Using Cash Value Life insurance to Increase Portfolio Returns While Reducing Risk

Life insurance has existed for nearly two centuries as essential planning tool that protects dependents from the risk of a breadwinner’s untimely death. However, given the unique investment properties of life insurance, financial planners are finding a number of ways it can be used in other ways to enhance portfolio returns while reducing risk. The following case, illustrated how whole life insurance can play multiple roles as an alternative investment class.

The Case of a Risk Adverse Couple

A couple in their mid 50s  is very risk averse and has therefore chosen to invest the entirety of their $10 million of investable assets in fixed income securities, with no exposure to equities. The fixed income portfolio has a weighted average rating between B and BB, placing it just below the investment grade.  The mean return on a BB rated bond portfolio over the last 5 years hovers around 2.5% annualized. This translates to about $250K in returns. Once the marginal tax rate and portfolio management fees are accounted for, the couple is left with about $93K – an actual return of just over 0.9%. The selection of securities placed in this bond portfolio ensures a moderate amount of return, while still keeping the risk of default below an acceptable level.

Now let’s look at how this changes if an insurance policy is brought into the picture.

The couple was presented with the idea of using a whole life policy as a way to mitigate the risks of their bond portfolio while boosting its overall returns. The proposed annual premiums of $500K, payable for 10 years would be reallocated from their bond portfolio. The premium pays for the cost of maintaining the policy and any surplus amount is invested by the insurance company and forms the “cash value account”. This cash account grows based on the credit or dividend rate of the insurance policy. The long-term return on the accumulated cash in a dividend-paying whole life insurance policy ranges from 4% to 6% after adjusting for operating costs and fees, thus boosting the couples overall return.

In addition, the portion of assets accumulating inside the cash account of the life insurance policy is shielded from taxes. When needed for income, they can be accessed tax free through policy loans. Upon their death, their beneficiaries would receive a tax free death benefit.

Using Life Insurance to Reduce Investment Risks

Those are just two ways the reallocation of assets to a life insurance policy helps to improve the couple’s financial position. But, the greater value may be in the way life insurance reduces the couple’s overall exposure to risk.

Credit Risk

The bond portfolio has a weighted risk rating between B and BB. Compare this to that of the insurer which is rated AA+. Investing a part of the $10 million of liquid assets in a whole life insurance policy drastically reduces the credit risk on the overall portfolio. This reduction in risk not only derives from the direct benefit of a higher credit rating of the insurer, but additionally the diversification benefit of being invested in differing asset classes.

Interest Rate Risk

The bond portfolio is highly susceptible to interest rate risks. If the interest rates rise, the value of the entire portfolio will decrease commensurately. However, whole life policies have a minimum rate guarantee and rising interest rate cans lead to a higher return on the accumulated cash. By investing in an insurance product, the couple can effectively hedge interest rate risk. An optimally hedged portfolio comprised of bonds and whole life insurance can effectively eliminate this risk altogether.

Liquidity Risk

In the event that some immediate liquid cash is required, a bond portfolio offers a less liquid option. Individual bonds have to be sold and this carries an inherent liquidity risk if bond prices have declined significantly. Even if exposures to bonds are gained through an index tracking instrument, there is an inherent liquidity risk involved. The other option is to borrow against the security which is usually capped at 50% of the market value of the bond or instrument. However, in the case of a whole life insurance product, any fractional amount may be borrowed to meet any unplanned needs while maintaining the tax shield.

Income Tax Risk

Up to 50% of the couple’s portfolio returns is subject to state and federal income taxes which reduces the portfolio’s potential income by half. Life insurance can reduce the taxation of the overall portfolio because it accumulation is shielded from taxes and income can be accessed through tax-free loans.

Finally, the death benefit proceeds can be used to pay taxes on the estate, which increases the total value of the estate being passed on to the heirs. Although life insurance proceeds are tax free, they are includable in the taxable estate. The couple placed the life insurance in an irrevocable trust which effectively removes the death benefit proceeds from the taxable estate while still allowing the heirs access to the funds.

*The cost and availability of life insurance depend on factors such as age, health, and the type and amount of insurance purchased. Before implementing a strategy involving life insurance, it would be prudent to make sure that you are insurable by having the policy approved. As with most financial decisions, there are expenses associated with the purchase of life insurance. Policies commonly have mortality and expense charges. In addition, if a policy is surrendered prematurely, there may be surrender charges and income tax implications.

*This content is developed from sources believed to be providing accurate information. The information provided is not written or intended as tax or legal advice and may not be relied on for purposes of avoiding any Federal tax penalties. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel. Neither the information presented nor any opinion expressed constitutes a representation by us of a specific investment or the purchase or sale of any securities. Asset allocation and diversification do not ensure a profit or protect against loss in declining markets. This material was developed and produced by Advisor Websites to provide information on a topic that may be of interest. Copyright 2024 Advisor Websites.