Monday, November 17, 2014

Should You Cash In Your Life Insurance?

What is the real rate or return on my State Farm policy and should I keep it or cash it in?

In an earlier posting, I was reviewing my whole life policies, after 20 years, and realizing what crummy "investments" they were.   Not crummy per se, as you have to realize that each policy is not just an investment, but also insurance as well.  So while the rates of return may be slim, the policies do have a death benefit worth five times as much as the cash value - which ordinary investments don't provide.

But as you get older, you need life insurance less and less.   And even a death benefit of $100,000 isn't really a lot, if you have other investments worth many times that.

The question, remains, are these policies worth keeping?   Or should you cash them in or convert them to "Paid up life" status (if possible).  I converted my Variable and Adjustable policies to "Paid up" policies, as I could no longer afford the staggering premiums.   As such, the policies need no more premiums, increase in cash value every year, and pay dividends as well.   From money-sink to money-maker, it was not a hard decision to make.  Should I do the same with my whole life policies?

Well, one of them, the Northwestern policy, is almost "paid up" at this point.   At least the dividends are now exceeding the premiums, so that I don't have to make any payments on the policy.   And the policy keeps increasing in value, every year, by a couple thousand dollars.   So I might as well keep it, right?

In my previous posting about these whole life policies, I mused that it "made sense" to keep my State Farm policy, as for every dollar in premium paid (e.g., $800 a year) the policy increased by nearly double in cash value (e.g., $1550 a year) and thus I was getting a nearly 200% return on my "investment".

I realize now that while that is a comforting way to look at it, it may not be an accurate one.   A better way to look at it is in terms of what the actual rate of return is, based on the cash value and the increase in cash value annually.

For example, in 2013, this policy had a cash value of $20,727.19 and increased in cash value by $1558.32 that year.  I also had to pay a premium of $739.43 that year.  Thus, an "investment" of about $20,000 increased in value by $818.89 in one year, or an annual rate of return of about 3.95% which is in Bond territory these days.

Putting it another way, I could "cash out" this policy and take than $20,727.19 and invest it in stock, for example, and probably get a rate of return of 7% or more - maybe much more.

(The Northwestern Policy does much better, with a cash value for 2013 of $33,730.14, an increase of $1715.60 plus a dividend of $1296.29 (which exceeds the premium of $1284, so the policy is self-funding at this point.   The rate of return is about 5.08%   I could still do better in stocks, perhaps).

But again, this falls into the fallacy of comparing apples and oranges.   It is like the fallacy of comparing paying off debt to investing.   My Fidelity adviser says I should have kept my mortgage (and its onerous monthly payments!) and then invested $400,000 in mutual funds, as the rate of return on the mutual funds could be higher than the annual interest I was paying on the mortgage.  But of course, the interest not paid is an "investment" that is guaranteed 1000% never to fail - it is safer than a government bond.   Mutual funds, on the other hand, could go up - or go down.   And while it is possible I could invest in the mutual funds and make enough to pay the mortgage every month (and have some left over) it is just as likely that by investing in the wrong funds, I could end up short - very short - and theoretically end up losing my home.

Similarly here, the increase in cash value may be low - in terms of overall percentage - but on a par with what bonds are paying these days - and about as secure.   And in addition, there is $100,000 in death benefits included in the policy - a feature stocks, bonds, or Real Estate doesn't have.

Suppose I wanted to cash in the policy?  Would there be any tax issues?  As you might expect, the amount you withdraw from a life insurance policy is generally not taxable up to your policy basis.   Of course, what your policy basis is, is anyone's guess.   While I might be inclined to view it as the overall amount of premiums paid over the life of the policy, the IRS will probably take a lower number, as part of each premium paid goes toward the investment portion, and part goes toward the insurance portion.  Consult your tax adviser for more details.  If the policy is worth more than the premiums paid in (as this policy is, after 20 years) there will likely be taxes on the overage - and then some.

For someone cashing in a policy early on, however, there are likely to be no tax consequences, as you have paid in far more than you are getting out.   Note that you can cash out a portion of some whole life policies, although which portion is taxable is a good question for your tax adviser.

So, should I stay or should I go?   If this was a significant part of my portfolio (it isn't) I would think about cashing it in and investing in something sexier with a higher rate of return.   As an adjunct to a portfolio, it makes sense to have some money invested in something "safe" which won't go down in value (even during 2009 these life insurance policies held steady, while some stock investments went down to zero and stayed there).

And that is a sound strategy for investing.   Some folks want to put all their money into risky, high-rate-of-return investments.   They argue that you "get the most back" this way, and when times are good and stocks are doing well (and your particular investments do well) then this might seem to "make sense".   And a lot of people I know did this - investing in  volatile stocks, well into retirement.  During the 1990's and the 2000's, it seemed like a good idea.  They made a lot of money on their investments and ended up with a nice income.   Some of them even dabbled in day-trading of stocks. 

Then 2009 happened, and they lost it all - or about half of it, anyway, sometimes more.   And many panicked and sold at that point, locking in their losses.   I know some folks here on Retirement Island who lost a boatload of money and, well, they no longer live on retirement island.   Trust me when I say you don't want to run out of money when you get old.   Life sucks trying to get by on Social Security.

A diversified portfolio is a better bet.   You might not get fabulously rich (the likelihood of this happening anyway, is very slim) but you won't end up dead broke.   And you only get one shot at this - there are no "do overs".

So, I think I will keep these polices.  Combined with my Real Estate investments, and some government bonds, they represent a little less than half my portfolio.   And at age 55, with retirement on the horizon, it pays to have about half your investments in safe harbors.