COVER STORY arguably be listed as the primary con- cern. In our 1 percent and 13 percent A Fresh Look at in Periods of Uncertainty collar example, each percentage point by E. Peter Tiboris, CFP®, CLU®, ChFC®, CAP subtracted from the cap reduces all of the rolling average yields by anywhere A properly balanced planning certain cash to heirs at the policy- from 0.45 to 0.60 percent per year. strategy can allow clients at any stage holder’s death. Irrespective of the Most carriers periodically adjust index of their financial plan to capture the market and the values of assets in the caps—upward as well as downward. significant long-term appreciation of client’s portfolio, the appropriate death Because most indexed UL policies have the equity markets while thoughtfully benefit allows the survivors to create relatively low guaranteed cap levels (in apportioning assets in cash or cash an orderly disposition of the family nearly all cases, 4 percent or lower), alternatives for liquidity needs. These assets to meet liquidity needs. If the a decision to lower the index cap to liquidity needs start with death, insurance amount is large enough, the the minimum guaranteed level could continue with emergencies and the survivors might not see a financial case significantly impair the performance of inevitable bear market, and extend to for selling any of the invested assets. the policy. However, similar to increasing distressed investment opportunities In this case, the life insurance death policy charges, an insurance carrier that such as buying a piece of real estate benefit represents choice. Having an lowers its index cap to the point where amidst a market crash. Theoretically, ability to choose whether or not to policies become economically unattractive a properly balanced, long-term dispose of assets could allow the family would risk a swift departure of all healthy financial plan will include cash and/ to maximize the overall legacy for members of its risk pool and risk substan- or cash alternatives to avoid the generations to come. tial damage to its reputation. need to sell shares in a down market, The risk of being harmed by an adverse and hence should outperform the Living Benefits exercise of the insurance carrier’s discre- alternative plan without adequate What about the living benefits of life tion is mitigated over time by the fact that cash-equivalent assets. insurance? How might these fit into a an increase in policy charges or a decrease Most financial planners recognize client’s overall portfolio in periods of in the index cap would be prospective that the benefits of liquid cash for vari- distress? Our clients use traditional, only; neither of these changes would have ous purposes are high. However, we high-quality, dividend-paying1 whole an immediate impact on policy value. must further recognize that the cost of life insurance contracts as an efficient The owner of an indexed UL policy this liquidity premium is high: yields means to accumulate cash value over can generally liquidate the investment on short-term liquid investments are long periods of time. after the occurrence of an adverse relatively low, and interest-bearing The concept is intuitive. For the event (such as news that the index cap investments generally translate into moment, put aside the costs of insur- is being reduced) for the exact same ordinary income tax. ance and other factors that impact value they could have received before Once inflation and ordinary income individual product performance, and the event had occurred. Surrender tax is considered, the cost of these consider: charges impose a cost to exiting the investments is high. For example, an Whole life insurance contracts policy within the early years, but once investor might have liquid investments rely on the performance of the life the cash surrender value of the policy paying 3 percent interest. Assuming insurance company and its general climbs above the total amount of pre- a 35 percent tax bracket, the post account2. That general account is miums paid (which, in the case of the ordinary income tax interest on these invested in primarily corporate and example policy used here, is projected investments is 1.95 percent. As a government bonds. It is very difficult to occur at the end of the fourth year), result, at 3 percent inflation, the inves- for the individual investor to replicate the policyholder should be able to get tor’s liquid investment has a negative this blended diversification on a risk- out without experiencing a loss. Of return relative to inflation. adjusted basis. course, the health of the insured and Most of these life insurers are the income tax consequences associ- Unique Characteristic highly rated and some have been ated with surrendering the policy are Life insurance is an asset whose incorporated since well before 1900. other factors that should be taken into unique and most important charac- The insurance company dividend account before a policy is surrendered. teristic—the death benefit— provides continued on page 26 continued on page 26 Reprinted with permission.

FPAJournal.org August 2015 | Journal of Financial Planning 25 COVER STORY Insurance

A Final Note Anyone considering an indexed UL policy as an alternative to more traditional conservative investments continued from page 25 received quickly. For example, a policy should have a thorough understanding scale interest rate1 is not directly owner could have had a lion’s share of of the income tax treatment of life subject to market volatility. Some their insurance cash value available insurance, as well as how that tax companies boast that they have never within a week in the most perilous treatment compares with the way missed a dividend through every bear periods of 2008–2009. in which other investments might market in history and even through the Lastly, and perhaps most impor- be taxed. Although the general rules Great Depression and Great Recession. tantly, life insurance offers flex- are that inside cash buildup, the For a relatively recent example, we can ibility. The life insurance benefit itself proceeds of policy loans and the death look to 2009, the year following the allows clients the flexibility within benefit on the policy are non-taxable Great Recession of 2008. In that year, their financial plan to help them meet for income tax purposes, exceptions the following insurance companies had their goals before and after retirement to these rules can be traps for the these dividend-scale interest rates: with some certainty. unwary. Accordingly, it is important to Mass Mutual: 7.6 percent Most clients don’t plan on using life work with a life insurance professional Guardian: 7.3 percent insurance cash values in the future, who is well-versed in tax matters, or MetLife: 6.25 percent but they do find opportunities over consult with an outside tax adviser New York Life: 6.14 percent time where it can be useful. Our when making decisions regarding the Northwestern Mutual: 6.5 percent clients often borrow from the insur- policy. This historic reference helps to ance company3 using their cash value illustrate the relatively low volatility as collateral to help meet liquidity Jordan H. Smith, J.D., LLM, is vice president of of insurance companies’ dividend needs. When they are flush with cash advanced design at Schechter Wealth, a third- scale interest rate in times of high again, they repay the loan. This may generation wealth advisory firm, where he works overall market volatility. Because of allow them an option to avoid having with advisers and their clients in the design and the mortality and expense charges, the to liquidate equities, bonds, real implementation of advanced strategies. dividend scale interest rate should not estate, or other investments in a down be used as a measure of the policy’s market, providing the opportunity Endnotes internal rate of return; rather it is one for those investments to recover. Of 1. The analysis in this article assumes that the factor used in determining a policy’s course, loans taken against a life insur- policy has a participation rate equal to 100 total dividend. The method an insurer ance policy, surrendered values, or percent of the index return between the cap uses to determine the total dividend withdrawn values can have potentially and the floor. Although some indexed UL paid on a policy can vary from adverse effects if not managed products offer alternatives of a lower cap company to company. properly. paired with a participation rate that exceeds Traditional whole life insurance Traditional dividend-paying whole 100 percent, those are not discussed here. It is contracts have a guaranteed set of life insurance on its own can be a the author’s belief that such arrangements are cash surrender values at contract compelling asset to own in any market statistically less favorable. inception. Once a dividend is earned and environment. When you factor in 2. The point of this analysis is not to suggest that reinvested by a policy owner, it becomes the benefits of its unique liquidity the collared return from an indexed UL policy part of the guarantee. As a result, the characteristics at death and during will outperform direct investment in the S&P cash value can never go down. life, it can have a significant impact 500 (in the long run, it won’t, because direct Life insurance is not subject to on an individual’s overall portfolio investors receive dividends in addition to tax as the cash value grows. Further, performance. market appreciation), but instead to illustrate borrowing against or surrendering how reducing volatility can dramatically additions from a non-modified Peter Tiboris is a wealth management adviser based improve investment returns. endowment contract policy via loan/ in New York City. His team specializes in working surrendering dividends up to the cost with individuals and businesses across all financial Editor’s note: For another take on basis are not subject to tax and can be planning disciplines with a focus on tax efficiency. indexed universal life insurance, see Peter Reprinted with permission. Katt’s column beginning on page 33.

26 Journal of Financial Planning | August 2015 FPAJournal.org Insurance COVER STORY arguably be listed as the primary con- cern. In our 1 percent and 13 percent Important disclosures: collar example, each percentage point subtracted from the cap reduces all of the rolling average yields by anywhere 1Because of the mortality and expense charges, the dividend scale interest rate should not be used from 0.45 to 0.60 percent per year. as a measure of the policy's internal rate of return, rather it is one factor used in determining a policy’s total dividend. The method an insurer uses to determine the total dividend paid on a policy Most carriers periodically adjust index can vary from company to company. Due to the size, predominantly fixed income composition, caps—upward as well as downward. and long term nature of insurance companies’ general accounts, short term market volatility Because most indexed UL policies have typically does not have a significant immediate impact on the dividend scale interest rate of the relatively low guaranteed cap levels (in respective insurance company. Rather the dividend scale interest rates tend to lag the trends of the bond and stock markets as a whole. The dividend scale and the underlying interest rates are nearly all cases, 4 percent or lower), reviewed annually and are subject to change. Future dividend policies are not guaranteed on life a decision to lower the index cap to insurance policies. The dividend scale and the underlying interest rates are reviewed annually and the minimum guaranteed level could are subject to change. significantly impair the performance of 2Policyowners are not investing in the general account portfolio when purchasing insurance or the policy. However, similar to increasing annuities. They are buying products that are backed by the financial strength of the insurance policy charges, an insurance carrier that company that issues the product. lowers its index cap to the point where policies become economically unattractive 3Loans taken against a life insurance policy, surrendered values, or withdrawn values can have potentially adverse effects if not managed properly. The death benefit will be reduced by any would risk a swift departure of all healthy outstanding loans, surrendered values, or withdrawn values. members of its risk pool and risk substan- tial damage to its reputation. Northwestern Mutual is the marketing name for The Northwestern Mutual Life Insurance The risk of being harmed by an adverse Company, , WI (NM) (life and disability insurance, annuities) and its subsidiaries. Ernest Peter Tiboris is a Representative of Northwestern Mutual Wealth Management Company® exercise of the insurance carrier’s discre- (NMWMC), Milwaukee, WI (investment management, trust services, and fee-based financial tion is mitigated over time by the fact that planning), a subsidiary of NM and limited purpose federal savings bank. All NMWMC products an increase in policy charges or a decrease and services are offered only by properly credentialed Representatives who operate from agency in the index cap would be prospective offices of NMWMC. Representative is an Insurance Agent of NM and Northwestern Long Term Care Insurance Company, Milwaukee, WI, (long-term care insurance) a subsidiary of NM, and a only; neither of these changes would have Registered Representative of Northwestern Mutual Investment Services, LLC (NMIS) (securities), an immediate impact on policy value. a subsidiary of NM, registered investment adviser, broker-dealer and member FINRA The owner of an indexed UL policy (www.finra.org) and SIPC (www.sipc.org). Representative may also be an Investment Advisor can generally liquidate the investment Representative of NMIS. after the occurrence of an adverse event (such as news that the index cap is being reduced) for the exact same value they could have received before the event had occurred. Surrender charges impose a cost to exiting the policy within the early years, but once the cash surrender value of the policy climbs above the total amount of pre- miums paid (which, in the case of the example policy used here, is projected to occur at the end of the fourth year), the policyholder should be able to get out without experiencing a loss. Of course, the health of the insured and the income tax consequences associ- ated with surrendering the policy are other factors that should be taken into account before a policy is surrendered. continued on page 26

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