MECing a life insurance policy instead of funding an FIAArticle added by Roccy DeFrancesco on March 5, 2010
Roccy Defrancesco

Roccy DeFrancesco


Joined: May 24, 2006

Many advisors use fixed indexed annuities (FIAs) for clients 55 and older who want to grow wealth in a conservative manner for retirement. Why? Because FIAs provide clients with "principal protection" (money does not go backwards) and decent upside potential if the stock market performs well (up to a cap). As you know, growth in an FIA is taxed as ordinary income when withdrawn.

On the other hand, for clients under 60, a cash-value life (CVL) insurance policy is a typically recommended wealth-building tool because cash inside the policy grows tax free and can be removed tax free in retirement via policy loans.

For CVL insurance to be a viable tax-favorable retirement vehicle, the policy must be "overfunded" and run with the lowest possible death benefit allowed by the Modified Endowment Contract (MEC) rules. If the insurance policy becomes an MEC, any borrowed funds from the policy in excess of the basis (premiums paid) are treated as taxable income (similar to a tax-deferred annuity).

An MEC is not necessarily a bad thing. Most advisors shudder at the thought of a policy becoming an MEC. Why? Because CVL insurance is sold so clients can borrow "tax free" from the policy in retirement. If the money removed from a life insurance policy is treated like an annuity, is that the worst thing in the world? Maybe not.

FIA caps -- The caps on FIAs are terrible right now. Annual point-to-point caps on FIAs are down to 4.5 percent to 6.5 percent versus the 7 percent to 12 percent that they've been at times over the last 10 years.

EIUL caps -- On the other hand, depending on the policy used, caps on EIUL policies are typically between 10 percent to 15 percent. That is much better than low caps on FIAs; but remember, there are mortality costs to a EIUL policy that a FIA does not have.

Living benefits with EIUL -- Another benefit to EIUL policies vs. FIAs is that an EIUL policy can have significant living benefits such as a free LTCI, critical illness, and terminal-illness rider (if you use the right policy like revolutionary life).

Tax-free death benefit -- Another benefit to using an EIUL policy versus a FIA is that when a client dies, the client's death benefit will pass income tax free to the heirs. With an annuity, all of the growth in the annuity is income taxable to the heirs.

Based on the above benefits of using EIULs vs. FIAs, you are probably ready to go to market with this idea. Right? Well, let's look at an example -- always helpful when understanding the numbers.

Let's take Dr. Smith, who is 55 years old and in good health. Assume he has an extra $100,000 sitting in CDs that he would like to reposition somewhere safe where the money will grow and can be used in retirement. Assume Dr. Smith will fund a one-time premium into both the FIA and the EIUL policy (revolutionary life) where the EIUL policy was designed to be a MEC with a minimum death benefit (DB.)

Which one will provide more retirement income for Dr. Smith when he turns 66 years old? I'm going to assume he will spend down the assets in an equal amount for 20 years.

Let's assume the FIA returns 5.0 percent annually and that the EIUL policy has returns of 7.5 percent. Why the difference in return? Because an EIUL policy has significantly higher caps.

How much can Dr. Smith remove from his FIA? $13,071 each year from ages 66-85, draining the account value to zero at age 85.

How much can Dr. Smith borrow from his life insurance policy at age 66? $17,314 each year from ages 66-85 (this assumes a 7.5 percent wash loan and max borrowing).

I found it very interesting that the EIUL policy generated a return that is 32 percent better than the FIA.

Variable loans -- If you know about EIUL policies, you know that they are forecast to have a positive loan arbitrage of in excess of 2 percent. I wanted to give you the numbers if the EIUL policy in my example had a 1 percent and 2 percent positive variable loan arbitrage.
  • With a 1 percent positive loan arbitrage, the client could borrow $19,315 each year.

  • With a 2 percent positive loan arbitrage, the client could borrow $21,592 each year.

An MECed life insurance policy has many advantages over an FIA, including higher caps, a tax-free death benefit (which by the way starts at $272,000 in my example above), and a FREE LTCI, critical, and terminal-illness rider.

Does the above mean that all clients should use single-premium MECed EIUL policies instead of FIAs? Not necessarily. However, now that you know the numbers, bringing this to the table for your clients under the age of 60 will help you give them the best options to choose from to grow wealth for retirement.

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