Expanding the whole life conversation

Image: FreeDigitalPhotos.netIf there’s a silver lining to the lackluster market performance of recent years, it’s that more clients appreciate the need for true — not just cosmetic — diversification in their approach to managing their financial investments.

While diversification is no guarantee of success, of course, many clients have embraced the long-held notion that the key to optimizing asset growth over both up and down markets is to diversify among asset classes (cash, equities, fixed-returns) to help ensure there may be a softer landing than if all investments are in one particular sector or asset class should the bottom fall out.

Except, today, there’s a new consideration for asset allocation. It’s not justabout uncorrelated asset classes. With an unprecedented federal deficit, most economists believe taxes will, at some point, have to go up from today’s historically low rates. As a result, the prudent planner must also assess the tax impact of a client’s investment and asset allocation choices, considering that impact for the long-term health of accumulation and distribution strategies.

Happily for our industry, there is an asset class with optimum synergy between asset allocation considerations, tax efficiency andour abiding concern for protecting families and businesses in the event of premature death. Yes, participating whole life insurance is the “new” asset class that, over the long term, can maintain conservative growth projections, has unique income tax advantages and offers cash value that provides portfolio stability. Meanwhile, the policy’s death benefit replaces the economic value forever lost when the insured dies.

Triangle 1Obviously, tax considerations have long factored into investment decisions. When asset classes are considered in the layered context of tax opportunities, it’s easy to envision a triangle. The triangle’s bottom is taxes paid on income and gains; the next layer is tax-deferred 401(k) and other retirement plans, as well as life insurance and annuity cash values; and the top layer is made up of the rarer items for which income tax is not paid, such as life insurance death benefits. So, in the face of likely higher future tax rates, we need to be mindful that there’s not only diversification of asset allocation, but tax treatment diversification as well.

The mathematics of volatility, diversification and taxes

When assets are in their accumulation phase — and when there are no expenses or other withdrawals made from the funds — the order in which returns “show up” doesn’t matter all that much. In the example below, a volatile 10-year return pattern is used to determine the value of $10,000 after 10 years, for a total of $13,839 and a resulting compound rate of return for the period of 3.55%.chart 1A

As can be seen, if those returns are reversed (i.e., a mirror image of the first example), the 10-year ending value — and the compound return — is the same. However, if we assume expense withdrawals in the form of taxes (20% annual turnover and 20% average tax), the returns are affected in absolute terms, and the order of returns matters quite a bit:

Chart 1B

Similarly, when distributions are to begin (assuming the purpose of the portfolio during accumulation was to produce retirement income), the order of returns willaffect the value of the portfolio after a period of years of income withdrawals. In Chart 2, we have assumed the targeted retirement income is $400 per $10,000 of invested assets (a 4% withdrawal rate), and it is clear volatility will lend truth to the typical client’s fear of outliving his or her money. While the mirror image of returns in Chart 2 preserves somewhat more principal, principal is deteriorating in both cases. It’s easy to imagine how just one year of a severe decline in market values could rapidly deplete the ability of your client’s portfolio to provide income for a normal lifespan.

Chart 2This is sobering stuff, certainly, but it gives you the opportunity to initiate or reopen a conversation about whole life with your client, by suggesting he or she consider a retirement portfolio that includes tax-favored life insurance and lifetime annuities as part of the asset allocation.

Using the principles demonstrated in Charts 1 and 2, it is possible to calculate several sample volatility models that could support a healthy couple (both currently age 65) to an 85/15 statistical life expectancy. What do we mean by this, exactly? Within a large population of 65-year-old couples, it is the age by which 85% of both spouses have died and just 15% of the couples have at least one spouse still living. For each $1,000 per month of desired income (inflation is not considered in this example), it requires approximately $800,000 of principal, based on an average 7% long-term return rate with a volatility standard deviation of 8.25%.

The problem we foresee in the 2012–2014 economy is the expectation of continued, historically low returns on fixed-income securities, with the double whammy that, once interest rates start to rise, longer-duration bonds are expected to lose value. Add to the mix of issues the likelihood we mentioned earlier of higher income taxes in the near future.

Introducing the 85/15 concept

So let’s say you have a 38-year-old client who has acknowledged the need for a substantial amount of permanent life insurance; has the resources to pay the premiums out of investment income, earnings or a combination of both; and is forward thinking enough to begin planning for the last third of his life, even though he’s barely completed the first third.

The hypothetical $2 million participating whole life policy indicated by his Human Life Value and other considerations has a hypothetical annual guaranteed premium of $27,680. With a sophisticated modeling technique to suggest likely, undulating dividend scales over a long period of time, the policy cash values project a mean average of $334,000 in tax-freewithdrawals (under current tax law) and net loans from the policy beginning at age 85 and continuing to age 100.

Triangle 2With his advanced life expectancy covered for income, the client can focus his investment energies on maximizing his retirement income between ages 65 and 84.

As advisors, you will want to review each client’s specific risk tolerance, investment experience, time frame and resources when customizing a recommendation about investing and accumulating for retirement, with specific attention being paid to any tax advantages of different opportunities within each risk class.

With the added dimension of tax considerations during accumulation — and especially during distribution — today’s financial representative and his or her clients can focus on the many intriguing opportunities that participating whole life insurance brings to the table.

By Kurt Shallow, Richard M. Weber, M.B.A., CLU, AEP

Kurt Shallow is vice president, Risk Products Distribution, at The Guardian Life Insurance Company of America, New York, N.Y.

Dick Weber is managing member of Ethical Edge Insurance Solutions LLC , Pleasant Hill, Calif., and is the 2012-2013 president of the Society of Financial Service Professionals


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