Coordinating assets toward combined benefits
by Emily Bannister, CFA, and John Przybylski, JD, LLM, CFP
Mr. Przybylski, a tax attorney and certified financial planner, is Director of Financial Planning for Federal Street Advisors, an investment consulting and wealth advisory firm in Boston.Ms. Bannister is Director of Research for Federal Street Advisors and is a voting member of the Investment Committee. Visit federalstreet.com
With bonds providing so little yield in today’s market, should life insurance be viewed as an investment? Whether or not you view insurance as an “asset class,” permanent life insurance is definitely an asset, and it can help investors achieve their long-term financial goals. Thoughtful coordination of insurance and investments can provide more combined benefits than either asset can deliver on its own. And since having a life insurance policy can affect a client’s willingness to take risk, it should be part of the investment conversation.
Though life insurance can be an incredibly complicated product, at its core it’s a pooled risk vehicle with a predictable, relatively stable death benefit. Life insurance is also income-tax advantaged. Policyholders do not pay current income tax as a policy grows in value, and death benefits are income tax free to heirs except when there has been a so-called transfer for value.
Comparing the benefits of term and life insurance
Term life insurance can make sense for people who do not have a permanent life insurance need. This is often the case for people who wish to provide for their dependents should they die prematurely. Term life insurance policies do not have a cash value that can be borrowed against or that can be monetized by surrendering the policy, and most people who buy term life insurance buy it with the expectation that they will likely survive the term. Except for people whose policies are likely to pay out, term insurance would typically not have any impact on how one’s investment portfolio should be allocated.
Permanent life insurance, on the other hand, is generally expected to be held to term, and often has cash value that can be accessed through a loan or through early surrender of the policy. Permanent life insurance takes many forms, including universal life, variable life, standard whole life, survivorship and even private placement life insurance (PPLI).
What these permanent life insurance products have in common is that they are designed to stay in place throughout the life of the insured and to deliver a death benefit for the policy’s beneficiaries. While the primary motivation for the contract is usually the death benefit, the policy has value throughout its term and therefore is an asset that should be taken into account when building an investment portfolio.
When an investment advisor designs an investment program, a critical component of the decision making process is to understand how much risk a client is able to take, and, just as importantly, how much risk the client is willing to take. A permanent life insurance policy can change a client’s ability to take risk by extending out his or her time horizon or providing liquidity at a critical moment. It can even change a client’s willingness to take risk.
Take, for example, the situation of an entrepreneur who has built a successful business that makes up the bulk of her net worth. She has successfully broadened the management of the company, but still retains ownership in the company. Over the years, she has saved a smaller but meaningful mount in her personal account that can be invested. She has three children, all of whom are in their early 30’s, do not have independent wealth in their own names, and would be her heirs.
Life insurance can be used to reduce the impact of estate taxes
Our entrepreneur knows that if she were to die, estate taxes would be significant and could result in a forced sale of the business. While this is hopefully an unlikely event, our entrepreneur considers it an unacceptable outcome to put her children in the position of needing to sell the business quickly due to estate taxes. They would not be in a good negotiating position to maximize the value of the business, and a forced sale could result in a destructive ownership structure at the company. The illiquid nature of the company, which is the bulk of our entrepreneur’s wealth, would generally constrain the rest of her portfolio to be invested in very liquid, very conservative holdings such as high quality bonds.
If, however, she had a permanent life insurance policy that would provide liquidity for her heirs to pay estate taxes, she could invest her personal account for growth in less conservative or less liquid assets such as stocks or private equity.
Life insurance can free clients to invest more aggressively
For clients who have more than enough wealth to take care of themselves, the anticipated death benefit from a permanent life insurance policy can free them to invest more aggressively and in less liquid assets.
Depending on how the policy is structured, permanent life insurance can build up a significant cash value that can be accessed during the insured’s life through a loan or by surrendering the policy. This cash value is often fairly stable, especially as measured against a basket of marketable investments. While there are many reasons to be cautious about taking a loan against a policy, most notably that an outsized loan could jeopardize the policy’s ability to pay a death benefit in some situations, the existence of an available cash value on a paid-up permanent life insurance policy may allow people to feel more comfortable living with the ups and downs of stocks or other less consistent assets in their investment portfolio.
Insurance and the investment portfolio: a two-way street
The effect that insurance can have on investment decisions is meaningful. But the relationship between insurance and the investment portfolio is really a two-way street. The investment portfolio can also influence which structure of permanent life insurance policy is likely to be most advantageous for the investor. For example, a retired banker may have substantial assets that are more than sufficient for his living needs, his philanthropic goals, and his desired bequests. But after experiencing the 2008 credit crisis one year into retirement, he may feel nervous about an equity-oriented portfolio, despite his long term time horizon and desire to grow the portfolio. He may be willing to continue holding a portfolio made up mostly of stocks knowing that his insurance policy could be an emergency source of cash if needed during a time of market stress (in addition to the death benefit it provides).
Since his investment portfolio is aggressive, our banker should be cautious about choosing a pure variable life insurance policy since it is more market-sensitive and could have a lower cash value or an increase in premiums exactly at the time he wants it to be available.
When advising on life insurance as part of holistic wealth planning services, it is important to consider the entirety of the client’s situation, including their investments. If a client buys a new policy, or surrenders or exchanges an existing policy, one must consider the impact of that change on the investment portfolio. With careful management, an investment portfolio and a permanent life insurance policy can complement each other. When done well, a coordinated approach to viewing insurance and investments can enhance a person’s overall financial picture.
*Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, Certified Financial Planner™ and CFP (with flame logo)® in the U.S., which it awards to individuals who successfully complete CFP Board’s initial and ongoing certification requirements.
