How to evaluate a cash value life insurance policy

Every day that I turn on the radio, I hear cash value life insurance get denigrated. The problem is, the comments are highly generalized and rife with big assumptions that aren’t always true.

First of all, let’s back up and look at what cash value life insurance is compared to term life insurance. Cash value life insurance is also known as permanent life insurance. Some people also call it “whole life”, because that version has been around for decades. But there are other types that are NOT whole life.

Boiling things down, cash value life insurance is designed such that the face value of the policy can be paid when the policy holder dies. So how DOES it work? Basically, you buy a policy with a given face value. Imagine we picked a policy that offered $100,000, payable upon death to the beneficiary. So how can an insurance company come up with a way to guarantee paying this amount of money at some random time in the future? They collect premium payments form you, and use part of it to buy some immediate term life insurance and the rest is set aside to build up “cash value”. As more and more premiums are collected over the years, the cash value builds up.

The cornerstone of cash value

What is cash value? Essentially, it provides a cornerstone of the face value. Imagine you had built up a $30,000 cash value to back the $100,000 face value. At that point, 30% of the insurance is covered by the cash value, meaning the insurance company only needs to buy an additional $70,000 of term life insurance. At a certain point, they no longer have to collect premiums from you. Instead, interest from the cash value can be used to fund term life insurance making up the difference.

This is what leads to haughty TV and radio show hosts balking at how insurance companies “only pay you the face value” and “keep the cash value for themselves”. Ahem. If you have a $100,000 policy backed by $30,000 of cash value, where do you get the idea that they owe you $130,000?

This is just the scenario I heard the other day on the radio. Most of the time, the dollars aren’t mentioned. Instead, the radio personality seems to imply that you could have racked up $50,000 of cash value, and yet only get paid something smaller, like $25,000. That WOULD be horrendous. What they don’t mention is that the face value is typically HIGHER than the cash value.

Some real numbers

The only real numbers i often hear on various shows is how cheap term life insurance is compared to cash value. Like how dollar for dollar, term life costs 5% of cash value life insurance.

In a rare moment, I heard someone call in with numbers precisely matching what I’ve said so far. This caller had paid $20,000 in premiums over 25 years, and built up a $30,000 cash value, backing a $100,000 face value policy. His primary concern was that if he cashed in this policy in order to ditch it, he would get the first $20,000 tax free. It would be consider return of capital and not cost a cent in taxes. The host tried to say people almost never have tax consequences. But in this case, he would be facing a $10,000 profit. This is where he would need to talk to an accountant. I don’t know if that would be long term capital gains, or something completely different.

The talk show host couldn’t believe his ears. He repeated his usual complaints about how you never GET the cash value. And then I heard the caller reveal the face value of $100,000. When he dies, his wife will ONLY get $100,000 and not the additional $30,000. Instead, the insurance company is keeping that money for itself! Sorry, but that is grossly wrong. At this stage, the insurance policy has $30,000 in cash along with an additional $70,000 of actual insurance. Liquidating everything would result in a combined total of, surprise, $100,000 to pay out. There is not pile of gold left behind that the insurance company dumps into a giant vault and begins to swim in like Scrooge McDuck.

HINT: Insurance companies gear things such that they rack up their maximum profits at the beginning not the end. Term life insurance policies tend to get cancelled within a couple years. Same for many policies. Things change and people stop paying premiums. Insurance companies aren’t dumb. They want to rack up their profits early and move on.

What really stunned me was how the talk show host failed to look at the actual growth of the caller’s insurance investment. The caller has the opportunity to borrow against the cash value, perhaps to fund retirement. In that event, imagine they could borrow the entire $30,000. It’s usually something less to avoid collapsing the whole policy, but let’s assume they can take it all. We should be asking, what was the rate of return on that?

Actual yield of a whole life policy

If the caller invested $20,000 and accumulated $30,000 over 25 years, we can easily calculate the annualized growth rate. Simply take $30,000/$20,000 and take the 25th root. Result? 1.6% annualized growth. THAT is the indicator that this policy was horribly set up. THIS is the reason I would dump the policy and instead take the cash elsewhere, like buying up a big chunk of VNR stock.

With $30,000, the caller could buy roughly 1350 units of VNR. That would yield $283.50 every month, resulting in a hair over $3400 annually. In ten short years, the caller could easily double his money due to VNR’s 7.5% yield. This is much better than the dismal 1.6% yield which isn’t even keeping up with inflation. And this analysis assumes no growth in distributions from VNR.

Or take this $30,000 and buy KO, WMT, GIS, or a dozen other solid companies you have known about your whole life. Or perhaps buy a real estate note. Anything is better than 1.6% in my book.

Thankfully, the EIUL I have setup is designed properly. The face value has been dialed back to the minimum amount allowed by the IRS. This means that the cash value will grow much faster than 1.6%. My agent plugged in a estimate of about 8% based on a 20 year look minus 10%. This paints a very conservative estimate. 8% of growth is certainly possible even though mutual funds are averaging 4% thanks to an EIUL’s ability to guard against market drops.

Happy investing!

Annual Wealth Building Review

It’s been a year since I started tracking my net worth. This started after I had made the big withdrawal on my 401K but before I purchased any real estate. It has been an exciting and tumultuous year! All I can say is that I wish I had started tracking my progress years ago. I might have realized sooner that things weren’t working. But there’s no value in lamenting the past.

I’ll start with total growth and then break things down to my various assets. In the past year, I’ve seen 85.48% total growth of my net worth.  That is pretty good considering I paid a 37% effective tax rate this year due to the penalties of making an early withdrawal on my 401K. With that tax burden out of the way, I’m hoping next year delivers a strong performance.

Real estate

My real estate holdings have grown by 20% since first purchase. Now take that with a grain of salt; the values are based on Zillow. I won’t really know the value until I sell a unit. But at least it gives me some sense of their value.

My Florida town home has increased from it’s purchase price by about 12%. This isn’t of much value, because I don’t plan to sell it. But instead, it gives me reassurance that I bought it at a good price. All the other short sales that were going on in the same subdivision are gone, and they have even built a new building in this yet uncompleted neighborhood. These are all signs of the real estate recovery in Florida. It definitely shores up future opportunities in case I need to open a HELOC against it to access any cash.

Mortgage debt on my rental properties has dropped by $7200. That’s only a 1.7% reduction in rental debt, but I just started paying off the smallest mortgage by an extra $1000 this month. So, you’ll have to read next year’s annual report to see how well this feeds my wealth building plan.

I could pencil in the value of my new home I purchased back in March and look at its appreciation, but there is no value in that. Nor is there any benefit in looking at the growth of my previous residence either. Instead, what’s more important is how I used this unplanned opportunity to open a new position in wealth building. Which leads us to…

Stocks

My biggest stock position is Vanguard Natural Resources. But you can’t measure it’s performance by growth in value. That’s because the monthly dividends are being used to pay off my HELOC. The price of the stock doesn’t show a big growth history like Berkshire Hathaway. To best way to illustrate its growth is to take its value and subtract the HELOC balance.  That would show where all the spare dividend cash has been going.

I started with a little over $1000 of VNR a year ago. I have increased that position several times. But back in March, I plunged in by putting the left over cash from the sale of my previous home (made possible by the HELOC used for financing) into more VNR. So far, I have reduce my HELOC balance by -0.82%. It doesn’t sound like much, but I have only been using this cash flow machine for a few months. Next year, the fruits of that should begin to show much better.

My position in Berkshire Hathaway has grown by a modest 6%. My position in Apple has grown by 21%. That is partially because I bought more Apple when it dipped below $400/share. I still believe Apple will continue to grow and innovate, and with the amount of cash they have, it feels like a safe investment to me.

EIUL

My EIUL has done exactly what is was supposed to do. My contributions were increased back in May by 4% to represent cost of living increases. It is slightly ahead due to some small credits being paid. It’s actual value compared to the amount of contributions represents a 5.1% growth factor. This isn’t bad considering I’m paying big values. But the most important thing it is doing right now is locking in its growth. The value of it will not go negative, and when the next market correction appears, it will keep chugging along even as my stock portfolio takes a hit.

401K and Roth IRA

I still have my 401K with my current employer. It’s value has grown by 31%. My Roth IRA, which are refocused on holding stocks and reinvesting by DRIP, has grown by 22%.

If I assume that the real estate holdings are unrealistic, it might suggest that the rest of investment plan is actually doing worse than these plans. But these plans are currently riding the tide of QE from the Fed and other factors. When the next correction hits, they will probably get a hard knock. My Roth IRA might be okay, because I have refocused it on stocks and not mutual funds. But considering I can’t put any more money in it, it’s fine where it is.

Next year

Next year’s report should be more exciting because I have upped the pay off of one rental mortgage by $1000/month. That combined with 100% occupancy is also helping me to increase my rental cash reserves by $1000/month as well. When things get replenished, I can direct that money towards a rental mortgage and knock it out even faster.
Do I expect the same amount of growth? Hardly. 85% growth in one year is actually way above the mean. You should never depend on it or think you can keep it up. A big piece of this is Zillow telling me my rentals are probably worth more than I could actually get for them. In the next five years, when I finally sell one, I’ll get a proper correction to my net worth.

But there is one thing I’m sure of: everything is doing much better now that I have taken an active role in wealth management.