How to Use Modern Life Insurance Retirement Planning

In a previous article, I recommend a life insurance retirement planning tool called Indexed Universal Life (IUL). IUL is an advanced equity life insurance strategy. As I said in that article, there is a lot of misunderstanding and misinformation out there about this financial tool. This is a shame, since if it is set up and implemented properly, it can be a game-changing option for meeting the financial planning challenges unique to the military and veteran community. The goal of this article is to explain the nuts and bolts of the IUL, including exactly how its “must be too good to be true” aspects work. Basically, this article explains how the money flows between all parties involved: the insurance companies, you, and the broker (my role). 

Flexibility in Funding

Because the IUL is a tool used primarily by the wealthy, you may assume that you need a large chunk of change as an initial investment, but this is not the case. You have complete flexibility in funding. You can start and fund a plan at whatever level is affordable for you. 

You can pay smaller amounts of money over a long period of time, or larger amounts of money over a short period of time. You can add big lump sums or spread it out month after month. The only limitations are the amount of insurance you can buy based on the health qualification and IRS limitations depending on your age and the amount of insurance you want to buy, should you not want to create a taxable event. Basically, there are thousands of options and flexible ways of using or funding an IUL.

Typically, those in the military will start off with some sort of monthly allotment, as with any savings plan. But that in no way restricts you to paying that same fixed amount forever. Nor are you limited to certain years and certain amounts. You determine the terms and contribution levels depending on how you structure the policy, not the government.

Your Money Grows Without Risk of Losses

One of the reasons why I am going into the IUL in such detail is because I want you to understand how it works. With the IUL, growth of your assets is not based on some Board of Directors declaring and paying a dividend. It’s based on the open equity stock markets ─ but only the upside. With an IUL, you only execute a market trade if there is a potential profit to be made. If there is no profit, then you don’t trade. 

This means that when the market goes up, you trade and make money. When the market goes down, you don’t trade, and therefore you don’t lose any money. It’s that simple. This is a huge differentiator between an IUL and your traditional retirement plan. In the traditional retirement plan, if the market goes up, so does the value of your account. If the market goes down, so does the value of your account. 

What makes this kind of risk-free market growth possible is called a long term options contract. An option is a contract with an expiration date in which one party agrees to purchase an asset (in this case, a stock or an index) from another party at a specified price and by a specified time (the expiration date). During that specified time, if the stock or index rises in value above the option price, then exercising the option represents a profit for the buyer because they are purchasing the asset at a price that is below market value.

In this situation, the buyer would want to exercise the option. On the other hand, if during the specified time the stock or index declines in value below the option price, then the buyer can decline their option to purchase the stock by simply letting the option expire, thus avoiding the market loss incurred by people who already own the stock. These options contracts used by insurance companies are not gambles.

They are very safe, standard financial instruments that have been around for decades, and these insurance companies leverage them in a very conservative way. Because holding an options contract doesn’t require you to have your money actually invested in the market, you aren’t continually taking risk on things that you simply aren’t going to understand. Instead, you can let the big insurance companies with billions of dollars who are playing a very, very low-risk, long-term game execute those options with your money on your behalf only when they are profitable. Any gains come from the same index that your 401(k) is invested in, but without the risk of having your money being in the index. Using an option to purchase stock is basically having an insurance policy on your purchase.

How Do the Insurance Companies Make Money?

Here's how the money flows. For every dollar that goes into an IUL, around 95 cents is going into the company’s general account. A portion of the money in this general account stays liquid so that it is available for participating loans, withdrawals, and the payment of death benefits, and the rest of it goes into investments. We are talking about very stable companies, most of them are well over 100 years old, with tens of billions of dollars in assets and A credit ratings across the board. Their longevity is part of the big picture. These companies are playing a very long game. 

When they receive the premium dollars from policyholders, a portion that they invest goes into an A-rated government and corporate bond portfolio that has a very long duration: 20, 30, 40 years. These are extremely secure bonds. The United States would pretty much have to cease to exist as a country in order for the insurance companies to lose money on these bonds. The longer the duration of these bonds, the higher the interest rate, so these companies are able to keep the money that comes in from policyholders ─ hundreds of millions of dollars a year ─ invested in long-term corporate debt at a rate of around 4-5%. That’s the primary way that these companies make their money. But remember, the 95 cents is still yours, that’s just how they are directly investing it for low-risk, long-term growth. Their goal is to make money for the company, which you, as a policy holder, are a part owner of.  So life insurance companies actually like to help their clients. This isn’t like what most people think of when they’re fighting with an insurance company to pay for healthcare costs or some other damages.  Those companies are public and answer to their shareholders for profit. Most life insurance companies just don’t work that way. 

What happens to the other nickel on every dollar?

Two or three cents of it goes to pay for the actual cost of your insurance. Exactly how much depends on your health. The better your health, the lower the cost of the insurance. The cost of insurance is actually quite cheap in the long run. 

The remaining two or three cents of every dollar goes to pay for these one, two, or three-year options contracts on an index like the S&P 500. The cost of these options contracts is based on the dollar value of the amount that you’re purchasing. They work out to something like two or three cents on the dollar. So instead of having the full dollar amount of the value of the contract invested, they only invest – and only stand to lose, if they don’t exercise the option – a few cents on the dollar. At the end of an option term, if the value of the index on which the company bought the option has gone up, then they execute the option. They buy the index below market value, immediately sell the stock, and then credit your account with a portion of the profits from that sale.

I’ll talk about exactly how big of a portion in a moment. If the value of the stock(s) on option has gone down, then the company doesn’t exercise the option, and they simply let the contract expire, and they are only out the small cost of the contract. Because neither they nor you ever actually owned the stock in the index during the option term, there is no loss. This is how money invested in an IUL can benefit from stock market gains without any risk of market losses. You never actually own any stock, and the insurance company only owns it long enough to resell it and pocket the growth.

In addition to making money from having their assets invested in the super stable, really long-term government and corporate bonds that I talked about above, they also make a little money from exercising these options on your behalf, typically about 10 to 15%. So as an IUL policyholder, you get between 80 and 85% of market gains on these options credited to your account as interest when the market goes up, but you never lose any money when the market goes down.    

The beauty of using an IUL for our financial strategy is that your money is in a safe place, where it is continually growing, while at the same time remaining liquid and accessible to you at any time if and when you need it. 

How to Access Your Money in a Life Insurance Retirement Planning Strategy

Which brings us to the question, how do you access the cash value from your policy? There are two options. The first is that you can simply withdraw your money, like you would from a bank, a mutual fund, or any other investment. If you do that, however, then you will miss out on the market growth we just talked about above. In order to access your cash while still allowing that same cash to grow in value, you use something called a participating loan. A participating loan allows you to access the cash value of your account while it is still growing in value as if it had never left your account.

When people hear the word loan, they immediately think of making payments and paying interest, but you do not pay back a participating loan. Nor do you pay interest on it out of pocket. The interest on a participating loan is typically between 3% and 4%. Right now is about 3.25%. This charge comes out of the balance of your policy, not out of your pocket as a loan payment. When you pass away, whatever money you've taken out of your account as a loan is paid back to the insurance company out of the death benefit amount. Once the loan(s) is satisfied, whatever is left is paid to your beneficiaries.

This is called a loan because your own money stays invested, and the insurance company loans you the money that you would otherwise have to withdraw from your account. Market returns typically average 7 to 8%, and remember, you can’t LOSE anything with your money invested this way, so if you are earning around 6% (80% to 85% of the actual growth), then even with the interest you are paying on the loan, you are still generating more in income than you are spending in interest. In this way, your money can be working for you in two places at the same time. How cool is that?

Access Your Money at Any Time

You can access up to about 90% of the cash surrender value in your IUL at any time, for any reason. The reason that you have to leave 10% of the value in the policy is to keep the account open and insurance available. If you take more than 90% of the value out of the account during the first ten years, you would pay surrender charges, and if you cancel the policy and just withdraw all of your money, you risk losing many of the tax advantages of the account.

I want to reiterate a couple of things when it comes to using a life insurance retirement planning strategy. First, it’s your money, and you can access it at any time. Second, you don’t have to withdraw your money and lose that growth opportunity. You can borrow it, continue to see growth on it, and then pay it back into the account. Third, you have the option to never pay it back at all, in which case the loan will be paid back out of the death benefit of the policy when you pass away. Keep in mind, however, that the earlier in the funding period that you take a participating loan, the less the cash surrender value of your policy will be, which means that you will have less money in the account earning growth. Down the road, if and when you decide you want to start using your IUL as an income stream, that income will be much smaller than if you leave your money in the account over a long period of time to grow. The big takeaway here is that the IUL gives you total flexibility to deal with whatever life throws at you, whenever it happens.

How the Death Benefit Works

Setting Up the Policy

When we first set up an IUL, we typically structure it so as to provide the lowest possible death benefit at the policy’s inception. We do this because the smaller the death benefit initially, the lower the cost to fund the plan. In this way, we can bring the typical timeline of a whole life policy, which takes 10 to 15 years just to break even, down to three to five years, if not sooner. This means that it takes a lot less time for the cash value of the policy to grow at a pace that outstrips inflation and quickly starts keeping pace with things like the S&P 500. The money you are using to fund the plan not only keeps pace with inflation, but grows in value over time, because it is invested and is tax deferred. 

The amount of death benefit you decide on for your policy will depend on your objectives. If you want to use an IUL as a cash accumulation vehicle, then the best way to make that vehicle as strong as possible is to make the policy as efficient as possible, and one way to do that is to reduce the death benefit, since that’s really where the cost is. We really look for a balance between the death benefit protection and that cash accumulation value, and we move those levers up and down as needed over time to manage the policy and mitigate costs. The younger and healthier you are, the less difference lowering the death benefit is going to make, but for someone in their 60s or 70s, reducing the death benefit can drop costs by thousands of dollars. Again, this is  an option, not a requirement.

Increasing the Death Benefit Over Time

There are a few ways that you can increase the death benefit later as you build this plan.  The most cost-effective way is to use both an IUL and a convertible term insurance policy together in some combination. The first part is to think about the offensive side of this strategy, everything we’ve been discussing in the last few chapters.  What’s the least amount of death benefit we need to buy in order to be able to contribute the amount of money you want to use to fund the plan?

Then, we increase that death benefit each time you put money into the policy during the funding period. Not to buy more insurance, but simply to keep a fixed window of the amount of death benefit you are buying that is always within the IRS’ limited funding amount.  Then, when the funding period is over, you have the option to level and/or reduce the death benefit, if you choose.  It’s an option to reduce costs and focus on the growth. Alternatively, you can continue to allow the death benefit to increase depending on the performance of the underlying index strategy.  It’s really up to you, and you can decide whenever you want.  

The other trick to getting enough insurance on the defensive side of our approach is accomplished with the modern version of what should really be called “death insurance:” convertible term insurance.  The amount of death benefit you purchase is always going to be the biggest driver of cost.  So the cheapest way to pay for a death benefit to hedge against the event of a catastrophe is with low-probability term insurance.  That’s why it’s cheap: there’s a low probability they’ll ever have to pay your beneficiaries. But thank God it’s there when they do. I’m not telling you not to buy term insurance, it’s just that we want to be smart about it and use term insurance as part of bigger picture.

So really, while yes, getting an IUL with the amount of death benefit needed for a worse case scenario in order to protect your family is good, what’s even better is locking in the insurability and health rating of that individual for a certain amount of death benefit at a much cheaper cost.  This is huge and often overlooked.  Most people think they’ll buy more insurance later in life when they “actually need it.”  It’s like, dude, you need it now because it’ll give you access at low cost.  Later in life is when people find out they’re uninsurable because of something they said to a VA psychologist once.  It’s nuts.  

Locking in the death benefit amount is a huge advantage because now you have that much more you can purchase in future IUL contributions when you want to fund it more, but your first policy is already at the IRS tax limit.  Now you can just transfer a portion of the term death benefit by converting it to an IUL, all without having to apply for insurance and go through underwriting again.  And of course, now you’ll also have more death benefit in a permanent policy meant to leave a legacy.  

There’s never been more flexibility in insurance before.  And there’s definitely never been a better insurance strategy to give you so many options for a return on your investment, without stock market gambling and without high investment costs, and most importantly, without having to pay Uncle Sam a dime in taxes.  You already served for it.  Why pay double? 

The best part is that you can get a tax-free return on your investment, without having to die! 

Life Insurance Retirement Planning Gives You A Tax-Free Income

Another important aspect of the participating loan feature is that you do not pay taxes on money that you loan to yourself. Why? Because you don’t pay taxes on loans. Think about it. When you get a loan for a car, do you have to pay taxes on that money? Do you have to pay taxes on money you borrow as a mortgage? Of course not, because you are ultimately going to pay that money back. Since you’re not keeping it, it’s not technically income. The same thing happens with a participating loan in an IUL. The money will eventually be paid back out of the death benefit on your policy. Whatever is left over of that death benefit will then pass to your beneficiary, again, tax-free, because the death benefit of a life insurance policy is not taxable either. 

According to the IRS tax code 7702, insurance products can grow not only tax-deferred, but you can access both your money and associated growth without paying any more taxes. This means that assuming the policy was properly funded within the generous IRS-mandated guidelines, you can access the money in an insurance policy tax-free. This is a hidden secret. It’s really cool and easy to set up, but it must be funded properly.

As you can see from the articles on my website and from my YouTube videos, I have done the research and developed a team to make something unique that solves a problem – when it’s designed properly. I can’t vouch for or endorse a product or strategy done by any other financial advisor. They may use it their own way, for a variety of reasons, and I use it for the reasons I outline in this book as the foundation for financial control.  So, if you work with me, then we teach you how to fund it properly.  Whether you do it or not is always up to you.

Additional Benefits

Pay for Long-term Care

People are living longer. They are acquiring additional health costs that didn’t exist just a few decades ago, but not all of these costs will be covered by the VA and Medicare. Among those aged 65 and over, 69% will develop disabilities before they die, and 35% will eventually enter a nursing home. What if you need assisted living? There’s no option to leverage the SBP death benefit to help with long term care costs. Neither do term life insurance or whole life offer any feasible long-term care option.

An IUL offers something called an accelerated benefits rider. That means that you can access the death benefit on your policy while you're still alive to pay for your health care costs. There is no cost for this rider. The difference between an accelerated benefits rider and taking participating loans is that the qualifying payments can come from the value of the death benefit rather than from the surrender value of the policy. This rider is a way to use the death benefit early without using a participating loan.

So if you get sick and you need a nurse to come to the house, or if you go into a nursing home or whatever you need to do, you can tap into about 2% of the death benefit on your policy tax-free and penalty-free on a monthly basis to help pay for those costs. For example, if you have a $500,000 death benefit on your policy, 2% of $500,000 is about 10 grand a month. That’s pretty good money, and again, it’s tax-free. You can even use this rider to pay assisted living or long term care costs for a close friend or family member. As with the participating loans, whatever is left over of the death benefit after you pass away is paid to your heirs.

Litigation Risk Protection

A permanent life insurance policy is not considered part of an estate tax bill or otherwise considered to be part of an individual’s net worth in terms of what lawyers are able to retain or what can be tapped to pay for legal damages. In the event that you are involved in a lawsuit that ends badly, whatever other assets might be taken from you, you will retain complete control over and access to your IUL.

Is It Too Good to Be True?

While it may seem like the advantages of an IUL are all on your side, these policies are very, very profitable for the companies who issue them.

First, the fact that an IUL is life insurance means that they are going to underwrite you, and the underwriters are very smart about estimating how long you are going to live. They're going to talk to your doctors and look at your medical records and your prescriptions, and from that they are going to extrapolate longevity. 

Second, these insurance companies only have about a 10% attrition rate. What does that mean? It means that 90% of the people that do business with them hang on to the policy for the rest of their lives. So these companies know that if they do a policy with you, nine times out of ten you're not going to go anywhere. This is very different from what usually happens in our industry, where people work with an advisor for a few years and then move their money to another company and then another. People do the same with bank accounts.

But these insurance companies are far more stable than banks. This particular company I was looking at in the example earlier in this chapter has been around for 135 years and has 75 billion in assets just in their general account, and they are A-rated across the board. They are very, very profitable, very old-line, very conservative companies, so that's part of that equation. 

Based on all those factors, the insurance companies have a really good idea of how long you're going to live, and they know that you've got a very high likelihood of being comfortable and satisfied with their product and will leave your money there. The fact that they are able to take the big pool of assets that they have and invest in the very long term is how they can make these attractive returns available to us.

Next Steps

Indexed Universal Life insurance is an excellent way for military retirees and their families to protect their retirement savings. The unique features of IUL make it the perfect tool for those who want to ensure that they have a stable financial future, especially in these uncertain times. If you are a military retiree or are close to retirement, please schedule a call with us today so we can discuss whether IUL might be right for you. We would be happy to answer any questions you have about this valuable life insurance strategy.

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