Seeking Alpha

Participate In Higher Rates Without Risk Of Principal

by: Alpha Gen Capital
Summary

Dividend rates for mutual insurers that have been declining for 30 years may be coming to an end.

For those under the age of 45, "overfunding" an already needed life insurance policy can be a great way to create a safe bucket.

For those over 50, income annuities are likely to become much more popular in the coming years as low future returns in the markets cause retirees to seek other means.

Some new tools have been created to participate in rising rates without principal reduction - that is rate arbitrage.

We've spent a lot of time discussing annuities and overfunded life insurance as mechanisms for building non-correlated safe buckets. For instance, needing a million dollar policy for my family, I purchased a whole life insurance policy for $1 million. It cost me approximately $9K per year (rounding numbers significantly). However, I put in close to $12K per year.

Why on Earth would I pay MORE for my life insurance than I need to? I mean, that is like getting a bill from a contractor doing work and paying 30% more.

But think of it this way, we are socking away that extra $3K. It is similar to a 'juiced' savings account that gives us access to the general account of the insurance company.

What is the general account? It is the aggregate investments and other assets held by the insurance company set aside to pay claims and all of the benefits entitled by the policyholder. Basically, the general pot that insurance companies use to invest and grow in order to pay future claims.

This is the collateral to the policy and it is required by law. Imagine if an insurance company collected premiums and when the time came to pay a claim they didn't have the funds?

By placing that extra $3K per month into the policy, I am building 'cash value', which is the amount offered to the policyholder by the issuing carrier to surrender the contract.

While term life insurance doesn't build cash value, other types of life insurance work differently. Whole life insurance, which is also called permanent life insurance, for example, offers a death benefit but also builds cash value you can borrow against.

In that sense, this "cash value life insurance" serves multiple purposes. Not only does it protect your family in the event of your death, but it can serve as a financial resource you can lean on when it makes sense.

That cash value never goes down (unless you withdraw or take a loan from it) and grows tax deferred. There are not many tools like it in the U.S. The IRS left open this loophole to promote financial security which becomes a fantastic mechanism for high net worth individuals (and even corporations) to put away capital and grow it safely.

We use Northwestern Mutual (primarily) but many mutual insurers can provide the same value. The dividends are largely equivalent among the top mutual companies (NY Life, Mass Mutual, Penn Mutual, Guardian, and MetLife) once you account for true expenses. What does that mean? There is no standard for the industry for reporting the dividend rate. Some insurers report it gross of some expenses, others report it net.

(Source: Northwestern Mutual website)

As we stated earlier, when you build cash value through an overfunded life policy, you are piggybacking a life insurance need (in my case I needed coverage for my family). You then place more cash into the policy then needed to sustain it (in excess of the premium) and it goes directly into your cash value. Of course, you cannot just put unlimited amount of capital into a policy because you could "MEC" it.

A MEC is a modified endowment contract which is a tax qualification test. It is a cap that the government puts on how much cash is in a policy. A trained life insurance agent will top out a contract to make it the most efficient possible- reducing total insurance costs per unit of death benefit.

Cash value is just like a bucket of liquid cash that you can access anytime. The notion that you have no access to that money until you die is one of the largest misnomers in the financial industry. For example, I know a commercial real estate developer who has a large universal life policy which had over a million dollars of cash value. In 2010, he took a substantial loan from the policy as collateral in order to acquire a bunch of properties during the downturn. Earlier this year, he sold the properties for roughly 4x their initial cost at which point he paid back the policy. The loan to himself was essentially interest free though the loan is credited at a 7.5% rate. But that just means he can put back into the policy more cash than he took out.

During the time the money is in the policy, it is being credited the dividend rate. The money is actually invested in the general account which is similar to a large closed-end interval fund. Most of the assets are invested in safe bonds and there is a monthly cash flow component as new premiums, minus any death benefits paid, are added to the portfolio allowing them to buy new securities. They can be opportunistic in that approach and their time horizon is very long- similar to an endowment.

Below is the Northwestern general account:

(Source: Northwestern Mutual)

Rising Rates have allowed the mutual insurers to start raising the dividend rate for the first time in many years. In the case of NML, the last time they raised rates was 1998 (+0.30%) which was a brief one year increase.

(Source: TopWholeLife.com)

Northwestern Mutual recently stated that they are increasing their dividend rate by 10 bps. While not a large increase, it was significant in that the rate is no longer falling.

Over the last year, we have discussed bolstering the safe bucket and building non-correlated income streams. We typically advise retirees to have 30%-50% of their annual income need to come from other sources outside of the portfolio. That would include social security, pensions, rental income, income annuities, etc.

Income annuities are one area where we think most of the industry is opaque and garbage but the product itself can be useful for many retirees. They are similar to purchasing a defined benefit pension plan with some clear advantages.

Those advantages over a traditional pension include:

  • Better credit quality
  • Survivorship benefits

Many defined benefit pensions are in rough shape. If they "go under"' your pension gets placed into the Pension Benefit Guarantee Company (OTC:PBGC) where it will most assuredly be reduced (see what happened to United pilots a decade ago). Most of the top insurers are triple A rated so the chance of them not paying is very low.

Survivorship benefits are a key consideration. If you have a defined benefit pension that starts paying at age 65, and you and your spouse die at 66, you received one year of benefits after paying into the system for decades. Crappy deal, huh? But many income annuities have 'period certain' and 'cash refund' options that protect against this very scenario.

Concluding Thoughts

We've discussed adding these two pieces to your retirement plan several times in the last year. For those under the age of 50, and especially those in their 30s with disposable income, think about allocating about 10%-15% of that income to an overfunded life insurance policy. This is a great way to build a safe bucket early and earn a very strong, risk-adjusted rate of return. Using the NM policy as an example, if your policy is seasons, you get a ~5.0% rate of return in 2019 with no principal risk. Hard to beat that trade-off.

As we've stated, many investors, especially high net worth individuals, use an overfunded policy as a bond proxy to earn better returns than what is available in the corporate bond market. The money is fully liquid with the policyholder allowed to borrow or withdraw up to 92% of the cash value. And it is 48-72 hour money.

For those over 50, think about the income annuity as a mechanism to create your own defined benefit pension plan. The largest hesitation is that you are dumping in a significant chunk of assets at once and you can never retrieve that principal back. However, think of it this way. Over a 30-40 year period covered under a typical defined benefit plan, you are paying in incrementally without any chance of withdrawing the principal, unless you have the option of a lump sum take at retirement. In many cases however, these can be a bad deal.

We believe income annuities could be a very useful tool over the next decade as the transparency of these formerly opaque products remove the more awful ones from the industry. Expenses are coming down and the products have more options/advantages than in prior years.

One of the drawbacks of these income annuities previously was that it locked you into the current low interest rate environment. Northwestern and now NY Life, both have income annuities that are tied to the general account (called portfolio income annuities) - similar to the cash value of life insurance. In other words, you can participate in rising rates and still have a "fixed" income (not variable) annuity.

This is what we call rate arbitrage without the risk of downside. If you are in good health, we think these will be very good tools that an investor adds to their tool chest. While the rate of return is not huge, you cannot outlive the income stream. Outliving the actuarial tables by just a couple of years, however, can really boost that internal rate of return. And we didn't even discuss the 'sleep well at night' benefits that these products can produce.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.