Why can life insurance benefit everyone?

I have some discussion with a good friend of mine regarding life insurance vs investment. Here is the question I got, which triggered me to put together some thoughts on the interesting topic.  

Question: For sake of argument if i don't buy WL, just invest $100,000 in index fund, assuming growth 7% per historic performance, I will have $196,715 in 10 yrs, $386,968 in 20 yes and $761,226 in 30 yrs. If I pay nursing care using this money 30 yrs after, I withdraw $12000/mo, ie 150,000/yr; roughly the money will last for 5 yrs. I pay tax on the gaining portion 150k-20k=130k; I pay 25% or $32500 tax/yr, so I have  $117,500 remaining to pay nursing care. This is pretty good supplement. The benefit is I'm in total control, and I don't pay WL management cost. If I have extra money left for kids, within 10.9 million it's tax free. Can you please check if my thinking is logic and making sense?

This is a great question, worth further discussion indeed. But first of all, I really don’t think we are suggesting that investment and life insurance are two mutually exclusive choices. Rather, I’d think life insurance should be one important pillars of the retirement planning for everyone, big or small. For most of us, I think we have already a lot stakes in at least one of the two: investment (stocks/bonds) and real estate. The 3^rd one is precious metals (physical or mining stocks) that most of people are still lacking probably. Then life insurance. Over years, I personally have accumulated sizable portfolio for the first three but only recently are starting to get into life insurance (LI) in a big way for a reason. More I study and learn about LI, more I find it is a great asset that one should not overlook.

So for the sake of discussion, let’s do assume one has to choose either the investment with the S&P stock index or LI. In the past, I probably would go with your logic and put money into the index, not LI. But nowadays, I’m not so sure and may be likely more lining towards LI, more specifically the special Whole Life (WL) that I love to have. Let me give you the answer first before getting into a bit details: Except the seemingly more flexibility/control as you point out with investment (which is not necessarily less with the WL), in my mind  WL has unbeatable advantages that integrate all the great features that one needs to have as a retirement planning: guaranteed compounding growth, tax-free living benefits, legal protection, long-term care & terminal illness benefits, and tax-free asset transfer (the death benefit within a limit)! All of these are just captured within one policy but one has to pay big money to set them up separately. Here are more details:

Investment return: Indeed historically the S&P index may likely generate a 7% annual return. But don’t forget, there is no guarantee about this, especially in terms of the timing that one can never predict what the market may do in 15-20 years from now when we mostly need reliably incomes! Yes, we have entered into almost a 10 year bull market without much corrections and people tend to believe this will just continue with the momentum. I also believe we likely have not seen the exact top yet and there could be a couple of more good years for the stock market. But here is the thing: no bull market can last forever and extended bull market may be followed by extended bear market as well. Personally I think we may be at 8^th inning of the bull if 10 is the peak. Historically, the market took 15-20 years to get out from the Great Depression in 1930s-40s and it took over 15 years to finally recover from the dot.com crash in early 2000s. Then for Japan, it has been 30 years since its peak but it is still struggling to get back on its foot, not mentioning returning to its peak of the stock market. Can we be so sure that we won’t see anything like this down the road in the US? At least I’m not so sure. What happens if it just so occurs unfortunately that during the period of time when we need the safe money most, the stock market is entering into a prolonged depressing bear that cut your early returns by half or more? With a good quality insurance company, you won’t see this kind of risk for your WL as the currently 5% return is virtually guaranteed for your life. Actually I even think life insurance companies are likely entering its golden earning period that may last for 10-20 years if we truly start to see high inflation moving forward. If so, we may see 5-10% dividend returns from WL on top of the guaranteed 4% interest return, based on the historical performance in similar settings. But let’s be simply more conservative and stick to what we have for now. Even though,  the situation will become even better when taking into consideration the tax aspect!

Tax advantage: Don’t need to say each penny gain from any investment outside of a tax shelter is taxable. So a taxable 7% return is actually only about 5.25% after tax return if one has to pay a 25% income tax. This is also a very uncertain aspect actually since there is good possibility we may need to pay much higher tax in 15-20 years from now given the huge debt crisis brewing in the US and short-founded social security and Medicare/Medcaid. But even treating the tax return as a constant, WL will be very comparable to the indexed investment after the tax is factored in. If so, why I want to take a lot of uncertainty and risks for the investment and not go with WL for a safe return that I can rely on?

So how about the estate tax? It is true that there is no tax for the first $10 million estate for a couple but don’t forget this is the after tax money. If one has $5 million from WL, it will be all tax-free for heirs but if one has $5 million from investment, the parent has to pay the income tax first on the day of death and can only pass the after tax amount (i.e. less than $4 million with a 25% tax rate) to the heirs. Again, WL has a much better tax advantage over investment, although the illustration is very simplified for easy discussion.

Legal protection: This is a state-dependent issue but many states have full or partial legal protection for insurance benefits. For practicing physicians, this is probably a much important aspect to consider regarding asset protection due to high legality risk involved. LI could be one easy step to do so without involving high legal fees for other more complicated types of asset protection strategies.

Long-term care/Terminated Illness: As illustrated in the question, for sure a good performing investment can provide good supplement to the LTC expenses. But this is only limited to the amount of after-tax gain from the investment. For WL, there is actually a multiple or leveraged factor that can allow one to use much more money for LTC than the investment return. The special WL will not only increase the cash value consistently and safely, it will actually also substantially increase the death benefits (DB) in a much faster pace. Usually after 10-15 years, the DB can easily be 3 times more than the total paid premium amount. And it is the DB (not CV) that will determine how much fund is available specifically for LTC (usually it is portion of DB, e.g. up to 50% or more of the DB). Obviously the more DB is, the more LTC will be available and this can be much larger than the amount the investment can generate. So a good WL will allow the policy holder to reliably cover the LTC cost if needed, which has no extra fees involved to include this option in the policy. Even without considering the magnitude difference, relying on investment is understandably subject to the market risks that no one can control! The last thing anyone wants to face is there is not much money available when he/she needs to use the money for critical illness.

Estate planning: We’ve already talked about this as part of the tax advantage for IL.

Flexibility/control: This is one most obvious advantage for investment in general as mentioned in the question, but this is also the most under-understood aspect for WL. People generally think for the money put into a WL policy, it is locked and cannot be easily used. This is totally wrong actually. The cash value (CV) generated in the policy is actually very liquid and can be easily used for any purpose with just a phone call or online request. You can simply treat it as a home equity line of credit that you can use at any time. The better part? It is often a zero loan at your disposal! Here is how it works: if one has CV say $500K in the policy, he can ask to take out a loan of any amount within this limit any time for any purposes. Not question will be asked by the company and no one will chase you to pay back the loan. Let’s say you want to take about $100K from your policy. This amount is actually not deducted from your policy but is borrowed out from the company’s general account. So your policy is still generating the said return (e.g. 5%) as usual as if you  never took out a loan. But there is no free lunch of course, as the company will charge you a loan interest. Actually the company will usually match the loan interest against your policy return (e.g. 5% return vs 5% loan), which in essence allows you to take a zero interest loan. In other words, your money is used twice at the same time, one for keeping your life insurance intact and you continue to enjoy the DB protection that is important for other aspects like LTC etc. But at the same time, your money is also used for other purposes. Of course, if the loan plus interest is not paid back during the life, it will be deducted from the DB at death. But there is simply no urgency or pressure when you need to pay it back and it won’t impact on your credit whatsoever! For investment, it is totally other story: when the money from any investment is used for other purposes, it gone forever and cannot be used to generate investment returns, right?

For more aggressive people, this great WL feature can be used to generate additional investment returns actually. E.g. if one think he can make more than the 5% after tax gain, he can take out a loan  e.g.  to buy a rental property or even in the stock market. In this case, the extra gain, say 1-2% more than the 5% will be his extra income than the guaranteed life insurance return. This will be an enhanced version of one stone for two birds from the WL on top of all the other great advantages. A simple index fund investment can never allow you to do that for sure!

I hope this discussion can better explain why I’ve become so much a fan of life insurance as part of retirement planning. Just one caution though, life insurance is very deep muddy water with a lot of complexity. There are simply too much misunderstanding and misleading promotions out there and as with anything else, there is no one shoe suitable for all sizes. Try to find out a reliable agent with good education first to determine which one meets your needs best before making long term commitment. A wrong initial decision may cause one dearly down the road!

Not back to the initial question, which one I will choose if only one choice? I will set up a special WL first and then take out the loan to invest as well. So I don’t miss either of them :)