Whole-Life Insurance Can Provide an 8%+ Equivalent Return for High-Income Earners

The primary investment, retirement, and financial planning benefits of whole-life insurance arise because it can provide a high after-tax, risk-adjusted return to those who structure it properly as a financial planning vehicle.

If you are a high-income earner living in states with high-income taxes like California, New York, New Jersey, etc., then it’s likely that you are paying more than 40% of your earnings in federal and state income taxes.

Certain states assess high marginal tax rates on ordinary income (e.g., bond dividends) – in addition to the federal tax rate residents pay (top federal rate is 37% +3.8% net investment income surcharge). This means that high earning individuals in these states can end up paying more than 50% in federal and state taxes on their gains.

High-income earners who earn their income from high salaries or business revenues are often looking for safe places to invest their after-tax earnings since they are already taking significant risk either with their businesses or their equity portfolio.

Such individuals are trusting in their own earning potential, businesses, and equity portfolio to grow their wealth. They understand that while investing in these opportunities comes with significant risk, it also allows them the best opportunity for them to grow their wealth significantly.

But if these individuals are taking significant risk in growing their wealth with these opportunities, what is the best way for them to protect their wealth with the rest of their investments?

Growth assets like stocks and private businesses typically have higher expected returns, but also higher risk, while safe assets have lower returns, but also lower risk.

However, by providing tax-benefits and downside protection to safe assets, safe assets can end up having a higher after-tax, risk-adjusted return than growth assets.

The traditional way for clients to do this is to increase the allocation of their portfolio to bond-like assets that are more stable than equity investments.

This is the same reason why advisors and target-date funds increase the client’s asset allocation towards bonds as clients get older and closer to retirement; they will need the income from their portfolio and can’t take as much risk with their investments.

Over time, advisors and target-date funds slowly shift the portfolio allocation from 100% stock allocation to a lower stock allocation and higher bond allocation in order to reduce risk in the portfolio as the client nears retirement.

The problem with this is that while it’s easier for advisors and target-date funds to allocate clients to bonds to reduce risk on a pre-tax basis, it doesn’t make sense for high-net-worth clients on an after-tax basis. This is because on an after-tax basis the client is earning very little from the bond allocation and is still subject to large losses if interest rates rise – as evidenced by bond returns in 2022. This is especially problematic in retirement when clients are withdrawing funds to meet their income needs.

While safe assets like bonds have less risk, they also are exposed to high tax rates leaving the client with very little on an after-tax basis.

The heavy allocation to bonds is a solution that helps advisors and target-date funds easily scale their business, but doesn’t provide better retirement solutions for high-net-worth clients.

Whole-life insurance offers significantly higher after-tax returns and significantly less volatility than long-term bonds without the heavy tax and interest rate risk exposure. Instead of investing in 4%-4.5% taxable bonds and earning 2%-2.5% on an after-tax basis, clients can invest in long-term bonds through whole-life insurance and earn that 4%-4.5% tax-free with significantly less investment risk. The key is to invest for the long term and structure the investment properly. Doing this allows clients the ability to invest in safer assets that can have a higher after-tax risk-adjusted return than some of the growth assets they are investing in.

While safe assets have lower pre-tax returns than growth assets, by protecting these assets from taxes, the assets can have the same after-tax return as growth assets but with significantly less investment risk.

How whole-life insurance provides better after-tax returns

Whole-life insurance is able to provide superior after-tax returns with limited investment risk to policy owners who keep the policy due to the fact that not all policy owners are using the policy properly.

In other words, some policy owners get a great after-tax risk-adjusted return from a whole-life insurance policy simply because other policy owners get a bad deal due to their poor decision making.

Whole-life insurance allows policy owners who keep the policy the ability to invest in long-term bonds tax-free and without interest rate risk while also sharing in the company’s profits via dividend payments in the later years.

Below are the top two reasons why some policy owners who understand how to use whole-life properly are able to get a great deal from the policy due to other policy owners who make poor decisions.

1. Policy owners who keep the policy for the long-term benefit from those who cancel the policy early

The most important thing for policy owners to realize when they purchase whole-life insurance is that for them to benefit, they have to keep it for the long-term.

In fact, with whole-life insurance the policy owners who keep the policy for the long-term benefit as a direct result of all the policy owners who buy the policy and then cancel it shortly thereafter.

What most policy owners don’t realize when they purchase a whole-life insurance policy is that most policy owners cancel the policy. In fact, Society of Actuaries’ studies show that almost 50% of policy owners will cancel their policy within 10 years and nearly 70% of policy owners will cancel their policy all together.

Why is this bad for policy owners who cancel the policy?

Well, for starters, life insurance companies charge heavy expenses and surrender charges in the early years of the policy. Therefore, unless the policy is structured properly (see point 2 below), if the policy owner cancels the policy within the first 15 years, they will often lose money on their investment.

This is horrible for the policy owners who cancel the policy. These policy owners will end up spending tens to hundreds of thousands of dollars on an “investment” and walk away with almost nothing – and then die afterwards.

The life insurance company collected tens to hundreds of thousands of dollars in premiums without ever having to pay a death benefit!

While buying a whole-life policy and then canceling it is horrible for policy owners who cancel the policy in the early years, this behavior is absolutely necessary for the policy owners who keep the policy to maximize the benefit they receive from the policy.

The IRRs of a poorly designed policy are negative for almost the first 15 years of the policy. While this is bad since more than 50% of policy owners will cancel the policy by that time, it is absolutely necessary in order for the policy owners who structure their policy properly to receive great returns in the later years of the policy.

Why do policy owners who keep the policy for the long-term benefit from those who cancel in the early years?

Mutual life insurance companies share their profits with policy owners who keep the policy in the later years through dividend payments made to policy owners. Since there are very few policy owners left in the later years, those who keep the policy are reaping all the benefits that otherwise would have to be shared with the other policy owners who bought policies from that carrier.

In the later years, mutual whole-life companies share profits with policy owners through the form of dividends. The fewer policy owners there are remaining, the larger the dividend each policy owner gets. This is why policy owners who keep the policy benefit from other policy owners canceling.

Since the policy owners who keep the policy don’t have to share these dividend payments with those who canceled, their returns are boosted at their expense.

The other reason why policy owners who keep the policy need other policy owners to cancel the policy is due to the amount of death benefit that the life insurance company provides to the policy owner if they pass away.

Since the life insurance company knows that ~70% of the policy owners will cancel the policy, it can offer greater death benefits relative to premium paid by the policy owner since most policy owners won’t keep the policy.

Similar to the dividend payment example I mentioned above, the policy owners who keep the policy don’t have to share the death benefit payouts that would have gone to the other policy owners who canceled the policy.

If all the policy owners kept the life insurance policy, then this wouldn’t be the case. policy owners who keep the policy are often paying ~50% less in premiums than they would be required to pay if all of the policy owners kept their policy.

And as you can imagine, if policy owners had to pay twice the amount of premiums for a life insurance policy with a given death benefit, then the life insurance company would sell a lot fewer policies. The life insurance company’s entire distribution strategy is dependent on a large number of policy owners canceling the policy without having to pay a death benefit on those policies.

2. Policy owners who structure the policy to pay less commissions to the agent get a much higher return than those who pay higher commissions

Another critique of whole-life insurance policies is that their return is low, often in the 2%-3% range. But even this is a high after-tax return for high-income earners who are paying 40%-50% plus in taxes every year and would otherwise be investing in bonds.

But most whole-life insurance policy owners don’t realize that they can improve the after-tax return of their policy to 4%-4.5% (equivalent to an 8%+ after-tax return for high income earners) simply by minimizing the commissions.

A typical whole-life insurance policy pays 80%-100% of the first-year premium to the agent who sold the policy. This is a huge expense for the life insurance company to bear. But the life insurance company has to do this in order to incent the agents to sell the policy. As you can imagine, the life insurance company has to make this expense back. It does this through high early year expenses and surrender charges for policy owners who cancel the policy (as described previously).

Policyowners can improve the return on the policy by reducing the commissions paid to the agent who sold the policy relative to the premium paid into the policy. They can do this by utilizing paid-up additions instead of traditional whole-life insurance as I’ve talked about previously here.

Paid-up additions allow clients to dump large amount of premiums into the policy that have a low commission rate. Instead of 80%-100% of the first-year premium amount being used to pay commissions, the commission rate on the paid-up addition portion of the policy is only 3%-5%.

Since the insurance company pays less commissions on the paid-up addition portion of the premiums than on the traditional premiums, the more the policy owner uses paid-up additions instead of traditional whole-life insurance, the less the expenses in the policy are and the higher the policy owner returns will be.

Maximizing the use of paid-up additions versus traditional whole-life insurance premiums is the difference between earning a 2%-3% tax-free return versus a 4%-4.5% tax-free return.

But very few policy owners use the paid-up additions feature in whole-life policies properly.

How do I structure a whole-life insurance policy to maximize the tax-free return versus maximizing the tax-free distribution I can receive?

Whole-life insurance offers policy owners the ability to choose between two ideal financial planning scenarios:

1. Maximizing the tax-free IRR; or
2. Maximizing the tax-free distribution.

These two goals are incompatible; the more you maximize one, the more you minimize the other.

In this section, I’ll show you how to do both depending on your goals.

1. Maximizing the tax-free IRR

To maximize the tax-free IRR, the client needs to maximize the use of paid-up additions and limit the withdrawals in the policy.

In the image below we can see the IRRs from a whole-life policy illustration that is structured properly to earn a 4%-4.5% tax-free IRR on the cash value.

By properly structuring a whole-life policy utilizing Paid-Up Additions, clients can earn a long-time tax-free IRR on their cash value of 4%-4.5%.

The policy illustrated above pays $95,620 for 8 years (total cumulative premium of $764,920) and maximizes the use of paid-up additions which reduces the commissions paid on the policy.

At the end of the eighth year, the client stops paying premiums on the policy by utilizing the reduced paid-up feature. In year 21, the client takes out $375,417 (~26% of the total value of the policy) through a tax-free withdrawal to help with their retirement needs.

But if the policy owner cancels the policy before year five, they will lose money on the transaction (-2.30% IRR). Hence, the 4%-4.5% is only actually earned by policy owners who keep the policy for 20+ years.

The tax-free IRR on total net cash value is 4.02% after 20 years, and 4.5% after 40 years.

For those wishing to see the full illustration, you can access it here.

The client can take out more of their value in tax-free withdrawals and loans (~90% of their value) if they wish. But doing so will reduce future returns due to the drag of the loan as well as reduced dividend payments as we’ll see in the following section.

2. Maximizing the tax-free distribution

Another goal may be to maximize the tax-free distributions the client can take out of the policy. This is particularly advantageous if the client is planning for retirement, as we’ll see.

In the illustration below, the client still pays $95,620 for eight years into the policy (total cumulative premium of $764,920).

But in year 21 the client takes out 90% of their policy value ($1,325,000) instead of 26% of the policy value in the previous example.

As seen below, the tax-free IRR after 20 years is 4.02% just like it was in the previous example. But it decreases after that for the reasons mentioned above.

By taking out the maximum tax-free distributions possible, the tax-free IRR drops to 3.61% after 40 years here compared to 4.5% in the previous example. Maximizing the tax-free distributions reduces the client’s IRR in the policy.

Clients can take out up to 90% of their policy value via tax-free withdrawals and loans. Doing so, however, will diminish future returns.

As discussed previously, maximizing the tax-free distribution reduces the IRR of the policy, but allows for better tax-efficient retirement planning as we’ll see in the retirement planning section later in this article.

For those wishing to see the full illustration, you can access it here.

The stability of whole-life insurance as an investment: Protecting clients from interest rate risk

While one key benefit of whole-life insurance is higher after-tax returns than bonds as shown in the previous sections, another large advantage is less risk than investing in bonds as well.

Whole-life insurance has less investment risk than long-term bonds for the following three reasons:

1. Protection from interest rate risk;
2. Stable mortality expectations; and
3. Stable lapse expectations.

1. Protection from interest rate risk

Interest-rate risk confronts bond investors. If interest rates rise, then bonds will take heavy losses. But the coupon payments are stable, as indicated by the table below.

Since 1928, the entirety of bond returns have been driven by the dividend return of bonds and not the price return. Furthermore, the price return is significantly more volatile than the dividend return of the bond.

As the table above shows, the entirety of the bond return over the past 95 years has been driven by the coupon return (6.80%) as opposed to the price return (-0.11%). The price return of the bond is driving the volatility (6.65% standard deviation of the price return of the bond as opposed to 2.93% standard deviation of the coupon return).

When advisors talk about using bonds for safety, it’s purely the coupon return that is providing the safety – not the price return. The price return of the bond is adding risk.

To capture the safety of the coupon payments of bonds due to rising interest rates, many advisors will invest in bond ladders by buying and holding bonds of varying maturities. They can hold the bonds to maturity and not have to worry about the embedded interest rate risk that comes with investing in bond funds.

The downside of this approach, of course, is that any attempt to exit the investment prior to maturity will expose the client to the same interest rate risk they were trying to avoid. Using bond ladders is a long-term approach that requires the investor to have a long-term horizon with preplanned liquidity needs. Furthermore, the utility of this bond ladder approach is minimized since the coupon payments are taxed at high ordinary income rates.

Advisors use bond ladders because the best use of bonds for downside protection in retirement is to capture the safety of the coupon return of bonds while not taking on the risk of the price return portion of bonds.

This is exactly what insurance products like whole-life insurance do while providing tax-free benefits and liquidity provisions to policy owners as well. Yes, it requires investors to have a long-term retirement approach, but the use of bond ladders or any other retirement plan requires the same approach.

Whole-life insurance allows investors to invest in long-term bonds similar to bond ladders except with more tax-advantageous liquidity provisions and benefits. Remember that when policy owners purchase whole-life insurance policies, they are essentially investing in the underlying general account of the life insurance company, which is invested in long-term bonds with an added bonus of profit sharing in the later years via dividend payments.

Each year that the policy owner makes a premium, the policy owner is essentially buying a part of the insurance company’s general account portfolio which primarily consists of investment-grade, long-term bonds. Ninety-five percent of these long-term bonds are investment grade.

The general account portfolio of a life insurance company primarily consists of long-term bonds. 95% of these are investment grade long-term bonds. Every time a policy owner makes a premium payment, they are making an investment into this long-term bond portfolio so that they can acquire the proceeds tax-free and without taking the interest rate risk that is associated with investing in long-term bonds.

The insurance company has long-term liabilities, so its strategy is to buy long-term and hold assets to match these liabilities. Any interest rate risk is born by the insurance company because they have a long-term horizon whereas the individual investor does not have the same investment horizon.

As we saw in Table 1, the yield on long-term bonds have been amazingly stable over the last 100 years. The coupon rate is very stable over the long-term even if interest rates change over the short term. Even if interest rates change in the short term, the effect of that short-term change on whole-life returns will be small relative to if the client were invested in the underlying long-term bonds directly since the insurance company is bearing the full weight of the change in market value of the bonds.

If interest rates rise in the short-term, whole-life investors will not see a large loss, whereas if they held the bonds directly, these policy owners would see a large upfront loss in market value. The opposite is also true. If interest rates drop, whole-life investors won’t see a large increase in their long-term returns, whereas if they held the bonds directly they would have experienced a large short-term gain in the upfront market value of their investment.

Therefore, investing in long-term bonds via a whole-life insurance policy allows the returns to be tax-free with less volatility since the insurance company is the one holding the bonds to maturity while allowing the client to take money out of the investment prior to maturity and keep the coupon payments.

In fact, clients can take out 70%-90% of principal and gains tax-free via a combination of withdrawals and tax-free loans.

We can think of investments in a whole-life insurance policy similar to a bond ladder.

The key difference here is that instead of a taxable coupon every six months to a year, with whole life you are investing in the equivalent of a zero coupon bond in which you invest via a premium payment to the insurance company during your working years when you’re in a high tax bracket and get the principal and compounded interest tax-free at the end of 15-20 years when you are in retirement.

With a traditional bond ladder, you make an initial investment, receive yearly or semi-annual coupon payments that are taxable, and at the end of 5-20 years you receive a tax-free return of principal.

With whole life you are making the initial investment during your working years when you are in a high tax bracket and letting the interest compound tax-free and then waiting 15-20 years to withdraw the principal and interest tax-free.

Whole-life insurance provides reduced volatility versus investing in long-term bonds directly via a bond ladder while also providing higher after-tax returns and more tax-efficient liquidity provisions than would otherwise be possible for a high-income tax earner during their working years.

2. Mortality expectations

Another key driver of whole-life returns are mortality expectations versus actual observed mortality. In other words, how many people who purchased whole-life insurance policies died in a given year versus how many the insurance company expected to die.

If more people die than the insurance company expected, the insurance company is losing money.

But insurance companies and their actuaries are excellent at estimating mortality based on their experience. In fact, most insurance companies tout actual-to-expected mortality ratios of 90%+.

Like long-term coupon rates, the volatility around mortality is low and rarely sways whole-life returns significantly.

3. Lapse expectations

As discussed previously, the entire mechanism of whole-life insurance is dependent on a large amount of people canceling the policy. If fewer people canceled the policy, then insurance companies would have to increase their reserves so they could pay future death benefits and it would make the product less profitable for the insurance company.

Luckily for the insurance company, policy owners are very consistent in canceling. When an individual policyholder purchases a policy, the insurance company doesn’t know with certainty if they will cancel. But they do know with a high level of confidence that on average a large amount of people will cancel their policies and that amount will be very close to what they expected.

The stability of the insurance company’s investment, mortality, and lapse expectations allow actuaries build these life-insurance products. If these expectations were extremely volatile, it would be too difficult to design a profitable product around it without extremely high profit margins that would make the product unsellable.

By building a product around stable assumptions, the insurance company can generate a product with stable profits and share some of those profits with policy owners who keep the policy so that they also receive stable long-term after-tax returns.

The only people who are losing are the large number of policy owners who cancel the policy or structure it poorly. And unfortunately, those people end up being from lower income brackets who don’t understand the product that was sold to them or can’t afford it anymore. On the other hand, wealthy people who buy larger face amount policies tend to be the ones who keep these policies for their investment and estate benefits and benefit from the poorer policy owners who cancel it.

It's yet another form of income inequality in which wealthy individuals capitalize and benefit from the economic loss experienced by middle class policy owners who are sold products they don’t understand.

But if you’re an advisor to wealthy clients, this is an arbitrage opportunity that can’t be easily replicated in the investment world.

With whole-life insurance, clients are getting stable long-term after-tax returns with limited volatility.

Whole life as a retirement planning tool

With whole-life insurance, high-net-worth clients are getting better risk-adjusted after-tax returns and downside protection than they could get investing directly in taxable bonds.

This is of significant advantage to those who are phased out of contributing to traditional retirement plans and would be forced to invest in bonds via taxable accounts to protect against downside risk.

In a previous article, I talked about how the rebalancing away from the equity portfolio towards the bond portfolio doesn’t make sense for high-net-worth clients because the portfolio is being shifted away from higher earning, tax-efficient equity investments into lower-earning, tax-inefficient bonds.

Instead of clients rebalancing away from stocks into bonds as clients get older – thereby experiencing tax drag from the constant buying and selling of assets – clients can slowly increase the percentage allocation of the portfolio into whole life by paying yearly annual premiums into the policy instead of investing in the equity markets in later years.

By the time they retire, instead of a 70% equity/30% bond portfolio, the client will have a 70% equity/30% whole-life portfolio. This portfolio will be both higher earning and less risky on an after-tax basis than the 70% equity/30% bond portfolio.

The example above shows a client using a 70% equity/30% whole-life portfolio instead of a 70% equity/30% bond portfolio.

By using whole-life insurance instead of bonds for downside protection, clients can achieve a higher after-tax and risk adjusted return. Instead of rebalancing the portfolio by selling stocks and buying bonds which exposes the client to tax drag, the client can simply slowly start paying the whole-life premiums each year as the client gets closer to retirement. This will eventually turn the 100% equity portfolio into a 70% equity/30% whole-life insurance portfolio.

Using whole life to manage effective tax rates in retirement

Another value of using whole life in retirement is that the tax-free income it provides helps reduce the effective tax-rate that clients would pay on their taxable gains. Since the tax-rate that people pay increases as their income increases, and since whole-life distributions are not included in taxable income, retirees can use tax-free whole-life distributions in retirement to meet their retirement income goals while also reducing the percentage of their income that retirees are losing to taxes.

Let’s consider the case of a married couple in California, both aged 65, who need $200,000 in after-tax retirement income. If this is taxed at ordinary income, then this married couple will have to withdraw $260,000 just to have $200,000 in after-tax income. The client is losing 23.1% of their income to taxes.

However, if the client can withdraw $150,000 in tax-free retirement income from their whole-life policy, then they will only need an additional $50,000 in after-tax income to meet their $200,000 after-tax retirement income goal. To get this after-tax income of $50,000 the client will need $54,000 in taxable income. In other words, the client will only lose $4,000 in taxes on this $54,000 of taxable income. In this case the client is only losing 7.4% of their income to taxes.

The client is reducing the percentage of taxable income that is being lost to taxes by 15.7% (23.1% to 7.4%) by using tax-free whole-life distributions.

By utilizing tax-free whole-life distributions to partially meet their $200,000 of after-tax income, the retiree is able to reduce the percentage of their taxable income lost to taxes from 23.1% to 7.4%

Reducing the client’s effective tax-rate in retirement accomplishes two tasks:

1. Reduces the total amount of withdrawals needed from the portfolio: Reducing the tax-rate on withdrawals from the portfolio means less drag on the portfolio since less has to be withdrawn from the portfolio to pay taxes. This allows the client to take more in withdrawals each year than would otherwise be possible if the client was at a higher tax-rate.

2. Allows for more financial tax-planning: Reducing the client’s effective tax-rate and taxable income in retirement via tax-free whole-life withdrawals increases the value of financial planning techniques such as Roth conversions as well as the ability to liquidate long-term capital gains at 0% taxation.

When clients are working their tax-rate is high, but after they retire they have no taxable income and a 0% tax-rate. They can use this window before they start taking Required Minimum Distributions (RMDs) and Social Security (SS) to implement smart financial planning strategies like Roth conversions and liquidating capital gains at 0%.

In the above graph, the client is working until age 65 which reduces the clients tax rate to 0%. This creates a financial planning window for the client to implement smart financial planning strategies until age 70 when they start receiving taxable income again through RMDs and Social Security.

In the above chart, we can see that there is a financial planning window where the client is in a 0% tax-bracket in between the time the client retires and in-between the time they start taking required minimum distributions and social security.

By using tax-free whole-life distributions during this time, clients can receive the income they need to pay their expenses while maximizing the use of this window to do either Roth conversions or take out income from their investment portfolio at a 0% capital gains tax-rate.

Conflict of interest

Since whole life makes more quantitative sense for high-net-worth individuals saving for retirement than taxable bonds, you might wonder why more financial advisors aren’t using it.

Well, there is a huge conflict of interest here.

Advisors who charge an AUM fee are not going to recommend whole-life insurance – even if it is in the best interest of their client – because doing so would take assets away from them and decrease their fee.

The same goes with advisors who don’t earn an AUM fee but have no idea how to use whole life as a financial planning and retirement tool and have no incentive to learn.

Advisors who earn a commission instead of an AUM fee are more than happy to sell clients whole-life insurance and earn a commission. The problem here is that these advisors are going to sell the high-commission whole-life insurance product that earns 2% to 3% instead of the low-commission product that will earn the client 4%-4.5% on an after-tax basis. And what’s worse, the clients who purchase the product from these advisors will probably cancel because they were sold it instead of understanding how to use it from an investment and financial planning perspective – thereby defeating any tax benefits the product would have had for them.

Conclusion

Whole life can provide better diversification, risk-adjusted, and tax-efficient returns than taxable bonds for high-net-worth clients as well as a wealth of tax-efficient financial planning strategies for those who are planning for retirement.

The difficulty is finding an advisor who is willing to work in your best interest to create a solution that benefits you instead of his or her business interests.

Rajiv Rebello, FSA, CERA is the principal and chief actuary of Colva Actuarial Services (www.colvaservices.com). Rajiv works with HNW clients, family offices, estate attorneys, and CPAs to help HNW advisors implement life insurance, annuity, and alternative investment solutions (including tax-free PPLI solutions) into their current practice in order to help increase clients’ after-tax returns and reduce volatility in their clients’ portfolios. Rajiv can be reached at [email protected].

A message from Advisor Perspectives and VettaFi: To learn more about this and other topics, check out our most recent white papers.

Read more articles by Rajiv Rebello