A well-diversified portfolio is an important thing to have when working with your client on their overall financial strategy. A variety of investments may help hedge against volatility, supply a guaranteed lifetime income through living benefits, and protect against inflation.
Life insurance is one part of a portfolio that a client often does not consider an investment. As a non-correlated asset, however, life insurance may be an important component in:
- Salary/family protection
- Mortgage protection
- Tax-efficient asset transfer
- Estate planning
- Business succession planning
Therefore, the death-benefit funds become part of the financial strategy when the insured dies.
Life insurance and the internal rate of return
While most clients understand the “rate of return” premise (ROR) in relation to many of their investments, they don’t always understand that the death benefit from a life insurance policy also enjoys a rate of return in relation to premiums paid. The internal rate of return (IRR) on life insurance works as follows:
Premiums are paid to the insurance company in exchange for a promise to pay a certain amount of money at death. The IRR is the rate that the cumulative premiums paid thus far would have to earn in order to equal the amount represented by the death benefit when paid in a given year. It is important to note that without a death, no ROR can materialize on life insurance. Rates of return on alternative investments can occur without a death, however.
In addition, because life insurance proceeds are generally paid income tax-free, (remember that estate taxes usually apply to the death benefit, while income taxes do not) the IRR on the death benefit is equivalent to an after-tax yield. Since some investments may have taxable gains each year, it is important the client understands the difference between an income tax-free rate of return and a taxable equivalent rate of return. The taxable equivalent return is the rate of return a person would have to earn in order to have in pocket, after taxes, the same amount of money that a tax-free investment would return. The calculation looks like this:
tax-free rate of return ÷ (100 – income tax rate) = taxable equivalent rate of return
So, using the above calculation, you can determine that if, for example, your client is in a 30 percent tax bracket and had a 10 percent rate of return on the death benefit of a life insurance policy, the same funds invested in a taxable vehicle would have had to earn 14.29 percent:
10 ÷ (100-30) = 14.29
Considering life expectancy
When determining if this approach is suitable for your client’s strategy, it helps to consider life expectancy along with risk tolerance. Life expectancy is a numerical statistic of the average expected future lifetime. The figure varies based on the underlying mortality tables used, and is based on actual mortality experience from insurance companies and the Social Security Administration. The rate of return on the death benefit will be significantly higher in the early years of the policy, but will decrease with time. The client may want to consider what the ROR and tax-equivalent return will be, not only in the early years of the policy but at their estimated life expectancy. The crossover point will be the age at which the client lived too long for the life insurance strategy to be as beneficial as another strategy of similar risk may have been. Let’s see how this strategy might look in the following case study.
Esther and wealth transfer
Esther, a 63-year-old widow, is rated non-tobacco preferred and is in a 28 percent tax bracket. She has plenty of income for retirement, and is looking for an investment strategy that will allow her to leave a more tax-efficient inheritance to her children.
After looking over her assets, Esther and her financial professional concluded that she can easily afford to invest $5,000 per year. Esther was shown several options in which she could invest, including a no-lapse universal life insurance policy. The no-lapse premium of $5,000, payable until age 100, would remain level, and the death benefit of $323,150 would be guaranteed as long as premiums were paid as agreed and based on the claims-paying ability of the company.
Esther was shown an example of her life expectancy with the rate of return she could expect based on premiums paid in relation to the death benefit. Here is what the rate of return on Esther’s policy looks like, the taxable equivalent rate of return, and her life expectancy, which is estimated to be age 83.
| Policy year |
Age |
Total premium paid |
Death benefit |
Tax-free internal rate of return on death benefit |
Taxable equivalent to tax-free IRR |
|
| 1 |
64 |
$5,000 |
$323,150 |
6363.00% |
837.50% |
|
| 5 |
68 |
$25,000 |
$323,150 |
102.00% |
141.67% |
|
| 10 |
73 |
$50,000 |
$323,150 |
32.69% |
45.40% |
|
| 15 |
78 |
$75,000 |
$323,150 |
16.83% |
23.38% |
|
| 20 |
83 |
$100,000 |
$323,150 |
10.21% |
14.18% |
Esther's life
expectancy is
age 83 |
| 25 |
88 |
$125,000 |
$323,150 |
6.70% |
9.31% |
|
| 30 |
93 |
$150,000 |
$323,150 |
4.58% |
6.36% |
|
| Life expectancy table is from “Tax Facts 2009,” Appendix A; no-lapse universal life insurance is used to supply the figures in the above example. | |
Insurance reviews
Annual reviews are an important part of planning and allow you to to keep up with a client’s financial goals and strategies. A life insurance checkup is an excellent way to maintain regular contact with your clients and ensure their coverage is appropriate for the current state of their affairs. Life can change quickly, and with it, the plan may need to be updated. This type of review may also provide an opportunity to explain the important role life insurance plays in the total portfolio strategy. Triggering events that may come up in an annual review and require reassessment of a client’s life insurance needs are:
- A change in marital status
- The birth of a child (or grandchild)
- A change in employment
- A home purchase
- Changes in the tax law
- A rise or loss in assets or net worth
- Business ownership or loss of ownership
- Retirement
After determining whether a life-changing event has occurred and once assets have been assessed, you and your client may find that additional life insurance coverage is needed. When requesting life insurance illustrations, you may want to request an internal rate of return report. This information will help you explain the investment value of the death benefit by demonstrating the after-tax rate of return at each possible year of death based on your client’s age of issue, planned premium payments, and death benefit dollar amount.
Other considerations
The rate of return on life insurance is not determined until death, so if the client lives far beyond their life expectancy, it is possible that the premium dollars, if invested elsewhere, might provide more funds to beneficiaries.
The life insurance purchase will use resources that could otherwise be used for investment savings needed in life, so life insurance should only be considered as a small part of the overall financial strategy, and only one aspect of a diversified financial picture.
Different products will result in different outcomes regarding the IRR. Products that are funded to non-modified endowment contract (non-MEC) capacity will generally result in a lower IRR on the death benefit due to the extra dollars intentionally invested.
It is important to educate your clients on the value of life insurance in meeting financial obligations brought about by an unforeseen death. In addition, educating your clients on the rate of return offered by a life insurance death benefit, and demonstrating its taxable equivalent, may help provide a better understanding of the investment value of life insurance in the overall strategy of a diversified portfolio.
As your clients’ personal situations change so will their life insurance needs. Care should be taken to ensure that these strategies are suitable for long-term life insurance needs. You should weigh your clients’ objectives, time horizon and risk tolerance as well as all associated costs and alternative strategies before suggesting a life insurance purchase.
Incorporating insurance reviews into your practice will offer you the opportunity to assess your clients current position and educate your clients on potential strategies, as well as show the value you bring to your clients with your professional and personalized service.
Shawn Britt is the director of advanced sales with Nationwide Financial Services in Columbus, OH. She can be reached at britts@nationwide.com.