Limited Pay Life Insurance Policies Have Cash Value Benefits with TradeoffsMar 11, 2022
Limited-pay life insurance policies, often called “short-pay” policies in the insurance industry, refer to the number of years a life insurance premium can be paid for a permanent life insurance policy that builds cash value.
Pay special attention to the words “can be paid.”
In this article, I’ll go over my thoughts on premium payment duration. I’ll show you what’s happening with limited pay life insurance policies and the tradeoffs of designing a policy with a short premium payment period.
First, a little context:
While cash value life insurance is not new, I think some of the recent popularization of limited-pay life insurance policies is due to people learning and doing research about The Infinite Banking Concept® (IBC).
Infinite Banking is defined as privatized banking, using the cash value of a dividend-paying whole life insurance policy as the platform. IBC is the life’s work of the late R. Nelson Nash and was introduced to the world in his book, Becoming Your Own Banker. Unlock the Infinite Banking Concept.
Cash value, technically called “Cash Surrender Value,” is the present value of the actuarily calculated future death benefit of a whole life insurance policy, less future premium payments. Practically speaking, it’s the amount of money the insurance company guarantees to pay you should you ever decide to “surrender” (give up) the policy.
Because it is a guaranteed amount, the cash value is an incredibly valuable component of a whole life insurance policy. The cash can be accessed through a guaranteed policy provision called a policy loan. This gives the policy owner the guaranteed ability to borrow money from the insurance company, no questions asked. The loan is collateralized by the death benefit.
This leverage, fully-backed by the guarantees of the cash value, is one of the key components to The Infinite Banking Concept.
However, there is an important timing aspect. Because the money we pay in premiums must go toward buying death benefit, there are costs early in the policy that cause the cash value to grow slowly in the early years. This is more than made up for in the later years, but it is this early cash value delay that has caused a lot of confusion, short-term thinking, and mistakes when it comes to policy design. Especially by non-authorized agents claiming to design life insurance policies for IBC.
Cash Value Noise
As this knowledge of cash value life insurance has spread, an incredible amount of (mis)information has been put out there on the various channels (YouTube and now TikTok especially) on how to “correctly” set up a life insurance policy. Unfortunately, much of the information that is being put out there is solely focused on “early cash value accumulation” as the most important factor in designing a whole life insurance policy.
If all other things were equal, focusing on high early cash value would, of course, be ideal. But there is an undeniable truth that most of the tiktokers are missing. And that is: all other things are most definitely not equal.
Life Insurance is an Actuarial Product
A powerful quote I learned from Todd Langford who learned it from Norm Baker:
There are no deals in the insurance business. Everything is a tradeoff between cost and risk.
Since life insurance calculations are actuarial calculations, every policy design trait has a corresponding tradeoff.
There are two main variables we are working with when designing a life insurance policy for cash value, especially when considering large lump sums.
- The underwriting limits
- The IRS’ Modified Endowment Contract (MEC) limits
In very basic terms, the first variable affects how much total premium can be paid. The second variable affects how much of that total premium can be allocated to “Paid Up Additional Life Insurance,” typically a policy rider that helps grow the early cash value of the policy. This is commonly called a Paid Up Additions rider, or “PUA rider.”
MEC rules place limits on how much cash value a policy can have in a given period of time, relative to the death benefit. If the cash value goes above the MEC limit, the policy is no longer considered “life insurance,” but rather a “Modified Endowment Contract” or “MEC.” Unlike life insurance, a MEC is subject to taxation, like that of an IRA.
Because of these variables, there have been corresponding “innovations” in the insurance industry to attempt to provide high cash value while staying within the MEC limits.
Without getting into every detail, because there are a lot of ways to skin this cat, I’ll go back to the earlier quote: Everything is a tradeoff between cost and risk.
There are very legitimate ways to increase the cash value of a life insurance policy. There are also some ways that I would say are illegitimate as they involve the transfer of risk back on to the policy owner. This goes against the very nature of insurance.
Illegitimate Methods of Increasing early Cash Value
The policy designs that illustrate the “best” cash value accumulation, especially unusually high early cash value, are often suboptimal at best. At worst, illegitimate and can cause serious problems in the future, putting the entire policy at risk.
These policies use special, often newly-created, and non-guaranteed policy riders to illustrate better cash value in the early years and beyond. These riders absolutely transfer risk back on to the policy-owner in the form of higher costs and/or reduced benefits.
Limited Pay Life Insurance Policy Design
A completely legitimate way to increase the early cash value of a whole life policy is to design it in a way that premiums are only paid for a relatively short period of time.
To provide a baseline, the industry standard whole life policy is designed to “pay up” (meaning no more premium payments are due) at age 100.
By contrast, limited pay life policies or “short-pay” policies might pay up in 5 years. This means no more premium payments can be made after the 5th year.
There are all kinds of whole life products out there that are shorter than the baseline of paid up at age 100. 5-pays, 10-pays, 20-pays, etc. These are all fine, by the way. I just don't think they are optimal for most people. Especially when implementing the IBC.
For various reasons, a shorter payment period often allows more premium dollars to be allocated to the PUA rider. This increases the cash value of the policy more quickly and provides more liquidity in the early years of the policy. Again, all other things being equal, the more cash value, the better! The problem appears by the fact that there are tradeoffs to limited-pay policy design.
Giving Up Acceleration of Your Capital
The first tradeoff comes in the form of the cash value “numbers” themselves.
Here is a question for you:
If you had a place to put cash that had these qualities:
- Had guarantees, where your money would grow every single year, with no down years
- Had growth ~40x that of a typical big bank
- Was tax-advantaged
- Had creditor protection
- Was liquid and
- Had a no-questions-asked loan provision (leverage)
If you had a place like this to store cash, would you want to only be able to put money there for as short of an amount of time as possible? Or for as long as you possibly could.
This is one of the main problems with limited pay life policies. Right when the policy is “breaking even” and providing incredible acceleration on liquidity, you are forced to stop paying a premium or the policy will MEC.
Here’s an example:
You have a 5-Pay. On the 5th year, you pay $50,000 in premium and your cash value grows by $50,000. By contrast, if this policy could have gone another 10 years, on the 15th year, you would have paid $50,000 and your cash value would have grown by $100,000!
This is where we go back to the beginning of the article where I said, ‘Pay special attention to the words “can be paid.”’
With these benefits, why on earth would you ever want to stop paying a premium? The mindset becomes “how long can I pay a premium!”
The longer you can pay a premium, the more it accelerates your capital accumulation. Remember, whole life is not an investment! It’s a place to strategically accumulate capital.
New Cash Value
So you understand, the “New Cash Value Created” is not the total cash value, that is the new available cash value created for that year. On year 30, it’s like you took $50k from your right pocket and by the time you put it in your left pocket, it turned into $200k.
This policy could have become a liquidity rocket engine. But it all stops on year 5 because of short-range thinking.
Multiple Limited Pay Life Insurance Policies
A counter to this argument is that once you pay up the 5-pay, you then just start your next 5-pay policy.
This can, of course, be done. But only if you still qualify for life insurance!
The fact is we will never be younger than we are today, and we don’t know what our health will be like tomorrow.
So, the big problems that I have with the strategy of buying multiple short-pay policies are fourfold:
- We are planning for the best-case scenario – that we will always be insurable, when obviously we don’t know if this will be the case.
- In many cases, the PUA-heavy design of a short-pay “eats up” the total underwriting amount that someone can qualify for. Depending on how their income has changed since the first policy, they may not even be allowed to buy as much (or any) insurance the next time.
- The PUA-heavy design also maxes-out the “room” in the policy to pay additional, unscheduled premiums, reducing our capacity to expand our system of capital.
- Each new policy has all the new costs to overcome before the cash value becomes a net positive once again. And all these new costs are now more expensive because they are based on your new age which is 5 years older!
I’ve Run the Numbers
We’re going to assume a 40-year-old male can qualify for life insurance every 5 years for 30 years. I ran a comparison of the following:
Six 5-Pay policies over 30 years
A single policy paid for 30 years, effectively a “30-pay”
The results over 30 years? Almost exactly the same.
- The 30 year Net Present Value of the 30-Pay is 5% higher than the 5-Pay
- The 30 year IRR of each is essentially the same. 0.14% higher with the 30-Pay
- The 30 year Total Cash Value is 3% higher with the 30-Pay
- The 30 Year Total Death Benefit is 3% higher with the 30-Pay
- The average available cash value over the first 20 years is 9% lower with the 30-Pay
- The average death benefit over the first 20 years is 44% higher with the 30-Pay
- 5-Pay capacity to accept additional, unscheduled premiums = 0%
- 30-Pay capacity to accept additional, unscheduled premiums = 150%
To the layman, item #5 could be seen as damning. At first glance, this would seem significant because this is an average of 10% less cash on hand with which to further leverage. And on the surface, the lost opportunity cost of the lower liquidity is a legitimate concern.
But it’s the last item, #8, that makes all the difference.
Outside of the lower cash value in the first 20 years, these policies perform almost identically, over the long term, paying the same premium. However, the 30-Pay can accept more (much more) premium, over and above the scheduled premium that was used to make the comparison, without the policy becoming a MEC.
I cannot overstate the significance of this difference.
The results of this capability are that, with one additional premium payment, the 30-Pay can match, then outperform the 5-Pay from every perspective, even in the early years.
Limited pay life policies do perform better from a cash value perspective when compared to longer-pay policies. But only when you compare the duration of the first short-pay.
If we agree that dividend-paying whole life insurance is an ideal place to store cash, then we must compare the two types of policies over the same time frame, with the same inputs. To correctly compare a 5-pay to a 30-pay, for example, we must analyze the same premium going into multiple 5-pays over 30 years.
Over the long-term, multiple short-pay policies will slightly under-perform longer-pay policies, when funded similarly. The only benefit is there is more available cash value, in the early years, with which to perform the banking function. This advantage, however, is completely eliminated with the payment of one additional premium in the longer-pay policy. Something that you cannot do in a short-pay policy without it becoming a MEC.
So, what we’ve determined here is this:
The number-one factor in the performance of a whole life insurance policy is the ability to pay a premium.
There is no super-secret way to “correctly design” a life insurance policy. Everything is a tradeoff. When looked at through this lens, a truly “correctly-designed” policy is the policy that is correct for the individual. And for most individuals, the correct policy is the one that allows them to pay a premium.
A Final Note on Short-Pays
I do want to say that short-pay policies exist for a reason. They can definitely make sense for some people. One example might be a retiree who no longer earns an income but has some money with which to buy a whole life insurance policy. In this case, they may be looking to diversify, offset taxes, or create a better legacy outcome for their family. Whatever the reason, the absence of future income could justify a shorter premium payment period.