Variable Loan Options in
This newsletter is based on the assumption that cash value life insurance can be a valuable tool to build wealth for retirement.
With a properly designed cash value life insurance policy (low death benefit with maximum over funding of cash within the Modified Endowment Contract rules), cash grows tax free and can be removed tax free in retirement. That’s the reason cash value life insurance is used in Equity Harvesting plans
As you'll recall from past newsletters, Equity Harvesting is removing equity from a personal residencence and repositioning it into cash value life insurance (discussed in great detail in my new book The Home Equity Management Guidebook: How to Achieve Maximum Wealth with Maximum Security. My new book is what I consider a full disclosure look at Missed Fortune 101. The new book also explains one of the best marketing tools I’ve ever seen called the Home Equity Acceleration Plan (H.E.A.P) (which is how to pay off your mortgage debt 10-15 years early without altering your lifestyle).
In the “old” days, everyone in the life insurance industry thought it was really neat when life policies with “wash” loans came out. As you may know, if you borrow money from the insurance company from your policy, the insurance company will charge you interest on the loan which is due every year. If the policy has a wash loan feature, the crediting rate on the cash in your policy will mirror the interest rate on the money borrowed from the life insurance company; and it’s a wash/neutral transaction for the insured.
A variable loan option allows the insured to play the market a little by allowing the cash in their policy to grow with the equity markets and borrow money from the insurance company at whatever the fixed interest rates happen to be at the time of borrowing. If the cash in your policy grows at a higher rate than the lending rate, you actually make money on the money you borrowed from your policy.
Let’s say the lending rate today in your policy is 6%. Unlike a wash loan where the cash in the policy would be credited with a return of 6%, with a Variable Loan, in any given year, the insured has no idea what the investment return will be in the policy.
If you purchased an EIUL policy, the growth in the policy is pegged to the S&P 500. If S&P 500 returns 10% in a year when there is a loan on the policy with an interest rate of 6%, the insured has a positive arbitrage (meaning the cash in the policy had a 4% positive return over the borrowed funds).
Conversely ─ if the S&P 500 goes negative (which in most EIUL policies will earn a return of zero-two percent in that particular year), your policy is still charged with a loan where the rate is 6%. What that means is that in the year when the S&P 500 underperforms the interest rate on the loan, the principal cash in the policy will have to be invaded to pay that interest.
Better Potential for Growth
The reason clients should consider using a life insurance policy with the option of using a variable loan is because IF borrowing rates and the S&P 500 perform as they have over the last many years, they should actually make money on the money borrowed from the life insurance policy.
How? As stated in the previous example, if the borrowing rate on a loan from your policy is 6% and the life policy which pegs the growth of the S&P 500 earns 10%, you have a 4% positive arbitrage on the cash in your policy.
Historically, the S&P 500 has returned in excess of 2% more per year than the borrowing rates used for loans. Will that trend continue? Most likely it will over the long term although as you know: “past performance is no guarantee of future performance.”
It’s tough to really get a feel for how a positive arbitrage on a loan can benefit a client when they start borrowing from the policy. To help crystallize the benefit, I created a life insurance illustration with wash loans and variable loans to show you the difference.
Assume in my example that the client is male, 45 years old, and in good health. Assume he will fund $10,000 a year into an EIUL policy each year until he turns 65 and then will borrow “tax free” from his policy from ages 66-85. Assume the average S&P 500 returns over the life of the policy are slightly less than 8%. How much could he remove from his policy with wash loans and how much from a variable loan where the interest rate spread is a positive 2%?
If the policy used wash loans where the interest rate is 4.25% and the crediting rate on the cash at the time of the loan is also 4.25%, the client could borrow $38,724 “tax free” from the policy every year from ages 66-85.
If the policy credited on average slightly less than 8% a year as a credited amount on the cash value AND the interest rate is 6%, the client could borrow $57,421 from the same policy from ages 66-85.
I’m not so sure that it is wise to assume there will be a 2% spread on average between what the S&P 500 returns and lending rates at the time loans are accessed from a life policy. I also do not believe that the S&P 500 over time will return less than what lending rates are when an insured borrows from his/her policy.
Typically when I run illustrations like the majority you’ll see in my new book, I manually changed the interest rate on the loan to equal whatever the assumed crediting rate is. In this example, the assumed crediting rate is slightly less than 8% annually. Therefore, if I used a 7.9% loan interest rate, how much could this same client borrow from his life insurance policy? $46,561 every year from ages 66-85.
I personally have no idea what the S&P 500 will do or what lending rates will be like in 10-20-30 years. What I simply want to do with my illustrations is come up with something that is not over-the-top aggressive and not pathetically conservative.
I also want to make sure readers understand how life insurance agents can manipulate illustrations to make them look very good based on the best of all worlds.
If you want to further protect your clients when they are in the borrowing phases of their life policy, I strongly recommend you look at Retirement Life™. This product has many beneficial features including the ability for the client to choose to place their cash value in a bucket that will credit 140% of what the S&P 500 returns every year. I like this policy when discussing the Variable Loan issue, and I think with an illustration you’ll see why.
Assume the interest rate on a loan from a life insurance policy is 6%. In most policies, if the S&P 500 returns say 4.5%, the insured is going to go backwards by 1.5% in the policy due to the fact that the return is less than the interest rate (the client would have been better with a wash loan). If the insured had a policy that credited 140% of what the S&P 500 returns, the insured would have been credited with 6.3% in the policy and would have done slightly better than a wash loan.
Carrying that forward, what if the S&P 500 returned only 3%? The client would be upside down 3% if the interest rate on the loan were 6% in a normal policy but would only be upside down by 1.8% in a policy that credits 140% of what the S&P 500 returns.
My point is simply that the 140% crediting policy allows for more security for the client and better growth for clients who think the S&P 500 is going to be flat for a period of time.
Summary on variable loans
Variable loans are a good option to have in a policy. When buying a policy with a variable loan option, clients can choose each year that they borrow from their policy whether to use the variable option or the fixed wash-loan option. The more options the better. Also, if you want to protect your clients when purchasing cash value policies, it is recommended that you consider having them use an EILI policy that allows them to move their money when in the borrowing phase to the 140% crediting method.
Roccy DeFrancesco, J.D., CWPP™, CAPP™, or MMB™
Founder, The Wealth Preservation Institute
Co-Founder, The Asset Protection Society
3260 S. Lakeshore Dr.
St. Joseph, MI 49085
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Author of The Doctor's Wealth Preservation Guide; The Home Equity Management Guidebook: How to Achieve Maximum Wealth with Maximum Security; The Home Equity Acceleration Plan; and Retiring Without Risk
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