The Truth about the Bank on Yourself Concept

Newsletter from Roccy DeFrancesco, JD, CWPP(tm), CAPP(tm), CMP(tm)
Founder, The Wealth Preservation Institute 

What is BYOB?

BYOB (also known as the Infinite Banking Concept and Bank on Yourself) revolves around the idea of "creating your own bank" so you can "borrow from yourself" instead of a third party lender like a bank. Most people hate paying lenders and therefore, the idea of borrowing from yourself sounds interesting to many who first hear about it.

Is BYOB a scam? You tell me if the following bullet points give rise to calling a sales concept a scam:

• confuses clients
• doesn't use math that ads up
• doesn't compare itself to other better wealth-building tools
• is sold by agents who don't understand what they are selling
• incorrectly tells clients that a specific type of life policy must be used to make it work

Scam is probably too strong a word to use for the BYOB concept. Just saying it's a concept that consumers are sold without understanding it, and if they did they wouldn't use it should suffice.

What's wrong with BYOB?

In short, BYOB is an A-S-S backwards sales concept that misses the point of using Cash Value Life insurance as a wealth-building tool. It makes no financial sense to fund a policy for seven years and then borrow from it in year eight to buy a car. It makes even less sense to borrow from a life insurance policy to pay off deductible home mortgage debt. The BYOB concept is the opposite of using other people's money to grow wealth; and in an age with historically low lending rates, such a sales approach simply makes no sense.

It also makes little sense to use whole life insurance as the tool of choice with BYOB when an EIUL policy is clearly a better option (even if you use EUIL, BYOB still makes no mathematical sense).

Other People's Money

If a lender would lend you money at 3% where you knew you had the reasonable likelihood of generating returns 6-8%, how much money would you borrow from the lender? The answer should be as much as they will give you.

When you use a lender's money at a reasonable interest rate, it frees up your money to build elsewhere for retirement. Many insurance agents selling BYOB don't understand this. If they did, they wouldn't be selling the BYOB concept, they'd be offering Cash Value Life to build wealth for retirement (not to buy a car).

BYOB protects the client from rising interest rates?

BYOB agents tout that the concept is protecting clients by creating their own bank so they don't have to rely on lenders.

What they fail to understand is that when you properly fund and use Cash Value Life for retirement purposes, you are also creating an emergency pool of money. The only difference is that you are not funding it with the intent to borrow from it in year eight to buy a car (which mathematically makes no sense). If an emergency comes along, the cash in the policy can be borrowed from. If no emergency, then the cash is allowed to grow tax-free for years and can be used in retirement (the ultimate goal of most clients).

Summary

I've talked with so many BYOB Kool-aid drinkers over the years I've lost count. I've never talked with one who compared the BYOB concept to other wealth-building tools to create retirement cash flow. Any sales concept that is sold in a vacuum (not comparing it to other alternatives) is a disingenuous sale.

I submit to all readers that if you have not compared BYOB to using other wealth-building tools for retirement, you should do so.

Life Insurance: Index Universal Life vs. Whole Life

One of the most common questions we are asked by both consumers and life insurance agents: Which one is better, Index Universal Life or Whole Life? Here's the answer. Almost everyone wants to get the best deal, the best value, the most return on their investment, and almost everyone wants to avoid significant risk when possible. This is true with life insurance as much as with any other product. Unfortunately, life insurance is relatively complex, and to add to the confusion there are a lot of opinions on the Internet that are NOT based on actual facts. These fallacious opinions are almost always offered by people with an agenda contrary to consumers best interest, usually based on willful ignorance, myopia, confirmation bias, mental accounting, and even stupidity. A savvy consumer uses a professional life insurance agent to examine the facts, and then chooses the policy, or portfolio of policies recommended by their agent that best solves all of their problems. Invariably, permanent life insurance decisions fall into two distinct objectives: Highest Internal Rate of Return (IRR) on Death, or Highest Internal Rate of Return on Cash Value Accumulation. Some policies try to solve both problems, but that is almost always a sub-optimal solution, because no policy can do both extremely well. If you're buying life insurance for liquidity at death, the policy design and premium structure will differ greatly from a life insurance purchase to fund stream of income at retirement. This should be intuitive, but we routinely find policy owners that own the wrong kind of insurance for their current financial planning objectives. For example, we find that some people who own permanent life insurance that really should own term insurance. Likewise, we find policy owners that own term insurance that really should own a permanent cash value policy, either because their needs are never going away, or they suffer from reverse discrmination in the retirement funding area. These permanent life insurance policy needs include: Cash for estate preservation due to income taxes, federal estate and gift taxes, state inheritance taxes, and capital gains taxes due, Cash business continuity and executive succession Phantom income tax reduction using group-term carve out Funding for excess benefit plans to correct reverse-discrimination in the qualified plan arena (nonqualified deferred compensation, select exectutive retirement plans, executive bonus plans, split dollar plans, death benefit only plans, etc.)  Funding for defined benefit pension plans Wealth replacement for Charitable Remainder Trusts Pension Maximization for workers eligible for a Defined Benefit Pension Social Security Maximization and, Supplemental Retirement Income To obtain the maximum IRR on death, one needs the highest death benefit in relation to the premiums paid. On the other extreme, in order to obtain the maximum IRR on cash values, one must pay the highest premium in relation to the death benefit. When the need for death benefits we identify are permanent, AND/OR there's a need for cash value accumulation, the two policies that are most commonly compared are Index Universal Life and Dividend Paying Whole Life. This begs the question: Which one is better? You decide... Type of Life Insurance: Index Universal Life Whole Life (dividend paying) Premiums Flexible Fixed Death Benefits Adjustable Fixed Cash Values Cash values grow with Index Linked Interest - market sensitive, with participation rates and/or interest rate caps set at the discretion of the insurance company, subject to guaranteed minimums/maximums set in the policy. Potentially higher interest than current fixed yields, with a hard floor (interest can never be less than zero, may be guaranteed to be as much as 3.00%).  Guaranteed cash values based on an assumed interest rate, usually 3% or 4%, plus non-guaranteed dividends, either a portfolio yield or new money rate, declared annually by the insurance company, based on the investment returns in the insurance company’s general account. Policy Loans Yes Yes Loan Interest Rate Fixed OR Variable, policy owner choice Fixed or Variable, determined by policy Tax Free Retirement Yes, when properly structured, policy can produce a lifetime of tax-free retirement income, as long as the policy stays inforce until death. Yes, by surrendering dividends to cost basis, then policy loans. Some policies may perform better by using only policy loans. Overloan Protection Yes Maybe Policy can be used as a Family Bank Yes Yes Arbitrage Potential Yes, with Variable Loan Interest Maybe, if policy uses Non-Direct Recognition Dividend scales. Sizzle - The Unique Owner Benefits Maximum Cash Accumulation Potential, with index linked interest credits upwards of 13-14% or more per year, with principal protection -- No market risk, cash values never lose when the stock market index is negative. Flexible premiums andadjustable death benefits. Guaranteed Cash Valuesscheduled in contract, plus standard non-forfeiture options -Reduced Paid-Up and Annuitization (partially taxable). Downside Positive stock market index growth is NOT guaranteed. What this means to you is that cash values may earn zero percent interest when index is negative, but that's actually a positive result. Dividends are NOT guaranteed. Industry wide, dividends have been trending downward for the last two decades, as long term interest rates on bonds have trended downward. Whole life premiums and death benefits areNOT flexible, generally. Which one should you own? If you want maximum non-guaranteed cash value growth potential for either a lump sum cash need, a tax-free retirement income stream, or maximum non-guaranteed internal rate of return on death, and you want or need a flexible premium structure, then Index Universal Life may be the superior choice for you. If you want guaranteed cash value growth with some sacrafice on the potential upside during periods of stock market index growth, or if you want the guaranteed option to elect a Reduced Paid-Up policy at some point in the future, and you have substantial discretionary cash flows so that the non-flexible premium schedule does not present a problem, then Dividend Paying Whole Life maybe the superior choice for you. Amateur agents always recommend the same type of policy, regardless of the needs of the client.Professional agents recommend the policy, or portfolio of policies, that best solves your problems and meets your needs. The purchase of life insurance is a serious decision, with significant financial implications for you, your business, and your heirs. That is why it is always a good idea to use a professional insurance agent when purchasing life insurance. The best choice is an insurance agent that has earned the professional designation Chartered Life Underwriter.

A Review of Indexed Universal Life Considerations

Originally Published in April 2010 by: Nease, Lagana, Eden & Culley, Inc.

Indexed Universal Life (IUL) Considerations
The following are common considerations when purchasing an IUL policy:
1. Index crediting levers may not be guaranteed.
2. Index returns do not include dividends.
3. Underlying IUL insurance charges may be higher than traditional UL.
4. Required rate of return on index call option package – aggressive or sustainable?
5. Comparing historical IUL crediting rates to a traditional UL current crediting rate offered today may not be appropriate.
6. What is an appropriate IUL crediting rate assumption?


Index Crediting Levers May Not be Guaranteed - It is true that the current cap and participation rates may not be guaranteed and therefore may be changed by the insurer at the end of each segment term. However, both are also subject to a guaranteed minimum. As an example, the current cap may be 12% with a guaranteed minimum of 3%, and the current participation rate may be 110% with a guaranteed minimum of 100%. Most IUL products with current cap rates that are not guaranteed provide a current participation rate of 100% that is guaranteed. If an IUL product does not contain a cap, then the current participation rate is typically not guaranteed. 


The current floor is typically guaranteed. As an example, the floor is 0% on a current and guaranteed basis. Both current and guaranteed index levers should be noted and considered when reviewing and comparing IUL products. However, the non-guaranteed nature of IUL crediting levers should be put in perspective. Traditional UL current crediting rates and whole life (WL) dividend interest rates are also not guaranteed and subject to a guaranteed minimum. As an example, traditional UL current crediting rates today typically range from 4%-5% with a guaranteed minimum crediting rate in the range of 2%-3%. Some current UL crediting rates may be guaranteed for one year but otherwise current rates may be changed by the insurer at any time. UL crediting rates and WL dividend rates are supported by a portfolio of bonds and mortgages; therefore, as interest rates have declined over the past 25+ years so have UL and WL rates. This same dynamic will also impact IUL crediting levers where a decrease in interest rates may reduce the cap or participation rate as more funds are needed to support the floor. This leaves less funds to purchase the index call options (and vice versa if interest rates increase).

The other dynamic with the pricing of IUL crediting levers is the cost of call options. If the cost increases then the levers may need to be reduced (and vice versa if the call option cost decreases). The cost of index call options will rise with increased equity market volatility (and vice versa). 

In summary, IUL crediting levers may indeed be non-guaranteed components. However, they are subject to guaranteed minimums and are based on disciplined pricing, which is similar to a traditional UL crediting rate and a WL dividend interest rate.

Index Returns Do Not Include Dividends - It is true that IUL index returns typically do not include dividends. This is significant as dividends have historically provided an additional 1% to 4% annual return to the S&P 500 index. The main reason for excluding dividends is that most publicly available and recognized index data is reported without dividends; therefore, the IUL index return is aligned with public data. It would be possible for insurers to price IUL index returns with dividends (a Total Return index), but the cost of the call option package would increase. Because there is disciplined pricing, the increased cost of the call option would then need to be offset with reduced index crediting levers (such as a lower cap) in order for the insurer to maintain its profit target.

Underlying IUL Insurance Charges May Be Higher Than Traditional UL - From a theoretical pricing standpoint there is no reason for IUL insurance charges to be higher than UL insurance charges. However, the reality is that many IUL products do indeed have higher insurance charges. Because the underlying pricing factors of mortality, expenses, and investment yields are very similar (if not exactly the same) between the two products, the insurance charges should also be very similar. But prospective buyers appear to focus more on the index crediting levers, which leads insurers to price with more favorable index levers (for marketing purposes) but offset with higher insurance charges. Prospective buyers should review and compare both the crediting rates and insurance charges for various IUL offerings (as seen in the illustrated values).

Required Rate of Return on Index Call Option Package – Aggressive or Sustainable? - Articles have criticized IUL by stating that aggressive index call option returns are required for the IUL crediting rate to exceed a UL 5 crediting rate. One example stated that a call option return of approximately 60% is needed to support an 8% IUL crediting rate—approximately 300 basis points (bps) higher than UL crediting rates offered today. The numbers behind this example are indeed basically correct, and therefore the required returns may appear to be aggressive and unsustainable. However, remember from earlier in this Bulletin that call options inherently provide leveraged returns. Let’s look at the numbers behind the following example:

• A conservative portfolio yield assumption of 5% 
• As seen in the earlier pricing section, $4.76 will be available to purchase a package of S&P 500 call options based on a $100 net premium and a 12% cap 
• An S&P 500 equity index return of 8% yields $8 (8% of 100) 
• This translates into a 68% S&P 500 call option return (8 / 4.76 – 1 = 68%)

While these numbers are approximate, they do provide a good general understanding of IUL pricing and returns. For this example, an 8% equity index return results in a leveraged return of 68% for the equity call option. S&P 500 call options exist today that support this type of pricing. In summary, while a 60% call option return sounds aggressive, in reality that return is sustainable based on an 8% S&P 500 index return assumption in conjunction with call option pricing offered today and the inherent leverage provided by a call option.

What is an Appropriate IUL Crediting Rate Assumption? - Illustration systems provide a default IUL crediting rate, which may or may not be appropriate for a crediting rate assumption. The default IUL crediting rates can vary significantly from product to product and should not be considered as similar to a UL current crediting rate. The UL 7 current crediting rate is based on the underlying general account portfolio yield comprised primarily of investment grade bonds and mortgages. The portfolio yield is relatively stable and is primarily impacted by changes in new money rates as the portfolio assets mature and new assets are purchased. IUL does not support a current crediting rate as the historical and likely future IUL crediting rates will be quite volatile due to the link to an equity index. Therefore IUL requires the potential buyer to determine an appropriate crediting rate assumption when running illustrations.

There certainly is no definitive answer for an appropriate IUL crediting rate assumption. It may be suggested that the assumption be based on a long-term return expectation but decreased for conservatism. While historical returns are no guarantee of future performance, they can provide a basis for developing an expected future return assumption. Many IUL illustration systems offer hypothetical historical crediting rates based on the IUL product’s current index crediting levers. Some insurers also offer a historical rate calculator, which provides hypothetical historical IUL crediting rates based on user defined crediting rate levers. This allows for comparisons between different index strategies.

For the IUL example (S&P 500 without dividends, 100% participation rate, 12% cap, 0% floor), the hypothetical 20- year historical cumulative annual crediting rate is 8.2% (October 1990 to October 2010). Some rate calculators are more thorough, providing a longer historical time period and a rolling start date by month. Confidence intervals and an average return may also be provided. 

Another consideration for determining an appropriate IUL crediting rate is the current interest rate environment and expectations for the direction of future interest rates. As reviewed in the pricing section of this Bulletin, general account portfolio yields will impact index crediting levers (typically the cap rate). Portfolio yields are currently experiencing downward pressure; therefore, current index cap rates should also be exposed to downward forces. But over the long term there may be expectations for increasing interest rates as today’s rates are at historical lows. Increasing interest rates would provide upward pressure for index cap rates. 

To put the possibility of a changing cap rate into perspective, below are historical hypothetical index crediting rate results based on varying cap rates. The hypothetical historical IUL crediting rates change by approximately 50 bps per 1% change in the cap rate. For the conservative buyer, funding a policy with a 6% IUL crediting rate assumption may be appropriate. A 6% crediting rate is higher than most current UL crediting rates and would appear to provide a cushion even if the cap rate is reduced to 10% based on hypothetical historical results.

20-Year Historical Hypothetical Cumulative Index Crediting Rates:
October 1990 – October 2010
S&P 500 Index (without Dividends), 0% Floor, 100% Participation Rate







As with UL and VUL, IUL requires active in-force management. Illustrated values are not guaranteed and assumptions and performance will change over time. This is particularly true for an IUL product where crediting rates will vary significantly. Policy reviews should be conducted to ensure that the policy remains on target. Inforce illustrations are critical in determining a policy’s status relative to the financial objective. Additional premium funding or a face amount reduction may be considered when actual policy performance falls behind schedule. Reducing premium funding or taking distributions may be considered when actual policy performance is ahead of schedule. A policy replacement, under certain circumstances, may also be an option.

Summary
IUL offers the potential for an enhanced crediting rate that is tied to an equity index (typically without dividends) and guarantees a minimum return. As with UL crediting rates, an IUL crediting rate is not guaranteed and will vary over time. However, IUL pricing is disciplined where the general account portfolio yield and call option pricing will determine the current crediting levers (participation rate, floor, and cap). Call options allow the insurer to transfer the equity index risk to a third party and provide leveraged returns. In many instances IUL insurance charges will be higher than UL insurance charges, and therefore IUL will require an enhanced crediting rate. Based on hypothetical historical results, IUL has provided an enhanced yield of 100 to 150 bps as compared to UL crediting rates.

A critical assumption when illustrating IUL is the crediting rate. Hypothetical historical crediting rates may be used as a basis for setting a crediting rate assumption (even though they do not provide a guarantee for future returns). Hypothetical rates calculated with current IUL crediting levers may be considered conservative as historical levers would likely have been more favorable due to higher historical general account portfolio yields. It may be suggested that a margin be deducted (such as 100 bps, at a minimum) or a 90% confidence factor be considered in order to provide a policy performance cushion.

Many valid considerations have been raised regarding IUL and they should not be ignored. IUL product education will provide the basis for a balanced review. IUL considerations should be reviewed in the context of the risk/return trade-offs and relative to the considerations of other life insurance products such as WL, UL, and VUL.

With an educated review, and a thorough assessment of objectives, it may be determined that IUL is an appropriate product choice for the life insurance buyer.

For Institutional Investor or Investment Professional use only. Article copyright 2014 by Nease, Lagana, Eden, & Culley, Inc. (NLEC). Reprinted with permission. NLEC is an independent company and not affiliated with Fidelity Investments. Listing NLEC does not suggest a recommendation or endorsement by Fidelity Investments. The information and opinions expressed in this presentation are solely those of the author and in no way represent the advice, opinions, or recommendations of Fidelity Investments or any of its affiliates. Fidelity Investments does not provide advice of any kind. There is no assurance that the information is accurate, complete or timely. You should conduct your own analysis, review and due diligence based on your specific situation. The third party products and services mentioned herein are the property of their respective owners. The information provided is general in nature and should not be considered legal or tax advice. Consult with an attorney or tax professional regarding your client's specific legal or tax situation. Fidelity Family Office Services is a division of Fidelity Brokerage Services LLC. Member NYSE, SIPC. Fidelity Family Office Services 200 Seaport Boulevard Z2N Boston, MA 02210 681585.1.0