When you think about the different investments that you hold in your portfolio, what do you think of? People typically hold some equity investments, some that pay interest (fixed income), and they may also hold some real estate investments and some derivatives; how all of the different types of assets that you own blend together contributes to the overall return on your portfolio as well as the risk level for your individual plan. Suppose an advisor suggested you consider adding a permanent, cash-value life insurance policy as an asset class to your portfolio. Particularly Participating Life Insurance. People think of life insurance as one particular thing. It is a policy that, when you die, your beneficiaries receive the face value of the policy. Of course, this is a big part of what these policies do, but there is another part of permanent, participating (PAR) life insurance. This additional part of the policy is the cash value. This cash value component makes permanent life insurance a viable option for use as part of your investment portfolio as well. Let’s take a look at how this works.
In this Article:
- Understanding Modern Portfolio Theory (MPT)
- Why is MPT Important?
- Cash Value Life Insurance
- What Makes PAR Life Insurance an Attractive Investment Asset Class?
- Conclusion
Understanding Modern Portfolio Theory (MPT)
At the core of most investment products, you see one correlation. There are investments that are high risk and carry high return potential, and there are those that are lower risk and carry lower return potential. In 1952, an American economist named Harry Markowitz published his idea of the Modern Portfolio Theory, which determined that investors could achieve their best results by mixing high and low-risk investments based on their individual risk tolerance. This sounds common today because this is the way that most investment portfolios are built, but Markowitz was on to something groundbreaking at the time, evidenced by the Nobel Prize he was awarded for his work. One of the key aspects of MPT is that you don’t look at individual investments alone, but instead, you look at how they affect your overall portfolio’s risk level. By doing this, it has been shown that you can construct a portfolio with higher potential returns without a higher level of risk.
Why is MPT Important?
Modern Portfolio Theory assumes that investors are risk averse. This means that for any given level of returns, they would choose the portfolio that demonstrates the lower risk level. Again, this is something that makes complete sense. The key to MPT was that it quantified this idea. Before Markowitz published his theory, most portfolios were built based on trial and error and intuition. It was more good luck if you hit the right risk/return balance for your portfolio. With MPT, there was a formula that followed the correlation between how your individual investments moved. This means you would reduce your overall portfolio risk by holding assets that are not expected to move in sync with one another. If the idea is to hold assets that don’t move in sync with one another to maximize returns while minimizing risk, would it make sense to use cash value life insurance as an alternative to some of the fixed-income investment options?
Cash Value Life Insurance
I need to make one particular thing clear here. There are two styles of permanent life insurance, and the way the cash values in each of them work differently. While it is an effective estate planning tool, Universal Life isn’t the type of permanent policy we are talking about in this article. Instead, we will be looking at Participating (PAR) Life Insurance. These policies are eligible for annual dividends and also have guaranteed cash values inside the policy, so they really make for a strong comparison to fixed-income investments. PAR works based on the fact that premiums are paid and deposited into something called the PAR account at the insurer. The PAR account is invested, and the annual growth that happens in that account is paid back to policyholders in the form of policy dividends. Often, these dividends are in the form of paid-up life insurance, which also has a cash value, so the growth in the value of the policy is accelerated by dividends being paid.
What Makes PAR Life Insurance an Attractive Investment Asset Class?
There are a number of things that make Participating Life Insurance policies attractive as an asset class that can make up a portion of your overall portfolio. Some of these include:
- Cash Value Growth – the growth in the cash value of your policy is laid out from the onset of the policy. When you receive your policy initially there is a guaranteed amount of cash value in it every year that it exists and this amount goes up at each policy anniversary.
- No Negative Returns – again, not a common thing with investments but with a participating life insurance policy the worst case scenario is that the PAR account pays no dividend. If this happened you would see the growth in the guaranteed cash value only, but they cannot take back previous years dividend payments due to poor returns in the current year.
- Tax Deferred Growth – similar to an RRSP, the cash value inside your life insurance policy grows without incurring annual taxes. You won’t be taxed on any of the cash value unless you decide to make a withdrawal from the policy. There is also one major advantage to this tax deferral as well. Unlike your RRSP, which you are forced to draw income out of annually and pay tax on that income, a life insurance policy does not carry a provision with it that, at a certain age, you must begin withdrawing from it.
- High Liquidity – you are always able to access the cash value in your life insurance policy. In the event that an emergency comes up, there are multiple ways that you can gain access to the cash value of the life insurance quickly to deal with your situation.
- Huge Estate Benefit – In the event that you pass away unexpectedly, life insurance truly shines on your beneficiaries. They receive the face value of the policy plus any extra coverage purchased by dividends over the years (fewer policy loans if you had any), and there is an estate bypass feature that protects this money from requiring probate. Another added benefit is increased privacy because it isn’t probated that the proceeds of a life insurance policy never become part of the public record.
Conclusion
Life insurance is a powerful financial planning tool that has applications that fall outside of the traditional applications. If you own a business and are looking for a tool that provides you with both the ability to invest in a product with tax-deferred growth, stable long-term returns, and a huge benefit to any estate plan that you have, you should consider looking into a Participating Life Insurance policy. If you are an individual who would like to avoid the potential double taxation of your estate along with all of the benefits listed above, PAR insurance may also fit into your portfolio.
When you look at building out your investment portfolio, it is important to remember the ideas that formed Modern Portfolio Theory. You should be searching for assets that move with little correlation to one another so that you can minimize risk while maximizing your potential for returns. This is where your financial advisor can help you add some life insurance to your asset mix to get you yet another tool in the ongoing battle against downside risk for your investments. Not sure if this is right for you? Book an appointment with one of the experts at Stara Wealth & Risk Management to review the strategy and see if it is a fit for you.
