Family Owned Life Insurance (FOLI): Creating Multi-generational Wealth

Creating Tax-free Multi-generational WealthCreating Tax-free Multi-generational WealthPreparing for retirement is filled with assumptions and “what ifs.” As you try to come up with that magical number you need in the future, consider all you have to assume. For example, do we know what rate of return we will earn on our retirement accounts? 

No.

Do we know what our future balance in our retirement accounts will be?

No.

Do we even know if we’ll get out more than we put in?

No.

Do we know what future tax rates will be (even if we are all-but-certain they will be higher)?

No.

Do we really know how much income we’ll need in retirement? What inflation will be like? Or what health care costs will be? If we’ll need long-term care coverage?

No to all.

Do we have any certainty that our retirement planning efforts will actually payoff? If we’re honest, not really. Everything is a guess, no matter how educated.

The point is that retirement planning is full of things we don’t know. And though we can use history as a guide (sometimes effectively and sometimes not), it is no guaranteed predictor of the future. You have likely read in our other posts that, when it comes to retirement planning, we believe very much in controlling what you can control. Whether its protection against market downturns, taxes on your retirement income, ensuring you don’t run out of money, etc., controlling what you can helps tremendously in the predictability of your retirement lifestyle.

Still, we cannot control everything. However, a simple strategy called Family Owned Life Insurance (FOLI) helps put one extra element of predictability into your overall arsenal. FOLI offers you a future tax-free lump sum (sometimes referred to as a “tax-free endowment”) whose value is known ahead of time. You know how much you put into it and you know how much you will get of it. By contrast to a 401K, IRA, Roth, LIRP, brokerage account, commodities, or real estate (or any number of other vehicles for saving money in), you don’t know what the end result will be.

Here’s how it works—and, fair warning, it’s going to sound morbid at first. But stay with us. It’s actually quite the opposite. None of us get out of here alive, so goes the saying. So far, that’s proven 100% true. The question then becomes, if we all eventually graduate from this life, “Why die for free?”

Family Owned Life Insurance is a scenario where a middle aged generation (presumably those in their 30s-50s) purchase a permanent insurance policy on one parent or the other, or both. This can be done by siblings as a group, or individually, purchasing a tax-free death benefit/endowment of anywhere from $100,000 to well into the tens of millions.

First Example: Dad Age 69

Consider this fairly typical scenario. Assume dad is 69 years old and in decent health (nothing superhuman, just average health for his age). You desire to purchase a tax-free death benefit on him of $500,000. After some research, you discover a suitable permanent policy that will guarantee the death benefit through age 100 for an annual premium of $11,500. Life expectancy (LE) for a male age 69 is roughly 14 years, making dad’s LE about age 83.

That’s the scenario. Remember, we said this was going to sound morbid at first, but does this change one thing about the facts? If we didn’t buy a tax-free death benefit on dad, would he be immortal? No. Is he somehow going to pass away sooner than he would otherwise? Of course not.

Now, we’re using this as a retirement planning strategy, so we have to see the math. We know what the input will be ($11,500/yr); we know what the outcome will be ($500,000 tax-free). But is it a good financial endeavor?

Here’s how it breaks down:

If dad lived until life expectancy, we would have essentially invested $11,500/yr for 14 years and received a tax-free endowment of $500,000 at that time. That constitutes a 14.18% annual tax-free rate of return. And the end result was known the whole time. No matter who you are, it’s difficult to not be thrilled about a 14%+ compound annual return leading to a guaranteed future lump sum value.

What would the annual rate of return have to have been to achieve the same result from a taxable account, such as a brokerage account with stocks/bonds/mutual funds/ETFs?

We challenge you to show us a 14-year time period in your current portfolio that has achieved these rates of return without the inherent risk of the investment markets and no uncertainty about the future nest egg value. We’d bet our reputations that you can’t. And considering the low-risk nature of this strategy, we’d suggest you’d have to find a CD at the bank (or something similar) to equal the risk profile of FOLI.

Not everyone lives to so-called “life expectancy.” So, let’s assume dad lived from age 69, when we bought the FOLI policy, to age 75. This shorter lifespan is not what we would hope for, but it happens often. What would the rate of return per year be then?

61.12% tax-free.

In other words, you would have to invest Ş11,500 per year somewhere else and get a net (after-tax) return of over 61% per year to match FOLI.

And these are typical numbers we see regularly.

What would the annual rate of return have to have been to achieve the same result from a taxable account, such as a brokerage account with stocks/bonds/mutual funds/ETFs?

Stratospheric returns, to say the least. But perhaps dad happily lives past life expectancy to age 90. What would the rate of return on our tax-free death benefit be then?

About 6.2%. Now, for a tax-free, known future value (i.e., low risk endeavor), is that a reasonable rate of return? Of course! Every day, people take much more risk than is required with FOLI to try and achieve a 5-7% average return, especially in the lower-risk portion of their portfolios.

Do you know any CDs or Money market accounts currently paying between 7.75% to over 9.5%?

Why is the future value you will receive guaranteed (so long as you pay the premiums)? Because, as we have covered, we all eventually pass away. This is a certainty. Further, when you purchase a FOLI policy through an A or A+ rated insurer that has been around for a century or more, you have the closest thing to a certainty you can get, in our opinion. After all, no insurer has failed to pay a death benefit for over 500 years. Banks and Wall Street firms cannot even come close to a similar claim. In fact, during the Great Depression, when thousands of banks were failing (it is estimated that over 9,000 banks failed following the crash of 1929), only 20 insurance companies were forced into receivership but still honored all financial commitments.

In other words, for every 500 hundred bank failures, there was one insurance company that struggled during the greatest economic upheaval of the past century. Life insurance companies are the financial backbone of the country’s economy.

Can you see how FOLI and its tax-free endowment might fit into an overall retirement strategy, add some certainty to the future, all in a tax-efficient way?

Second Example: Mom Age 75

Let’s assume mom is age 75 for our next example, and we decide to purchase a tax-free endowment of 5250,000 on her life. She is in standard health. For a female aged 75, mom’s LE is 87. The tax-free death benefit might typically cost around $8,000 per year. So, that’s our required input. Just as with dad above, we’ll assume death at LE, a few years prior, and a few years after, showing the rates of return for each scenario.

$250,000 TAX-FREE PAYOUT

And the required annual tax-equivalent (taxable) return:

TAX BRACKET

Obviously, the numbers are compelling. Perhaps such a strategy is a welcome complement to your overall current retirement strategy. Should FOLI be your only retirement strategy? Absolutely not. It should complement your existing tax-efficient strategies (Roths, LIRPs, and perhaps matched qualified plans).

Why Are The Numbers This Good?

What this question is really trying to ask is, “How can the life insurance companies do this? Won’t they go broke?”

Well, if every policy holder held their policy until death, this would never work. In fact, life insurance would not exist. But, through actuarial math (and vast experience), they know they will come out ahead in the end. Why? Because, according to LIMRA (Life Insurance Marketing Research Association), only 3% of all term insurance policies ever pay a death benefit. If you had to blink at that, we understand. A whole 97% of term policies never pay out a death benefit because they lapse without value before life expectancy. This is also why, incidentally, term insurance is a poor policy for Family Owned Life Insurance. They are designed to lapse before life expectancy. Try buying a term policy that extends beyond your early 80s and you’ll be very frustrated. Term insurance is by far the most profitable type of policy to an insurance company. That’s why they love to sell you term insurance.

If you wanted to roll the dice and use term insurance for FOLI, you can, but your chance of collecting absolutely zero after all those premiums is, well, 97%. Yes, you might be able to convert it to a permanent policy before a certain age, but the premiums at that time will be much higher than they would have been had you used permanent from the beginning, potentially eroding your rate of return when the tax-free death benefit/endowment pays out.

What about permanent policies? What is their lapse rate? This might be shocking, because a “permanent policy” is intended to last your entire life until death. However, 87% never pay a death benefit because policy holders cash them in or simply let them lapse when they get older. That means only 1 in 8 actually pays out. That’s how the math works. For every policy that is held until death, you have 7 other policies helping to pay for it because those 7 will not be held until the death of the insured. Those are the cold statics.

That works to your advantage with FOLI, giving you a potential fantastic risk-adjusted return. It’s the best type of leverage.

Some Advantages

• No Market Risk—Most vehicles used toward retirement—whether stocks, bonds, real estate, commodities, etc.—are all subject to market forces and extreme volatility. Of course, upward volatility is good! Unfortunately, you are likely to deal with severe downward volatility several times along the way that can be devastating to your nest egg.

In 2008, the S&P 500 lost nearly 40% of its value. From October 2007 (the high) through March 2009 (the low), the S&P lost 51%. Oil went from $147 per barrel to $29 per barrel. Real estate tanked. Happily, those things recovered but it took many years, while heartburn medication sales went through the roof. People were nervous and scared. A similar occurrence happened in 2000-2002 (the dot com bubble), in 1993, in 1987, and on back for as long as markets have existed. During each of those crashes, what happened to the value of FOLI?

Nothing. Its value remained unchanged. If the market crashes, FOLI doesn’t care. If inflation skyrockets, FOLI doesn’t care. If taxes double in the future, the FOLI death benefit is still tax-free. If real estate sinks again, FOLI remains unaffected.

FOLI is highly insulated to the rest of the market and your holdings that are swayed by those market forces. Predictability is a wonderful thing.

• Low-correlation—Highly related to the above (see what we did there?), FOLI is not a stock, or a bond, or a commodity, or a currency, or real estate. It is an asset class unto itself, not linked to more traditional types of holdings. Thus, it allows you to gain a truly diversified asset in your portfolio, rather than yet another stock/bond/mutual fund that has a high-degree of correlation to your existing holdings.

Family Owned Life Insurance is not just an low-correlated asset, it is truly uncorrelated. Unconnected. Independent. The movement of other asset classes does not influence the tax-free value of FOLI. 

• Control What Can Be Controlled— FOLI allows you some additional elements of control with your retirement planning not usually possible with other holdings.
  • Known future value of the nest egg
  • No taxes
  • Known investment amount (the premium) needed to hit the goal

Most people throw money into a retirement account, assume a growth rate, and pray it works out. Just imagine knowing what the end result will be. If you purchased a $1,000,000 tax-free face amount (technical term for death benefit or endowment), you know you will receive that $1,000,000 in the future. It’s there. Inevitable (assuming you outlive mom and/or dad, but even if you don’t, your heirs inherit ownership of the FOLI policy like any other asset). Really, take a moment and run through how much stress this takes off your mind, being certain that a portion of your retirement needs are assured and not dependent on whether or not an unpredictable market performs favorably for you, and at the right time. It’s hard to overvalue this element.

“I’m putting $1,000/mo into my 401K. I don’t know what the end result will be, or what taxes will be when I retire, but I hope it works out. I’m also putting $500/mo into my Roth IRA. At least I know the gains won’t be taxed, but I still don’t know how much I’ll get out of it. I hope it works out. But, I do have a $300,000 FOLI policy on my mother that I put in $600/mo for, and I know I will get $300,000 tax-free from that. No hope required.” [Sigh of relief] 

• Tax-free—The Honorable David M. Walker, former Comptroller General of the United States under two presidents (Clinton and Bush II), testified before Congress that in order for the country to deal with the skyrocketing debt and cost of social programs, taxes must double. The Comptroller General is basically the CPA for the nation. No one would know the books of the country’s finances better than someone in that position. Mr. Walker has written a book and made a documentary on this topic as well. That was when the national debt was only around S8 trillion (circa 2007). As of this writing, it’s just shy of $29 trillion.

Politicians, economists, and financial experts by the droves have made similar statements. It’s a dire situation. As it relates to FOLI, the endowment that FOLI bestows is tax-free. So, if taxes rates do double in the future (or rise significantly), FOLI does not care. Your endowment is still tax-free. If Congress cuts deductions significantly (a sneaky way of raising taxes without actually “raising” taxes), FOLI is unaffected.

Remember, the easiest way to “earn more” is to keep more of what you already are earning or already have. Reducing or eliminating taxes is the most effective way to do this since taxes are the largest fee we pay in retirement. 

• Creditor Proof— Most states protect the death benefit of an insurance policy from creditors. Bankruptcies and civil lawsuits rarely, if ever, have claim on the proceeds of insurance policies. Remember, there is no cash value build up within the FOLI policy to even try and attack. It is a future lump sum that will pay out as a tax-free death benefit/endowment. Paper assets (stocks/bonds/mutual funds, etc.), real estate, and other assets can often be attacked in a civil or bankruptcy proceeding against you. This is rarely, if at all, possible with FOLI.

Ease of Planning—Perhaps we’ve already covered this enough, but it bears repeating in a slightly different light. One of the best ways to prepare for retirement is to take the time to really imagine what you want your retirement to look and feel like.

Suffice it to say that when you have a large portion of your retirement needs taken care of by knowing what the future value of this slice of the pie will be, you can more confidently plan out your golden years. Not to mention you’ll sleep better now as you work toward retirement.

Alternative Methods of Structure

The scenarios we depicted above assume an annual (or monthly) premium. What about a larger lump sum deposit upfront? That structure can easily be accommodated, and often ends up being less expensive over the long run, thereby potentially increasing your rate of return.

Also, we could utilize a second-to-die policy, where both parents are insured but the payout only happens after they have both graduated from this life. This is particularly helpful if one parent is not healthy enough to qualify for insurance on his or her own, or at least not at a low cost.

An advanced structure is to use premium financing to enhance the tax-free death benefit. This is not available to everyone, as there are net worth requirements before lending institutions will consider you as a premium financing candidate. In brevity, using the first example as a template, what if we instead used our premium payment of $11,500 to finance a $230,000 loan at a 5% borrowing rate? Then, we’d use that $230,000 to buy a much larger tax-free death benefit with a lump sum payment, and our $11,500 is used to service that loan. Thus, the FOLI premium ($230,000 lump sum) has been financed (using the $11,500/yr to service the loan). In either case, we’re sending $11,500 out the door, right?

The tax-free death benefit on dad would now be about $1M instead of $500,000. The lending institution collateralizes the death benefit so that they are paid back their loan out of those proceeds (assuming you haven’t paid it off previously), leaving a net tax-free death benefit to you of $770,000.

Now what are you rates of return for your annual investment of $11,500?

Premium financing can be a powerful enhancement to a Family Owned Life Insurance strategy. Even without premium financing, we find the math for FOLI on its own quite compelling.

Some Drawbacks

Like every strategy, FOLI is not perfect. Though it gives us a known future tax-free lump sum that is extremely predictable, there are some negatives.

First, we don’t know when this payout will occur because we can’t predict when mom and/or dad will pass away (only that they will). That can make this portion of the retirement strategy a bit squirrelly to factor in, which is why it certainly should not be the only arrow in the retirement quiver. However, the certainty of the eventual tax-free payout is notable. 

Second, health concerns. If mom or dad is not in insurable health, FOLI will not usually pan out. That being said, many things are workable, including high-blood pressure, high-cholesterol, previous bouts with some types of skin cancer, and many other conditions that typically come with aging. Often, a second-to-die FOLI policy, discussed above, is a solution to this challenge. 

Third is liquidity. Retirement vehicles, such as 401Ks, annuities, IRAs, Roths, and LIRPs allow you access to the proceeds inside them. Yes, taxes and/or penalties might apply, but there are funds available to you if you had to get to them. FOLI is more like a pension from this perspective. There are no proceeds to get to along the way. There is typically no cash-value build up (or very little) within the policy by design. So, while typical retirement vehicles do not offer a predictable tax-free ending value (like FOLI), they do have some liquidity for you if needed along the way. 

Fourth is inflexibility. While some policies used for FOLI can allow flexibility along the way if you experience cash flow troubles, FOLI in general is a rigid endeavor. Do not bite of more than you can comfortably chew. In situations where you cannot continue with FOLI due to devastating financial changes, the possibility of selling the ownership of the policy through a life settlement will usually be available, allowing you to potentially recover your investment and perhaps come out ahead. 

The fifth and last drawback we will mention is what might be called an “illogical aversion" to life insurance. Some absolutely despise life insurance as a financial tool, despite the math. After understanding the math involved here, especially the potential superior risk-adjusted returns, and you can’t bring yourself utilize FOLI as a financial tool because of “life insurance," we will simply stare in bewildered befuddlement. Understand that this is a tax-free retirement strategy, like a Roth. WHO CARES what the engine is? Let the math do the talking. We want tax-free retirement strategies. PERIOD. Don’t trip over a dollar trying to pick up a dime.

In The End

FOLI offers a potentiality powerful complementary tax-free strategy to your overall retirement planning. It belongs in the conservative portion of your portfolio, though the potential returns can prove much more rewarding than typical conservative holdings.

A word on the "morbid" perception of this strategy. First, this is not new. Wealthy families have used the positive leverage of life insurance for centuries to create multi-generational wealth and continue to do so. This is not just for the wealthy, however—it’s available to everyone. Whenever we introduce this to a client, the reaction is almost universal: “It sounds good, but it feels so morbid!”

We understand. After explaining the strategy to a client’s parents, the reaction there is also nearly universal: “You mean I can leave my children something meaningful that I don’t even have to pay for? Why didn’t we do this earlier?“

See, many of the aging generation feel some pressure to leave an inheritance behind. This can help relieve that stress. It also frees mom and dad up to spend their retirement savings more liberally, should they so choose, knowing that with FOLI in place, their heirs are more likely to be just fine when they graduate from Earth. Mom and dad understand that death is inevitable, and the perspective of being able to leave behind a greater endowment than otherwise possible by the advent of something inevitable and natural (death) is usually received very warmly. In fact, once properly understood, FOLI is seen as not only an effective tax-free retirement strategy, but as a compassionate endeavor from one generation to the next.

We posed the question in the beginning, “Why die for free?” How about, “Why not create multi-generational wealth for those we love? Why not create a family endowment born of tenderness and love for our posterity?”

We know of nothing that does this as effectively as Family Owned Life Insurance.

Want to discuss tax-free strategies? Talk with us. 

Kristen Cooper, NSSA®

President

Axios Capital Strategies