Chapter 9

Life Insurance, Annuities, and How They Relate to Your Wealth Code

Life insurance and the various products that come from life insurance companies have always been a great source of debate among financial advisors, as well as the general public. Some call it a necessary evil, others say it is the Holy Grail, while still others say it is a complete waste of time and money.

As with everything, no two people will have the same needs, but many of us could potentially benefit from some form of life insurance or life insurance products, such as annuities, at some point depending on our situation. When used appropriately, insurance is most certainly a part of a successful financial table. A problem we see consistently is the sale of life insurance products by insurance agents who are not licensed in securities, or by insurance representatives who are licensed in securities yet only focus on life insurance products. One-trick ponies one might say. Their answer to all financial questions comes back to either life insurance or annuities, either fixed or variable.

I view insurance products as another tool in the financial toolbox to be used when appropriate and suitable for the client’s needs. Here again, one size does not fit all.

This discussion will serve as a brief opinion on this very complicated basket of financial tools, tools that all too often are sold by representatives and agents who tell only a part of the story. This is a common problem with the sale of annuities.

There are countless books that cover all aspects of life insurance products, and it is not the focus of this book to dive deeply into this topic but to provide a primer or reference on which to build your understanding.

General Need for Life Insurance—Family Liabilities

Why is life insurance part of most everyone’s financial journey at some point? Because we all take similar paths in life in one form or another. We grow up, go to school, find jobs, and eventually, many of us start families. As we follow our financial road, many check points deem life insurance to be a vital part of protecting our wealth and our family’s financial well-being.

Family liability is generally the first major reason to get life insurance. If you have young children, a spouse, or other dependent(s) who would suffer financially if you died, you have what is called an insurable interest. That is, a need for life insurance protection.

Ask yourself a question. If you had the misfortune of being run over by a steamroller tomorrow, what would the financial liabilities and needs of the following be:

• Spouse
• Children
• Other beneficiaries who might depend on your support
• Your estate and possible tax consequences to your heirs

Family liabilities include everything from income needs to education, health care, and so on. If you earn significantly more money than your spouse and you are run over by that steamroller, think of where that would leave your spouse. Besides needing a spatula to get you off the road, your income and future earnings potential would be gone overnight. Will there be money to pay for the bills such as the mortgage and utilities? How will his/her lifestyle be affected? Some would say it’s unfortunate but they can go to work. That’s one view, but most would probably prefer to leave a spouse with the lifestyle you both had before the accident. The spouse will face many other challenges, and financial hardship doesn’t have to be one of them.

What would happen to your children and their future needs? Do you envision them going to college? If yes, then how would they pay for it? If you think they can work, just like you did, then great, more power to you. But if you had financial help going through school from your parents, wouldn’t you like to extend that same support to your children?

Life insurance allows you to hedge a bet. The bet is that you will live a long time and it will be totally unnecessary and, thus, some will view it as a waste of money. We believe the smarter way to view it is that it is cheap protection in case the unthinkable happens. By the way, I use silly examples of death as being run over by a steamroller because one day I was discussing with a client the future issue of death and said, “Let’s say you get hit by a truck.”

The client’s face dropped and he said, “My dad was hit and killed by a truck.”

Needless to say, after I pulled my foot out of my mouth, I have never used a real-life situation like getting hit by a truck ever again. In case someone’s loved one was actually run over by a steamroller, the shear amazement of that form of meeting your maker, I hope, would outweigh the foot in mouth disease.

All forms of insurance are hedges against a bet that something bad will happen, and the current price you pay will be small compared to the future value. For instance, you have a heart attack and need heart surgery. You’ve purchased health insurance at work or privately. Isn’t the $5,000 deductible better than the $1M in hospital bills?

Estate planning uses life insurance for the very reason that it is cheap money and it bypasses the probate process. Your beneficiary or estate gets a check from the insurance company. Many people who have built sizable estates are facing a dilemma with the estate tax, also commonly known as the death tax. We will all kick the bucket at some point, and if we have estate tax consequences, life insurance can be a real blessing.

For instance, if you have a $10M estate and, as of 2012 with current laws on the books, the exemption is only $5M, what would your estate tax liability be? In this scenario, $5M is in excess and will be taxed at roughly 40 percent nine months after death. How’s that for a parting shot from this planet? Thanks for building a great estate and paying all your tax along the way. For one last congratulatory pat on the back, please send us $2M. Where will the money come from?

Will your beneficiaries have the cash, will they need to sell your vintage car collection, paintings, real estate or other investments at fire sale prices, or will they have to borrow the money and pay interest over many years?

The answer to these questions is based on the actual cost of money. Bottom line, insurance is generally the cheapest form of money.

Federal Estate Taxes

There are four ways you can pay Federal Estate Taxes, which can run as high as 55 percent on the portion of the estate that is over the exempt amount. Currently, the exempt amount for 2012 is $5M per person, but remember that in 2013 it will revert back to $1M unless Congress acts again to change the amount.

If you are thinking, no way, of course they will keep it at the higher amount, I challenge you to think again. In 1901, the estate death tax exemption was $1M per person. As recently as 2001 it was $625,000. The reality is the estate death tax is based on whatever direction the political winds may blow, and they are heavily influenced by the economic state of the government. If the government is running surpluses, then they might be generous and lift the exemption amount. If they are broke, well, it doesn’t take a rocket scientist to figure out where the exemption is heading.

Today, is the government awash in surplus budgets or starving for tax revenue? That should help you form an opinion on which direction the estate tax exemption will go. The key to the death tax is planning and understanding what are the best methods for paying Uncle Sam the final bar tab on your life.

The four ways to pay for estate taxes are as follows:

Here are the costs of each choice:

1. Use of Liquid Assets

The cost of using liquid assets is generally one dollar for each dollar paid in taxes. Since these assets are being held in easily accessible forms (checking, money market or savings), the problem is they are only making around 1 percent interest. For the following example, let’s just presume that you could be investing those liquid dollars at a hypothetical 7% compounded annually. Let’s see what the effect is.

The additional cost is lost opportunity. If you are making only 1 percent, the difference over 10 years could be hundreds of thousands of dollars, that is,

• $1 million at 1 percent for 10 years = $104,622 potential interest earned.
• $1 million at 7 percent for 10 years = $967,151 potential interest earned.

The opportunity cost is the difference, which is $862,529 in this case.

$967,151 − $104,622 = $862,529

Therefore, the cost was actually $1.86 dollars for each dollar paid in taxes.

$1,000,000 tax paid = $1,000,000 liquid savings plus $862,529 opportunity cost

For simplicity, let’s not count opportunity cost and just assume that each dollar paid in tax ONLY costs one dollar held in liquid savings.

• Cost = $1 for each $1 paid in taxes

2. Forced Sale of Assets

There are two faces to forced estate sales: the buyers who are happy they are getting such great deals and the sellers who are losing heirlooms at pennies on the dollar to raise cash for taxes due in nine months. If you happen to die when the economy is booming, then perhaps prices are at a high point, but what if you happen to die, say, in the middle of another recession. Prices could be at an all-time low-just when your family needs to raise cash. So selling real estate or long-term bonds or stocks at depressed values can be another big problem.

Most forced sales raise only 50 to 70 cents on the dollar. For instance, selling a piece of real estate in a quick sale may only bring in 70 percent of the fair market value of the property (leaving 30 percent on the table as a loss). Let’s use the upper estimate of 70 cents on the dollar.

• Cost = $1.30 for each $1 paid in taxes

3. Borrow Funds

Paying long-term interest escalates the true cost of the estate settlement. Suppose you borrow $1M at 7 percent amortizing interest for 10 years. The actual cost is repayment of $1M, plus an additional $400,000 in interest, for a total of $1.4M paid.

• Cost = $1.40 for each $1 paid in taxes

4. Life Insurance

Life insurance is one of the best ways to leverage your dollars. Usually, for each 20 to 30 cents you pay out, you will receive $1 in return. If life insurance is not part of the estate, it is free from federal and state estate taxes. As an added bonus, the premiums you pay for life insurance reduce the estate by like amounts and therefore further reduce the portion of the estate that is taxable.

It is important to note that life insurance, to be excluded from your estate, must be part of a more comprehensive trust arrangement. If you purchase a life insurance policy, you must place the policy in a special IRS exempt trust, so that the death benefits will not be included in your estate and will therefore not be subject to the estate tax. When you set up these life policies, you must insist on setting up all of the necessary parts and not cutting any corners. Use of an estate planning attorney, licensed in your state of residence, is critical.

Many insurance agents love to sell estate tax policies because they are generally very large. The problem occurs when an agent focuses on the sale and is not well versed in estate planning and does not include an estate planning attorney in the process. For fear of complicating the sale, or to speed up the time to receive their payday, he or she may skip necessary steps, such as an Irrevocable Life Insurance Trust. This probably sounds like the opinion of someone who is very jaded. I am. I have seen many examples of people who were sold a life policy and had the right idea, but due to an incomplete process on the part of the sales person, the client’s situation was not protected and he or she was left vulnerable and little improved.

The bottom line for using life insurance is that estate liabilities are paid FOR the estate but not FROM the estate! The estate receives the funds it requires to meet its liabilities, and the estate beneficiaries receive their full inheritance, undiminished in any way.

• Cost = $0.20 to $0.30 for each $1 paid in taxes

The order of importance when designing your estate plan should always be:

The goal is to reduce your estate tax liability as much as possible via trust and accounting work. After reducing the estate tax liability using the first two estate-planning priorities, use life insurance to cover the taxes that are left. This is not a popular belief among insurance agents because using this priority system will most likely drastically reduce their commission and could save you a lot of money each year in lower insurance premiums.

Annuities

Life insurance is the financial tool that protects you from living too short. Annuities are the life insurance tool for protecting you from living too long. Anyone who has retired from a company and is being paid a monthly check has an annuity. The annuity was purchased by your previous employer from the pension funds available for your retirement, and now you are benefiting with a monthly payout.

Most people know of annuities as lifetime investments, a payout that stops the day you die, leaving nothing to your beneficiaries. Though this is one path you can take with annuities, many people use them instead as tax-deferred savings, vehicles that work similar to a CD. You save your money, it potentially grows over time, and, eventually, the CD or annuity matures and you can withdraw your money and move it somewhere else.

The annuitization features can be implemented, or they may never be used. Annuitization means converting the annuity policy from a deferred-savings vehicle to an income-paying vehicle. You can pick from different periods for the payout to continue, from five, ten, to fifteen or more year increments for various life payout options.

Again, this book is not intended to teach everything about annuities and life insurance, as there are hundreds of others you can easily pick up at your local bookstore or library or go online to further your education.

This chapter is intended to give you my opinion from personal experience and hopefully introduce you to some of the little-known features of annuities, which few if any insurance representatives will share with a client before they buy.

Index Universal Life and Index Fixed Annuities

These versions of universal life (UL) and fixed annuities (FA) have the potential to earn interest based on common indexes such as the S&P 500, the NASDAQ 100, or others. They are sold as the ideal product. They will make money for you if the stock market goes up, and they will protect your principal if the stock market goes down. Sounds like the ultimate investment vehicle.

The single biggest problem we see with these financial tools is the ability of the insurance company issuing the products to change the way they calculate the interest. To explain in more detail, each Index UL and Index FA has different means of calculating what interest you earn each year based on the various stock market indexes.

We like to describe the different means of calculating interest as engines in a car. Imagine you have a garage with four cars, maybe all Toyota Camrys. From the outside, they appear exactly the same, but on the inside, each car has a different type of engine. One has an electric motor, one a 4-cyclinder, one has a V6, and the most powerful one has a V8-turbo. Each engine will perform differently under different road conditions.

One of the engines in Index UL and FA is called the participation rate. Again, this is a method of calculating the interest that a particular UL or FA will earn based on the performance of an index such as the S&P 500.

Assume an annuity has a participation rate of 80 percent of the S&P 500. On the anniversary of your Index UL or FA, they will record the value of the S&P 500. On the next anniversary, they will again record the value of the S&P 500, and calculate the return. Let’s say for example that the markets rose 10 percent, and then apply the participation rate, 80 percent, to the market gains and you have a total return for the annuity of 8 percent.

Market gains × Participation Rate = Index credit for that year

10 × 80 percent = 8

This 8 percent interest rate is then applied to your annuity contract value for that year. If you have an annuity starting at $100,000 and you gain 8 percent, your new contract value is $108,000 for the next year. This value can never drop due to poor market conditions in the future; it is locked in! Sounds good so far, right?

This is usually where the story ends when most insurance agents sell these products. The problem, buried in the Index UL or FA contract, is that the insurance company has the ability to change the participation rate on each contract anniversary at its discretion. This is sort of like changing the governor on an engine.

A governor is a device that limits the performance or top speed of a car’s engine. A particular BMW might be able to drive 175 mph, but the manufacturer puts a governor on the engine to limit it to a maximum speed of 125 mph.

On each anniversary insurance companies have the ability to change the settings on the governors they placed on their Index UL policies and Index FA policies. The reason they do this is to limit the upside potential of the contract, and frankly, keep the difference.

Agents will say the companies will not do this because it would not be good for the clients and thus not good for them, but in my experience this means nothing.

More often than not, the first year in these contracts, the engines are set for full power. It makes them easy to sell. But once you have purchased a particular Index UL or FA, and are committed to the policy for five, ten, or fifteen years or longer, with high surrender charges for canceling the contract early, I have seen virtually every insurance carrier crank down the governors so much that the up-side potential of the policies is almost insignificant in most normal stock market years.

For one particular Index FA, I saw the insurance company set the governors on the contract so low that if the S&P 500 rose 30 percent in a year, this contract might earn 4.5 percent. Remember, the insurance company keeps the difference. Sounds like these Wall Street companies are stacking the deck against the client, doesn’t it?

Other crediting methods or engines in Index UL or FAs are called spread fees and cap rates. The engines are usually mixtures of these three methods of calculating the rate of return of an index like the S&P 500.

Before buying one of these Index UL or FAs, find out the minimum rates to which these methods can be reduced. Ask for a history from the company on existing policies. There are a few companies that have maintained an honorable co-existence with their policy owners. That is, the insurance company has kept its side of the bargain and has not lowered rates very much, if at all.

Why is it important to have some upside potential with an Index UL or FA? Sure, your principal is protected in bad years, but in good years, if you are not making anything, you are basically going sideways or barely up, and inflation will eat you alive. This is why I do not include these products on the teeter-totter because they don’t really match the three main asset categories. They are not able to achieve our goal for high return but rather a low to mid-return.

According to the rule that you only have to give up one of three attributes—High Return or Capital Preservation or Liquidity—Index UL and FAs really only accomplish Capital Preservation. They are not liquid and will not achieve the high return goal. You give up two of the three descriptions.

MVA versus Non-MVA Annuities and Why You Need to Know This

The second important piece of advice to ask concerning Index UL and FAs, is whether a contract is an MVA contract or not.

MVA stands for Market Value Adjustment and is a feature that affects the surrender value of a policy. Since all annuities and life policies are bond based, they are affected by fluctuating market interest rates.

The surrender value is the amount you could walk away with if you decided to cancel the policy early.

For instance, let’s imagine you put $100,000 into an FA that has a surrender fee of 10 percent the first three years. If you walk away after the first year, assuming no growth, the most they would give you is $90,000. You are breaking the contract early, and after paying the 10 percent or $10,000 penalty, you end up with $90,000.

In an MVA policy, the surrender value is based on current market interest rates, which are compared to the rate when you got in. As this book goes to print in 2012, rates are at all-time lows. If interest rates take off and rise 3 to 5 percent, you will see the surrender value in an MVA policy fall like a rock.

For instance, in the above example, if market interest rates rise 5 percent, the MVA surrender value might drop from $90,000 to $50,000. Though the contract states a 10 percent surrender charge, it is easy to see how an unaware investor might erroneously presume their worst case scenario for early withdrawal being a $10,000 surrender fee. This investor will be in for a nasty surprise when the $50,000 check shows up from the insurance carrier, not the $90,000 they expected.

In non-MVA contracts, the surrender value is not based on the rising and falling interest rate tide. If the contract states a 10 percent surrender charge, then the surrender value will be 10 percent less than the full contract value. In low interest rate environments, these would be the only FA and UL policies I would generally recommend.

The flipside to this discussion is in high interest rate environments, you would want to buy an MVA fixed annuity or universal life policy because if interest rates came down, you would see the exact opposite effect as described above. The surrender value would actually shrink faster than stated in the contract.

In Summary

Life insurance and annuities serve a purpose and can be vital parts of a well-rounded financial table. From family liabilities and estate taxes to the need for another pension or CD-like investment, the most important tip when buying insurance products or any investment for that matter is to ask questions. Every financial situation is different and calls for different solutions. No investment is always bad or always good; it depends on each client and their personal situations as well as the current economic landscape.

From the gentleman who loves watching unaware ATM users looking at his $1M checking account balance, to the engineer with the 401(k), which after close inspection had lost money over the last 14 years, each situation is different. The job of your financial advisor is to help guide you through the twists and turns of the financial maze and to pick ideas that make common sense. For instance, I would not buy a fixed annuity or bond in the extremely low interest rate environment we are currently experiencing. That being said, if interest rates go above 8 to 10 percent, I would unwind as many of my clients investments as possible and load the boat with bonds and fixed annuities. In high interest rate environments these are probably the best ideas to be in.

Always apply common sense, an open mind, and the current economic landscape to determine your pathway and which financial tools you use to build your Wealth Code portfolio.