The Top Frequently Asked Questions Part 2

01:07 How much money can I contribute to a policy, and for how long?

Patrick Donohoe:

Hello everyone, welcome back. Today, we’ll discuss the top ten questions we consistently receive from you. Joining me is my good friend and colleague, Nick Welch, who has been with our organization for about ten years. He works closely with many of our existing clients. Since 2007, we’ve worked with approximately 8,500 people, exposing us to various scenarios and frequently asked questions. Thanks for being here, Nick.

Nicholas Welch:

Thanks for having me.

Patrick Donohoe:

So, let’s delve into a common topic. Clients often want to understand how to maximize their existing policies in terms of investment and duration. Specifically, they ask about the limits on contributions and the duration for these investments. Nick, how do you usually approach this?

Nicholas Welch:

It’s a complex issue, varying from client to client and policy to policy. Each insurance company has its own guidelines and limits for annual contributions. There are also IRS limitations for maximum funding. Given that policies grow funds in a tax-favorable environment, there are inevitably restrictions on the amount of money that can be invested. These specifics depend on the client and the individual policy.

Patrick Donohoe:

From an IRS perspective, there are specific tests built into the process, which help us demonstrate the policy’s performance over time based on the premiums paid. This helps us determine the annual maximum contribution without triggering undesirable taxation.

Nicholas Welch:

That’s correct. It’s important for clients to consult their wealth strategists, who can illustrate these specifics for them. The modified endowment contract limit set by the IRS can be confusing. There’s a stress test involving the premium amount, the insurance environment’s financial input, and the resultant death benefit. If the input exceeds the supporting death benefit, it crosses the IRS threshold.

Patrick Donohoe:

When setting up a Wealth Maximization Account, we typically also establish term insurance, which is usually convertible into permanent insurance. The conversion specifics vary depending on the carrier and policy. In cases where clients can contribute more than their policy initially allows, they can convert some of this term insurance without needing a medical qualification.

Nicholas Welch:

Exactly. When dealing with whole life insurance and the Wealth Maximization Account, we assess the client’s cash flow, savings ability, and dormant assets. We aim to find the minimal death benefit needed to maximize the living benefits of the policy. However, this approach often results in significantly less coverage than what’s needed from a human life value perspective. That’s why we supplement this with either internal or external term coverage. Convertible term coverage allows clients to increase their investment as their savings ability grows, without undergoing underwriting.

06:49 How do the returns from life insurance compare to other investment vehicles?

Patrick Donohoe:

A common question we encounter is clients comparing their policy to other assets. They’re curious about their policy’s performance and whether it’s meeting expectations, especially when they see high returns in other areas. This comparison is natural. Nick, how do you address this?

Nicholas Welch:

There are a few aspects to consider here. First, it’s crucial to understand the context. Clients should recognize that their policy functions as a savings vehicle, not an investment. Sure, there are asset classes or investments that can outperform a life insurance policy in any given year. If you can’t beat a life insurance policy’s returns, you’re likely not investing effectively. However, we must consider the tax implications, certainty, and risk involved in diverting funds to other investments. The distinction between a savings vehicle and an investment is vital.

Patrick Donohoe:

That’s where the Hierarchy Of Wealth comes into play. This concept helps balance and blend the various assets in a portfolio, considering their inherent risks, control, and influence. Comparing a Wealth Maximization Account to a real estate investment, for instance, is not always fair or balanced. Real estate focuses on a single aspect – generating a return on investment. In contrast, a Wealth Maximization Account, being a Tier One asset, operates differently. Our approach with the Hierarchy Of Wealth is to categorize investments by tiers, with whole life insurance and its specific cash value in Tier One. We usually allocate around 40% to this tier, leaving room for other types of investments. Whole life insurance is not about generating the highest return; it’s about balancing the uncertainties associated with other investments.

09:37 How do I know if my policy is performing well?

Patrick Donohoe:

So, regarding policy performance, how do you usually demonstrate to a client how their policy is performing?

Nicholas Welch:

Addressing policy performance, I find it intriguing to compare the initial expectations set when the policy was started with its actual performance over time. I’ve seen policies from as far back as the eighties, and when we compare original projections to actual outcomes, there’s remarkably little variation. Life insurance policies generally perform within a very narrow margin of error, closely aligning with what we predict they will do. This consistency is often reassuring for clients, confirming that the policy is performing as expected from the start.

Patrick Donohoe:

This point is crucial, especially when clients come in questioning their policy’s performance in light of short-term gains they might be seeing elsewhere, like in a savings or money market account, the stock market, or their 401(k). They wonder why they’re not seeing similar returns with their policy. It’s important to distinguish between short-term and long-term perspectives. Our experiences in life often make us focus on the immediate, but when it comes to financial planning, we must acknowledge that tools like life insurance are designed for long-term stability. They may not offer exciting ups and downs or big gains, but they provide small, consistent gains without any loss, ultimately performing predictably over the long haul.

Nicholas Welch:

That stability and absence of loss are key characteristics of this asset class. When comparing an original policy ledger to its current status, there are typically only two variables: the client’s outlays and the dividends. Everything else, including the insurance company’s contractual obligations, is guaranteed. Even dividends, though not guaranteed, become a part of the policy contract once issued, securing their future value. This predictability and security are what make these policies unique. Clients often ask about their policy’s performance, especially when experiencing losses in other areas, like their 401(k) or brokerage accounts. With minimal variation and provided the client meets their contribution obligations, the policy will perform as promised.

Patrick Donohoe:

We’ve discussed frequently asked questions, covering how whole life policies and Wealth Maximization Accounts apply to various aspects of financial life. Typically, clients are curious about the performance of their policy’s cash value and dividends. Illustrating the growth aspect helps them understand the annual increase in relation to their contributions. Another critical element in the realm of wealth is the legacy value, which is an essential part of our Wealth Strategy 360 approach.

14:23 What is legacy value, and why is it important?

Patrick Donohoe:

In Wealthy 360, a person’s net worth is a prominent figure, offering a snapshot of their financial status. However, legacy value is also crucial. Legacy value is essentially the net worth plus the permanent death benefit, minus the cash value. This metric is important because it reflects the growth of your death benefit over time, which in turn increases your legacy value. While the cash value also grows, the increasing death benefit plays a significant role in enhancing the legacy value. Keeping Wealthy 360 updated allows individuals to track the amount that will pass on to their beneficiaries, trustees, or as part of their estate planning. This number, which includes the permanent death benefit, is a financial metric not typically found in other assets often compared to whole life policies.

15:28 Where should I prioritize my money if I have a loan against the cash value from the insurance company?

Patrick Donohoe:

One situational question we often receive concerns taking a loan against the insurance cash value. Clients might use this loan for various purposes like buying a car, a down payment on a property, or education. But afterward, they face a decision: should they use their available funds to pay additions, base policies for premiums, or to pay down the loan? Nick, how do you usually approach this?

Nicholas Welch:

The answer depends largely on cash flow. My general approach is to prioritize policy contributions if there’s cash flow beyond expenses. The first priority is ensuring the base premium is paid since it’s vital to the policy. This often includes a term rider or similar elements. The second priority is paying any interest due on outstanding loans to prevent compound growth of the loan. Third, I focus on maximizing paid additions contributions, and lastly, paying down loan principal. However, this is a general guideline and may not apply to every situation. For instance, someone at the beginning of their policy or nearing retirement might have different priorities. It’s important to consult with a wealth strategist for personalized advice.

Patrick Donohoe:

Right, and it’s crucial to use diagnostic tools like Wealth View 360 and the Hierarchy Of Wealth in such scenarios. These tools help assess cash flow, protection, wealth, and asset distribution within the Hierarchy Of Wealth. Decisions about whether to pay down a loan or contribute to cash value through premiums can vary greatly, so it’s important to have these evaluations done first. This information can then be discussed with a wealth strategist to determine the best course of action.

Nicholas Welch:

Absolutely, and it’s also important to consider the original purpose of the policy loan. Generally, policy loans should be used for saving on interest costs or increasing interest earnings. If the loan is used for purchases or debt, it should be paid back with the same discipline as a loan from a financial institution. Understanding the value of the policy and following this logic helps manage repayments and contributions effectively. If the loan is used for asset acquisition to increase cash flow or earnings, any surplus cash flow should be directed back to the policy. Ideally, saving or earning interest should increase your cash flow, allowing for further contributions or even the need for an additional policy.

Patrick Donohoe:

And to add to that, policy loans are often used for both expected and unexpected expenses, like emergencies, vacations, tuition, or significant one-time expenses. The goal is to use the loan and then replenish it using cash flow, just as you would with a loan from a financial institution. Policy loans can also be invested in a business or property to grow wealth and improve cash flow. The principle is to repay the debt and grow wealth. Since each client situation is unique, there’s no one-size-fits-all answer, which underscores the importance of self-evaluation and keeping Wealth View 360 and the Hierarchy Of Wealth updated.

Nicholas Welch:

Exactly, and it’s essential to meet with your advisor to tailor these strategies to your specific circumstances.

24:25 How secure are life insurance companies, and subsequently, how safe is my money?

Patrick Donohoe:

We often get questions relating to current financial times and the spread of information, particularly in light of changing economic circumstances, such as those we saw in 2009, 2010, and 2011. The financial world is subject to fluctuations and volatility due to unpredictable human behavior. Additionally, the media tends to sensationalize events, which can skew perceptions. This brings us to the common question about the safety of insurance policies and cash values in the wake of bank and corporate failures, and sometimes even struggles within insurance companies.

Nicholas Welch:

This question became more prominent with recent unexpected bank failures. People naturally wonder if insurance companies face similar risks. However, insurance companies operate differently, especially regarding fractional reserve lending. They have sufficient reserves to meet their obligations and invest in conservative assets like treasuries, investment-grade mortgage-backed securities, and buildings producing cash flow. These companies don’t chase high-risk, high-return investments as they’re not obligated to satisfy quarterly stockholder projections. Instead, they aim for conservative returns to meet future obligations like guaranteed mortality payouts.

Patrick Donohoe:

Insurance companies employ actuarial science, which is based on the law of large numbers, to pool various risks like disability, premature passing, and longevity. Mutual insurance companies, where policyholders are essentially the owners, gain from pooling these risks. The policies are guaranteed contracts, and history shows that even when insurance companies falter, the contracts have been honored. This industry is highly regulated, further ensuring the safety of these policies.

Nicholas Welch:

Indeed, insurance companies have historically been a resilient asset class, surviving economic downturns like the Great Depression, the Great Recession, and world wars. In some cases, they even provided funding for governments and municipalities. Additional safeguards like reinsurance kick in for unexpected losses. Reinsurance is essentially an insurance policy for insurance companies, adding another layer of protection.

Patrick Donohoe:

Yes, and this reinsurance is regulated and tied to the insurance companies’ asset base, ratings, and investment performance. It’s an additional safety measure for extreme events like the COVID pandemic, covering excessive claims.

Nicholas Welch:

Ultimately, life insurance policies are among the safest asset classes available. The only potentially safer assets might be physical commodities like ammunition and seeds in a complete macroeconomic collapse. In such a scenario, the value of the dollar would be irrelevant, making life insurance the last asset class to fail. If it were to fail, we’d have bigger problems at hand, and where the dollars are wouldn’t matter.

35:19 What is the cash value? What is a death benefit? And why don’t I receive both?

Patrick Donohoe:

We frequently encounter questions influenced by financial gurus comparing investments and financial products to whole life insurance, specifically regarding the misconception that you can’t receive both the cash value and the death benefit. There’s confusion about what cash value and death benefit actually are and why both aren’t received together. How do you address this confusion?

Nicholas Welch:

The key lies in understanding what cash value represents. For policyholders, it’s a living benefit, accessible and usable throughout their lives. For insurance companies, cash value represents the equity built up in the policy. The difference between this equity and the death benefit is the risk the insurance company undertakes. Similar to how a mortgage works, where you’re essentially financing the value of your life, the cash value or equity grows over time. As you age, this cash value amount approaches the death benefit, eventually equaling each other at policy maturity.

Patrick Donohoe:

So, it’s like a long-term financing arrangement, akin to a 100-year mortgage with a very low payment. Over time, a home builds up equity, but it doesn’t have much immediately after financing. Similarly, in life insurance, there are single premium policies where you can pay for the entire death benefit upfront. If you want a $1,000,000 death benefit, you could pay, depending on age and health, about $100,000 upfront, the majority of which is immediately in equity, and it grows over time. However, most policies we recommend involve paying a base premium and potentially additional paid-up additions (PUAs), effectively financing the large death benefit over time.

Nicholas Welch:

Exactly. With a mortgage, if you pass away early into a 30-year term, your family only gets the equity built up in the property. But with life insurance, the company is responsible for the entire death benefit whenever you pass away. This is why health and lifestyle are considered, as the company is under a significant amount of risk, especially in the early years of a policy. They account for this risk using the law of large numbers, spreading it over thousands of policyholders.

Patrick Donohoe:

So, in essence, cash value is the net present value, the present value today, of a future death benefit. This future death benefit is contingent on continually paying premiums and receiving interest and dividends. The cash value is like the equity in a house; you don’t get both the equity and the house’s full value. It’s understanding what cash value signifies both as a living benefit for us and as the net present value of the policy for the insurance company.

Nicholas Welch:

Precisely. A better understanding of what cash value represents, both from our perspective and the insurance company’s, is crucial. It’s not just about the living benefits for us, but also understanding its role as the net present value of the policy.

40:22 How do interest rates affect my policy’s performance?

Patrick Donohoe:

A common question we receive relates to changes in the economy, specifically interest rates. Since the 2009 financial crisis, we’ve been in a low interest rate environment, which dipped further during COVID. Post-COVID, with rising inflation, interest rates have started to climb. People are curious about how these interest rate fluctuations affect policy performance, given that insurance companies’ assets are often based on market interest rates. The assumption is that as interest rates rise, so should the investment returns of insurance companies. How do you address this?

Nicholas Welch:

This question indicates an understanding of the correlation between interest rates and policy performance. However, the correlation isn’t always immediate. Insurance companies invest in interest-sensitive vehicles like bonds and treasuries, but they don’t offload all their assets immediately in a rising interest rate environment to buy higher-yielding instruments. They hold these assets to maturity. Historically, in high-interest rate environments, there’s been an increase in the dividends and yields of insurance companies, which is passed on to policyholders, but this increase usually has a lag effect.

Patrick Donohoe:

There’s a historical spreadsheet showing that in periods like the late seventies and early eighties with high interest rates, dividend yields of insurance companies also went up, but with a delay. It’s notable that despite prolonged low interest rates since the late nineties, insurance companies have remained profitable. This speaks to their ability to adapt, reduce costs, and automate processes. While recent spikes in interest rates might increase dividends, it’s important to consider this in the context of the larger economic picture.

Nicholas Welch:

Insurance companies’ ability to remain profitable in low-interest rate environments is commendable. The recent rise in interest rates might increase dividends, but it’s not immediate. The dividend is affected by portfolio returns, mortality expenses, and general costs of doing business. The recent increase in interest rates will impact portfolio profitability, one of the factors in dividend calculation.

Patrick Donohoe:

Higher interest rates lead to higher yields for insurance companies, which are then passed on to policyholders as dividends. However, insurance companies find deals regardless of the interest rate environment. They’re always seeking opportunities, especially during economic shifts when the cost of money fluctuates. In a low interest rate environment, businesses and entrepreneurs may take more risks, but when interest rates rise, it can lead to discounted asset opportunities for cash-rich entities like insurance companies.

Nicholas Welch:

This strategy mirrors what we advocate for our clients. A policy puts us in a strong cash position to take advantage of market dips or when assets go on sale. The policy provides the best cash storehouse, allowing us to seize opportunities when others are trying to reduce losses. Our approach with insurance policies enables us to capitalize on macroeconomic fluctuations.

Patrick Donohoe:

Insurance companies also benefit from more stringent underwriting guidelines, selecting healthier individuals for specific ratings. This conservatism helps balance their profitability, not just from interest rates but also from mortality expenses.

Nicholas Welch:

Exactly. Portfolio returns, mortality expenses, and the overall cost of doing business all contribute to how a dividend is calculated and paid out to policyholders. Increases in interest rates benefit portfolio profitability, one of these key factors.