Blog #171: Arbitrage vs. Accelerated Arbitrage™

(Part 1 of 2)

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Bob Ritter's blog 171 accelerated arbitrage image

Interest rate arbitrage occurs with Indexed Universal Life (“IUL”) when:

  • The loan interest rate is fixed (typically 4% to 5%);
  • There are outstanding policy loans and the selected index yields more than the loan interest rate;
  • The cash values securing the loan balances are credited with the yield produced by the selected index as if there were no loans.

Interest rate arbitrage with IUL is a powerful force when coupled with max-funded policies with serious participating loans scheduled for retirement years.

As you will see, there is a way to accelerate the arbitrage further by coupling it with higher premiums and greater policy loans where the policy owner funds the increase in premiums from another source.

Positive arbitrage is created in any year when the yield outperforms the loan interest being charged on the outstanding policy loan.

Negative arbitrage is created in any year when the yield underperforms the loan interest being charged on the outstanding policy loan; however, IUL includes the guarantee that the yield credited to cash values can never go negative regardless of the performance of the selected index.  This means that once policy cash values are established, they can never be adjusted downward with a negative yield.  The worst case would be a 0.00% yield.  (Policy fees such as mortality charges will continue to be debited from policy values.  Values shown throughout this Blog reflect all policy charges.)

Case Study #1

An example of positive arbitrage can be illustrated with the following IUL data:

  • Client name, age, occupation, and tax bracket:
    Robert Sterling, Age 45, Attorney, 40%
  • Face amount of IUL policy: $1,054,069
  • Death benefit: Increasing for 20 years; level thereafter
  • Annual premiums for 15 years: $50,000
  • Illustrated interest rate: 7.00%
  • Policy loans for retirement cash flow begin at age: 65
  • Annual amount of continuing policy loans: $170,000
  • Duration of illustration: Age 45 to Age 100
  • Cash value (net of loans) at age 100: $1,708,722

Below is a graphic of this illustration:

Image 1
Illustration of Values
(Including the Effect of Interest Arbitrage)

Bob Ritter's blog 171 illustration of values accelerated arbitrage image

Click here to review the entire illustration.

Compared to What?

The IUL is neither good nor bad until it is compared to something else.  So let’s compare it to identical costs directed to various financial alternatives:

  • Taxable Account:
    Yield: 7.00%, Mgt. Fee: 0.50%
  • Tax Deferred Account:
    Yield: 7.00%, Mgt. Fee: 0.50%
  • Equity Account:
    Growth: 7.00%, Dividend: 1.00%, Cap Gains / Dividend Tax: 25.00%,
    Portion of Cap Gains Long-Term: 75.00%, Portfolio Turnover: 15.00%,
    Mgt. Fee: 0.50%

The graphic below summarizes the results of the comparison using the same IUL numbers as Image 1.

Image 2
Various Financial Alternatives

Bob Ritter's blog 171 various financial alternatives image

The IUL is a superb financial instrument, and arbitrage is how much of the performance is realized.

Click here to review the entire illustration of alternatives.

Assume that Robert has determined that the IUL is a life insurance policy he wants to acquire.  He is comfortable with the $50,000 premium for 15 years and finds the annual $170,000 after tax, retirement cash flow compelling.  Accelerated arbitrage can improve the results even further.

Case Study #2
Accelerated Arbitrage

Premium financing is another financial strategy that works because of positive arbitrage if the loan interest charged by the bank is less than the indexed yield credited to IUL cash values.

Let’s marry the two concepts by increasing the 15-year scheduled premiums for the IUL from $50,000 to $200,000 which increases the face amount of the IUL policy to $4,216,273.  However, we will keep Robert’s premium contribution at $50,000 a year – the balance of $150,000 will be funded by bank loans, and the loan interest will be accrued.  The goal is to repay the bank loan at the beginning of the 16th year using a policy loan on the IUL.

Below is a look at the first 16 years of the plan funding.  As you can see in Column (2), Robert’s premium share is identical to his premium cost in Case Study #1.

Image 3
Premium Financing Plan
(Short Summary #1)

Bob Ritter's blog 171 premium financing plan short summary number 1 image

Click here to review all 55 years of this Summary report with the addition of Columns 7, 8, 9, and 10 (cash flow, cash value, net cash value, and net death benefit).  Notice in all years of Column (9) that the net cash value exceeds the bank loan (including accrued loan interest.)

Below is a graphic of the overall results of the premium financing.

Image 4
Premium Financing Plan
(Results for Robert Sterling)

Bob Ritter's blog 171 premium-financing-plan-results-for-robert-sterling image

As you can see, the results of the accelerated arbitrage are considerable.

Click here to review the entire Premium Financing illustration.

Arbitrage vs. Accelerated Arbitrage

Using the new InsMark Compare module in the InsMark Illustration System, we’ll import Robert’s costs and values from Case Study #1 and compare them to his share of the costs and values from Case Study #2.

Below is a graphic from InsMark Compare showing the results.

Image 5
Case Study #1 vs. Case Study #2
(Comparative Results for Robert Sterling)

Bob Ritter's blog 171 case study number 1 vs case study number 2 image

As you can see, the effect of accelerated arbitrage is considerable.

Click here to review all the illustrations and graphics for this comparison.

Conclusion

Accelerated arbitrage produces an extraordinary increase in benefits for the same personal contribution, but it is not a plan for the faint-hearted.  Suitability of the two arbitrage variations examined in this Blog is an important consideration:

  • A very conservative client may not be willing to acquire IUL let alone couple it with a premium financing arrangement.
  • A moderate client may welcome IUL for its arbitrage potential but be unwilling to include it in a premium financing arrangement.
  • A moderately aggressive or aggressive client may be willing to couple both concepts in search of accelerated arbitrage provided the safety valve discussed below is present.

Safety Valve

With IUL/premium financing coupled as illustrated in this Blog and assuming a policy with high early cash values is used, termination of the plan mid-stream will likely result in the policy having significant residual value (“safety valve”) after repayment of the bank loan.  This is further enhanced by the guarantee that negative arbitrage cannot occur due the carrier guarantee that the yield credited to cash values can never go negative regardless of the performance of the selected index.

Below are the pertinent columns from the Premium Financing Summary report which illustrates Robert’s portion of policy cash value in excess of the bank loan during the first sixteen years (the year the bank loan is illustrated as repaid).  Values in Column (9) show the extent of the safety valve.

Image 6
Premium Financing Plan
(Short Summary #2)

Bob Ritter's blog 171 premium financing plan short summary number 2 image

Conclusion

For those comfortable with accelerated arbitrage, the combination of IUL and premium financing may well be irresistible.

Coming Up

Premium financing has been a very significant development in the life insurance industry, and the impact of funding IUL with bank loans is considerable.  The long-range consequences are difficult to appreciate fully without the mathematical comparisons illustrated in this Blog.

That said, I fundamentally believe that any financial transaction becomes more meaningful to a client if it is integrated within an overall wealth analysis on a “do-it” vs. “don’t do it” basis, an alternative form of “Compared to What”.  In Blog #172: Arbitrage vs. Accelerated Arbitrage (Part 2 of 2) scheduled for early December, I will address that issue by integrating the Arbitrage vs. Accelerated Arbitrage reports in this Blog into our Wealthy and Wise® planning system to gauge its impact on cash flow, net worth, and wealth to heirs.

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Chris Jacob, CFP, SFI-Cadeau, St. Louis, MO, InsMark Platinum Power Producer®

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Important Note #1:  The hypothetical values associated with this Blog assume the nonguaranteed values shown continue in all years.  This is not likely, and actual results may be more or less favorable.  Life insurance illustrations are not valid unless accompanied by a basic illustration from the issuing life insurance company.

Important Note #2:  The information in this Blog is for educational purposes only.  In all cases, the approval of a client’s legal and tax advisers must be secured regarding the implementation or modification of any planning technique as well as the applicability and consequences of new cases, rulings, or legislation upon existing or impending plans.

Important Note #3:  Many of you are rightly concerned about the potential tax bomb in life insurance that can accidentally be triggered by a careless policyowner when policy loans are present and net cash values are so low that the income tax on the gain on surrender (calculated using gross cash values less basis) is more – often significantly more – than the net cash surrender value.

This lurking tax bomb can be present in all forms of whole life and universal life where policy loans of any type are utilized.  It can be avoided, and you, the producer, are key to making sure your clients are aware of how to sidestep it.

A tax bomb can be avoided if the policy is neither surrendered nor allowed to lapse, since the policy death benefit wipes away the income tax liability.  The foundation of this special treatment is IRC Section 101.  This statute provides that the proceeds of life insurance maturing as a death claim are exempt from federal income tax.  This applies to the full death benefit, including any cash value component whether loans exist or not.

Note: It is best if you design the policy with no premiums scheduled after retirement if loans are anticipated in retirement years.  This may require higher premiums during pre-retirement years, but a policy with no premiums scheduled is much more tolerable at advanced ages than one with continuous premiums.

Can your clients remember these facts years into the future?  If they are incapacitated, will family members understand the issues?  It is probably best to file a short note with the policy – something like this (although your compliance officer will likely have preferred language):

If/when you take policy loans on this policy, be sure to talk to your financial adviser before surrendering or lapsing the policy in order to anticipate unexpected tax consequences that may otherwise be avoided.

Does this note make it harder or easier to deliver the policy?  It’s harder if you haven’t discussed it with your client; easier if you have.  And that’s the point – you should discuss it.

Some life insurance companies have concierge units that monitor loan status at the point of lapse or surrender, and you would be well-advised to select an insurance company with this capacity.  To be effective regarding the tax bomb, such carriers need to be proactive in their client relationships, not merely reactive to client inquiries.  I hope that ultimately the policyholder service division of all life insurance companies will bring this potential liability to the attention of those surrendering or lapsing policies, particularly those policies with 50% or more of the gross cash value subject to outstanding loans.

 

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