We have had a really good run in the stock market over the last 10+ years. It seemed as if the market was on a non-stop race towards higher and higher levels. In fact, many hobby investors made unimaginable fortunes by launching blogs and dispensing investment advice that largely sought the long-standing ethos of the now-deceased Jack Bogle. And they looked like geniuses until very recently.
Now everyone is looking to diversify their risk and find assets that protect them from market volatility that won’t go away. Bonds don’t work. According to Morningstar, the 10 largest bond funds lost an average of 5.42% in the first quarter of 2022.
And if we look at the same collection of funds, we find that performance has deteriorated since the first quarter of this year:
Now the average nominal decline among all funds is -7.22%. It remains true that bonds seem safer than the overall stock market. Using the S&P500 index as our yardstick, it’s down about 12.62% YTD.
Life insurance, the real flight to safety
Using either whole life insurance or indexed universal life insurance as a buffer against volatility is something we’ve been doing for a few decades. I’m not out to make an “us vs. them” argument trying to convince someone to immediately sell all their stocks/bonds and buy up as much life insurance as it allows. That is idiotic and has never been the position we take here The insurance professional blog.
What I want to argue today is that you can use life insurance as a strategy to de-risk your portfolio with great success if you follow the right path.
Let me first point out that life insurance (excluding variable life insurance products) is a product with very low or zero volatility in account values from year to year. It is designed to guarantee against losses, and there are a number of benefits that this gives you. Today is not the day we can describe every single one of these benefits, but I want you to stick with that idea as we unpack the rest of this discussion.
And since it is extremely difficult to really understand what a financial product of any kind has to offer when it is discussed purely theoretically, I will instead use some examples to more explicitly mention what life insurance has to offer.
De-risk your whole life insurance portfolio by moving assets into life insurance
Let’s look at the following situation. Male, 50 years old who has accumulated a couple of million dollars in assets. He is on the right track in terms of retirement readiness, but he worries that losses will deplete his accumulated assets. He understands that just because he has achieved a certain balance thus far, stocks and bonds cannot guarantee that his portfolio will always be worth what it is today or more.
He will sell $500,000 worth of assets and move it into whole life insurance. This policy uses several advanced design adjustments to ensure it offers the highest possible level of cash value accumulation while minimizing less important offers from the insurance company (namely death benefit).
Here is a ledger showing what he will achieve with this move:
Notice that after 10 years he has achieved a 3.10% return on his money. That’s a very attractive return for an asset with zero chance of going negative. This result will be even better in 20 when the result is 4.28%. But the yield is an often misleading number and it generally means nothing when you want to use the money for daily living expenses.
By year 20, he can take an income of almost 5.5% of the account balance and maintain this income all the way to age 100 (not pictured in the ledger above). This income is free of income tax, not subject to modified adjusted gross income calculations and completely flexible. When I say flexible, I mean that he is not required to take any specific amount over any specific time frame – as an annuity or dividend investment might require.
The ability to take an income against this asset that is quite a bit higher than the traditional 4% recommendation comes from the lack of volatility in the asset. The fact that this policy will never experience a year where the return on cash value is negative gives the owner greater drawing power. The rate of accumulation can vary, but it has a significantly smaller impact on distributable income than the timing of negative returns.
Remember, he still owns over a million dollars in stock that will hopefully grow at a rate commensurate with normal stock market returns. The whole life insurance game only locks in a certain amount of asset value to provide peace of mind against future volatility in the equity segment of the portfolio.
It’s also important to note that all of this is scalable in both directions. If he had more assets and wanted a larger amount for life insurance or if he had fewer assets and invested less in life insurance, the relative results are very similar. I simply bring this up to point out that if your situation is different, that doesn’t rule you out as a candidate for such a strategy.
But there is another approach that may be the better option for many people.
Set the stage to reduce risk in the future
Now let’s take a look at another scenario. 40-year-old who begins to worry about the risks he may face as he nears retirement. He has saved a decent amount to this point, but he wonders if he should adjust his strategy to address future risks proactively. He prefers to leave the assets he has in the market and take advantage of what is likely to produce in the coming decades.
He will take $50,000 from the amount of his annual savings and use it in a whole life insurance policy. Normally, insurance agents can show him a scenario very close to this:
This is perfectly fine and will work quite well as a retirement income asset. But we can make some adjustments that potentially bring even more buying power from this asset, but coordinate it with his other assets as a risk mitigation strategy.
We know he will accumulate riches through other assets beyond just this whole life policy. So what if he took some of those assets and moved them to a less risky allocation in life insurance when he retires?
The income projection above assumes several things about the whole life policy. It presupposes a certain dividend. It assumes that the policy owner takes income until age 100 and then stops. It also assumes that the loan used to generate this income will accumulate interest each year and that interest will be added to the loan balance – ie not paid by the policy owner.
But think about him did pay the loan interest? What if he took some money from his other assets and made an interest payment each year? This is what happens:
He gets almost $92,000 a year in income. He accomplishes this by effectively moving some of his riskier assets into whole life insurance through loan repayment, giving himself the opportunity to enhance the more stable and non-taxable income he received from his whole life insurance. Notice that in the first five years he pays a total of $79,246 in loan interest and receives $459,115 in income. It’s a sweet trade-off.
Think of it this way, the income share here is exactly $91,823. That means if he’s going to leave money in his other assets, he needs to be sure he can generate at least that much income—or whatever it’s worth to him—per year by leaving the money in the other assets.
Remember that life insurance lacks volatility which makes its income generating ability very strong compared to other assets. Also, don’t forget that the income figures for the life insurance are net after everything – e.g. taxes and fees.
Even if he chose to stop selling other assets to pay the life insurance loan interest at some point, he can still generate more income than the original $106,291. It is at this point that many people will get stuck on what is the exact right mix. How much of my other assets should I reallocate to life insurance as I get older to improve my income? It’s an unknown answer, and you shouldn’t torture yourself with it. The point of this thought experiment is not to prove the exact method one should use in all circumstances. It is to point out what is there. To help people realize the options available to them when incorporating life insurance into their portfolio. And most importantly, how effective life insurance products are in minimizing risk when used in this way.
And you know what else? There are even more options than you will probably notice by reading this article. And that’s a good topic for another day.