Thursday, September 21, 2017

Every year, Thornburg Investment Management publishes a report entitled, “A Study of Real Real Returns,” in which the performance of various financial assets is evaluated after taking into account the diminishing factors of management expenses, dividend taxes, capital gains taxes and inflation. Recognizing that individual circumstances may vary significantly, this calculation still provides a broad approximation of the real real return, i.e., the gain (or loss) an investor realizes after all investment costs have been considered.

In its 2013 summary (issued October 2014), the report assessed the performance of 10 asset classes over periods of 1, 5, 10, 15, 20, and 30 years. While the shorter periods showed significant return fluctuations due to market factors, the long-term numbers were impacted primarily by the previously mentioned expenses. Even the best-performing asset class over 30 years registered a real annualized return of just 5.97%, as expenses wiped off 46% of nominal investment gains. While several asset classes registered small losses over shorter periods, two of the 10 categories showed negative real returns over 30-year periods.

What About Whole Life Insurance?

Using the same methodology, a major U.S. insurance company published a real real return assessment based on the historical performance of a “previously sold participating whole life policy, bought in 1985, for which full premiums were paid for 25 years.”

Whole life insurance is unique in that it can be considered two assets with two returns. One is the income-tax-free death benefit, with its return calculated by considering the benefit received against premiums paid. The other return is a “living benefit”—an assessment of accumulated cash values in relation to premiums. In calculating real real returns, for both the insurance benefit and cash values, the nominal return for these two assets is diminished only by inflation—taxes and investment expenses are essentially non-issues under most circumstances.

Given the actuarial paradigm of insurance, the real returns on the death benefit are inverted over time. If an insured individual died in the year a policy was purchased, the “return” to beneficiaries would be extremely high. But the longer the individual lives (and pays premiums), the lower the return on the eventual death benefit. While a whole life policy is expressly designed to be in force at death, the real real return can only be assessed when the individual passes; i.e., you can’t assign a rate of return at any time period unless you assume the period ends with the investor’s passing. Cash values, however, can be assessed for time periods similar to the other asset classes in the Thornburg report.

Regarding the living benefits (the cash value accumulation) the assessment yielded the following 30-year results:

Nominal Return:            5.19%

Real Real Return:          1.68%

Since cash value accumulations reported for the whole life policy used were already net of taxes and expenses for the policyholder, the only factor diminishing returns was inflation—which impacted all asset classes equally. On a real real return basis, this performance placed whole life squarely in the middle of the asset classes Thornburg evaluated—5 were higher, 5 lower. And the results were comparable to other high-quality, fixed return assets.

A Unique Asset—With Unique Applications

The long-term returns from cash values are primarily from dividends which a participating (mutual) insurance company credits to accumulation values. Dividends are not guaranteed, but most insurers have a long history of consistent annual distributions.1 And because dividends may result from less-than-projected mortality costs and efficient management, as well as returns from the insurance company’s General Account, the insurance company’s report notes that cash values are “not impacted by market volatility like other assets.”

While these factors can make cash values attractive, it is necessary to keep the dual asset character of a whole life insurance policy in mind, as well as the structural limitations imposed by law. You can’t have a cash value accumulation without also paying for a life insurance benefit. The cost of the insurance portion of a policy is amortized over a policy’s life, in that a larger percentage of premiums is applied to insurance costs in the early years. This means the 30-year returns for cash values cannot be achieved in shorter time periods, such as five or ten years.

In addition, tax law changes in 1988 restricted the ability of policy owners to accelerate the amortization schedule and increase cash value accumulations. Policies “paid up” with either a single premium or in too short a time period are designated Modified Endowment Contracts (MECs), and lose many of their tax advantages, significantly diminishing real real returns.2

More financial experts are beginning to recognize whole life as a unique asset class, and appreciate its benefits. But maximizing the “dual-asset” values of whole life insurance requires an understanding of strategies for integrating it with the rest of one’s financial transactions. Achieving real real returns from whole life, means working with a real real life insurance specialist.

1 Dividends are not guaranteed and are declared annually by the company’s board of directors.

2 A Modified Endowment Contract (MEC) is a type of life insurance contract that is subject to first-in-first-out (FIFO) ordinary income tax treatment, similar to distributions from an annuity. The distribution may also be subject to a 10% federal tax penalty on the gain portion of the policy if the owner is under age 59½. The death benefit is generally income tax free.

By Elozor M. Preil

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