Written By — David Shafer
History has pointed out that those who sell mutual funds [and stocks in general] tend toward an idealized view of the future that can be rightly called Pollyannaism [having an overly positive view]. While those selling Life Insurance tend to be exactly the opposite, perhaps alarmist in viewpoint. I try to stay in the middle of those two extremes by cementing my strategy into real life experience and data. This “middle-way” will provide the basis for this post.
When comparing two different retirement strategies it is best that we strip away as much of the hyperbole as possible, so I will not demonize those that push either side. 401Ks were originally designed as an avenue to get additional compensation to corporate upper level management. As such it was thought as simply one of many points of compensation, but one that took special consideration about immediate taxation. Long-term tax issues were best dealt with by strategies designed by tax accountants and attorneys. Since those meager beginnings, 401Ks have become the only retirement plans for the majority of workers. Note, that they were not designed to be the majority retirement plans that they have become. So as a retirement tool, they will always be a little off. Most people fund their 401Ks with mutual funds. The mutual funds offered within corporate plans are both limited and have high expenses. In fact, among corporate offered mutual funds the expenses are extremely high, 3% on average.
Universal Life Insurance was developed by Wall Street legend, EF Hutton. It was designed in the 1970s so that high net worth individuals could avoid taxation on their wealth and still receive a decent rate of return on their money. In the early days the wealthy were able to move huge amounts of their wealth off the tax books into these policies without carrying much life insurance. The IRS stepped in and over a 10 year period of time established rules and regulations over the use of UL. The IRS did not stop the practice, but developed UL rules that allow us to create wealth without taxation.
So from the beginning, 401Ks were not designed for long-term tax efficiency while UL was. Over time UL developed three strategies for dealing with the wealth put into the policies [fixed rate, variable, equity indexed]. These three strategies have a history that can point us to which strategy works best for retirement — Equity Indexed.
Using historic data from the two different strategies is a good place to flesh out the different prospects.
Returns from mutual funds that actual investors get are well documented, and over the last 20 years average 3.1%. But remember the variance is extremely high with one-year index returns as high as 36% or as low as -21%. The historic rate of return for the Minnesota Life Index crediting for that same 20-year period, under current cap rates is 8.6%. But that does not include expenses, which are substantial in the first 10 years. When I create policies I am able to run the internal rate of return charts and the illustrations generally point to expenses between .5% and 1.5% depending on age and how the premiums are paid. For the point of this exercise let us take 1% as an average expense, which gives an internal rate of return of 7.6%. You can see that the expected average rate of return from the last 20 years is over twice as high for the EIUL than the mutual fund [7.6% v. 3.1%].
So even with a 100% match you are likely to do better over the long run with an EIUL and no match.
But with the EIUL you are also buying something else, death benefit. Death benefit that will be there for your heirs even after you have taken out substantial retirement income. And an EIUL is also self-completing for your spouse. If you die earlier than you planned, before you have a chance to accumulate fully, your heirs will have a fully funded retirement with the tax-free death benefit.
What happens to your 401K if you die before you have had a chance to fully fund it?
Because of the strategy involved your 401K will show great variance in value from year to year while your EIUL will not. Why is that important? Because we know how people behave. Every time there is a bear market of any consequence millions of people sell their mutual funds. Whenever there is a great bull market millions of people sell their current mutual funds and buy the latest “hot” fund. And whenever we have bad economic times [like now] people get laid off and access their 401Ks incurring penalties and taxes. Every one of these actions dampens their overall returns significantly. And even if you have a rock of a constitution that can ignore all this, what happens when you are close to retirement or just retired and a bear market turns your retirement plan value negative? Your future income is lowered significantly because you don’t have the time to allow the value to come back up before you use the income.
Remember back at the start of this when I pointed out the designs of the two options were different? Well, when you take out retirement income is when this becomes huge. Pulling money from your 401K will create an income tax liability. A liability that can’t be put off any further than age 70½. What will be the taxation rate then? You also will create a tax liability for your social security by having other income. And if you need your money before age 59½ then you must pay an additional penalty.
So after you have paid great expenses to Wall Street, suffered from painful market induced anxiety, had real losses in your retirement accounts right before or after you retire [the chances are close to 100% this will occur in a 5 year window before or after retirement], had mediocre returns over the long run, you then have to pay taxes that are several times more than if you paid them when you earned the income.
And that is the exact situation the majority of folks who chose to fund their 401Ks find themselves in for their main retirement plan.
So the question is, should you buy a 401K or an EIUL? Even with a 100% match, the question can be re-phrased like this:
Do you think you will live a long life, without significant disability or financial misfortune, which might cause you to need to use some of your retirement funds? Do you think you can avoid doing anything in a gut-wrenching bear market that might go on for 20 years or if you make a move, make the right move? Do you think taxes are staying stable or going down in the future? Does it make sense to use a tool not designed for tax-efficient retirement income, but designed exactly the opposite? Or does it make sense to have as one of your retirement strategies a tool designed to move wealth into a non-taxable situation, receive modest but consistent returns, with the flexibility to stop paying premium or curtail the majority of it for short periods of time, and that will be self-completing for your spouse?
Now I know most people will be unable to tell their employer, thanks but no thanks, for that 401K match and that is fine. But just know that, even with the free money, the odds are you would do better with an EIUL.
BawldGuy Here: Though I’ve been sayin’ this since a year before the last huge stock market crash, I’ve never come within shoutin’ distance of sayin’ this well. I’ll add expound on just one thought.
Dave mentioned the time problem created by those years in which your 401K loses money. The time it takes to get back to where you were is lost forever. Over a 10, 20, 30+ year period, the total of those lost years are what crushes what could’ve been a much higher retirement income. We can make up for much in our lives, but we can’t create more time.
Picture yourself having retired in late 2006 with a ‘satisfactory’ retirement, based upon your 401K/IRA. Now, just as you’re gettin’ used to your new life, 40% of your 401K/IRA disappears like steam in the wind.
Now what?
Here’s what — call me at 619 889-7100 — together we’ll figure out what’s possible for you. Have a good one.
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About David Shafer
Is funding an EIUL something that must be done from current income, or can one “rollover” part of their IRA or 401K?
No you can’t rollover into an EIUL. You can take the money out of the 401K and incur the penalty.