As we have discussed, having a well-designed investment plan is only a necessary condition for investment success. The sufficient condition is integrating it into a well-designed estate, tax, and risk management plan. There are noninvestment risks to consider: mortality, disability, the need for long-term care, and even longevity risk (living longer than expected). If these risks are not integrated into the overall financial plan, even the best investment plan can fail. Consider this example.
John is a thirty-two-year-old investment adviser. He is married and has two young children. He has just finished paying off his college debts, and his income is now sufficient to begin saving (and investing) significant amounts. He has a well-designed investment plan. Unfortunately, John dies in an auto accident. While he had a good investment plan, he did not live long enough to execute it. If he did not have enough life insurance his family will not have sufficient resources to provide for the standard of living John desired.
Analyzing the need for life, health, long-term care, disability, and umbrella coverage is a critical part of the financial-planning process. All types of "personal lines" insurance should be considered, so reviewing all existing policies with a personal lines specialist (home, auto, liability, boats, and art) can add significant value.
There are three main points underlying the philosophy of managing insurance risk:
Choosing only from among the highest-rated insurers is critical:
Credit risk is positively correlated with the length of the horizon: the longer the term, the greater the credit risk. With many forms of insurance, the horizon can be decades long.
Unlike equity investing, in most cases it is more difficult and costly to diversify the credit risk of insurers. The lower the credit rating, the more important the diversification.
There are several ways to check an insurer's credit worthiness. Joseph Belth, PhD, professor emeritus from Indiana University, has established widely accepted academic standards for evaluating insurance companies. Every September, Belth publishes a ratings issue of his Insurance Forum newsletter. Moody's, Standard & Poor's, Fitch, and A.M. Best also publish ratings. Only buy insurance from companies with the highest rating.
Taking investment risk inside an insurance contract should be avoided because doing so can jeopardize the death benefit. In fact, life insurance should not be viewed as part of the investment strategy, but rather as a tool to achieve an objective. Other reasons to avoid investment risk inside of an insurance contract:
Investment options are often limited to actively managed options with high internal expense charges and lack proper diversification.
Mortality and administrative charges are an additional layer of expense reducing returns. If the investment is made outside the insurance contract, those expenses are avoided.
While many insurance contracts are considered "permanent"—their coverage is not limited to a number of years—that does not mean the contract is guaranteed to provide the death benefit in the future. Only three types guarantee death benefits: term life (for the term of the contract), whole life, and guaranteed death benefit universal life. Of course, the guarantees only apply if the required payments are made. Note that whole life and guaranteed universal life can have the death benefit guaranteed for different periods of time. For example, a whole life policy might mature at age one hundred or age 120, depending on the issuing company. Guaranteed universal life can be arranged with premiums to guarantee a death benefit for a specific number of years or up to age 120, also dependent on the issuing company.
Term life insurance provides a death benefit as long as premiums are paid for a period of time. For level premium term, the premiums are level for a set number of years. After that point, they can dramatically increase.
Whole life insurance provides a guaranteed death benefit and does not take investment risk. As long as premiums are paid, the policy death benefit will be guaranteed.
Guaranteed death benefit universal life is essentially term insurance until you die. The typical interest rate assumption in universal life contracts is stripped away and provides a guarantee for life (usually age 110 or 120). These contracts provide no cash value access or growth of death benefit over time, but they generally cost less than whole life.
Universal life insurance is the equivalent of a term insurance policy with a fixed annuity rider. As the insured ages, the insurance expense ramps up. If the crediting interest rate and premiums combined are insufficient to cover these costs, premiums will rise. In addition, charges assessed to the policy can be increased to maximum levels at the company's discretion, further diminishing the contract's long-term viability.
Variable universal life is equivalent to a term insurance policy with a variable annuity rider. It has the same issues as universal life, the difference being that it is a mutual fund subaccount—not an interest rate—with returns determining the policy's cash value. Rapidly rising expenses and poor investment options can cause these policies to lapse without large premium payments made later in life, when most investors can least afford to pay them.
With variable whole life, the majority of premiums pay for a guaranteed base death benefit. The rest is allocated to mutual fund subaccounts that grow the cash value and death benefit. Because the excess premium is being invested inside an insurance contract when the insured could get more cost-effective market exposure elsewhere, this type of coverage is not recommended.
We buy insurance to protect our homes, cars, and lives, transferring some or all of risks we prefer not to bear ourselves. So, buying insurance is really about diversifying risks we find unacceptable to bear because the costs of not being insured are too great. The same logic applies to the purchase of payout annuities, the payments of which can be in either nominal or inflation-adjusted dollars.
At its most basic level, deciding to purchase an immediate annuity is a decision to insure against longevity risk: the risk of outliving one's financial assets. As the "cost" of outliving one's financial assets is extremely high, for individuals running that risk purchasing payout annuities makes sense. You should carefully consider their benefits.
Consider the following: A healthy male (female) at age sixty-five has a 50 percent chance of living beyond the age of eighty-five (eighty-eight) and a 25 percent chance of living beyond the age of ninety-two (ninety-four). For a healthy couple, both sixty-five, there is a 50 percent chance one will live beyond the age of ninety-two and a 25 percent chance one will live beyond the age of ninety-seven.
Typically we find that the most appropriate candidates for payout annuities are those whose portfolios are borderline for supporting their desired lifestyle throughout retirement. We recommend using a Monte Carlo simulation to analyze the benefits of a payout annuity.
Application: The following example illustrates why fixed annuities can be an appropriate investment in the right circumstance. John and Jane Smith are both sixty-five. They realize their portfolio is of relatively modest size. When combined with their retirement income from Social Security, it is just enough to provide for a comfortable retirement. They would like to be able to spend a bit more in retirement and have more "margin for error." But they do not want to take any action increasing their chance of running out of money during retirement.
They are concerned they might live longer than expected and have insufficient assets to fund their desired spending in their later years. Further, they are worried that if they do live beyond their life expectancies, their two sons might have to help them financially. Their worst fear is becoming financially dependent on their children.
While they would like to leave a modest estate to their sons, this goal is of minor importance relative to that of not becoming dependent on their children. They are secure in the knowledge their children have both been successful and have their own financial affairs in good order.
Purchasing a payout annuity could provide the Smiths the peace of mind they seek. The higher "return" from mortality credits combined with the guaranteed payments for life could help them achieve their desired standard of living and decreases the risk of outliving their assets and becoming a financial burden on their children.
The concept of a mortality credit is illustrated by the following example. On January 1, we have fifty eighty-five-year-old males who each agree to contribute $100 to a pool of investments earning 5 percent. They further agree to split the total pool equally among those who are still alive at the end of the year. Also, suppose that we (but not them) know for certain that five of the fifty will pass away by the end of the year. This means the total pool of $5,250 ($5,000 principal plus $250 interest) will be split among just forty-five people. Each will receive $116.67, or a return on investment of 16.67 percent. If each person had invested independent of the pool, the total amount of money earned would have been $105 or a return on investment of 5 percent. The difference in returns is the mortality credit.
For the Smiths, the benefits provided by the mortality credits and the guaranteed payments for life outweigh the loss of liquidity and the potential reduction in the value of the estate should they die before their life expectancies.
In general, the research indicates it is preferable to delay annuitization until the mid 70s or early 80s. One study concluded that a sixty-five-year-old female has an 85 percent chance of being able to beat the rate of return from a life annuity until age eighty. For males, the figure was 80 percent. Thus, unless investors are highly risk averse, they should probably not buy an immediate fixed annuity until they reach their mid to late seventies.
We offer two caveats: There are risks in delaying the purchase of an immediate annuity. First, if life expectancy increases, the cost of the annuity will increase. A 2006 study calculated that a 1 percent annual improvement in mortality is associated with roughly a 5 percent increase in the price of an annuity, or a 5 percent reduction in monthly payouts.[23] Second, if interest rates fall, annuitizing at a later date will lead to lower monthly payouts.
While payout annuities increase the odds of investors not depleting their financial assets, very few are purchased and very few deferred annuities are annuitized. The main reason for this anomaly is what we might call "buyers' regret": If they die before their expected lifespan, the assets used to purchase the annuity will be lost to the estate. Of course, if they live longer than expected, assets are preserved. By delaying annuitization until the age of eighty-five, a sixty-five-year-old investor can dramatically reduce the amount of dollars needed to purchase a fixed-income stream, retaining assets for the estate.
If you wish to learn more about the benefits of payout annuities, read Chapter 5 of The Only Guide to Alternative Investments You'll Ever Need.
It is estimated that at least 60 percent of people over age sixty-five will require some long-term care services. Medicare and private health insurance programs do not pay for the majority of long-term care services most people need, such as help with dressing or using the bathroom.
To get the care you might need, planning is essential. Yet long-term care is often overlooked as a crucial planning tool. According to an April 2007 article in Financial Planning, only seven million of the nation's 76 million baby boomers actually have a policy that will cover the costs of long-term care.
There are many reasons why people fail to plan for long-term care: the natural tendency to avoid thinking about becoming dependent on others for your care, misinformation about the risks of needing care, and lack of knowledge about the cost of care and payment options. In addition, most people just don't like to think about these types of issues.
LTCI can provide for personal and custodial care for an extended period of time. Coverage is triggered by needing help with or losing at least two activities of daily living (ADLs). There are six categories: bathing, dressing, eating, transferring, toileting, and continence.
The "loss of ADLs" could be the need for substantial hands on, standby, or supervisory assistance. Any cognitive impairment, such as Alzheimer's or dementia, are automatically covered whether or not the two-ADL trigger is met.
A common misperception of long-term care is that it is only for nursing home care. While care may be received at a nursing home, it can also be received at an assisted living facility, adult day care with respite services, or for home-based care. Care can be defined in two ways:
Care for custodial (personal) needs. Care provided to assist with ADLs or to meet personal needs (assistance with bathing, dressing, eating, or getting in or out of bed).
Care for skilled needs. Care provided by a licensed health care professional such as an RN, LPN, physical therapist, or speech therapist. A physician must order this care.
Long-term care is a tool that can help preserve and protect financial assets. It provides flexibility in choosing the type of care and where care is received. It can help ensure high-quality care and provide financial and emotional support for the family. There are six issues to consider when purchasing long-term care coverage:
How much coverage is right for you?
Where would you like to receive care?
Nursing home
Home-based health care
How would you like to receive your benefits?
Reimbursement: Reimbursement for actual expenses accrued on a monthly basis.
Indemnity: Full DBA payments when receiving licensed care whether or not maximum DBA is being used, that is, full payment of DBA for each day of care no matter how much is spent.
Cash: This does not require licensed care. It is the most expensive option, up to 20 percent additional cost.
How long do you want to receive benefits?
Typical benefit periods are two, three, five, seven, and ten years (this is carrier specific).
Lifetime option is available but seldom used.
Benefit period is driven by a pool of money. Example: A $150 DBA × 365 days × 5 years = $273,750 total lifetime benefits. Even if five years have elapsed, the benefit remains until the pool of money is depleted.
What type of inflation protection would you like?
None
Simple. Typically 5 percent.
Compound. Also typically 5 percent.
How long can you wait before benefits are paid?
The "elimination period" is the period of time during which you are responsible for paying the cost of your care services.
A typical elimination period is ninety to one-hundred days.
Using the tool of Monte Carlo analysis, the following case study demonstrates the importance of long-term care.
Mr. and Mrs. Smith are both sixty-five years old. They have financial assets of $6 million. A Monte Carlo analysis reveals that their portfolio has a high likelihood of providing sufficient assets to maintain their desired lifestyle if neither ever has a need for long-term care. If one or both need long-term care for an extended period, the portfolio has a significant likelihood of being strained or even depleted. The Monte Carlo analysis also reveals that the costs of a LTCI policy will not significantly reduce the odds of success.
If no insurance is needed, the costs of purchasing a long-term care policy increases the odds of running out of money by just 3 percent (94 to 91 percent). If long-term care is needed, and no insurance purchased, the odds of running out of money increase by 20 percent: the odds of success falling from 94 to 74 percent (see Table 13.1). That is almost seven times the 3 percent increase in likelihood of failure caused by the purchase of insurance.
For some affluent investors, the analysis may show they can self-insure and still have sufficiently low odds of failure, that is, outliving sufficient financial assets. Let's take an investor with substantial bequeath objectives and analyze her likelihood of having at least $1 million, $3 million, or $5 million at death (see Table 13.2). The addition or absence of long-term care significantly impacts the odds of success.
Table 13.1. The Impact of Adding Long-Term Care Insurance
Long-Term Care Scenarios[a] | Odds the Portfolio Will Have Sufficient Assets (%) |
|---|---|
No long-term care insurance, no need for care | 94 |
Have long-term care insurance, no need for care | 91 |
Have long-term care insurance coverage for 20 years, need care for 5 years (age 85–90) | 83 |
No long-term care insurance, need care from age 85–90 | 74 |
Table 13.2. The Impact of Adding Long-Term Care Insurance
Long-Term Care Scenarios[a] | Odds Ending Portfolio Will Have at Least $1mm, $3mm, and $5mm |
|---|---|
No long-term care insurance, no need for care | 94%, 68%, 48% |
Have long-term care insurance, no need for care | 91%, 63%, 45% |
Have long-term care insurance coverage for 20 years, need care for 5 years (age 85–90) | 83%, 55%, 38% |
No long-term care insurance, need care from age 85–90 | 74%, 49%, 32% |
[a] The following assumptions are used in the above analysis: LTCI Policy Coverages
Care assumptions without LTC:
Care assumptions with LTC insurance:
| |
The addition or absence of long-term care signifi cantly impacts the odds of success.
We see that while the odds of leaving a large estate decrease somewhat if long-term care insurance is purchased and no care is needed, the odds of success fall by a greater amount if long-term care insurance is not purchased and care is needed. Thus, both risk-averse individuals and those with large bequeath objectives should prefer to purchase such insurance.
Traditional life settlements offer policyholders the opportunity to access additional cash by unloading policies they no longer need or can afford. Recently, the industry has seen the emergence of speculator-initiated life insurance policies, or "spin-life policies" that promote the purchase of life insurance only to sell it to an investor a few years later for a single payment. While traditional life settlements can be useful tools for financial and estate planners, a spin-life strategy is not recommended as the benefits do not outweigh the costs and inherent risks.
Purchasers of life settlements are generally large institutions like banks or hedge funds. The ideal policyholder is an older individual (sixty-five or older) who can no longer afford the premiums or no longer needs the death benefits from a life insurance policy. Life-settlement investors pool the purchased policies, dividing them into life-settlement-backed securities typically sold to hedge funds, pension funds, and other institutional investors.
Life-settlement brokers are also in the market. While some help investors sell their existing policies to other investors, others are taking a more aggressive approach. Some brokers seek out older high-net-worth individuals with life insurance capacity, lend them money to pay for premiums on high-value life insurance policies, and prearrange to purchase the policy a few years later for a one-time cash payout (less the amount loaned for the premiums). These speculator-initiated spin-life contracts are also known as stranger-owned life insurance (STOLI) policies.
Selling policies to fund medical care and living expenses is referred to as traditional life settlements. With anticipated changes to estate-tax laws, traditional life-settlements can provide investors with an additional estate and financial planning tool. For example, a life settlement could be used to remove the value of an individually held life insurance policy from an estate's assets. A charitable organization receiving a donated life insurance policy can use a life settlement to receive an immediate cash benefit with no further premium obligations. The donor would receive a tax deduction from the donation and an additional amount in excess of the surrender value from the life-settlement transaction.
Life-settlement payouts are often about a third of policy value and much greater than the surrender value or cash value of the contract.[24] There is no official guidance from the IRS regarding the tax treatment of life settlements. The IRS could consider all proceeds above the cost basis as ordinary income—not the industry's customary tax treatment.[25] There are trade-offs, as "the tax consequences to the seller of receiving a cash payment during the insured's lifetime are not as favorable (or certain) as that of receiving the policy's death benefit."[26] You should consult a tax expert prior to arranging for a life-settlement payout.
One big obstacle to completing a traditional life-settlement transaction is finding an investor. Individuals should always obtain more than one bid for their policies and request full transparency during the bidding process. There is evidence that in some cases, brokers negotiated settlements and did not pass along the full bid amounts to the clients.[27] According to a study conducted by Deloitte, seniors completing a life-settlement transaction received just 20 cents on the dollar instead of the 64 cents on the dollar Deloitte calculated to be the intrinsic value of the policy.[28]
Where policies contain personal data and medical history, sellers should verify that investors are well-established institutions that will transfer such information anonymously. If personal information is known, one can argue the insured risks a moral hazard.
Industry regulations have not been firmly established in this new industry, and there have been several well-publicized life-settlement investigations and lawsuits. As more regulations are adopted, there may be fewer investors to offer liquidity from insurance policies, and the ability to sell policies and transfer ownership may become more difficult.
Spin-life policies are also subject to additional risks and costs that traditional life settlements do not face. There is credit risk with the investors, since the insured must both:
Rely on funds from the investors to pay for the premiums.
Ensure the investors will have enough capital to purchase the policy.
Carefully review contracts with an insurance expert. Some may include clauses where, if an investor cannot be found, you are not released from the debt or interest on the debt.
Some states are increasing the number of contestable years for life insurance. Some thirty states are currently weighing two- or five-year waiting periods before policyholders can sell their policies. In an effort to target STOLIs directly, others prohibit the sale of a life insurance policy within five years of purchase if the insured borrowed money to pay for the premiums.[29] Finally, a few states are contesting the legality of life settlements. To purchase insurance, one must have an insurable interest (usually in their own lives), but there are currently no laws prohibiting life settlements. Insurance lobbyists are hard at work to make those changes. This could allow insurance companies to cancel or void spin-life policies, leaving the policyholder without a policy to sell and a large amount of debt from loans on the insurance premiums.
Increases in regulations and in life insurance premiums to cover falling lapse ratios (number of lapsed policies to total number of policies in force at the beginning of the year) lead to a more restrictive life-settlements market and one with reduced individual profit. The higher premiums also make it more expensive for individuals who truly need life insurance to purchase new policies. With the legal and tax treatment of STOLI policies so uncertain, and given such lack of transparency in the arrangements, these transactions cannot be recommended. However, traditional life settlements continue to be useful financial and estate planning tools. For individuals who have unnecessary policies and do not need immediate access to a lump sum of cash, there are other options. Some possible alternatives include using a 1035 exchange to convert from an insurance asset to:
An investment asset (such as a low-cost deferred variable annuity).
An immediate annuity for income.
A new life insurance policy.