another typical story. I have recently consulted with a business owner who was on the verge of jumping into a $100,000 a year commitment to a life insurance policy for “tax advantage investment planning”. His accountant pulled me in for my analysis and I opined that it would not work as suggested and that if I were in his shoes, knowing what I know, I would not move forward. In the course of casual conversation I told him that based solely on experience I was not a fan of insurance based accumulation planning but that I could see the benefit, in the appropriate circumstance, of layering in a reasonable amount of life insurance on older partners or parents for portfolio diversification. Though I thought this was an off hand comment, he immediately latched on to it and asked that I run numbers on his parents and in-laws. Here is what I came up with.
Preferred non-smoker rate for a 65 year old couple is roughly $11,000 annually per $1,000,000
Once he realized that a fact of nature is that your parent’s life expectancy and your traditional retirement age generally line up in the same neighborhood, he was quite interested in more closely exploring this strategy for $25,000 to $50,000 of annual premium which he would more likely structure as a guaranteed “short pay” scenario. These numbers are very similar to Richard’s example.
As Richard states, “Life insurance makes sense as an investment and diversifier for individuals with assets that they’re otherwise not consuming; in effect, a portfolio that will become an inheritance for their heirs.” I’m going to call this testamentary investment planning. If you’ve made a lifetime habit of making astute financial decisions, why stop now?
Richard goes on to discuss the importance of Managing Life Insurance, which, for anyone who knows me, understands these exact words could have come right out of my mouth. Finally, he concludes with commentary about fee-for-service work and states “With the proper tools used by professionals, your client can know his options for managing his life insurance policies and can make informed decisions about how to pay their premiums.” This sounds eerily similar to the tag line for my practice which is, Objective Information Drives Informed Decisions.
Clearly Richard and I are of precisely the same mindset regarding life insurance consulting and management and I’m proud to be of his acquaintance but I’m still pissed he published his piece before I did.