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A tax freight train is bearing down on your retirement. To protect yourself, you'll have to harness The Power of Zero.
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Hello. David McKnight with The Power of Zero show. Grateful that you're with us today. Today, we're going to talk about various types of LIRPs and how to figure out which one is right for you. They all have their strengths and weaknesses, and which one you choose ultimately ends up based on your situation. Today, we're going to assess the strengths and weaknesses of each one of those and in what circumstances they might fit best for you. By the way, you can find out more about me at davidmcknight.com, you can find out more about our best-selling books, The Power of Zero, Look Before You LIRP, as well as my new book coming out called The Volatility Shield about which we will do a podcast coming soon.
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The first type of LIRP or permanent life insurance, if you will, some people call it cash value life insurance, it’s what we call whole life, and this can be a very, very popular option, it's been around forever, it goes back to the very beginning of the invention of life insurance so it's been around for a long time. As the nomenclature indicates, it's designed to last you your whole life, till death do you part. These types of permanent policies account for literally 95% of all death benefits paid out. The idea behind a whole life is that you are contributing a premium to a life insurance company and they are growing your money inside your growth account in a very predictable way. They give you illustrations that show you what your cash value will be in any given year. This is what we call a non-correlated asset because even if the stock market is down, your cash value is going up. These are very predictable, the insurance company is typically growing your money in the general portfolio of their investment, high-quality bonds. Over the life of the program, you can expect that this might give you anywhere from 3% to 5% growth inside the growth portion of your portfolio or inside the growth account in your LIRP. People like this has a very stable predictable sort of a bond portion of their portfolio, so people will use this as a way to build safe and productive growth allowing them to, therefore, take a little bit more risk in the stock portion of their portfolio, a stable predictable safe productive rates of growth, very, very big in our industry, this accounts for quite a few of the LIRP sales overall.
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Similar to a whole life policy, but a few distinct differences is what we call universal life. Universal life, you are contributing your premium to the life insurance company, but the ebb and flow of your cash flow over time really is based on interest rate, so as interest rates go up, the amount that they can credit to your growth account can grow up. For example, back in the 80s, some of these policies were projected at 10%, 15% because that's what interest rates were back there. But the downside of this is as interest rates crater, then what they're actually crediting on the money in your growth account can also go down as well. This is very interest-rate sensitive, it's handled through the insurance company, and to some extent, whole life is also interest-rate sensitive, but you are really locking into these bonds so that long term, there's a little bit more stability. There can be quite a bit more flex with the universal life policy, but there's also a little bit more flexibility with the universal life policy where you can stop your premiums without any real significant implications, you can start them up again, you can catch up, so on and so forth. The UL policy is an option out there, it tends to not have as many guarantees. They may guarantee that you have a minimum rate of return that they'll credit you, sometimes that's 3%, but that's not a guarantee that your policy will stay in force. If you're only getting a 3% rate of growth, for example, as time wears on and as the insurance expense inherent to your policy goes up with the aging of the insured, then those expenses can overwhelm a minimum of 3% credit on your policy. These policies, you don't see them as much anymore being utilized for Power of Zero type purposes, you generally see them with guarantees where people are saying, “Hey, look, I want a death benefit in force when I die, I want to put as little money as I can into it and get a guarantee that it'll be in force when I die. I know term insurance, there's a 99% likelihood that it's going to expire before I do so that's not going to work, what is the cheapest way to get a death benefit guaranteed to be in force when I die?” That's what these guaranteed ULs or sort of minimum-funded type policies, what is the least amount of money I can give to an insurance company and get a guaranteed death benefit.
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There's another type of policy called variable universal life or what we call VUL. I talk really about all four of these policies in The Power of Zero. VUL basically says that you're going to give your premium to an insurance company, and that premium, after they take off their administrative fees, and they're going to pass that money through into sub-accounts where your money's invested in mutual fund type investments, and from those investments, the insurance expenses are taken every month. But essentially, these mutual funds can really mirror the growth in the stock market. If the Dow Jones or the S&P is up 20% in any given year, you may get credited 20%, of course, they'll take the expenses off of that. If you're younger—when I say younger, I mean really 45 or less—if you're younger, this can be a good option for you because you're not worried about the ebb and flow of the stock market over time. Where does this strategy become worrisome? Why have the sales of variable universal life really trailed off since 2008? Part of the problem is that when you get older, as the expenses internal to the policy go up, if you have a down year in the stock market, let's say your sub-accounts have gone down 30%, not only has it gone down 30%, but you also have the increased expenses of being older that are also coming out of your bucket, so you just lost 30%. Actually, how these policies work is as your cash value goes down, the amount of life insurance that you have to pay for actually goes up. If you look at my book, Look Before You LIRP, I explain the relationship between cash value and life insurance. I'll give you a little example. The amount of cash value plus the amount of life insurance you're paying for in any given year equals your death benefit. For example, if you have $500,000 death benefit—and this is what we call option A or option 1, it's one way to configure the policy—if you have $250,000 of cash value, your death benefit is $500,000, then the amount of life insurance you're paying for that year is actually $250,000. As your cash value goes up to $350,000, then you're paying for $150,000 of life insurance for a total death benefit of $500,000. Let's say you've got $250,000 of cash value, the market goes down by 30%, now you've got $150,000 of cash value, guess what, you're at a later phase of your life insurance expenses or more, so you just went from paying for $250,000 of life insurance to $350,000 of life insurance. Guess what, if you're now paying for $350,000 of life insurance as a 55 or 60-year-old, what happened to the expenses coming out of your bucket? What happened to those drops? They’re now quite a bit bigger which causes your cash value to go down even more. What happens when your cash value goes down even more? Then the amount of life insurance you're paying for goes up, causing the drops to get bigger, causing your cash value to go down even more. You can get to a point where your VUL, your variable universal life, if you have one or two of these down years in a row during the later years of the policy, it can go into a death spiral from which it never recovers. If you don't remember, if you don't have at least $1 in your cash value at the date of death, then all of the tax-free growth that you experienced all along the way becomes taxable to you all in the same year. That's one of the big bugaboos with variable universal life, that's one of the reasons why people aren't using it as much anymore because of that potential death spiral that can come into play in your later years.
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One of the ways that the industry has mitigated that threat, that Achilles heel if you will, is they've come out with a product called indexed universal life. With indexed universal life, what's happening is your money flows into that growth account and the growth of the money in that account is linked to the upward movement of a stock market index, typically, the S&P 500. Whatever the S&P 500 does in any given year, you get to keep up to a cap, that cap might be 12%, 13%, or 14%, that also tends to ebb and flow with interest rates. You get to keep whatever your money does up to a cap, for example, the S&P 500 does 20%, you get to keep 12%. If the S&P 500 was to go down in any given year, they would simply credit you a zero. Your growth in any given year is going to be between 0% and 12%, or 13%, whatever the cap is. Historical rates of returns have shown that these can do anywhere between 6.5% and 8%, depending on what time frame you're looking at. This can be a very safe and productive way to grow at least a portion of your money. However, even in the flat years, you're still paying the expenses, even though you didn't lose money in the stock market, you did have to pay for some expenses those years, those expenses would be administrative expenses, the cost of life insurance. Technically, you could still lose a little bit of money, and you don't want to have too many of those down years in a row or that could be problematic. We do know, however, historically that every 10-year-period, it only averages between two and three down years per decade. Historically, these types of policies acquit themselves pretty well. The IUL has grown in popularity because you don't fall into that trap that you fall into with the VUL where if the stock market goes down in any given year, all of a sudden, you're paying for more death benefit or more life insurance in any given year and then go into that death spiral from which it's very hard to pull out of. The IUL has grown in popularity. The other reason why the IUL can be attractive is because you can get stock-market like returns without the risk. For example, if you're taking money out of an IRA or 401(k) where you're accustomed to getting 6.5%, and you're putting it into a life insurance retirement plan that's also growing at 6.5%, you're not losing any rate of return there, you're getting similar rates of return.
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Now, I did mention earlier, with whole life, you are getting lower rates of return, but like I said, a lot of people are just using this as the bond portion of their portfolio and they're taking a little bit more risk in their stock portfolio to compensate. I'll tell you what, if you can get between 3% and 5% consistently over time without taking any more risks than what you're accustomed to take into your savings account with that whole life policy, very safe and productive way to grow, at least a portion of your money. With the IUL, you can nudge that up a little bit getting anywhere between 4% to 6% net of any fees over time. If you can get a 4% to 6% net of fees over time and a portion of your portfolio, it's a very, very safe, very, very productive way to grow at least a portion of your money. Of course, with all of these policies, you need to fund them correctly, you need to buy as little death benefit as the IRS requires. If you stuff as much money into it as the IRS allows in an attempt to mimic all of the tax-free benefits of the Roth IRA, without any of the limitations of the Roth IRA, and the analogy I use in the book is out of an ATM. If the ATM is going to charge you $3 every time you take money out, then when you take money out, you want to take out as much as you can, you want to take up to the max, the maximum, I don't know, $300. $3 as a percentage of $300 is only 1%. If instead of taking out $300, you only took out $20 and $3 as a percentage of $20 is a much higher percentage. Proportionately, you're paying a much higher fee. Life insurance works the same way, the fees that they charge you are generally going to be the same no matter how much money you put into it. If you put in $100, your fees are going to be X, if you put in $200, your fee’s going to be X, that's generally how it works. If your fees are relatively static in a given year, you want to put in as much money as you possibly can so that the fees as a percentage of the overall contribution and of your overall bucket remain as small as possible. All of these policies will acquit themselves pretty well when they're funded in these types of ways, when they're not funded, when they're minimally funded, or funded at the middle, not funded aggressively, they're funded just enough to give you some death benefit, that's not the way to use these programs in The Power of Zero universe. In The Power of Zero paradigm, you want to get as little death benefit as the IRS requires if you stuff as much money into it as the IRS allows, of course, all the while trying to mimic those tax-free benefits of the Roth IRA.
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Those are the four types of LIRPs, which one is best for you ultimately depends on your situation. Talk to the person that gave you The Power of Zero book to find out which one might ultimately suit you the best. Of course, if you found us on Amazon and you want more information, you can certainly go to davidmcknight.com.
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Thank you for being on the podcast today. Please subscribe so that every time we have a new episode of our show, then you will be apprised via email. Again, davidmcknight.com. Thank you for being with us today and we will see you next week.
