Missed Fortune – A Critique Part 5/5

[Editor's Note: This is Part 5/5 of a critique of Missed Fortune 101, a book by Douglas Andrew.  If you're not coming here from part 4, better go back and read parts 1-4 first.]

Insurance Is Not Triple Tax-Free

There is an investment account that gives you a tax deduction when you contribute, grows tax-free, and then comes out tax-free.  It isn’t a universal life insurance policy.  It’s a health savings account.  Mr. Andrew likes to pretend that contributions to a UL policy are tax-free.  It takes a huge mental leap to buy into his logic. He suggests that because you can deduct your home equity interest, taking out a bigger home equity loan to put the money into a UL policy is like putting tax-free money into the policy.  That’s like saying I can buy a boat tax-free if I borrow from my home to do so.  That’s like saying if I borrowed money from my home to put into a Roth IRA it’s a tax-free contribution.  It’s silly logic, but that’s how it works to him.  In reality, you buy life insurance contracts with after-tax money, just like boats and Roth IRAs.  It does grow tax-free and upon withdrawal, your basis is tax free.  You can borrow from the policy tax-free, and the death benefit is income tax-free.  But the contributions ARE NOT tax-free, no matter how much Mr. Andrew wishes they were.  This further demonstrates why it’s almost surely an awful idea to pull money out of your 401K (paying penalties and taxes) in order to put it into an account whose tax benefits are really no better and whose costs are likely much higher.

The Early Years Of A Life Insurance Policy


Structuring a life insurance policy as an investment isn’t that complicated.  You’re basically trying to get the benefits of life insurance (tax-free growth, tax-free loans, tax-free death benefit) without the downsides of life insurance (primarily high costs but also ongoing required premium payments.)  You overfund the policy, basically paying for the whole policy as soon as you can without it becoming a modified endowment contract (because then the loans you’re planning to use for retirement income aren’t tax-free).  You choose as low a death benefit as possible in order to maximize the cash value.  But even with doing these things, you still have a few years at the beginning of the policy when your returns absolutely suck.   To make matters worse, if you want out, you’ll likely be paying a significant surrender charge.  It’s hilarious to me that Mr. Andrew preaches liquidity, then advocates for this as an investment.  I suppose you could consider it liquid later on when the cash value has grown (if by liquid you mean you can get your money within a few business days).  But it sure isn’t liquid in any sense of the word in the first few years.  I agree with Mr. Andrew that an investment is best judged over the time period it is intended for, and over very long time periods a well-structured life insurance contract bought at today’s rates is likely to have low, but positive returns (2-5%).  But it seems an awfully big sacrifice to have such crappy early returns just to get okay returns later.  It would be one thing if it would provide 15% returns if you held on long enough, but that just isn’t the way it works.

Bank On Yourself – esque

This strategy isn’t all that different from the Bank On Yourself concept I’ve discussed before.  The BOY folks seem to prefer using whole life policies whereas the Missed Fortune folks like Universal life.  A UL policy can be funded a little faster, but UL policies don’t offer non-direct recognition on loans from the policy, an essential part of the BOY concept.  The main concept is the same – earn tax-free returns similar to fixed income investments and take out tax-free loans as needed, whether to buy a car or pay for golf as retiree.

Borrowing from your life insurance policy cash value is tax-free, but it isn’t interest free.  In fact, you usually pay interest of 4-8% when borrowing from your own money.  It isn’t a huge deal with a non-direct recognition policy, since the dividend rate is usually pretty similar to the loan rate, but with a universal life policy or a direct recognition WL policy, borrowing from your policy may really cost you.

Current Expected Returns On Universal Life

I asked an insurance agent, Larry Keller, to provide me a quote for a UL contract for a 30 year old male. Since Mr. Andrew always makes the assumption that the UL “side-fund” is going to grow at 7.75%, I was curious to see what I could really expect it to grow at given today’s low interest rate environment.  Looking at the illustration was disappointing to say the least. There are actually two illustrations, one with the guaranteed scale and one using the current dividend scale.

The Guaranteed Scale

The policy shows you put in $25K a year for four years for this policy with a $1 Million death benefit.  The guaranteed minimum dividend (not your return) is 2.5% per year.  After one year, you have $17,530 if you surrender it.  After four years, you have $88,036 (remember you’ve put in $100K at this point.)  In fact, the surrender value never actually gets to $100K, and due to the increasing costs of the insurance you must pay each year, the policy lapses at year 43 (unless you add cash to it.)  So, in fact, there is no guaranteed permanent death benefit with this policy and it never actually guarantees you a positive return, no matter how long you hold it.  Not much of a guarantee, is it?

The Non-Guaranteed Scale


Let’s look at the scale using their current projections (which are almost surely to fall given our current interest rate environment.)  Again, you put in $25K a year for four years for this $1M policy.  Assuming the current dividend rate of 4.95% AND the current insurance charges, your net surrender value after one year is $18,074.  After four years it is $93,824.  After 10 years it would be $119,265, a return of 2.09%.  After 20 years, it would be $175,531, an annualized return of 3.08%.  After 30 years it would be $258,457 for a return of 3.38%.  After a full 40 years (you’re now 70 years old), this $100K you invested would now be worth $369,021, giving you an annualized return over 4 decades of 3.45%. At least on the non-guaranteed scale you get to keep your $1 Million in life insurance, instead of losing it at Age 73.  In fact, starting about age 72 it actually starts increasing, and if you die at your age expectancy of 83, and never borrowed from the policy, your heirs would get $1.587M.  The return on that would be 5.51%.

There are four things you can learn from this exercise.  First, if you’re trying to arbitrage between your mortgage rate and the return on these policies, you’d better have a very cheap mortgage.  Even using my 2.75% mortgage (1.7% or so after-tax), you’re only making 0.39% a year on this arbitrage, for the first ten years, and that’s assuming it performs no worse than illustrated, which it is almost surely going to do. Second, that 2.09-3.45% number looks an awful lot like inflation.  The real, after-inflation, return is going to pretty darn close to zero.  I don’t know how you feel about inflation, but I’m not really into locking my money up for decades and then not actually making any money on it.  Third, that 2.09-3.45% number is very different from the dividend rate of 4.95%.  WITH PERMANENT LIFE INSURANCE THE DIVIDEND RATE IS NOT YOUR RATE OF RETURN.  Last the return on the death benefit is higher than the return on the cash surrender value.  That’s why life insurance is much better used for money you plan to leave behind than for money you plan to spend in retirement.  Surprise, surprise, life insurance is actually life insurance, not an “alternative retirement plan.”

Conclusion

I’m not the first to criticize Douglas Andrews “Missed Fortune” ideas.  You can find other critiques here, here, and here.  It isn’t that the whole philosophy is flat-out wrong.  But there are a lot of bad assumptions and half-truths so that when you add them all up, “this dog don’t hunt.”  Avoiding retirement plans causes most people to have less after-tax money in the end.  Withdrawing from them early is also generally a mistake, especially if you’re paying significant taxes and penalties.  Buying real estate with nothing down is a mistake that not only increases the risk of foreclosure, but also raises the costs of your mortgage.  Universal life policies as an investment are likely to have long-term returns of no more than 2-3.5% going forward, and quite possibly may have negative returns, especially for shorter time periods.  Arbitraging a low mortgage rate for a possibly slightly higher return on a universal life policy not only increases your financial risks, but is unlikely to make any kind of a significant positive difference in your personal finances.  In summary, if you follow Douglas Andrew’s ill-conceived financial plan, the only people likely to end up wealthy due to your efforts are your lender and your life insurance agent.

What do you think?  Have you read the book?  Are you a Missed Fortune believer?  Do you like keeping zero equity in your home or buying universal life policies as an investment?  Fire off below in the comments section!  As always, keep the discussion focused on ideas, rather than individuals.

 

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Comments

Missed Fortune – A Critique Part 5/5 — 29 Comments

  1. Reading this blog I have come to realize that WCI is a voracious reader. I however can not understand how he managed to get all the way through this book. I wanted to comment from day 1. Horrible financial advice. I am very thankful to have found this blog not only for its content but its links to further content.

    whole life insurance is never an investment for yourself. It could, at a high cost usually, be an investment for your children’s retirement. I for one don’t work hard every day to fund my kids retirement.

  2. “Buying real estate with nothing down is a mistake that not only increases the risk of foreclosure, but also raises the costs of your mortgage” – WCI

    I would agree with this in most but not all cases. If it is your principle mortgage and you have access to preferred lending (VA loan, Doctor loan) and a job with very little career unemployment (like physicians) than I see no problem with a zero down mortgage as long as the home is within your means (which I define as mortgage + taxes + homeowners > 25% of after tax pay)

    • I do see a problem with a zero down mortgage. You not only get a more expensive loan, but you also have some additional risks. That said, they aren’t necessarily bad risks to take.

      One thing to consider is that if the housing market tanks you may not be able to refinance the mortgage and you may not be able to sell the house readily as you’re much more likely to be underwater. It might not be a big risk to you personally, but to pretend it doesn’t exist at all is folly.

  3. Great article. I think the big failure in missed fortune is the failure to address inflation if it skyrockets. That is where this could faireally badly.

    My question. Can I open up a heath savings account myself in a place with low fees, or does my employer have to offer it? My employer does not offer a health savigns account, but it seems like a great way to invest money in a tax free manner, it seems to work out like a roth.

    • Actually, inflation would help someone who has their real estate highly leveraged. You could pay back the loans with depreciated dollars. The “investment” returns would obviously get killed though.

      If you have an HDHP you can open up an HSA anywhere. If you don’t have an HDHP, you can’t open one anywhere.

  4. There is a lot to criticize here, but i find these kinds of discussions interesting. The criticism you offer is generally reasonable, but i would point out that if you want to be very successful (the intent here is to become wealthy) you cant always take the strait path. Think differently.

    I would take a good look at 401ks. The benefits are far less than they are made out to be. You always pay income tax rates (lower 15% rates were made permanant recently on taxable investment earnings).
    So, the main benefit is deferral. You give up control of the money and limit your investment options (to understand the first point consider that the account is not in your estate – the same as if it were a trust) .

    • I’m not sure what you mean when you say “benefits are far less than they are made out to be.” I’m not sure what they’re made out to be. I expect to save money in my 401K at about 38% and withdraw it at a rate between 10 and 20%. That’s a pretty good benefit. It also grows without taxes on distributions. Investment choices in my 401K are limited….to anything you can buy through a Charles Schwab Brokerage account. My other 401K, the TSP, also had limited, although extremely low cost funds.

      I’m not sure what you’re talking about with the capital gains rates. We were talking about 401Ks which obviously have nothing to do with capital gains rates. The recent changes to the capital gains rates includes an INCREASE in rates to 18.8% for those with a taxable income over $200K ($250K married) and 23.8% for those over $400K ($450K married). You are correct that the 15% rate for those with taxable income between $36,250 ($72,850 married)and $400K was made permanent (as was the 0% rate for those under $36,250 ($72,850 married)).

      I’m not sure why you think having a 401K outside your estate is such a bad thing. That’s usually the goal of estate planning. The 401K doesn’t have to go through probate since it has named beneficiaries. I don’t see that as “giving up control of the money.” I could cash out both of my 401Ks tomorrow if I wanted to. That’s hardly a loss of control.

  5. Most physicians will be paying lower tax rates later on period. He has shown this several times. Deferral is a benefit as you mentioned but it isnt the only benefit.

    you only give up some control in the 401k and the investment options only need to include a few common vanguard index funds. There is no rule that the 401k has to include bad funds.

    even taxable investing would be superior to the approach by missed fortune

  6. I can’t believe you read the whole book. From the first day of your review it was pretty easy to see that this guy sells snake oil. The fact that the guy can’t even pay his debts is icing on the cake.

    Thanks for reviewing his ‘literature’ for us.

  7. What advice would you give to someone that has made the mistake of starting to fund one of these life insurance policies? I’ve had some “financial gurus” of my own who have very generously given me investing advice for the past two or so years. Thus far, they’ve had me move my Roth IRA from Vanguard to some company they work with and they’ve had me buy a life insurance policy which I am overpaying as a “foolproof” way to save for retirement. From your blog, it seems like backing out now may be foolish because of the high surrender charges. So am I committed to see this through?

    PS, Wish I’d started reading WCI years ago!

    • Cash value life insurance policies are one of those things that, strangely enough, can be good to hold on to if you’ve already had them for decades. If you’ve only had it a year or two, and you now realize you don’t want it, you’re almost surely better off getting rid of it ASAP despite surrender charges. The reason why is that you’ll have to throw away MORE money waiting for the surrender charges to go away than to just pay them now. Why not order a new illustration from the life insurance company and go to a fee-only adviser for a second opinion before deciding what to do? You can also pay a small fee and have a guy like this:

      http://www.evaluatelifeinsurance.org/

      take a look at it.

      An adviser suggesting you move money away from Vanguard is almost surely not good for you. Don’t get me wrong, I’ve occasionally moved money away from Vanguard to take advantage of other opportunities, but I would guess your adviser moved you from low-cost index funds to high-cost loaded mutual funds (or worse annuities or cash-value life insurance), no?

      Consider this, in the words of Dave Ramsey, your “stupid tax.” We’ve all paid it at one time or another. Better to pay it when you’re young and learn from it than to get to age 60 and realize your “stupid tax” bill is millions of dollars. You might try getting some of your money back from the adviser by threatening a suit, but I would guess you wouldn’t be very successful…all those forms you signed and all.

      • WCI,
        Thanks for the thoughtful response. This certainly would qualify as my stupid tax. The light bulb only went off when i saw how much higher my fees were for the Roth this year than any of the previous 5 years (and how much of that fee was going to my adviser!). I will check out the sources you pointed out and figure out the best way forward. Your 5-part series on insurance as an investment vehicle was a great read. Thanks again!

      • Enjoyed your thorough critique of Mr. Andrews. As an advisor I have found that perhaps the most tax efficient way to dispose of unwanted life insurance is through a 1035 exchange to a low-cost variable annuity (such as Vanguard). Your basis in the life insurance contract carries over to the new annuity leaving you “unused” gains. Keep the annuity until the gains are exhausted and then surrender the contract w/o tax or penalty.

  8. I find that solution is far less useful than it should be. Most people disposing of unwanted life insurance don’t have any gains at all, and can just surrender the policy and take the cash tax-free. Most people who have significant gains (and thus have been in it 20+ years) are often-times better off keeping the policy, especially a typical whole life policy. Perhaps not a universal policy as discussed in this post. That leaves a pretty small segment of folks who don’t want their policy, should get rid of it, AND have a taxable gain.

  9. Allow me to clarify the strategy… The fact that most who surrender insurance policies early on don’t have a gain is exactly why the 1035 works. For example, suppose I paid in $25,000 over two years but the cash value is now $15k (not unusal at all in the early years of a policy). By transferring the $15k cash value in the life insurance to a variable annuity I get $10k in “free” gains until I recoup my $25k basis. This saves capital gains tax on that $10k earned down the road compared to simply cashing out and investing in a brokerage account. Additionally, some CPAs argue that losses incurred on the surrender of a variable annuity contract may be deducted as a miscellaneous itemized deduction subject to the 2% floor (as long as there is a profit motive). Either way it’s win.

    • I have paid 50,000 k total and cash value of 30,000 but AVIVA is charging Surrender fees:45,000$:so I have no cash I can get out( Cash balance – surrender value).I can just cancel the policy( loosing 50 k vs keeping the policy and keep bleeding 25 K every year for the rest of the policy).
      Any ideas?

      • Sounds like a great investment. Another $50K loss for cash value life insurance. The agents who post comments on this blog somehow never run into people like you. They all think these things are awesome. Since you’ve spent so much on this, I’d probably pay some money to get it professionally evaluated. Try this guy: evaluatelifeinsurance.org and perhaps get a second opinion from a life insurance agent.

  10. While Missed Fortune is flawed in its logic and mathematics, the use of UL has its place. First of all if I were to fund a cash value policy as a retirement accumulation vehicle, I would use well designed indexed universal life (IUL) that is similar to an indexed annuity (protection of principle with upside potential linked to a stock index and subject to a cap of 11-15% depending on the carrier used). I would over fund up to the MEC limit for 5 years with the minimum death benefit allowed and then let it grow for many years. One should understand that this is a long term plan and the growth in the policy will not start to accelerate until 10-12 years into the policy. While the Roth IRA and 401K are ok, one must realize that you are limited in the amount you can put into these plans vs the unlimited amount you can fund an IUL and that there is no downside protection if the market crashes as in 2002 or 2008. What happens to my 401k if the market goes down 40% in the year I retire and start taking distributions? Yes, there is a cost of insurance but over 30 years it will approach 1-2% of the cash value in the policy. Most people are today are very concerned about the loss of principal and are willing to make a reasonable rate of return in exchange for that peace of mind that their principal is safe.

    • I agree that it is worth giving up some return in exchange for safe principal. Unfortunately, 1-2% over a long period of time is an awful lot of money. Consider a return of 8% vs a return of 10% for instance. If you’re saving $100K a year over 30 years, the difference between 8% and 10% is $11.3M vs $16.4M. $5.1M may not be much to you….

      At any rate, I’ve written before about a similar product, equity-indexed annuities, and they’ve definitely got their issues. Mixing investing and insurance is generally a mistake. Buy life insurance for the death benefit. Use retirement accounts for retirement. Yes, there are limits to retirement accounts, but they’re usually much higher than most assume. Between my profit-sharing plan, two backdoor Roths, an HSA (stealth IRA), and a defined benefit plan I’m looking at over $83K this year in tax-advantaged, asset-protected accounts. At any rate, investing in a tax-efficient manner inside a taxable account is a reasonable alternative. The tax costs can be kept lower in many cases than the costs of insurance especially when you add in the cost of the guarantees with an indexed insurance product.

      http://whitecoatinvestor.com/pros-and-cons-of-equity-indexed-annuities/

    • I understand that many people are not aware of the fees in their retirement plans, but I assure you I am quite aware.

      My overall portfolio expense ratio is 0.16% per year. My cheapest investment is the TSP at about 2.5 basis points. My most expensive is Bridgeway’s Ultra Small Market Fund at 0.87%. My 401K charges $200 a year from the 401K provider (something like 15 basis points in my case) plus fees that total around 5 basis points for “recordkeeping” by Schwab. The ETFs in that account have ERs that average less than 10 basis points. My defined benefit plan has a 0.6% fee plus the fees from the mutual funds held in it, which average around 0.4-0.5%, but which I hope to help decrease by replacing the actively managed funds with index funds when I meet with the 401K committee next month.

      Thanks for the links to these recent programs. I agree that retirement plan fees are a big issue, just like insurance company fees and expenses are.

      I’ve discussed the holdings in my portfolio elsewhere:

      http://whitecoatinvestor.com/how-i-currently-implement-my-asset-allocation/

      It’s not quite up to date, but it hasn’t changed much (and doesn’t change often.)

  11. Have you thought about any strategies to employ if the market takes a downturn? Do you go to cash if any of your funds go down by a certain percentage or are you strictly a buy and hold investor? As you get older will you change your allocation for less risk?

    • Yes. I rebalance. No, I am a buy and hold investor. It’s the worst way to invest except all the other ways that have been tried. Yes, I will decrease risk as I get older.

      What do you plan to do?

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