Moment on Money

On the Radar: Tax Effect of Return of Premium Life Insurance

Sorry the blog has been quiet for a couple days. I went to a conference out of state and it interfered with my writing schedule. That combined with the delay I need to get my blog material reviewed by compliance results in a few missed days. Thanks for being patient. The good news is the conference was good and I will be writing about some of the topics in the near future.

Last October I wrote about Return of Premium Term Life Insurance. I have been considering return of premium (ROP) as an option for several clients and the results are very interesting. In some cases, ROP makes a lot of sense and in others it doesn't. It all depends on the rate of return you would need to earn if you purchased a regular term and invested the difference in a side fund.

Calculating the raw return of the return of premium policy is straightforward. Here are the variables which can be plugged into any financial calculator:

• N = number of years
• PV = 0
• PMT = the difference between the annual cost of a straight term and the ROP term
• FV = annual cost of the ROP term multiplied by the number of years
• For greatest accuracy all payments should occur at the BEGINNING of the period.
• Calculate for INT/yr.

Recently I have been giving a lot of thought to the tax effect of this analysis. If you purchase ROP term, the money you receive at the end of the term is not taxable since there is no gain … it is a return of the premiums you paid. However, if you purchase the regular term and invest in a side fund, the gains in the side fund will be taxable. In order to calculate the tax effective rate of return of the ROP policy, you need to add the tax liability to the future value so you have the same net result after taxes.

I've made it easy for you. Here is an excel spreadsheet (Download rop_analysis.xls) to do the math for you. All you need to do is provide the cost of the regular term, the cost of the ROP term, the term period, and a tax rate. The spread sheet will calculate both the raw return and the tax effective return of the ROP policy.

Keep in mind that the raw return is guaranteed by the issuing insurance company. The effective return is based on that guaranteed return and the tax rate you provide. If the tax effective return is attractive, purchasing ROP makes a lot of sense considering the very low risk.

Radar by BenFrantzDale

Financial Evolution

I was talking with a colleague the other day. We were discussing recent case work when a fairly new associate came in to the room and wanted our assistance analyzing a case he was working on. His prospective client was considering purchasing a variable universal life insurance policy to fund his children's college education. For the record, this was not our associate's recommendation. Someone else the client had been talking to made that proposal.

The three of us discussed concepts I have openly written about here. Things like saving for education should not detract from retirement funding, life insurance needs can all be defined into "If I die" and "When I die" categories, "If I die" needs are best served by term insurance, "When I die" needs require permanent insurance, but in most cases life insurance makes a lousy investment.

In the course of our discussion we came to the conclusion that life insurance could accomplish the client's goals, but that new tools have evolved which are a lot more attractive. For example, term insurance rates have declined so dramatically that we can purchase the death benefit separately. This leaves the remainder of the budget to accumulate without the drag of insurance costs.

When I first started my career (1989) we still carried rate books, computed premiums on a pad of paper and desktop computers were just being introduced into the business world. The fax machine was a revolutionary method of instant document transmission, but was difficult to deal with as the thermal paper would fade over time and had a tendency to curl up back into a roll. I was proud the day I had a car phone installed so I no longer had to carry bags of coins and search for a pay phone to make calls away from my desk.

Today we send instant e-mails on our laptops, can do complex analysis very quickly, and need to shut off our cell phones so no one calls when we need some quiet time. So many organizations are going "paperless".

Tomorrow someone may look at today's solutions and consider them as inefficient as using whole life insurance for college funding. The tools have changed.

Financial product development is happening with amazing speed. I doubt it will ever slow down.

11/02/2007 (Day 73) – Evolution by Kaptain Kobold

Wellness for Life

Would you like to love longer, feel better, and save? Aviva Life and Annuity Company (formerly AmerUs Life) has developed a product that could help you do just that.

I am fortunate to have been selected to participate in a pilot program for Aviva's Wellness for Life. Here In a nutshell, Wellness for Life is a rider that's designed to help policyholders maintain or improve their health by making them eligible to receive certain wellness services and information from Mayo Clinic. The rider offers the potential for future cost of insurance reductions that may be declared at the discretion of Aviva.

Aviva's Wellness for Life program entitles participants to receive a confidential health risk assessment and personalized health information from Mayo Clinic Health Solutions. Current services include:

• Access to the Mayo Clinic EmbodyHealth portal on the web
• The personalized Mayo Clinic Health Risk Assessment via the portal
• Access to the 24-hour Ask Mayo Clinic Nurse Line
• Quarterly Mayo Clinic EmbodyHealth newsletter
• Annual Wellness Calendar

There really is something for everyone. You do not have to be the picture of health or an athlete to benefit. All you have to do to get the most out of Wellness for Life is see your doctor, maintain your weight and take care of yourself. The tag line sums it up well; Live Longer, Feel Better, & Save. Let me know if you want more information.

Products issued by AmerUS Life Insurance Company (Des Moines, Iowa). Rider form number 2WFLAJ07 – availability may vary by state.

Analyzing Return of Premium Life Insurance

All life insurance needs can be expressed as IF you die and WHEN you die. For the IF you die needs, term insurance is your best bet. In general, you just match the length of the term with the need and buy the least expensive coverage from a reputable company. A new breed of term insurance is gaining popularity called Return of Premium (ROP) term insurance.

These new policies are still term insurance, but they have a twist. At the end of the term period you have a couple options:

1. You can continue the contract at a higher premium.
2. You can get 100% of the premiums paid returned to you, or
3. You can forfeit the return of premium for a reduced amount of fully paid up life insurance.

Of course these additional options come at a price. The real question is; are the new Return of Premium features worth the extra premium? To do the analysis we should first explore which option we would likely take.

Most term insurance policies let you renew at a higher premium. Generally, they are not designed to entice renewal. The renewal premiums are very high (somewhere in the neighborhood of eight to ten times the original premium for a 20 year term) and would only be attractive for someone who had become ill and it looked like the death benefits would be paid sooner rather than later.

It is also unlikely that you would forfeit the return of premium in exchange for a fully paid up life insurance policy with a reduced death benefit because of the IF you die original need. Unless your needs have changed, chances are that at the end of the term period you would no longer have a need for the coverage.

The most likely option is that you would exercise the return of premium option.

Let's take a sample case I recently did for a client.

This client is a 32 year old, non-smoking female who would probably qualify for standard non-tobacco rates. She has a 20 year need for $250,000 of term insurance. In traditional term insurance, she selected a policy from (ING) ReliaStar which would have a $33 a month premium. Her return of premium option is with [company name removed at their request] which has a premium of $46.20 a month and would return $11,088 after 20 years. Keep in mind that she needs the insurance so $33 a month is effective spent already and that provides only the insurance coverage she needs. The question is really is it worth spending an additional $13.20 a month to get the return of premium?

By doing a time value of money calculation (PV = 0, FV = 11,088, PMT = -13.20, N = 240) we come to the conclusion that we are earning 10.77% returns on the additional premium. Considering the only risk lies with the financial stability of the issuing insurance company, that seems like an excellent proposition to me.

Put another way, if she purchased the traditional 20 year term insurance and invested the additional $13.20 a month, she would have to earn 10.77% in the side fund to have the same $11,088 after 240 months. But since the ROP insurance returns the premiums without tax consequences (there is no gain, you are simply getting your money back) and the side fund would have $7,920 of taxable gains, she would actually have to earn more than 11% to have the same net result.

Not all cases work out as well for ROP as this one did, but by following the same process you can assess if ROP is good choice for you.

The Decision by levendis

Getting Real

Over at Political Calculations, Ironman decided to take a statement I made and put it to the test. He titled his post Got Time? Get Positive Returns. I had written "there was never a single ten year period where the indexes went negative" referring to the S&P 500 and the DJIA in the later half of the 20^th century. See my post on Understanding Indexed Annuities for the full timeframe and context. Ironman ran an inflation adjusted rolling 10 year rate of return for the S&P going all the way back from January 1871 to August 1997. He found that during that time there were a few 10 year periods where the real return was indeed negative.

Real return looks at buying power as opposed to nominal return which is a pure return. For example, if I gave you $1.00 in 1974 when candy bars were a nickel, you could have purchased 20 candy bars. Today, if you still had the dollar, you could only buy 1 candy bar since they now cost a buck each. In this example your nominal return was 0% - you neither gained nor lost any money – but your real return was negative since you can not buy nearly as many candy bars.

My analysis used nominal returns since the discussion was about indexed annuities. Since there are no claims made by indexed annuities that your buying power will be maintained, nominal returns are a more appropriate measurement than real returns.

I like Ironman's study. It is interesting and applicable to understanding long term market behavior. He even takes it one step further and looked at 20 year inflation adjusted returns for the S&P. Then he found only one 20 year period, June 1901 – June 1921 where the S&P's real return was negative (and barely so at -0.2%). In addition, he found that that average real return was +6.9%. That means that with a 20 year holding period, the S&P increased investors buying power by almost 7% per year!

I still stand behind my original statement, "the S&P has never provided a negative return in a single ten year period" but now I will add the Ironman corollary, "One should hold the S&P 500 for at least 20 years to maximize the probability of keeping pace with inflation."

Good work Ironman! Thanks.

Hardcore Study Time by Wysz

Understanding Indexed Annuities

Last week All Financial Matters posted about a seminar his father went to where the presenter offered indexed annuities as a safer investment alternative. That inspired him to compare a hypothetical indexed annuity to the S&P 500 from 1950 – 2006. The conversation it started is very interesting. Most interesting to me was to read different peoples perceptions of indexed annuities and see some of the misconceptions about how they work and when they can be useful.

First a disclaimer, I remain neutral in the whole debate. I have no emotional ties to any financial products. It is my belief that financial products are neither good nor bad, they are just tools. When a helpful tool is used improperly it may no longer be safe. If you need some background, you may want to read my post "What Is An Annuity?" before jumping into this.

What are Indexed Annuities?

Simply put, indexed annuities are fixed annuities where the interest credited is calculated based on market index performance. In the marketplace today there are a wide variety of formulas and indexes available. It would be counter-productive to try and define all the possible combinations. For illustrative purposes I will use the same assumption All Financial Matters used which is a 1 year point to point of the S&P 500 with 100% participation and a 10% cap. Huh? What does that mean? Let me translate that for you.

A point to point formula looks at a market index at the beginning an end of the year. In this case, we are using the S&P 500 but we could have used the Dow, Russell, or any other index. Let's say the S&P was 1000 at the beginning of the year and 1070 at the end of the year. That is a growth of 7%. Multiply the growth by the participation rate (in this case 100% so it is still 7%). Finally, if the growth is higher than the cap, reduce the rate to match the cap. That is, the interest credited can never exceed the cap rate in any given year regardless of the index performance. You also need to know that in an indexed annuity, you can never have a negative return. The lowest the return can be in any given year is 0%.

As annuities, indexed annuities are often subject to surrender charges. Surrender charges are a penalty like fee you have to pay if you terminate the contract in a specified number of years. Early indexed annuities often had long surrender charge periods (15 or more years) but guidance from the National Association of Insurance Commissioners has resulted in newer products with surrender charge periods of 10 years or less.

Are Indexed Annuities a safer investment alternative?

No. Indexed annuities should not be compared to or considered investments. The returns are much closer to a certificate of deposit than they are a mutual fund. In a CD the five year rate is hovering at about 5.5%. The 5 year average return for the S&P (period ending 8-31-2007) was 12.01%. I would hope that an indexed annuity would average returns somewhere in the 5% - 8% range, but there is no assurance that will actually happen. (All Financial Matters study from 1950 – 2006 showed the hypothetical indexed annuity would have averaged 6.81%)

If someone has the ability to stomach the ups and downs of the market, and a sufficient timeframe, I believe they are better off in the market. In 2002, when the markets were at a low point, I calculated the 10 year total returns on the last day of each month for the S&P and the DJIA. The S&P study started January 1950, and the Dow study started 1960. In all that time there was never a single ten year period where the indexes went negative. While this is no guarantee, history has shown that the risk of loss in the markets diminishes significantly if your timeframe is long enough. If someone is an investor, they should stay away from indexed annuities.

Are Indexed Annuities appropriate for anyone?

Yes. Some people have significant money in CD's. If the annuity surrender charges are not an issue, one may want to consider an indexed product. In exchange for FDIC insurance and an interest rate which is set in advance, you can gain tax deferral and potentially higher interest. Of course the interest could end up being lower too depending on how the index performs. Another appropriate use of indexed annuities would be when an investor no longer has a long enough time frame to be comfortable with the gyrations of the market.

Can you lose money in an indexed annuity?

Yes you can. If you exit an indexed annuity while the surrender charges are still more than the interest you have been credited, you will end up with less money than you started with. But once the interest earned exceeds the surrender costs, taking a loss is no longer an issue.

In summary, indexed annuities are complex tools. They are not investments, nor should they be considered alternatives to investments. While they can serve a useful function for a limited group of people, they are not for everyone. Seek trusted professional advice if you have any doubts.

Confusion! Photo by LuluP

Is Life Insurance a Good Investment?

Did you know that September is Life Insurance Awareness Month. I would be remiss if I had nothing to add.

I had a discussion with someone recently who asked if I thought life insurance was a good investment and my answer came quick and easy. No, no way, no how. Life insurance is for death benefits, it is NOT an investment.

If you are looking to accumulate cash, there are better ways. Like every other service, insurance has a cost component. It would be tough to find a life insurance product which can consistently out perform an investment of equivalent risk which does not have to cover the cost of insurance. "But life insurance cash values accumulate income tax free" argue the proponents. They argue that the tax benefits offset the cost of insurance. Baloney. There are other ways to invest tax efficiently that come far cheaper than insurance.

Yes, I know that properly structured low cost loans can be used to get cash out of a life insurance policy without ever paying income tax on it. Most of the policy owners who are using those techniques do not understand the associated risks, and the risks are huge. These loans avoid taxation because the loan is ultimately repaid out of the tax free death benefit. But if the policy were to underperform (that is, earnings within the contract do not grow fast enough to service the interest on the loan), the policy would lapse and the loan would be repaid using the contacts cash values. While that seems harmless enough, in the eyes of the IRS the life insurance loan was forgiven and the forgiveness of a loan is taxable as income! Worse yet this loan may be forgiven years and years after the money was spent.

Imagine a man 65 years old who has accumulated a nice chunk of change in his life insurance policy. His insurance agent shows him that he can borrow $25,000 a year for the next 10 years from his policy and avoid paying income tax on the income. So he borrows the $250,000 from age 65-75 and lets the interest accumulate on the loan. Now at age 90, the outstanding loan has grown quite a bit. Let's call it around $650,000. If the loan amount is essentially the same as the insurance policy's cash value, the policy lapses and the loan is forgiven. Now this 90 year old man must either repay enough of the loan to keep the policy from lapsing or pay income tax on $650,000! Either option is going to require significant expense. Mind you, the last of the $250,000 was spent 15 years ago. A qualified competent professional can prevent this from happening, but who is that going to be? If you are 35 years old now, I can not promise to be here for you when you are 90.

There is a role for permanent life insurance. It is just not an investment.

new briefcase photo by dcJohn

A Reader Asks #6

This comment was left on the post What Happens When You Die?

Art- Thanks for your answer about indexed annuities a while back. This issue is something that most young individuals do not want to think about, but what do you recommend for a young couple or young family in deciding how much is enough if one of the income earners dies or becomes disabled? Thank you.

Thank you for your readership, support, as well as your question.

When it comes to preparing for a potential death or disability, any couple or family has to consider what the economic impact would be. In both cases we need to consider both the lost wages as well as changes in expenses. While the process is the same, the answers may be different when looking at a death as compared to an extended disability so we will look at each separately.

Preparing for a Death

It is a myth that household expenses will decrease proportionally with the death of a family member. Some budget areas can decrease such as clothing and food, but not necessarily proportionally. I remember when my wife and I became a family being surprised that food expenses did not double. After some consideration I realized that we were able to enjoy an economy of scale buying food for two people. For example, I used to buy about a quart of milk a week. Together with my wife we started buying the gallon size which had a lower cost per ounce. If I died, the reverse would also be true. Other areas of a family's budget are not paid on a "per person" basis such as housing costs, property taxes. There are some expenses which are both such as utilities. With one less family member there would be less water and electric use, but heating and air conditioning costs would remain about the same.

The best place to start is a record of the families spending over the past year. For every category the couple should discuss how that spending would change if one of them died. At the end of the discussion they should have a viable "survivors budget" which reflects the lifestyle the survivor would want to lead if they were widowed. Don't forget to consider new expenses like an increase in daycare or baby sitting.

Finally, compare this survivor budget to the survivor's income. Would the surviving spouse's income support the planned expenses? If not, life insurance to cover the difference would be appropriate. There are a couple of different ways to convert this income shortfall to a death benefit and this is one reason to seek professional assistance. But for those comfortable doing it I would recommend a time value of money calculation (but be sure to factor in inflation).

On top of the income needs add final expenses such as funeral costs, education funds, and possibly even charitable intentions. The sum is the amount of life insurance needed.

Preparing for a Disability

Financially, an extended disability can be even more devastating than a death. Many people have disability benefits of some kind through their employer, but few employees ever take the time to understand their benefits … until they need them. The first step is to take the time to understand what your existing coverage will (and will not) provide.

Expenses definitely do not decrease in a disability. This usually means an increase in utilities as well as medical expenses. Often the able family members take time off of work to provide care, which causes their income to decrease.

Once again a family should start with their spending history, and adjust it to anticipate a disability. Then compare the results with the expected income. If there is a shortfall, the good news is you can purchase disability income protection for the exact monthly income you will need.

Conclusion

I fear you were looking for a definitive answer instead I gave you process. The truth is there is no universal truth. I can not tell you how to protect your family until you know what you want to have happen. Two income families are not uncommon. I submit for your consideration that in most two income families, both incomes are needed. The family will need to adapt to a new lifestyle if they are forced to live on one income.

Resources

• How Much Life Insurance Do You Really Need?
• When Staying Alive Means Going Bankrupt
• Disability Insurance: How Much Do I Need?
• Protect Your Most Important Asset With Disability Insurance

Do you have a question you would like to ask? If so, just email me. I will answer it here on the blog but will remove any personally identifiable information. Or, if you would rather I not post the answer, just let me know and I would be happy to keep your question and my response confidential.

Photo on flickr by chona kasinger

Iowa’s Continuing Hearings on Long Term Care Insurance

If you have not been following this thread, you missed my original report about the public hearing on long term care insurance as well as the follow up post from August 7^th. In the follow up post I referenced the statistics the state made available as well as those from a reader, Scott Olson, CLTC. The statistics were in conflict and I asked if anyone could explain the difference. Once again, Scott stepped up to the plate and delivered the answer. Here was his response:

The problem with the chart that you posted on your blog is that it is only a survey of the "top writers" of LTC [Long Term Care]. In other words, it's only listing the in force policies of companies that are currently writing LTCi [Long Term Care Insurance] and companies that were in the top 5, in terms of placed new premium, that particular year.

For example, in 2002, the top 5 writers on long term care insurance were, in order: Genworth, John Hancock, Bankers Life and Casualty, CNA, and UNUM. At that time, CNA, had about 500,000 long term care policyholders.

In 2003, CNA sales plummeted for a few different reasons. In 2003, they wrote less than half the amount of business as they had written in 2002. The dropped from 4^th place to 7^th place for issued new premium in 2003. Therefore the chart that is posted on your blog would NOT include CNA and their 500,000 policyholders for "Policies in Force (end of year)" for year 2003.

Met Life replaced CNA as one of the top 5 long term care writers. But, at that time, Met Life had about 150,000 less LTCi policyholders than CNA had. Just because CNA was not in the top 5 that year, does NOT mean that their 500,000 in-force long term care policies vanished into thin air. Yet that's what the chart is implying.

The chart gives the impression that the number of in-force policies is decreasing each year. Nothing can be further from the truth. The number of in-force polices continues to grow every year for two reasons: 

1. Policyholders are NOT cancelling their policies. The persistency with long term care insurance is about 98%.
2. About 500,000 new policies are written each year.

I'll send you a document which is published by the exact same company that published the chart on your blog. The name of the company is LifePlans. You'll see that new sales has decreased. In 2002, the top 10 long term care writers placed $807 million in new LTCi premium. In 2005, the top 10 long term care writers placed $574 million in new LTCi premium. But, just because new sales have decreased does NOT mean that the number of in-force policies is decreasing.

Thanks Scott. I really appreciate you adding to the conversation. For other readers, I can not provide the document for your review as it is clearly labeled "For Producer Use Only. Not for public use or distribution." but I can verify that the numbers Scott refers to are indeed reflected in the document and LifePlans is the source of the data.

I am going to see to it that the Iowa Insurance Division has your comments, Scott. Iowa Insurance Commissioner Susan Voss held a second public hearing early this month. I was not able to attend but I understand that she is considering asking the legislature to strengthen consumer rights when long term care insurance claims are denied. The establishment of a State Long Term Care Ombudsman is also being considered. I was surprised to learn that the Independent Insurance Agents of Iowa CEO, Bob Skow, believes that an ombudsman could harm Iowa's relationship with insurance carriers. Instead, he would like to see better standardization of LTC policies.

Commissioner Voss will hold one more public hearing on September 11^th before she finalizes her recommendations to Governor Culver. I will continue to monitor the situation and report back to you.

Photo in Flickr by Tony_ia

More Long Term Care Public Hearing Follow Up

I reported on the Iowa Insurance Division's public hearing on Long Term Care Insurance which was held July 11^th.

Here is one response I received from Scott A. Olson, CLTC: 

I'm not sure where Klete Geren got her [his] statistics, but she [he] made some factual errors.

1. I am aware of 24 different long term care insurers that currently offer long term care insurance in Iowa (not including a myriad of group long term care policies that are available through organizations like AARP, other associations, and large employers). However, it is true that the vast majority of policies are sold by about ten companies or so, including: Genworth, John Hancock, Met Life, Allianz, Prudential, New York Life, Mass Mutual, State Farm, Mutual of Omaha and Medamerica.
2. The statement, "Nationally, long term care new sales and policies in force peaked in 2002 and have been declining ever since" is incorrect also. The number of policies in force and the amount of premium in force has been increasing every year. The reason is persistency. Most people who purchase long term care insurance keep their policies. They rarely cancel. There are about 1 million more policies in force today than there were in force in 2002.
3. Clarification: What has decreased is the growth in sales. Less policies were sold in 2003 than in 2002. Less policies were sold in 2004 than were sold in 2002. Less policies were sold in 2005 than were sold in 2002. Last year the number of policies sold was near the number of policies that were sold in 2002. The industry continues to grow each year, it's just not growing as fast as it was in the late 90's and up to 2002.
4. According to the NY Times article, the long term care insurer with the worst complaint ratio has a complaint ratio of .29%. That means that 29 out of every 10,000 policyholders have filed a complaint against that insurer.
5. But, here's the real shocker, according to the New York Times, the top long term care insurers have a complaint ratio of .01%. That means that 1 out of every 10,000 policyholders have filed a complaint against those insurers. (I'll be happy to email you that chart if you would like to see it.) I'm sure that General Motors, surgeons, and Starbuck's franchisees would love to have only 1 complaint for every car owner, patient, and coffee connoisseur, respectively.

As you can see, Scott is a CLTC which according to the issuing organization, Corporation for Long Term Care Certification, Inc., designates him "Certified in Long-Term Care". I think Scott makes some good points so I wanted to share them with everyone although his first and second points and Klete Geren's data are in conflict.

From the handouts, here is the data from the State of Iowa (sources cited are the ones cited on the handout):

U.S. Data Regarding New Sales and Policies Inforce

Year	Policies Sold	New Sales Premium (Millions)	Policies Inforce End of Year
2001	536,281	$929.02	3,516,324
2002	545,092	$951.72	3,723,231
2003	489,289	$857.70	3,543,318
2004	364,830	$708.30	3,448,826
2005	324,948	$647.80	3,439,300
2006	281,179	$592.80	3,205,737

Source: LifePlans Survey of Top LTC Writers

Iowa Long Term Care Policies Inforce and Premiums by Year

Year	Policies Inforce	Total Premiums By Year
2003	110,589	Not Available
2004	125,204	$166,504,351
2005	127,809	$188,266,006

Source: National Association of Insurance Commissioners LTC Report

I have no idea who is correct. Can anyone provide some insight?

Iowa State Capital (sic) photo by Tony_ia