Have you ever heard of hyper-funding a life insurance policy?
Chances are you have not. I hadn't heard of it until last year when an IMO I work with started rolling out hyper-funding illustrations. When I saw the illustrations, two things came to my mind.
1) That the client can receive significantly more tax-free income from the life insurance policy in retirement (versus a non-hyper-funded policy).
2) That some agents would get sued for misrepresenting the illustration (making it look too good without the client understanding why).
Actually, there was a third thing that came to my mind - that agents would very much like to learn about it to help increase their sales.
What type of cash-value life insurance policy can you hyper-fund?
Any policy that has growth pegged to a variable investment return (such as the S&P 500 index) and one that has a variable loan option. If you are not fully up to speed on variable loans in life insurance policies, contact me using the forum below for more information.
What is hyper-funding?
It's actually quite simple, and I'll explain it with an example.
Let's assume that a 45-year-old client is going to budget $50,000 a year into a low-expense cash building life insurance policy (equity indexed life) for 10 years. Assume the client has determined that one of the best tax-favorable wealth building retirement tools is a cash-value life insurance policy.
In years one and two, the client pays a $50,000 premium.
In year three, the client decides to hyper-fund it. How does he do that?
In year three, the client will take a $30,000 loan from his policy and will turn around and re-deposit that borrowed money into the life insurance policy as premium. Therefore, his premium in year three is $80,000 (and will be $80,000 for years three through ten).
In years 11-20, the client will fund only $30,000 (which is borrowed from the policy).
At this point, the majority of readers should start scratching their heads. Why would a client want to borrow money and then put it back into the life insurance policy as premium? Because of the "variable loan" benefits.
Historically, if you look at the returns of the S&P 500 and lending rates in life insurance policies which are pegged to bond returns, the S&P 500 has outperformed the lender rates on life insurance policy loans by more than 2 percent a year.
In an equity indexed life insurance policy where the client borrows $30,000 a year from the policy, he is charged interest on it. But the client is putting the borrowed funds back into the policy where it will grow tax-free at the rate of the S&P 500 index. Because the interest on the loan is paid internally, the client has no out-of-pocket expenses to hyper-fund (unless the policy significantly underperforms which is why this is a risky concept).
One of the very beneficial options in an indexed life policy is the variable loan option. It sets a client up in retirement to actually make money on borrowed funds from a policy. In our example, if the money accumulating in the client's life insurance policy returns, on average, 7.5 percent and the lending rate on the policy averages, say, 5.5 percent, the client will end up making significant money on the money borrowed from the policy.
This concept is supercharged by hyper-funding the policy as outlined above.
How can hyper-funding grow wealth?
Back to our example. The client is going to fund $50,000 into the policy in years one and two, $80,000 as premium ($30,000a year from borrowed funds) from years three through ten, and $30,000 a year premium (all from borrowed funds) from years 11-20).
How much tax-free retirement income could the client receive in retirement from age 61-100 (which many agents like to illustrate)? $196,350
How much tax-free retirement income could the client receive in retirement from age 61-100 in a non-hyper-funded policy? $152,500
How much better did the client do by hyper-funding the policy? $43,850 a year from age 61 until death. Or, in other words, 29 percent better with hyper-funding.
What assumptions did I use to come to the above numbers? Fairly conservative. I used a rate of return in the policy of 7.4 percent and a lending rate of 5.1 percent. The insurance company software with these types of policies typically illustrate returns north of 8.5 percent and lending rate of 2 percent to 2.5 percent less than the crediting rate.
Isn't hyper-funding risky?
I think it's very risky. I'm not advocating that agents go out and show hyper-funding illustrations to their clients. I think doing so can be very risky and if you do illustrate and sell clients based on a hyper-funded illustration, I strongly recommend you have a full-page disclaimer letter outlining the risks and assumptions used to create the illustration.
Having said that, hyper-funding can work, and is an option in certain life insurance policies. Our job as fully informed advisors is to fit the best products with our clients and inform them of the benefits of the policies. Hyper-funding is one of those potential benefits.
*For further information or to contact this author, please use the forum below.