Though it requires patience, as it takes time for the initial policy creation costs to be recovered and for cash value to accumulate, long-term investors may find that the long-term net returns on cash value accumulation within a whole life policy may be competitive with the fixed-income returns a household could otherwise obtain from traditional bond investments. This fourth role for life insurance focuses on cash value growth, with the postretirement death benefit serving as an afterthought. In this regard, one might even consider whole life insurance as an alternative source for a temporary death benefit instead of term insurance with the intention to build tax-deferred cash value to later surrender as an alternative to buying term and investing the difference in bonds.
Cash value life insurance provides a way for the policyowner and the insurance company to share the benefits of tax-deferral afforded to life insurance. To be comparable with cash value, the net return on bonds would have to be evaluated as the gross return less investment expenses, taxes, and the term premiums required to purchase an equivalent death benefit for preretirement human capital replacement needs.
The ability for cash value returns to potentially outperform other fixed-income investments relates to several factors. First, regarding the underlying portfolio of assets, the general account of the insurance company is better positioned than the household to manage the risks involved in earning higher fixed-income returns by accepting duration, illiquidity, and credit risk. Actuaries at insurance companies generally can make reasonable estimates about their future claims-related expenses. This allows for a longer-term investment focus with assets held to maturity that can offer higher yields than households could otherwise muster within their own fixed-income portfolios.
The general account is highly regulated with respect to the amount of assets to be maintained relative to liabilities and to asset allocation. Assets must be sufficient to fund policy claims, including death benefits, policy surrenders, and loans, after accounting for future premiums and investment returns.
General account investments typically include corporate and government bonds, mortgages, policy loans, a small allocation to equities, and potentially other types of alternative investments. The general account has greater return potential through its ability to invest in longer-term and less liquid assets, and to diversify the credit risk of higher-yielding corporate bonds. Households have less capacity to diversify and manage these risks. Asset values for households are too small, their timeframes are too short, and their liquidity needs are too high. Policyholders do not have individual accounts within the general account. The account value is aggregated across all policyholders.
The general account of the insurance company is using projections about the inflows of premiums and outflows of benefits and surrenders/loans and is using an asset-liability matching framework so that bonds do not have to be sold at a loss. Because insurance companies generally hold the fixed-income assets to maturity, rising rates will not trigger capital losses, but will allow new premiums to be invested at a higher rate. Any policy dividends should generally be more closely related to interest rate movements, slowly rising after interest rates rise and slowly falling after interest rates fall. Because insurance companies use asset-liability matching, a rise in interest rates allow subsequent bond purchases to be made at higher yields. This stable value aspect of cash value is a key motivator for using it in the volatility buffer strategies.
As well, fixed-income returns must be considered net of taxes. For bonds held in a taxable account, taxes must be paid on the annual interest payments, reducing the compounding growth potential of the assets. Likewise, in a tax-deferred account, taxes must be paid when distributions are made. Cash value within life insurance accumulates on a tax-deferred basis while the asset can potentially also be accessed without needing to pay any additional taxes.
Furthermore, cash value accumulation is already reported net of fees. Fees are internal to the policy and loaded into the stated premium. To be comparable, investment and advisory fees charged on bonds must be incorporated so that bond returns are identified on a net-of-fees basis.
Finally, cash value life insurance also provides a valuable death benefit. If we assume that a pre-retiree needs life insurance and is considering between term and permanent life insurance, the net returns on a bond portfolio would also need to be reduced to account for the cost of term premiums as a percentage of the whole life premiums. Bond investments could only be made with remaining funds after paying for the term premiums covering the preretirement life insurance need.
*This is an excerpt from Wade Pfau’s book, Safety-First Retirement Planning: An Integrated Approach for a Worry-Free Retirement. (The Retirement Researcher’s Guide Series), available now on Amazon.