Whole Life question - when to stop making annual payments?

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lhl12
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Whole Life question - when to stop making annual payments?

Post by lhl12 » Sat Sep 30, 2017 11:09 am

About 20 years ago, my father-in-law (now age 82) purchased a whole life insurance policy on his life with my mother-in-law (now age 77) as the primary beneficiary and their three children (one of whom is my wife) as secondary beneficiaries at the time of my MIL's death (assuming he predeceases her.) The policy (from New York Life) is held in an irrevocable trust and he makes gifts into the trust to cover the annual premiums. He has asked me for my input on one aspect of the policy and I am now consulting the Bogleheads.

My FIL's practice has been to pay the premium in full each year and allow the dividend to purchase additional paid-up insurance each year.

After about 20 years of full premium payments, the policy has significant cash value and the annual dividend covers about 88% of the cost of the annual premium.

Over the past five years, the dividend has been growing at a rate of about 5.9% per year. If my FIL continues to pay the premiums in full each year, and if the dividend continues to grow at the same 5.9% rate in the future, then after three more years of full premium payments the annual dividend will exceed the annual premium.

Now the question: Which of these three approaches makes the most sense for this policy?

(a) stop making premium payments immediately, allowing the dividend to cover most of the annual premiums and allowing the cash value of the policy to cover the difference. (I believe this approach will allow the policy eventually to become self-sustaining, but in a lot more than three years.)
(b) make three more years of premium payments, then stop making premium payments after the policy becomes self-sustaining (i.e. the annual dividend exceeds the annual premium).
(c) continue to make the annual payments indefinitely, until the time of my FIL's death.

For asset allocation purposes, my FIL treats this policy as part of his fixed income allocation - low risk, low return -- and would also view any further premium payments as allocations to fixed income. He has enough other assets (both equity and fixed income) at Vanguard that he can rebalance without having to access the policy itself.

For purposes of the analysis, let's assume that my FIL's health and life expectancy are actuarially neutral.

inbox788
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Re: Whole Life question - when to stop making annual payments?

Post by inbox788 » Sat Sep 30, 2017 11:39 am

Without the relevant numbers (and a lot of them/all of them), it's going to be hard to come to any rational conclusion, but in general (for a 20 year old policy and 82 year old), I think the answer is "C".

What is the expected return (based on the neutral actuarial assumption) of the PUA currently being purchased? Is it fixed or will it decrease with age? I'm guessing it's facing diminishing returns, but remains positive benefit.
http://bankingtruths.com/the-power-of-a-pua/

Nate79
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Re: Whole Life question - when to stop making annual payments?

Post by Nate79 » Sat Sep 30, 2017 9:49 pm

What happens to the cash value upon death? My understanding is the cash value goes to the insurance company, so you lose it. Only the death benefit face value is laid. So why would you keep putting money into this at such an age?

ThePrince
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Re: Whole Life question - when to stop making annual payments?

Post by ThePrince » Sat Sep 30, 2017 10:29 pm

Nate79 wrote:
Sat Sep 30, 2017 9:49 pm
What happens to the cash value upon death? My understanding is the cash value goes to the insurance company, so you lose it. Only the death benefit face value is laid. So why would you keep putting money into this at such an age?
Exactly. The FIL should have purchased term insurance.

inbox788
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Re: Whole Life question - when to stop making annual payments?

Post by inbox788 » Sat Sep 30, 2017 11:36 pm

ThePrince wrote:
Sat Sep 30, 2017 10:29 pm
Nate79 wrote:
Sat Sep 30, 2017 9:49 pm
What happens to the cash value upon death? My understanding is the cash value goes to the insurance company, so you lose it. Only the death benefit face value is laid. So why would you keep putting money into this at such an age?
Exactly. The FIL should have purchased term insurance.
There is no suitable 20 year term for an 82 year old to compare. Usual arguments for term against whole don't apply. Examine the current situation to make a good decision.

With whole life insurance, the amount the insurance company is on the hook for decreases, which is why the premium doesn't go through the roof.

Two Headed Mule
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Re: Whole Life question - when to stop making annual payments?

Post by Two Headed Mule » Sun Oct 01, 2017 6:53 am

"Which of these three approaches makes the most sense for this policy?" is not the right question. The question is which approach makes sense given your FIL's goals, which are unclear. Each option can make sense depending on what is attempting to be accomplished. For example, (c) makes sense if he doesn't need the money while alive and wants to maximize cash value/death benefit for MIL/kids (or doesn't expect to live much longer); (a) can make sense if he wants more spendable cash now or has a better use for the money.

Mule

Dandy
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Re: Whole Life question - when to stop making annual payments?

Post by Dandy » Sun Oct 01, 2017 7:25 am

Most whole life policies can be made into a paid up insurance with a reduced face amount. In this case I would assume the reduction would be minimal. I would check with the insurance company or agent to see if this is available. He would still earn dividends but they would likely be a bit smaller. This approach might be the best option if paying any premium is a burden.

If the cash surrender value is $7000 and the face amount of the policy is $10,000 upon death the beneficiary gets $10,000.

While 5.9% isn't guaranteed it is a better deal than he can get outside of the policy if he surrenders it.

Whole life is usually a bad deal but once it has been inforce for decades you have already paid the price for most the bad - i.e. the higher premium than term. After several decades the level premiums, the high cash value, the higher dividend rate, the ability to pass the benefits on tax free often makes it worth keeping- especially if you are paying little or no premiums.

lhl12
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Re: Whole Life question - when to stop making annual payments?

Post by lhl12 » Sun Oct 01, 2017 8:15 am

I agree that he shouldn't have bought the policy to begin with, but that's water under the bridge. The question is what to do from here.

My FIL doesn't need the money for the premium payments during his lifetime, so the payments are not a burden. The funds he is using to make the payments are coming out of his fixed income allocation. I have encouraged him to view the policy simply as a substitute for his fixed income bucket, with the payments simply as a transfer from one type of fixed income fund (let's say Vanguard Total Bond Fund) to another (paid up whole life). He agrees with this approach - let me know if you do not.

So, the question really has to do with the expected fixed income return of paid up additions into a mature whole life policy as compared to a bond fund, as well as the cost of funds taken from the cash value of a mature whole life policy (to pay premiums if new money is not added.) His "goal" is simply to maximize his fixed income return.

Note that the 5.9% figure I quoted was not a pure fixed income return - if it were, then I think the decision would be easy. That figure was the annual increase in the dividend, which includes the effect of the current year's premium payment (as if it were a transfer into the account). If you back out the effect of the premium payment then the true fixed income return of the cash value of the policy over the past three years has been 0.22%, 0.24% and 0.38% (oldest to youngest). That figure alone obviously isn't very attractive, but if he doesn't make the payment then I think it gets even worse because cash value is taken from the policy to cover the premium shortfall (i.e. the difference between the premium and the annual dividend).

Two Headed Mule
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Re: Whole Life question - when to stop making annual payments?

Post by Two Headed Mule » Sun Oct 01, 2017 9:11 am

I find it hard to believe a 20 year old whole life policy is yielding so little on the cash value. Are you sure those numbers are correct, particularly since you've indicated that the dividend can pay almost all of the premium at this point?

bsteiner
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Re: Whole Life question - when to stop making annual payments?

Post by bsteiner » Sun Oct 01, 2017 9:42 am

Does he need life insurance?

Will the trust be out of his wife's estate and his children's estates?

Did he elect GST exemption or no allocation?

inbox788
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Re: Whole Life question - when to stop making annual payments?

Post by inbox788 » Sun Oct 01, 2017 11:55 am

lhl12 wrote:
Sun Oct 01, 2017 8:15 am
My FIL doesn't need the money for the premium payments during his lifetime, so the payments are not a burden. The funds he is using to make the payments are coming out of his fixed income allocation. I have encouraged him to view the policy simply as a substitute for his fixed income bucket, with the payments simply as a transfer from one type of fixed income fund (let's say Vanguard Total Bond Fund) to another (paid up whole life). He agrees with this approach - let me know if you do not.
Yes, it's mainly a wealth transfer vehicle and investment at this point.
If you back out the effect of the premium payment then the true fixed income return of the cash value of the policy over the past three years has been 0.22%, 0.24% and 0.38% (oldest to youngest). That figure alone obviously isn't very attractive, but if he doesn't make the payment then I think it gets even worse because cash value is taken from the policy to cover the premium shortfall (i.e. the difference between the premium and the annual dividend).
How are you calculating this? Are you taking into account the PUA purchased? What was the latest dividend and cost of the PUA and how much additional death benefit did it provide? Is the current cash value at the guarantee rate or does it exceed it?

I look at the Y/Y return in cash value to figure out return, ignoring COI.

return = 1 - [cash value current year]/[cash value last year + premium]

Reminds me, I need to look ahead at future years guaranteed values to make sure this calculation remains positive.

lhl12
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Re: Whole Life question - when to stop making annual payments?

Post by lhl12 » Sun Oct 01, 2017 3:41 pm

6/7/17 Statement:
Death Benefit: $244,417
Cash Value: $154,560
Dividend: $5,890

6/7/16 Statement:
Death Benefit: $236,806
Cash Value: $143,689
Dividend: $5,646

The annual premium is $6,716.

I calculated the fixed income return as the rate of change in the Death Benefit (not the Cash Value) so the effect of the PUA's would be included. Perhaps that's incorrect analysis, though. For 2017, my return calculation was (244,417/(236,806 + 6716)) - 1 = 0.37%.
Last edited by lhl12 on Sun Oct 01, 2017 3:52 pm, edited 2 times in total.

lhl12
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Re: Whole Life question - when to stop making annual payments?

Post by lhl12 » Sun Oct 01, 2017 3:49 pm

bsteiner wrote:
Sun Oct 01, 2017 9:42 am
Does he need life insurance?

Will the trust be out of his wife's estate and his children's estates?

Did he elect GST exemption or no allocation?
No, he does not need life insurance. This trust was set up as an estate planning vehicle. I was not part of the conversation at the time he set it up, otherwise I would have recommended that he use the contributions to the trust to invest in a 70/30 portfolio rather than life insurance.

The trust will be out of his wife's estate. The plan would be that she would live on their other assets for the remainder of her lifetime, not touching this trust unless necessary.

I believe it will be out of his children's estates as well, though I'm not certain of that. I believe he did elect GST exemption, though again I'm not certain. I can find out the answers to these two questions if it's important.

Dandy
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Re: Whole Life question - when to stop making annual payments?

Post by Dandy » Sun Oct 01, 2017 3:52 pm

I'd keep it. Life insurance proceeds are usually tax free to heirs, the annual out of pocket for him is minimal, it should be paid fully by the premiums in a few years - have him take any excess in cash then.

Some whole life policies have a provision you may be able to add that is called living needs benefits. If he needs to use this money for care he may be able to use the cash value. I know Prudential offered this Living Needs Benefit for no cost at one time.

inbox788
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Re: Whole Life question - when to stop making annual payments?

Post by inbox788 » Sun Oct 01, 2017 4:22 pm

lhl12 wrote:
Sun Oct 01, 2017 3:41 pm
6/7/17 Statement:
Death Benefit: $244,417
Cash Value: $154,560
Dividend: $5,890

6/7/16 Statement:
Death Benefit: $236,806
Cash Value: $143,689
Dividend: $5,646

The annual premium is $6,716.

I calculated the fixed income return as the rate of change in the Death Benefit (not the Cash Value) so the effect of the PUA' would be included. Perhaps that's incorrect, though. For 2017, my return calculation was (244,417/(236,806 + 6716)) - 1 = 0.37%.
These are my conjectures, so don't take these ideas as fact, and please let me know if I'm wrong in any way. I've been struggling with my WL policy for decades, and it's still foreign to me.

Ah, you're using the Death Benefit. I'd look at it a little differently. If you cashed out in '16, you'd get $143,689 plus you'd save $6,716 premium, so your opportunity cost is $150,405 that you could put towards a bond fund. What you got was $154,560 cash value in '17, so I calculate the return on Cash Value as $154,560/150,405 -1 = 2.76%, which isn't bad, plus you got the COI free and PUA (which I don't really know how to value, but it's > $0). I don't know what to make of the dividends, since they don't directly go anywhere, so I ignore it. Since few bond funds are yielding > 2-3%, I'd say the life insurance policy is a better choice. Somewhere in the 4-5%+ range, you might choose to take the extra $2-3000+ (1% of $150k is $1500) in bond return and do something else instead of buy around $100k in insurance (difference between Death Benefit and Cash Value). You probably can't buy a 1 year life insurance on an 80+ year old for only $2-3000, and more with increasing age.

If I understand it correctly, the Death Benefit went up by $7611 from $236,806 to $244,471. Your premium went towards keeping the WL policy intact at $236,806 (what you would have gotten without PUA). The $5,646 dividend bought you that $7611 in additional Death Benefit, so 35%. If you assume a 7 year expected longevity, that's about a 5% return (simple math) on the dividend as an investment. Not bad especially since it's tax free. Now if the policyholder lives 23 more years, the bad news is that the return drops to around 1.5%, which isn't so good, but the good news is happy 105th.

Is the Cash Value railed against the Guaranteed Cash Value (i.e. equal)? Many policies are now with very low interest rates. Now if they're above, they could go up or down, but most likely down towards the Guaranteed Value. You can use Guaranteed Cash Value to figure out future expected Y/Y returns. The PUA may complicate calculation because the Cash Value may be a function of Guaranteed Value and the PUA.

So if you figure 2% return by maintaining core whole life policy as investment, 4-5% return on PUA, and some free insurance thrown in, and it's looking good compared to many bonds.

BTW, what's the tax bracket? I'm currently in a high tax bracket, so cashing out now would mean more in taxes. Another reason to at least postpone cashing out now to at least later if not indefinitely.

[Addendum: In some ways, you may be looking at FV while I'm looking at PV, and the discounting mechanism is wacky (you don't have interest rate(rate of return) or time(number of periods)).]

lhl12
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Re: Whole Life question - when to stop making annual payments?

Post by lhl12 » Tue Oct 03, 2017 3:16 am

I calculated the rate of return on the Death Benefit rather than cash value on the theory that he WILL hold the policy until death and the only question is what incremental return he’s earning on the premium (if he continues to make the payments). So, if he dies the day before making the next payment, then he receives the current Death Benefit (and still has the premium payment in his account). If he lives an extra year (and makes the premium payment) then he has just the new, higher Death Benefit (including the new PUAs).

Again, this might not be the right way to think of it, but it made sense to me.

lhl12
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Re: Whole Life question - when to stop making annual payments?

Post by lhl12 » Wed Oct 11, 2017 7:26 pm

I have confirmed that the trust is GST exempt.

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