I hope you enjoyed Part 1 and learned the importance of policy design, we now move into the discussion on where WL for CV fits into your overall portfolio.
Part 2 – Diversification and Why Whole Life
Diversifying investments comes from the original concept of Modern Portfolio Theory. This theory is centered around the idea of examining your investable assets (stocks, bonds and cash), while being mindful of your overall risk tolerance. From that examination, you would create a customized asset allocation by combining these assets, in order to maximize growth, while minimizing your exposure to risk. Risk is a complex issue all investors/savers face and implementing a buffer to minimize the negative consequences of it can be tricky. Beyond these three basic asset classes, some investment advisors might recommend real estate or other commodities to further diversify their portfolio. Whole Life, when designed for Cash Value, can be another path for diversification.
- WL for CV is never going to replace your stocks, it acts as a complement.
- WL for CV is not subject to the uncertainty of market volatility.
The fixed income (Bonds, Bond Funds, CD’s, Fixed Annuities, Cash) portion of your allocation is where a WL for CV should be compared and analyzed. All these other fixed income products/accounts can’t offer the same tax efficiency, liquidity, high risk adjusted return, and stability that WL for CV offers.
A properly designed whole life policy has the following differentiators:
- Above market returns – Long-term returns on whole life policies ranges from 4% to 6% with no market correlation.
- Tax Deferred Cash Growth – No annual income tax implications. Owning either induvial bonds or a bond fund could have income tax implications. More on the taxation of bonds in future posts.
- Tax Free Cash Access to your cash value via withdrawals and loans.
- Tax Free Death Benefit paid to the beneficiaries.
Using Life Insurance to Reduce Investment Risks
In addition to the benefits shown above, when an individual reallocates a portion of their fixed income portfolio to Whole Life, besides improving the individuals overall financial position, the greater value may be in the way it reduces one’s overall exposure to risk.
Credit Risk
Each bond portfolio has a different weighted risk, depending on its holdings. Over the last decade, in order to achieve a return on those bonds, your portfolio would be buying more BB rated bonds vs A Bonds. Compare this to that of the insurer which is rated A+ or even AA+. Investing a portion of your liquid assets in a whole life insurance policy drastically reduces the credit risk on the overall portfolio. This reduction in risk not only derives from the direct benefit of a higher credit rating of the insurer, but additionally the diversification benefit of being invested in differing asset classes.
Interest Rate Risk
A bond portfolio is highly susceptible to interest rate risks. If the interest rates rise, the value of the entire portfolio will decrease commensurately. However, WL for CV has a minimum rate guarantee and rising interest rate cans lead to a higher return on the accumulated cash. By investing in an insurance product, an individual can effectively hedge interest rate risk. An optimally hedged portfolio comprised of bonds and whole life insurance can effectively eliminate this risk altogether.
Liquidity Risk
If some immediate liquid cash is required, a bond portfolio offers a less liquid option. Individual bonds must be sold, and this carries an inherent liquidity risk if bond prices have declined significantly. Even if exposures to bonds are gained through an index tracking instrument, there is an inherent liquidity risk involved. The other option is to borrow against the security which is usually capped at 50% of the market value of the bond or instrument. However, in the case of a WL for CV, any fractional amount may be borrowed to meet any unplanned needs while maintaining the tax shield.
WL for CV is not the solution to everything, but it is a smart, stable, secure, tax efficient policy that will add value to your diversified portfolio.
