Life insurance for investors – single-premium life
LIFE INSURANCE FOR INVESTORS
In the upside-down world of life insurance after tax reform, one of the hottest products has a premium paid all at once instead of over several years. It appeals more to people who want an investment than to those who need insurance. And it represents one of the few ways remaining, after tax reform, of sheltering income.
The name of the product is single-premium life. If you’ve heard of it only recently, don’t be misled–it’s been around for a number of years.
In 1986, insurance companies took in $4.1 billion in single-premium policies. For just the first quarter of last year, premiums totaled about $2 billion, according to preliminary estimates by the Life Insurance Industry and Research Association.
The way single-premium works is quite simple. You make a one-time payment, usually of $5,000 or more, which goes into an investment fund. Earnings are usually based either on an interest rate adjustable every one to three years (this policy is called “single-premium whole life’) or on the returns from a company-sponsored mutual fund (called “single-premium variable life’). Earnings in the account are tax-deferred until the policy is canceled (or “surrendered,’ in insurance lingo).
The principal (the amount you originally invest) in single-premium whole life is guaranteed despite the interest-rate variations, and there is often a guaranteed minimum annual return on the investment. Investors willing to risk principal in exchange for potentially greater returns can opt to purchase single-premium variable life. They could get higher returns with a variable policy if the underlying investments do well, but they could also lose principal if those investments happen to do poorly.
Many financial planners feel that single-premium whole life is a solid investment. Says Andrew Gross, a Washington, D.C., planner, “Its yield is often comparable to that of a bond fund without the risk to principal [that bond holders can experience] if interest rates spike up, as happened [in 1987].’ Most planners advise investors to be cautious about single-premium variable life, however, because of the risk of losing principal.
Along with the investment possibilities available with single-premium life, you also get a relatively small amount of life insurance –but remember, single-premium life is designed mainly for investors, not for people who need insurance. However, the younger you are, the greater the amount of insurance you receive. For example, one company offers a 30-year-old woman $29,300 in insurance with a $5,000 single-premium whole-life deposit. A 55-year-old man opening precisely the same account would receive only $11,525 in life insurance.
In addition to protecting investment income from the tax man, another advantage of single-premium insurance is that you can make tax-free withdrawals by borrowing against the cash value in your policy. (Cash value is the money you put into the policy, plus any interest the investment has earned.) You don’t have to pay taxes, because you are borrowing the money, not withdrawing it. In addition, these loans are usually interest-free, because the interest rate charged on the loan is generally calculated to equal the interest rate earned on the policy. For example, if the policy pays 7.5 percent interest, the loan rate will also be 7.5 percent, so that net result is a loan at no cost. And finally, you don’t ever have to repay the loan; it will simply be deducted from the eventual death benefit.
For older Americans, an added benefit of single-premium policies is that any interest accrued is not counted as income by the Social Security Administration. For example, a 70-year-old male client of Gross’ recently deposited $15,000 in a single-premium whole-life account paying a fixed interest rate of 7.75 percent for three years. Assuming that the policy returns 7.75 percent for ten years (remember, the rate’s adjustable after three), the account would accrue $16,642 in interest–none of which would have to be included in any Social Security-benefit calculations.
This policy also carries a guarantee of at least $26,589 in life insurance. The amount of life insurance can increase, depending on the return in the policy; the higher the return, the higher the death benefit.
Single-premium life also has distinct advantages for younger people. For instance, it can be used as a college fund. “Parents could give a $5,000 whole-life policy to their six-year-old child,’ says Charles D. Hendrickson, a Columbus, Ohio, insurance agent. One current policy paying 8.25 percent in the first year is adjusted annually. If the policy continues to return 8.25 percent, it will have a cash value of $12,945 when the child reaches age 18. The child could then borrow the $7,945 in interest at no cost to pay for college and could borrow against the principal at a net cost of 3 percent.
Some financial planners also recommend single-premium policies as an option for IRA or 401(k) plan contributors looking for another way of sheltering their investment income.
Most single-premium-life policies charge a penalty, or surrender fee, for cancellations during the first few years of the policy. These fees usually are eliminated in five or ten years. As in other types of insurance, the early-year fees can make a policy a bad buy if surrendered soon after purchase, no matter how well the underlying investments are doing.
Although most investors plan to hold their policies for a decade or more, some are forced by changing personal fortunes and economic conditions to cash in their policies early, which can be costly. For example, a $5,000 single-premium policy yielding a guaranteed 8 percent in its early years, with a 9 percent surrender charge in the first year, would be worth $5,400 after one year. If the investor cancelled the policy to get that money back, he’d pay more in penalties than he received in interest–and he’d still have to pay taxes on that $400 in interest. Obviously, it’s usually best to stick with such a policy in the first years after buying it.
Your best bet when screening single-premium policies is to consider only contracts that allow you to surrender the policy at the end of one year and get back as much as you paid for it. In these cases, the interest earned in one year will balance the surrender charge.
Even if you do find a policy that allows you to get back at the end of a year what you paid for it, you’re still better off purchasing your policy as an investment you’re going to hold for a decade or more. That way, you won’t have to worry about paying any surrender charges, and you’ll benefit from the long-term compounding of interest that gives most interest-bearing investments much of their appeal.
There’s another good reason for not surrendering your policy: as the example above shows, the interest earned on that money is taxable when the policy is surrendered. If you’ve surrendered a policy after borrowing several thousand dollars in interest, the tax bill on that interest could put you in a financial bind. And deferring taxes on your interest, remember, is one of the chief advantages of these policies.
Finally, if you do purchase a single-premium insurance policy, be sure to keep your eye on the actions of Congress. After the recent sweeping changes in the tax laws, few financial advisers are willing to say that the protected status of interest on insurance policies will never change –although there are currently no indications that Congress is going to do any such thing. But if those laws ever are changed, you will have to be ready to scurry back to your financial drawing board to contemplate life after yet another tax revision.
Photo: The policy he receives as a child will grow by college time into a neat nest egg from which he can borrow at no cost.
COPYRIGHT 1988 Saturday Evening Post Society
COPYRIGHT 2004 Gale Group