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Fatten That Policy

James McGlynn  |  September 15, 2020

I WORKED in the investment department of three different insurance companies. But I never had any interest in buying a whole-life insurance policy. I knew term insurance was the best way to get the maximum death benefit for my premium dollars.

Instead, as a mutual fund manager, I was always more interested in investing in the stock market. (That said, I didn’t invest in the first mutual fund I managed. Why not? I didn’t want to pay the 7% “load”—the upfront sales commission.)

But my attitude toward whole-life insurance changed six years ago. In researching retirement income issues—and getting an insurance license along the way—I learned about “blended” life insurance. Many whole-life policies let you take the policy’s base coverage and combine it with a paid-up additions (PUA) rider. That way, you can design a policy that pays a lower commission to the agent and delivers better value to the consumer.

Insurance agents can get commissions as high as 55% of the first year’s premium for selling a whole-life policy, whereas the commission on a paid-up addition might be as little as 3%. Result? If you add $1 to a whole-life policy using a PUA rider, almost the entire $1 gets added to the policy’s cash value.

That’s a huge benefit. Most whole-life policies accumulate cash value very slowly, similar to paying down a home mortgage in the early years, when very little of your monthly payment goes toward principal. If you’re interested in whole-life insurance, be sure to ask your agent about blended insurance policies.

But there’s a catch. In 1988, Congress changed the rules on life insurance to limit the premium amount that could be contributed to a policy in the first seven years, relative to the size of the death benefit. If you breach these legal limits, your policy could become a “modified endowment contract” and lose key tax advantages.

The legislation prompted insurance companies to devise blended policies as a workaround. These blended policies often involve not only PUA riders, but also a term life insurance rider that increases the death benefit, thus avoiding the risk that a policy will be deemed a modified endowment contract. Five years ago, I bought a blended policy that was roughly one-third whole-life and two-thirds term insurance, and then took advantage of the paid-up additions rider to rapidly build up the policy’s cash value. I’m now approaching the point where I can drop the term insurance without worrying that the policy will be considered a modified endowment contract.

Why go through all these machinations? As I see it, whole-life insurance is a unique fixed-income category. No matter which direction interest rates go, your cash value only increases. This was appealing to me, since I wanted a secure yield but was—and remain—fearful that interest rates could skyrocket someday.

My hope is to leave the policy untouched, so my children inherit the policy’s death benefit income-tax free. But if I need extra money later in retirement, I can tap into my policy’s cash value. That cash value will grow tax-deferred—and any withdrawals I make will be tax-free, provided I limit my withdrawals to the premiums I’ve paid.

On top of that, I’ll get dividends from the insurance company. These dividends are a strange beast. They’re never guaranteed. But for many top insurers, they’ve been paid since the Civil War. I think of the dividend partly as a return to policyholders of premiums that are set at an overly conservative level.

In addition, when other policyholders let their whole-life policies lapse—often because they find the premiums too steep—that results in excess profit that contributes to the dividends paid. In other words, the reason many people hate insurance companies is a reason I earn a higher dividend. This dividend can be paid out or reinvested in further paid-up additions. I expect the annual dividends I’ll receive will be equal to slightly over 3% of my policy’s cash value, which compares favorably with current high-quality bond yields.

James McGlynn, CFA, RICP, is chief executive of Next Quarter Century LLC in Fort Worth, Texas, a firm focused on helping clients make smarter decisions about long-term-care insurance, Social Security and other retirement planning issues. He was a mutual fund manager for 30 years. James is the author of Retirement Planning Tips for Baby Boomers. His previous articles include My RetirementEarly Decision and Your 10-Year Reward.

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