Blog #187: Permanent vs. Term Comparison (Part 1)

Wall Street Journal – You Are So Wrong!

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Bob Ritter's Blog #187 Permanent vs. Term Comparison image

In the February 5, 2019, issue of The Wall Street Journal (WSJ), there is a flawed and misleading article in the Journal Report section entitled The Case Against Permanent Life Insurance.  Due to the reputation of the WSJ, you will soon be fending off criticism of permanent life insurance from your prospects and clients.

American humorist Josh Billings once said, “It ain’t ignorance causes so much trouble; it’s folks knowing so much that ain’t so.”

I first ran across this anti-permanent insurance evaluation in a 1950s book entitled The Grim Truth About Life Insurance written by Ralph Hendershot, a retired financial editor and columnist of The World-Telegram and The Sun.  At the time, it caused considerable controversy within the life insurance community as an unproved theory.

This same criticism has also been voiced frequently over the years by such folks as Suze Orman and Dave Ramsey.  It is also often heard from stockbrokers.

This is how Suze does it:


“I HATE WHOLE LIFE INSURANCE”
“I HATE UNIVERSAL LIFE INSURANCE”
“I HATE VARIABLE LIFE INSURANCE”
“THE ONLY TYPE I LIKE IS TERM INSURANCE”

 

Buy term and invest the difference?  There is no valid economic theory that explains why a bad idea is acceptable just because one hears it frequently.

The criticism is always words and no math.  You would think a commentator like Peter Lazaroff, chief investment officer at Plancorp, the author of the WSJ article referenced above, would include a mathematical comparison to prove his point – because it is primarily a numerical issue.  He didn’t.

So I’ll do the math so you can gauge the validity — or deficiency — of the term vs. permanent proposition narrated in the WSJ.

Case Study
Indexed Universal Life vs. Term Insurance and a Side Fund

Jack Baker, age 45, is in a marginal federal and state income tax bracket of 35%.  As part of his retirement planning, he intends to purchase $500,000 Indexed UL with scheduled premiums of $20,000 a year for the first 20 years; $0 after that.  We illustrated the policy at 6.90% to provide:

  • Protection for his family;
  • After tax cash flow of $75,000 a year from age 65 to 95.

One of Jack’s advisers asks, “Why would you spend $20,000 when you could get $500,000 of 20-year term insurance for $600?”

If that’s all there is to it, he shouldn’t.  However, has anyone ever bothered to show mathematically why term insurance is a preferred choice?

We compared Jack’s Indexed UL to $500,000 of 20-year term insurance costing $600 a year (the lowest premium we could find).  We included an equity side fund with an investment of $19,400 a year, the difference between the $20,000 premium for the Indexed UL and the $600 premium for the term.  We scheduled the growth of the side fund at 6.90% plus a 2.00% dividend1.  We also included a management fee of 1.00% for the side fund.

1 Most indices available to IUL typically do not account for a dividend, so we added a 2.00% dividend to the equity side fund.

Below is a summary of all the factors used to illustrate the growth of the side fund:

  • Growth: 6.90%.
  • Dividend: 2.00%.
  • Federal and State income tax assumption: 35%.
  • Federal and State Capital Gains and Dividend tax assumption: 25%.
  • Portfolio turnover rate: 40% through age 65; 10% after that.
  • Portion of realized gains that are long-term: 60%.

Click here for comments on “Yields and Sequence of Returns”.

Check out the following graphic:

Image 1
Indexed UL
vs.
Term and Equity Side Fund

Bob Ritter's Blog #187 Indexed Universal Life Insurance vs Term Insurance and Equity Side Fund Image

Click here to review the comparison illustration in detail.

The equity side fund is unable to deliver the same $75,000 from age 65 to 95 to equal the $75,000 cash flow from the Indexed UL.  It doesn’t even come close to doing so and is only 46.1% as competitive, collapsing at Jack’s age 78.

The equity side fund would need growth of 9.75% plus the 2.00% dividend for a total yield of 11.75 to match the IUL, almost 500 basis points higher than the assumed 6.90% of the Indexed UL

One of the reasons that Indexed UL performs so well in comparison to the equity side fund is the significant differences in plan costs.  You can see the comparison of these expenses on Pages 5 and 6 of the comparison illustration.

The death benefit of the Indexed UL remains in force long after the term insurance expires at age 65.  All this occurs with no life insurance premiums scheduled by Jack during his retirement years.  Some self-appointed experts say, “You don’t need life insurance in retirement.”  It’s not a difficult decision to keep a policy in force that has no more premiums due.

Conclusion

“Buy term and invest the difference” continues to be a siren song of the uninformed.

Cash value life insurance is an exceptional alternative to “buy term and invest the difference”.  InsMark illustrations can help you convey this critical point to your clients and prospects – and maybe even The Wall Street Journal.

If cash flow is in short supply or if the need for coverage is for a brief period, term insurance can make significant sense; however, for longer intervals, if cash flow exists to buy what you want, a cash value policy is the only logical choice.

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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.

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.

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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