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Privatized Banking, Bank On Yourself or Cash Flow Banking Concept Using Participating Whole Life or Indexed Universal Life Insurance
Warning: This is a long post about the use of Participating Whole Life or Specially Designed Indexed Universal Life Insurance commonly referred to as Privatized Banking, Cash Flow Banking, Bank On Yourself, or Specially Designed Life Insurance. Throughout this post when referring to “Participating Whole Life or Specially Designed Indexed Universal Life Insurance” If you have zero interest in this concept, how it works, or if it makes sense at all then this post isn’t for you.
Why This “Privatised Banking” Discussion Will Help You
I often get questions from blog readers and clients about “privatized banking” policies. I think the main reasons this Privatized Banking concept has become such a hot topic as of late, are the following:
- Over the last several years we have had a lot of volatility in the stock market, which has shaken a lot of investors’ confidence in investments like stocks and mutual funds. Not knowing when, not if the market crashes there is a flight to safety.
- We have a large number of baby boomers retiring or nearing retirement that want to begin protecting their assets.
- Banks continue to pay zero interest on bank deposits while charging interest to use their money for big-ticket purchases.
- The public as a whole is a bit more savvy thanks in part to the internet and they are looking for smarter ways to fund their lifestyle and run their businesses.
Though life insurance has not evolved much over the years, certain product features and riders have improved. For a handful of companies, such as F&G, Foresters, Lafayette Life, Ohio National, Mass Mutual, and others, this “banking” concept has become a niche and they have worked to enhance features within their “Privatised Banking” products specifically designed for this purpose.
What I will be covering
I’ll be covering the following information on the use of participating whole life insurance and indexed universal life as a “banking” policy (privatized banking, cash flow banking, bank on yourself, or specially designed life insurance):
- Important Terminology
- How it works
- How it is best used
- How it is poorly used
- Tax Considerations
What you’ll find is that like all life insurance, the idea of “private banking” has its benefits. However, there are things some agents might say about its performance or practical use that is not entirely clear.
It’s important you understand the details of this concept, so you can determine if this strategy is right for your personal situation.
The Privatized Banking, Bank On Yourself or Cash Flow Banking Concept
I am going to discuss “Privatised Banking” insurance contracts specifically designed around this “banking” concept. This type of insurance is offered by several life insurance companies and is not a proprietary design.
Before continuing I want to make a few things clear:
- This is NOT an investment – It is a savings strategy
- After reviewing a lot of different concepts and ideas floating around in the financial industry, I think this concept can be beneficial for certain situations.
- The terminology of “Private Bank” or “Privatized Banking” does not suggest that a policy is an actual bank. The name represents a process of saving or borrowing money that most people associate as activities with a bank. So, the terms “Private Bank” or “Privatized Banking” is referring to the banking activity
- It is common for someone to adopt opinions from someone or something they read. However, I believe that most people really have no idea how life insurance works.
The Idea Behind Privatized Banking, Bank On Yourself or Cash Flow Banking Policies.
Many of us use banks on a daily basis to transact business for personal or business purposes. You have income flow into your accounts and you have bills you pay from those accounts. It is a continuous process of earning, spending, and replenishing your supply of money to meet the ongoing need you have for it. It’s like filling up a gas tank and driving. You have to keep filling the tank in order to have the ability to keep driving.
Aside from these recurring obligations, you may have other things you are saving for such as a new car, home improvements, or a child’s education among other things. These would be considered big-ticket items that you would save for overtime then spend the money on in large chunks. You may even find yourself needing to borrow money from a bank to fund these types of transactions.
Regardless of how you approach these big-ticket items, one thing is for certain, you will save and accumulate money then spend it or you will borrow the money then pay the loan off over time.
Either way, it is a zero sum game considering all arrows lead to zero and requires a continuous need to earn, spend and replenish your supply of money to be able to make those less frequent but large transactions when they are needed.
Capturing and maintaining control over some of this money while it flows through your hands is the purpose behind this concept. It is an idea to have the ability to earn interest on the money you would otherwise spend.
Now, to clarify a point here that many agents and financial advisors get wrong – we are not talking about investing long term with this concept nor are we talking about simply buying life insurance.
The idea is for this to be used as a cash alternative or bank alternative not an investment alternative (however with certain policies the return can be quite lucrative) or a basic life insurance solution. We are talking about fulfilling the need for capital on an ongoing basis using the cash value of the insurance policy.
A “Privatized Banking” policy has a specific feature designed to allow the policy owner access to money through non-direct loan recognition from the insurance company. In other words, the insurance company will loan you money from their assets using your death benefit and cash surrender value as collateral up to the amount of cash surrender value you have in the policy. This allows for your entire cash value to remain inside the contract and continue earning dividends and interest as if you did not take any money from the policy.
This is an important point to grasp because without fully understanding this loan provision it will be difficult to understand why anyone would use this concept in their financial planning.
How A “Banking” Strategy Is “Specially Designed”
Now, there are a few key things you should understand about the term “Specially Designed”. This concept will not work well unless the contract being used has certain characteristics.
To help you out a bit here, it would be beneficial for you to know and understand some of the terminologies that go along with how a “Privatized Banking” policy is designed for this purpose.
To repeat what I stated at the beginning of this post, there are two types of Privatized Banking enabled policies that I work with
Participating Whole Life & Over-Funded Indexed Universal Life
- A participating whole life policy can only be with a mutual life insurance company, which simply means that the company is a private company and is not stock owner owned. If a company is a mutual company, then its policy owners technically own it. This benefits you since the boards of directors are not accountable to shareholders but rather the policyholders.
- LPUA or a Level Paid-Up Addition rider allows policy owners to add more money to the policy than just the required premium of the contract. This provision provides an advantage to the policy owner since they can rapidly accumulate cash to build their “banking system” while also purchasing additional insurance that is paid up.
- An indexed universal life policy has to have certain characteristics that will allow for privatized banking features.
- The main characteristic is that it be “Over Funded”. This is similar to the LPUA feature of the Participating Whole Life policy
- Both use the non-direct recognition loan which is a loan provision where the insurance company will loan you money from their assets using your death benefit (if you pass away) and cash surrender value (while you are alive) as collateral up to the amount of cash surrender value you have in the policy. This allows for your entire cash value to remain inside the contract and continue earning dividends and interest.
An advantage to “Privatized Banking” insurance is that the cash values grow tax-free and you have tax-free access to cash either through withdrawals of principal or through a policy loan.
Now I am not making a recommendation to use this strategy nor am I attempting to convince you that this is a good idea. What I am attempting to do is provide you with the details of what this is and how it works so you don’t decide to do something that you end up regretting later.
Warning: Math Ahead!
In my opinion, some agents/advisors don’t take the time to fully explain how this concept works. There is good and bad to this strategy that I am going to walk you through.
Read this carefully if you really want to understand how this works.
Let me give an example, you have $100,000 in a bank account earning interest, and you withdraw $40,000 from the account, the amount of money remaining and earning interest is $60,000.
Now, let’s look at the general concept behind a “banking” policy and assume you have the same $100,000 in the policy earning dividends (and/or interest) and you withdraw $40,000 in the form of a loan. In a “banking” policy, the amount of money remaining and earning dividends and interest is $100,000.
The policy functions as if the money was never removed from the policy because technically it never was removed. The insurance company lends the $40,000 to you from their assets and only uses your policy as collateral.
Now, you may ask why the insurance company would do this. Well, from their position, it is a simple and safe investment for them to lend money to their policy owners at a competitive interest rate.
On the topic of interest charged on the loan, there is a cost to doing business and for the insurance company to offer this method of accessing money from your policy, there needs to be a benefit for them to make the loan.
The design of the policy is important to be able to recapture the interest paid on the loan through the dividends earned in the policy.
The advantage to a “banking” policy is that it provides an opportunity for you to have your money remain in the policy and continue to grow uninterrupted within the policy while simultaneously using a policy loan from the insurance company to access money and use it.
So, let’s say you have $100,000 in cash value within your policy earning 7% and you take a loan of $30,000 to purchase an automobile at 5% (these loans can be fixed or variable. The insurance carriers that I use cap their loans at 5%) from the insurance company. By taking the money as a loan, your $100,000 remains in the policy and continues to grow. In this example, you are earning 2% on the money borrowed.
Now, since the concept functions using a loan from the insurance company, we need to address the repayment of the loan. The loan on a policy does have flexibility since the insurance company does not have a required repayment schedule.
From the insurance company’s perspective, they can charge you interest every year on the loan and know that if you die the loan is repaid, or if you surrender the contract they deduct the loan balance plus interest before they send you the proceeds from your contract.
The downside to not repaying the loan is that it limits access to money in the future but having the flexibility of how the loan is repaid is one of the advantages of this concept.
Clearly, it is to your advantage to repay the loan since you are likely to want to use money again in the future, and repaying the loan it will allow for more access to money later.
The idea behind this is how money is flowing in and out of your life. It should be viewed as a conduit to funnel money in an effort to earn interest on the money you are planning to ultimately spend anyway.
Now there are disadvantages and problems with this strategy. The entire concept has its limitations.
First of all, the biggest determining factor in whether or not you should consider the use of this strategy is to be honest with yourself and determine if you are a “good” saver. If you have poor money habits and do not have a solid track record of saving money then this strategy is not a good fit.
The reason is due to the temporary illiquidity of cash within the contract. Any person setting up a “banking” policy needs to understand that they will not have access to 100% of their money for up to 5 to 8 years, depending on the age and health of the insured and the capitalization or funding by the owner. The lack of liquidity covers the cost of the permanent life insurance and to disregard the lack of liquidity would be careless.
In the majority of tests that I have run on this concept, what I have found is that the amount of available cash after twelve months can range from 70% to 85% of your first year’s premium.
Now, a good saver seldom needs access to all of their money at any one time, which is what enables this strategy to work. The entire foundation of this strategy is built on having access to money but not necessarily all of your money.
But again, if you are someone who needs access to all of your money immediately (from day one), this strategy is not likely a good idea.
This strategy is highly complex and if designed incorrectly can cause a loss of capital as well as potential tax issues.
Understanding the tax rules is critical when designing a “banking” policy to help avoid an accidental or purposeful MEC (Modified Endowment Contract). How a contract is funded (capitalized) and how withdrawals or policy loans are taken needs to be done carefully to prevent adverse tax ramifications.
Also, if a contract is surrendered or were to lapse while the insured is still alive, there could be negative income tax consequences.
Tax liabilities will occur if the policy lapses or is surrendered and the policy’s cash value exceeds the amount of money you deposited. The difference may be subject to tax.
You may also have a tax liability if while the policy is in force your withdrawals from the policy exceed the premiums paid.
Proper capitalization (funding) of the policy can minimize a lot of potential problems being mentioned. If you do not fund the contracts in a manner where the base of the contract and LPUA rider is maximized within the first 3-5 years, it is possible that the policy could underperform causing your cash value growth to be less than expected.
Underperformance would then be magnified as the contract experiences loan activity. If you are planning to utilize the policy early in its setup (within the first 24 months), it is imperative that you continue to capitalize the policy through year five or at least begin a payback of the policy loan in some capacity. The compounding impact of the interest accumulating in a policy that has early loan activity without proper capitalization or loan payback could very well result in a policy lapsing or requiring unfavorable modifications.
I know this is a lot of information but you have to understand when something is appropriate for your situation and when it simply is not a good fit.
There is no perfect product out there. They all have their pros and cons. You just have to weigh out the good and the bad and determine if it is a good fit.
Let’s look at the pros and cons of using this strategy.
The Cons:
- You do not have access to all of your money for multiple years and in some cases longer if you have substandard health or use tobacco.
- You are buying life insurance so you have to qualify for the policy.
- The amount of money available to you can fluctuate throughout the year based on the insurance company’s proprietary calculations, and what indexes are used.
- If you access cash through a policy loan, you will have to consider the loan interest and the long-term effects on your cash value and death benefit.
- Though you will have some flexibility, the premiums are payable for multiple years. There is a funding commitment to the policy.
- If designed incorrectly there could be adverse tax consequences.
The Pros:
- You have the potential of earning interest on the money you are otherwise going to spend.
- You have a permanent death benefit that once paid for is owned by you or your estate.
- You can earn 5-12+% on money otherwise sitting in the bank earning 0.0-0.75% interest.
- You have the ability to become independent of banks.
- Unlike a bank loan, you set the terms of the repayment of the loan.
- If you are a business owner, you have the advantage of having the money in the policy earn interest while using a loan to invest in your business and earn money on the same dollar.
- Protection against market crashes.
- Have your money shielded from creditor demands, lawsuits, judgments, and liens?
- Built-in tax-free retirement.
For someone looking for guarantees with no market risk and looking for a way to earn interest on money they are storing in a bank, this is actually a fairly clever strategy to consider.
There are exceptions to every rule, so be sure to analyze your unique situation to determine what is best for you. Better yet just get in touch with me and I’ll walk you through these options using your exact situation.
I use a 3-phase approach:
Phase I: Plan Concept & Understanding
Phase II: Plan Design (based on your unique circumstance)
Phase III: Plan Choice (Choose the plan that best suits your needs)
Contact me for more information or to design a plan.
Are You A Candidate for Privatized Banking?