Life Insurance for Supplemental Retirement: a Q&A Podcast
Life Insurance for Supplemental Retirement: a Q&A Podcast
February 11, 2020

BGA Insurance’s own Shawn Bragdon joins financial advisor Eric Bell for an in-depth Q&A session discussing life insurance retirement plans (or LIRP).  They’re great ways for individuals and business owners to accumulate money free of taxes. Plus, the proper case design of an LIRP can supplement your retirement and allow you to have a tax-free income stream until you’re 100 years old.

Listen to the full audio recording here, and read below for the entire script: 

 

Question: Shawn, are a lot of people buying life insurance for supplemental retirement plans today?

Answer: Actually, we are selling a lot of life insurance to people that don’t want or need any more death benefit protection. It’s pretty amazing.

Q: So why is that?

A: The primary reason is taxes. There are only three financial products in this country you can enjoy completely tax-free: municipal bonds (where you might get a 3% return today which won’t even beat inflation), a Roth IRA (where you can only contribute $6,000 a year unless you make over $193k then you can’t contribute at all), and cash value life insurance. That’s it. Every other retirement product out there, you will pay taxes on it at some point in time.

Q: Can you get a tax-deduction or use pre-tax money to buy a life insurance policy?

A: No. Unfortunately, you are using after-tax money when you contribute to a life insurance policy. But keep in mind, we are actually in a low tax environment. Today the top federal tax rate is 37%. Historically, the average top tax rate in this country has been over 57%. Many people are better off paying taxes now, while we are in a low tax bracket, versus rolling the dice to see what tax bracket they’ll be in 15 or 20 years from now. 401(k) plans are actually ticking tax time bombs. When you pull money out of a 401(k) plan you will pay tax on every dollar (all the money you put in and all the gains). With cash value life insurance, you pay taxes now but you will never pay tax on the money again.

Q: Shawn, do you think tax rates will go up?

A: Absolutely. Right now, Medicare, Medicaid, Social Security, and the interest on the U.S. debt uses up 92% of the current U.S. tax revenue. By the year 2025, it’s projected that 100% of the U.S. tax revenue will be used for the same four items. The only option the government has is to increase taxes, reduce benefits, or maybe reduce both.

Q: What type of life insurance products are people buying for supplemental retirement plans?

A: There are really three options: Whole Life (WL), Variable Universal Life (VUL), and Index Universal Life (IUL). There are pros and cons for each product, but in my opinion, the Index UL product is far and away the best life insurance product for a supplemental retirement plan.

Q: Why do you like Index UL?

A: You get the upside of an index like the S&P 500, but you are guaranteed to never have a negative return. The product also provides a lot of flexibility and can be designed specifically for a client’s needs and goals.

Q: Can you explain how IUL returns are credited to a policy?

A: Insurance companies typically have three to five different index strategies to choose from in an IUL product. The most common strategy is called an S&P 500 annual point to point with a cap and a floor. A typical cap would be 12%, and a typical floor would be 0%. This means your annual return will be somewhere between 0% and 12%. If the S&P 500 goes up 20%, you get the cap of 12%, but if you have a bear market like we did in 2008, where the market dropped 35%, you are guaranteed to get a 0% return that year.

Q: If you are giving up some of the upside in an IUL policy, wouldn’t someone be better off maxing out their 401(k) plan and then putting any additional disposable income into a brokerage account or maybe investing in real estate?

A: Great question. First off, let’s talk about the unique self-completing feature of a life insurance policy. Let’s assume you’re a 40-year-old guy, married with one kid. You’ve got a good job and are finally starting to contribute to a 401(k) plan. If you keep funding your 401(k) for the next 25 years, you and your wife will have a pretty good retirement. Unfortunately, you die in a car accident. The big 401(k) balance in 25 years never happens. A simple life insurance policy protects your wife’s retirement as well as your family’s lifestyle. To win a Super Bowl, you need a good offense and a good defense (don’t forget the defense).

Now let’s assume the same 40-year-old guy lives. We have analytical tools and reports that can compare an IUL product to just about any investment vehicle taking real-world taxes, management fees, and insurance costs into account. The results typically show that a taxable retirement product needs to get returns north of 9 to 10% to equal the performance of an IUL policy. Keep in mind, these reports do not take into account the risk of losing principal in a traditional retirement vehicle. If you recall, an IUL product guarantees you will never have a negative rate of return. Eliminating principal loss is a huge advantage for the IUL product. With a traditional equity investment, if the market drops 30%, you need to get a 42% return the following year just to be at breakeven. With an IUL policy, you lock in your gains in the up years and are guaranteed to get a zero in the down years.

Q: What age groups are best suited for an IUL product designed for retirement?

A: The sooner you start, the better, but most people that are buying this type of policy are between the ages of 35 and 65.

Q: Isn’t 65 too old to buy a life insurance policy for retirement?

A: Not really. Think about it. A 65-year-old guy has a life expectancy of 22 years. He’s a long-term investor. We did a case recently. The client had a net worth of about $6 million. He had more than enough wealth to maintain his lifestyle, but he had a lot of money in equities and bonds. He was concerned about losing principal, and he didn’t like the low yields he was getting on his bonds. We repositioned some of his assets into an IUL policy, which reduced his risk exposure and provided a tax-free bucket for future income.

The sequence of return risk can also be reduced or eliminated by owning an IUL policy. We call this smooth sailing. You’re 75 years old, you have a 401(k) plan, a brokerage account, real estate assets, and an IUL policy. You need $100,000 for your lifestyle, but the stock market just dropped 20%. Pulling money out of your equity accounts would be the worst thing you could do (selling at the low). If you had an alternative asset class that didn’t go down, you could tap into it for your lifestyle needs, allowing your equity accounts to rebound. This smooth sailing concept will dramatically improve your overall retirement plan.

Q: Shawn, how much does an IUL policy cost?

A: That’s a good question. I typically respond by asking how much does a mutual fund cost or how much does a 401(k) plan cost? It’s not about cost. It’s about how much money you want to contribute to the plan each year. You can put any dollar figure into an IUL policy. We have people putting in as little as $300 a month and we have very wealthy people putting in millions a year into an IUL policy. The key to using a life insurance policy for supplemental retirement is having the proper design.

Q: What does the proper design mean?

A: There are really two ways to design a permanent cash value life insurance policy. You either design it for death benefit protection, or you design it for accumulation proposes. If you try to both with one policy, you are either overpaying or underperforming.

Q: Okay, let’s say I have $100,000, and I want to put into an IUL policy for supplemental retirement. How would you design it?

A: Putting in $100,000 one time would be a bad idea. You would create what’s known as a Modified Endowment Contract (MEC). This means any gains pulled out of the policy would be taxable. A better design would be to put $20,000 a year for five years. We would then solve for the minimum death benefit based on your age and underwriting class so we avoid creating a modified endowment contract. By avoiding an MEC, you can pull all the gains out of the policy tax-free.

Q: Can I put more money into the policy in the future?

A: Yes and no. In our example, you can continue to contribute $20,000 a year into the policy after year five, which will increase your retirement income, but you can’t increase the premium 25k or 30k. This would create a MEC. This type of max funded design will reduce the mortality costs in the policy and increase your tax-free retirement income.

Q: What if I have a bad year, and I can’t make a premium payment?

A: No problem. With a max-funded design, you can skip or reduce your premium, and you always have the ability to catch up on missed or reduced premiums. The key in the design is you need to make at least five premium payments (they don’t need to be all in a row). Anything more than five premium payments means you just have more retirement income.

Q: A lot of people say it doesn’t make financial sense to buy a life insurance policy for retirement because of all the fees, loads, and charges in the policy. Do you have a response to this?

A: Anyone that makes that statement hasn’t taken the time to understand how a permanent life insurance product works and hasn’t done the math. I can run a report on any IUL illustration that shows all the fees, loads, and charges year by year for that specific policy. An IUL product is front-end loaded. Most of the fees and charges are in the early years of the policy. After that, the charges come down dramatically. A managed equity account is back-end loaded. The money manager might be charging you 1.25% on the value of the account each year. Initially, it’s a small number, but as time goes on and the account grows, that 1.25% becomes a big number. If you actually do the math, the long-term costs of some of the best IUL products in the industry are 1.25% to 1.50%. This matches up with the cost of an actively managed equity account. The big advantage: you don’t pay taxes on the gains in an IUL policy.

Q: How can you pull money out of an IUL policy and not pay taxes?

A: There are four ways you can pull money out of an Indexed UL policy tax-free. The first is called withdrawal, which is a tax-free recovery of your cost basis. To pull gains out of an IUL policy tax-free, we call them a loan, and this is a loan you never have to pay back. Most IUL policies have what I call a “standard loan,” which is usually the first 10 years of the policy. The insurance company charges you 4% on the loan but also credits you 3%, so you have a 1% net loan charge eating away some of the cash value in the policy. The next option is a “preferred loan.” This is usually after year 10 where the insurance company charges you 4% on the loan but then also credits you back 4% within the policy, so you have a zero-cost loan.  Some carriers offer loans that can be better than a zero-cost loan called a participating or index loan. Let’s assume you put a bunch of money into the policy and down the road you pull out a $75,000 participating loan to buy a new BMW.  With the participating loan, the insurance company is going to charge you 5% on the loan, but they will credit you whatever you achieved on your index account.  So, if your index earns 8%, then you are actually earning a positive 3% on your BMW. The downside to this type of loan is if the market tanks that year, you are going to have a negative 5% loan charge on that $75,000 BMW loan. This does pose more risk to a client, but the question is, risk compared to what? I lost over 35% of my 401(k) plan in 2008. The absolute worst-case scenario with this type of index loan is you’ll lose 5% on a percentage of the money you put into the plan. You can also switch from a participating loan to a zero-cost loan if you think the market is going to go south. There are two tax codes that describe the tax advantages of life insurance: IRS section 7702 allows you to pull gains out of a life insurance policy tax-free via policy loans, IRS section 101(a) allows beneficiaries to receive death benefits tax-free.

Q: What kind of returns can you get on an IUL product?

A: Historically these products have generated returns between 6% to 8%. These products have been around for about 16 or 17 years, and we actually have some of the insurance carriers that will publish the rate of return, every single premium payment that has gone into their indexed UL policy over this last, you know, 10 to 12 years. And the actual returns on some of the best products out there have actually been north of 8%. Tax-free. So the returns have been very attractive, and as I mentioned earlier, if you’re getting, you know, 7% for example on an index UL, and that’s a tax-free rate of return, we can show you that analytical report that compares your 401k plan getting 10%, and the index UL will just crush it. It’s not even close.

Q: You know, I wanted to shift gears a little bit, Shawn. I know on a couple of my clients, we added what they call long-term care or LTC rider. Can you talk about that?

A: Absolutely. That is a very popular rider that is being added to a lot of different life insurance products today. We’re not even selling traditional long-term care insurance anymore. Especially in the state of California. There are only a couple of carriers that even offer the product, and if you don’t need long-term care, you just wasted all those premiums all those years. What we’re selling is, what you described, Eric, a hybrid. And a hybrid is a product that provides both long-term care protection and death benefit protection. So, one way or another, it’s going to pay off. And often, you can add that rider to a policy that does not increase the cost dramatically, and that death benefit can be used for long-term care protection. It’s amazing how many people don’t have long-term care. It’s a big, big issue. Right now, a long-term care event is going to cost you in the range of $225,000, at least in Southern California. It’s going to last 3 to 5 years. You’re either going to get better, or you’re going to die. There’s not a lot of in-between. If you’re having to drain your IRA or drain your 401k plan to cover that cost, you know, all of the sudden, your family is not getting a legacy, your wife or spouse might be in trouble. Where, for pennies on the dollar, you can have that long-term care protection on a life insurance policy.

Q: Octogenarians are the biggest growing demographic in the United States right now, and a lot of people just have not planned at all for long-term care. I remember there was one case design that you guys had done for me, we did the accumulation policy, but also you did a life insurance policy with the bare-bones cost in it to provide for long-term care.

A: Yeah, we’re actually doing what I would call a combination plan, where you might have a client that “hey I have some money I can set aside for retirement,” and that’s the accumulation indexed UL that we’ve been talking about. “But hey, I do need more death benefit protection than that to protect my family.” And they’re adding that long-term care rider. So, with that type of client, we would often recommend two different policies. One designed purely for accumulation purposes, and one for low-cost death benefit protection with a long-term care rider. A very popular sale.

Q: Yeah, the client loved that, because if they had long-term care needs, that policy was specific for that, while their accumulation policy was not being touched, other than the income they were already pulling out.

A: Yeah, even people that are very successful, very wealthy, that could easily afford a long-term care event, are still buying these hybrid long-term care policies. It just makes financial sense. Pennies on the dollar. Pennies on the dollar.

Q: You know, Shawn, we went through a lot. I don’t know if we need to talk any more. Is there anything that you can think of that we didn’t cover, in regards to the LIRP, life insurance retirement plan?

A: Often when I’m talking to customers about the indexed UL product, they say, “it sounds too good to be true, what’s the catch?” And the catch is, first off, you need to be reasonably healthy. I mean, because to get a life insurance policy these days, you need to go through underwriting, you have to take an insurance exam, they’re drawing blood, they’re taking fluids, they’re going to order your medical records. So, if you’re uninsurable, this isn’t the product for you. We’ve had many cases, though, where we might have a husband that is not insurable, but he then uses his wife as the insured and is still the owner of the policy and can use the policy for tax-free income. So, that’s one of the major drawbacks of using life insurance is that you have to go through underwriting.

Q: Okay. Anything else, Shawn, that you can think of?

A: Nothing that comes to mind at the moment. You know, there are a lot of good insurance companies out there. One of the things that you might look at is diversifying a case. If you’re putting a lot of money into an indexed UL policy for supplement retirement, you might diversify between a couple of different insurance carriers, because there are indexed UL products some carriers have which have unique index strategies that no one else has. And by diversifying between maybe a couple of carriers, you have the additional advantage of carrier diversification, as well as maybe some unique index strategies.

Q: You know, that’s one of the things I really liked about BGA Insurance, is that you guys had about 67 different options. And you could diversify based on what the client’s health was, or needs, age, and so forth. I liked that there was no propriety solution, like you have with some of the major carriers.

A: Yeah, we actually did business with 64 different insurance carriers last year. It’s our goal and our target market are people like you, Eric: financial advisors. What our job is, is to find the very best insurance products and the very best underwriting decisions that we can find for the advisors that we’re working for. Life insurance underwriting, it is not a science. It’s truly an art form. You would not believe how many cases where you have one insurance carrier that might decline a case or highly rate a case, meaning a lot more mortality costs, where we’re able to pivot that case to another carrier and get a standard underwriting class. It happens all the time.

Q: Wow. Thanks for being with us, Shawn, today on Wait What: Financial Matters That Matter for Business and the People Who Own Them. Have a great day.

A: Thanks for having me here.