Why the withdrawals to basis, then loans strategy is blasé
By Sheryl J. Moore
Moore Market Intelligence
Today, indexed life insurance offers partial withdrawal options as well as three different types of policy loan options. Here, we will discuss each of these loan options, their pros and cons, and explain why withdrawals have fallen out-of-favor in the IUL market.
Since the creation of cash value life insurance, insurance agents have been advising their clients how to tap into that value. Accessing your life insurance policy’s cash value for retirement income, education funding, and other income scenarios while you are living not only provides living benefits to you, but also leaves the net death benefit as a tax-free benefit to your life insurance beneficiaries.
So, how does one gain access to their life insurance policy’s cash values?
Historically, insurance agents have advised their clients to take partial withdrawals of the policy’s cash value, until the contract’s cost basis is reached. Once the cost basis threshold has been reached, loans are initiated against the policy’s cash value as a method of accessing funds.
It is important to understand that partial withdrawals permanently reduce a policy’s death benefit and cash value. Therefore, the benefit payable to heirs is forever reduced when withdrawals are initiated and interest earned is thereafter credited on a lesser cash value balance.
By contrast, loans reduce the policy’s cash value and death benefit until repaid and also have loan interest that is payable annually on the total loan balance. So, the benefit payable to heirs can be fully restored if a loan is repaid, but until such time, a lesser death benefit is payable and interest is earned only on the net cash value.
It goes without saying that this method has its drawbacks, but the "withdrawals to basis, then loans" strategy ensures that taxable consequences are avoided, while protecting the policy owner’s rights to access their cash values. But this strategy is now a thing of the past. It has been falling out-of-favor since the introduction of indexed universal life insurance in the late 20th century.
With the introduction of indexed life came the opportunity to continue earning indexed gains on policy cash values that were loaned against, a feature never before available on universal life. While such benefits had long been offered on participating whole life contracts with dividends not of the direct-recognition variety, customers purchasing unbundled, interest-sensitive products were never allowed the opportunity to earn interest on monies that were loaned against.
Today, indexed life insurance offers partial withdrawal options as well as three different types of policy loan options. Here, we will discuss each of these loan options, their pros and cons, and explain why withdrawals have fallen out-of-favor in the IUL market. Fixed rate loans
Fixed rate loans have traditionally been the vehicle of choice when accessing cash values on life insurance, once the cost basis has been hit via withdrawals. Fixed rate loans are, quite simply, loans that are charged a fixed rate of interest, which is declared by the insurance company.
Often, life insurance contracts with fixed rate loans also offer a “preferred loan” provision, which charges a loan rate that is equal to the credited rate on the policy once a specified time period has elapsed (typically 10 years). In the past, some insurance agents referred to such loans as wash loans, as the interest charged and the interest credited appeared to be a wash. This is technically not an accurate way to describe the favorable loan provision, but gives one an idea of how marketable this policy feature can be.
Fixed rate loans have pluses and minuses: With fixed rate loans, you always know the amount of interest you’ll be charged. However, neither fixed loans, nor their preferred loan benefits, credit interest on the monies that are loaned against.
Variable rate loans
Variable rate loans aren’t really new; they have been utilized on whole life policies for eons. Yet indexed life insurance has reinvigorated this once-forgotten loan option. Variable rate loan provisions charge a loan rate that varies, based on the Moody’s Corporate Bond Yield Average. Considering the historical Moody’s rate has been around 8 percent, one can see why fixed rate loans (typically averaging around 6 percent) have prevailed in popularity in past decades.
Over the past few years, however, Moody’s has remained in the 4 percent to 5 percent range, meaning that variable rate loans have taken favor over fixed rate loans, which have been charging a higher rate of interest.
Variable rate loans have their pros and cons too. The ultimate pro of variable rate loans is that the policy values that are loaned against continue to earn indexed interest on IUL products. Variable rate loans can also offer more competitive loan rates when you consider that fixed rate loans are typically charging a rate of 6 percent, but some companies today have variable loan interest (VLI) rates as low as 4.39 percent.
On the other hand, variable rate loans charge interest that will likely change in the future. This makes it difficult to predict what rate will be charged on monies taken out of the policy when the agent is illustrating life insurance policy distributions at point of sale.
The insurance agent may illustrate a rate of 5.50 percent being credited to the policy, and a loan rate of 4.5 percent being charged against the loan balance; this would effectively be a 1 percent net gain (5.5 percent - 4.5 percent = 1 percent). In reality, however, the loan rate could exceed the policy’s credited interest rate, meaning that the policy holder is upside down on their life insurance. This phenomenon is further complicated when considering indexed life, where the illustrated rate may be as high as 10 percent, but the credited rate could be as low as 0 percent.
For this reason, many companies have scorned the VLI provision on some IULs, citing that the propensity for both the policy’s credited rate and the loan’s variable rate charged can deviate significantly from what is illustrated at point-of-sale. As a result, some companies with VLI provisions guarantee that the variable loan rate will never exceed a stated rate of interest (typically 10 percent).
Participating fixed rate loans
Also as a result of the negative stigma that has surrounded VLI on indexed life, some companies in the IUL market have begun offering an entirely new type of loan option: the participating fixed rate loan. Participating fixed rate loans (sometimes called indexed loans) are like fixed rate loans in that the interest rate charged on the policy loan is fixed (usually at 5 percent or 6 percent), and declared by the insurance company.
Conversely, participating fixed rate loans continue to credit indexed interest on the monies that are loaned against. This new type of loan options effectively offers the best of both worlds when it comes to fixed rate and variable rate loans.
That being said, we clearly see the argument for participating fixed rate loans; but what about the case against this innovative loan option? Some have argued that such loans are not sustainable. After all, if Moody’s Corporate Bond Yield Average has historically been around 8 percent, and the rate being charged against the policy cash values is only 5 percent, how is the insurance company going to account for the shortfall of 3 percent interest? Some speculate that non-guaranteed insurance charges will have to be increased, or that non-guaranteed caps and participation rates will have to be reduced, in order to compensate for such scenarios.
In the end, the loan provision chosen is up to the agent and the policy holder. Everyone selling cash value life insurance should understand that no one loan provision is better than the other. No loan provision is right for every client either. Agents need to understand the benefits and shortfalls of all life insurance distribution options. In the interim, only time will tell which loan feature ends up being the preferable option for IUL policy holders.
It is undeniable however, that both variable rate loans and participating fixed rate loans are the more powerful options for indexed life insurance purchasers. With the power of compounding interest and the ability to earn indexed gains on the loaned-against cash values, these two loan options have made “withdrawals to basis, then loans” a thing of the past when it comes to indexed life.