MoneyMerc

(Warning: this article is long, and gets technical at times. In general, my mission is to state concepts simply and concisely, so this goes against that mantra. But I wanted to share my full experience because I think it is very similar to what you may experience in the future. If you are short on time, the summary is: if you need life insurance, buy term, and do your research before listening to what an agent says, especially if they called you first.)

I work in a large office building with lots of smart people. Most of these people are great at their jobs, and work a lot – par for the course at a big bank and in NYC. My recent experience shows, though, that during the course of the work day there are some “rats” lurking around, and they don’t work for my company. But they are preying on what intelligent employees with little time for personal finance research don’t know. They are self-proclaimed ‘financial planners’ with no credentials except an insurance license. Often of similar age to their prey, and good at sales, they are making a ton of money off unwitting young employees. Here’s how it went for me. My advice is, watch out. Make sure you do your research before signing anything.

Contact with a rat

A couple of weeks ago, this guy called me randomly (Red Flag #1 – he was not recommended by someone I trust) saying he had been talking to a lot of my colleagues and was able to “help them out” with their financial planning (Red Flag #2 – many people claim to be financial planners these days, be wary if he/she has no credentials). He threw in a couple buzz words like ‘deferred compensation’ and ‘tax optimization’. I told him I was a CFP and did my own planning. He said that was fine, but it maybe a second look might help, maybe he’d mention something I didn’t think of (classic sales line, and Red Flag #3). I asked what company he worked for, and lo-and-behold, it was Northwestern Mutual (Red Flag #4!). This would eventually turn into an insurance pitch, no matter what initial reason, or what color lipstick they put on the pig. Chances are this guy is peddling permanent insurance (universal life or whole life) as a tax-free investment tool, since through working at a big company we already have health insurance and disability insurance. For my own plan, I have no need for this guy. But why not have a little fun? See what his strategies are for “helping out my colleagues”. So I agreed to meet with him.

After a reschedule, he met me at my office. He already had a guest pass since ‘he has many other clients in the building’. He was slickly dressed, but had ‘just [given] away his last business card’ (red flag? Maybe.) His pitch started with the platform they offer: investments (open-ended mutual funds, the only investment product that non-bank-approved vendors can offer employees, and load funds at that, no doubt) and tax-advantaged savings products (read: fixed or variable permanent life insurance), life insurance, long-term disability insurance, and long-term care insurance (“for my parents”).

The pitch

He focused immediately on the “safe, tax-free savings” product, which he called “blended over-funded whole life”. He had a bound, very professional looking illustration with someone just about my age putting $30,000 per year (!) into the contract. Here are the highlights of the ‘benefits’:

• Excellent rate of return (7.15% based on past earnings history and NWM dividend rates)
• All money comes out tax free
• All earnings are locked-in (you can’t lose money)
• No limitations on contributions like IRAs or 401k
• Plus you get life insurance to protect the ones you love if you die, with a death benefit that grows over time! AND, after year 8 you can stop contributing completely, and “you’ll never have to paid into it again” since the growth will be enough to pay the premiums keep your permanent insurance in effect indefinitely!

Wow, sounds like the perfect investment solution.

Here are the drawbacks, which he disclosed after questioning (he obviously had never been asked some of these questions at a first meeting):

• Withdrawals are in ‘loan’ format, which is paid off from the death benefit if you die. The loan rate (8%) is removed from the dividends the policy usually pays.
• Before crediting the 7.15%, mortality and expense charges are deducted for the insurance, so it’s actually closer to 6% return.
• Even though it looks like you can stop paying the 30,000 premium in year 8, if the dividends drop at all, or if you take a loan that reduces dividends, the policy premiums start to be paid from earnings, not “you’ll never have to paid into it again” like he said originally. Don’t worry, the client always pays somehow.

Here are the drawbacks he didn’t disclose:

• Since this policy is ‘over-funded’, it becomes a Modified Endowment Contract (MEC – see the * at the end of this post). This means it loses all it’s tax benefits. Loans and other removals of the cash value are taxed at ordinary rates in the year received. Of course the illustration says it ‘does not take tax consequences of a MEC into account’ and I should ‘see a tax advisor’. (Funny now they know enough to tell you it’s tax free, but not enough to tell you when it’s not)
• If you take a loan (to get money out) you decrease the interest credits and potentially the dividends so the death benefit doesn’t grow, and the cash value grows much more slowly
• This one happens to be stated in the very back of the 26-page illustration: “If the policy terminates prior to the insured’s death, the amount of the loan principal, the loan interest and the remaining unborrowed cash value is taxed as ordinary income to the extent it exceeds the amount of premiums paid”. Ouch. Bye-bye tax benefits if you ever want out, or can’t afford the premiums.

I didn’t mention to him that I have $1 million in 15-yr term life insurance from a AA rated (NY) company that costs $300 per year, which is the general going rate for a healthy late-20s to early 30s male who doesn’t smoke. (20 yr for $1.5mm, more like his example, would be $950/yr) Considering that, let’s see how this policy shakes out in the illustration:

If you do the math, your rate of return after 20 years is 5.93% (you’ve put in 600,000, and in total it’s worth $1,159,705). Since it’s a MEC, the 559k gain will be taxable at ordinary rates. But this rate is based on the “if’s” in this illustration:

• If you keep paying the premium
• If you don’t take a loan (or any money out) until after 20 years
• If the dividends don’t go down
• If the interest credit rate doesn’t go down

That’s a lot of ifs. If you keep it to age 76, the rate of return is 6.65%. Woohoo.

Summary and Opportunity cost

For most people in their 20s and 30s, saving an additional $30,000 per year beyond 401(k) contributions of $15,500 (2008) is absurd. Congratulations if you are (heck, congratulations if you are maxing out your 401(k))! What would be more absurd, though, is if you put that into a policy like this. This is by definition a long-term investment, because of all clauses within the contract to keep you in. If you are in your 20s and 30s, investing in the stock market, via index funds, even in a taxable brokerage account, has a much higher chance of growing your money over the long-term. A oft-quoted long-term return of the stock market is 12%. Even if you do terribly compared to that, and get 8% on your equities, you’ve still beaten this product, even considering taxes. Plus you have flexibility along the way.

My general recommendation is to keep your investing and your life insurance separate. If you need insurance (not everyone does), then buy term insurance, which is simple, cheap and efficient. Invest separately, first by maximizing your 401(k) or IRA contributions, and then in a taxable account to the extent that it fits your budget.

The only way a cash-value life insurance policy would be even considered as a savings vehicle is if it was part of a savings plan for someone who really had trouble putting money away and leaving it there. But even then, if that person stopped paying the premium, the policy lapses and would generally get out less than they put in. Doh.

Hopefully all of that makes you pretty clear on what you should tell the next agent that calls you. But if not, here’s the final kicker: guess what the commission to the agent is on this policy: it’s the full first year premium, or $30,000!!

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*MEC:

• LIFO taxation (income is withdrawn first, and therefore you are taxed starting with your first dollar out)
• Gains taxed as ordinary income (IRC §72(e)(10))
• Types of withdrawals with income-first treatment: policy loans, interest accrued on loans, withdrawals