This has almost nothing to do with real estate but I recently realized that the topic of life insurance as an investment often gets a pretty bad rap. A lot of people will tell you that life insurance is a terrible investment and that if you need life insurance you should simply buy a term policy and save the difference. And there is some truth to this but, as with most financial matters, the real truth is a lot more complicated.
I’m not suggesting that you go out and buy a life insurance policy in order to take advantage of what I’m about to tell you. However, it’s possible that you already own a policy that provides you with this opportunity. For instance a lot of life insurance plans offered through employers are what’s called universal life insurance plans, which are specifically designed with a flexible investment component embedded in them, or you may have purchased such a plan on your own. And there may be other types of life insurance plans out there that also offer this opportunity but I’m just not that familiar with them all. The bottom line is that you are going to have to call your insurance company to find out if you can do this.
The Investment Component Of Life Insurance
What a lot of people don’t understand is that, with the exception of term life insurance, most life insurance policies are some kind of a bundle of an investment and a true death benefit. When evaluating these policies you need to break them apart into their individual components and analyze them separately to really understand what it is that you are getting into. Unfortunately, I can’t get into all the details of that analysis today but I can give you a taste for it.
So here’s the opportunity. Some of these life insurance policies, such as the universal life plan, allow you to either make an additional lump sum contribution or simply increase your monthly or annual payments. The additional contribution goes towards your cash value, which will then earn essentially tax free interest. And you can pretty much withdraw your money any time without penalty or income taxes, though you need to consult with your insurance company on exactly how that works. However, the basic concept is that you can take out the total of all your payments into the policy, including insurance premiums, before they start taxing you.
How much interest? You need to call your insurance company to find out and it can fluctuate over time but I currently have 3 different life insurance policies that offer these options and one of them pays 4%, another 4.5% and a third one pays 5.6%. These rates are from top notch life insurance companies like MetLife and Northwestern Mutual. Those are pretty good tax free returns since 10 year municipal bonds are only yielding like 2.5%. And this strikes me as a lot safer than the stock market – especially in light of recent volatility.
It turns out that this investment might actually be safer than municipal bonds too. One thing that people don’t realize about municipal bonds is that their value fluctuates with interest rates – when rates go up their value goes down in order to provide a higher return on that lower price.
For example, let’s say you buy FLORIDA ST DEPT MGMTSVCS CTFS PARTN REF 5.00% 08/01/2025 COPS SER. 2015A (isn’t that a mouthful?) today. It’s priced at 122.04 to provide a 2.48% yield over the next 10 years. However, if interest rates move up 1% tomorrow then this bond will reprice to 112.66. In other words, your so-called safe investment just lost 7.7% of its value.
The nice thing about the cash value of your life insurance policy is that it does not fluctuate with interest rates. It only goes up in value as it earns interest every month.
What about the risk that your insurance company will go out of business? Well, first of all you definitely want to be sure you’re dealing with a top rated insurance company. In addition, this is something you can monitor and you can yank your money out if the company starts to get shaky. For instance, with publicly traded companies you can monitor their stock price and if starts to nose dive you immediately phone in a redemption request. Of course, if you wait until they are on their last legs they may just refuse your request.
But aside from an outright refusal you would normally get 100% of your money out. In contrast, if a municipality starts to risk default the value of their bonds are going to decline in real time. You will not get 100% of your money out.
There Actually Is A Real Estate Connection
Because of the flexibility and relative safety of this investment vehicle there actually are implications for someone planning on buying a home in the near future. Let’s say you are saving towards a down payment on a purchase 1 – 2 years down the road. It would be a huge mistake to invest that money in the stock market because of the day to day volatility. When you need the money you may find that you actually have 30% less than what you thought you’d have.
Investing in stocks should really be reserved for money that you won’t need for many years – experts often advise 10 years or longer. What’s really nice about putting money into the cash value of a life insurance policy is the fact that you can withdraw it two years down the road and be fairly certain that all of it will still be there plus interest.
There Has To Be A Catch, Right?
In the current interest rate environment how can insurance companies afford to pay such high rates? If it’s too good to be true…well, yes and no.
This opportunity exists because of some unique aspects of the life insurance business. First, the US government has decided to give these earnings a free pass on taxes so the insurance companies basically get to create a tax arbitrage. They take taxable earnings, at a higher rate than municipal bonds, and pass them on tax free to their policyholders. Don’t you love our tax system?
In addition, fluctuations in interest rates do not immediately impact the policyholders because they are basically drawing on the earnings of a large investment portfolio that was constructed over the course of many years. As long as the insurance company doesn’t sell those investments there really is no immediate impact on policyholders. However, future earnings are impacted as the insurance company acquires investments at the new rates. So the interest rate paid out on cash value will generally follow current rate trends with a lag.
However, you do need to be careful in making these additional cash contributions. You want to confirm with your insurance company that there are no fees/ commissions being taken out at either the front end or the back end – i.e. $100 in translates to a $100 increase in cash value and a $100 withdrawal at any time reduces your cash value by exactly $100.
And, as I said in the beginning of this post, you do not want to buy a life insurance policy just so you get this investment option. If you do that you will incur insurance costs which may or may not be of value to you. However, if you already own a life insurance policy or are planning on buying one anyway then this investment option could make a lot of sense for you.
Gary Lucido is the President of Lucid Realty, the Chicago area’s full service discount real estate brokerage. If you want to keep up to date on the Chicago real estate market, get an insider’s view of the seamy underbelly of the real estate industry, or you just think he’s the next Kurt Vonnegut you can Subscribe to Getting Real by Email. Please be sure to verify your email address when you receive the verification notice.