Editor’s note: Howard Sharfman is a columnist for Rethinking65. See his other articles here.
Howard Sharfman
The financial planning landscape is rich with tools and strategies for building cash reserves and preparing for the future. There are, of course, obvious avenues: Think buying a home, opening savings accounts, and qualified plans. However, an often-overlooked option that advisors can present to clients, to diversify savings in a comprehensive plan, is indexed life insurance.
Unlike traditional whole life insurance, indexed life insurance allows policyholders to allocate their premiums into indexed accounts. These accounts mirror the performance of stock market indexes, such as the S&P 500, and offer the potential for higher returns based on market performance. Indexed accounts also provide downside protection through performance caps and floors.
The cash component of indexed life insurance policies has assisted my clients with achieving financial security and meeting goals such as saving for a child’s education, preparing for retirement, and achieving other financial milestones.
Is this a one-size-fits-all tool? No. That’s why advisors can play a critical role in assessing their client’s individual circumstances to determine if it’s the right fit. When used correctly, I have witnessed savers use the flexibility of indexed life insurance to thoughtfully fulfill long-term financial goals.
One of the primary benefits of life insurance, a point often missed in broader discussions about these policies, lies in its tax treatment. Contributions are made with after-tax dollars, growth within the policy is tax-deferred, and funds can be accessed tax-free. This tax treatment sets life insurance apart as an efficient tax-planning tool and provides unique benefits compared with other investment options. It’s important to make sure your clients understand this before delving into how these policies can serve various financial planning needs.
In addition, recent changes to Section 7702 of the tax code affect the maximum premium that can be paid into insurance policies. These changes allow policyholders to overfund their policies with more premiums, potentially increasing the policy’s performance. Even if you have clients who utilize these policies, they may be unaware of the new rules and the impact they can have.
In brief, larger contributions mean more money can flow into the policy’s cash while its fixed costs remain constant regardless of its cash value. This makes additional contributions increasingly efficient as they primarily go toward the savings component.
Start Early
This highlights the importance of starting clients early and making sure they are contributing regularly — a principle that mirrors the forced savings nature of a mortgage or a 401(k) plan.
“People often accumulate significant wealth, not because they chose the best possible investment from the onset, but because they committed to a disciplined saving and investment strategy.”
I’ve observed firsthand the power of systematic saving through these mechanisms. People often accumulate significant wealth, not because they chose the best possible investment from the onset, but because they committed to a disciplined saving and investment strategy. Indexed life insurance fits seamlessly into this paradigm.
Not only does indexed life insurance offer a savings mechanism, provisions such as a disability waiver and death benefit ensure the policy remains effective in unforeseen circumstances.
These factors come together to create an insurance vehicle that can be used as a financial planning tool and a means of financial protection. At the most basic level, some of my clients use the policies as a supplemental retirement fund that they can turn to for tax-free cash flow.
Client Examples
Perhaps one of my proudest examples of how these policies can really protect someone is a construction company I worked with. This company was able to leverage its policy’s cash value to navigate through financial straits caused by the Covid-19 pandemic. As a result, they were able to retain and pay all of their employees.
Another client, a family, started contributing to an indexed life insurance policy at a young age. They didn’t have much money, but they built up financial momentum by increasing the size of their payments over time. One day, they came to me and said, “We are going to open a pizza franchise.” As part of their business plan, they used their policy to finance the restaurant. And now, just a few years later, they have a thriving business. This would not have been possible without borrowing against the cash value of their life insurance.
Limitations
These are just a couple of examples that not only highlight an indexed life insurance policy’s flexibility but also its potential to serve as a critical financial safety net and growth vehicle for clients. That said, indexed life insurance policies have limitations.
Notable, their efficacy as a cash accumulation tool diminishes for individuals over 55 due to the escalating cost of insurance that comes with age and because the benefits are maximized with a long-term perspective in mind. And although a well-priced, well-underwritten policy has extremely low costs and expenses in the long run, the policy may have significant expenses and surrender charges during its first 10 years. So, it is imperative that clients who allocate to an IUL have a longer-term time horizon if they are using the policy for accumulation and distribution.
Remember, an indexed universal life insurance (IUL) policy is part of a financial plan, but it is not a financial plan.
Set Realistic Expectations
Indexed life insurance policies also demand a level of financial commitment and discipline that may not be feasible for everyone, particularly those unable to commit to regular, long-term contributions. If you have a client who cannot commit to comfortably paying at least $100 into a policy each month, suggesting such a plan won’t offer much value for them.
When my clients consider the uses of an indexed life insurance policy, I try to set realistic expectations. Advisors have to make sure that clients know the distinction between gross and net returns, recognize the impact of insurance costs and administrative fees, and understand the caps and floors on earnings tied to market performance.
It’s critical, too, to make clients aware that although the long-term cost efficiency of these policies can be highly advantageous, this assumes the policy is held over a significant duration. It’s also important to recognize that not all insurance carriers are created equal. When you buy indexed policies, you must consider the stability, history and reputation of the company.
Find the Right Use
An indexed life insurance policy is not a fix-all for anyone’s financial life. I wouldn’t be comfortable recommending its use to someone who hasn’t taken the time to understand what it takes to get the most out of the policy as a financial planning strategy. But I have seen how systematic saving in this kind of policy can benefit clients over time.
The truth is, people often grow their wealth because they stick over the long run to their plan and their contributions — not because they were lucky enough to choose the best possible investment strategy.
As we navigate the myriad of options available for financial planning for clients, the insights and experiences of those who have successfully integrated indexed life insurance into their portfolios offer valuable lessons and underscore the importance of informed and strategic decision-making.
Howard Sharfman, senior managing director of NFP Insurance Solutions, a wealth-transfer consulting and planning firm, has been recognized as an innovative leader in the insurance business for over two decades. His practice focuses on servicing families with multigenerational wealth, family offices, private equity managers and the advisors who serve ultra-high net worth clients. His firm has additional expertise in executive benefits, corporate benefits, general insurance and risk management.
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