Bank on Yourself – A Review

In a nutshell, the book’s author, Pamela Yellen, advocates using dividend-paying whole life insurance policies, designed with a small death benefit and funded right up to the “MEC limit” to build up cash value as quickly as possible. You then use the tax-free withdrawals and tax-free loans from the cash value in the whole life policy to supplement your retirement savings, or finance large purchases, such as college tuition and cars, using your policy (and paying yourself back – or not – the loan is secured by the death benefit, so it’s the safest loan any financial institution has going).

The idea, in part, is to become your own bank. You’re financing your large purchases yourself, using your life insurance policy, and paying interest to yourself instead of to a bank or finance company.

It’s not a new idea: I’ve seen the same concept in different forms, from Robert Castiglione’s LEAP to the Infinite Banking concept to Be Your Own Banker. Bank on Yourself seems to be the one that’s had the most success getting broad public buy in at the consumer level  in recent years, though a lot of insurance agents use the LEAP system. And, in fact, before we had today’s large and easily accessible mutual funds, and term life insurance got so cheap, there was a lot of financial planning done using precisely this approach.

So should you use the Bank On Yourself approach? Well, as with so many things in financial planning, the answer is “it depends.”

The system is not a scam, by a long shot. And for certain people, it can work extremely well. It works so well, in fact, that banks themselves frequently use the cash value in life insurance policies as tier one capital on their own books, a concept called COLI, for company-owned life insurance.

But the concept is oversold. Actually, as with so many financial products and services and concepts, it’s undersold to the people who can benefit from it and oversoldto the people who can’t.

You will benefit most from the Bank on Yourself concept if you meet most of these criteria:

1. You want or need a permanent death benefit.
2. You have substantial free cash flow to devote to contributing a lot of premium into your policy
3. That cash flow is from a reasonably stable source. There’s no reason to expect you’ll have to lapse it.
4. You can pay the insurance policy up in full, with no more premiums due, by the time you retire.
5. You have already contributed the maximum allowable to your IRA, Roth IRA or 401(k), or you don’t qualify.
6. You make too much money for your children to be considered for need-based financial aid. Assets in life insurance cash values aren’t counted as parental assets for the purpose of computing need-based financial aid under the federal system.
7. You’re going to need to start pulling money out within the next several years. Life insurance is a front-loaded product. Half your first year’s premium or more will go to paying commissions and fees. It takes years, typically, to reach the breakeven point on non-MEC whole life insurance policies.
8. You own a small business and you can use the cash value as a reserve pool of money. (Historically, farmers frequently used loans from whole life policies to borrow money to plant in the spring, and paid their policy back at the harvest.)
9. You like the tax benefits of the Roth IRA and you want to “go big” with more than $5,000 per year, or as much as you possibly can.
10. You might want to retire prior to age 59½ and want a pool of money you can tap without paying penalties or committing to a Section 72(t) arrangement.
11. Your state provides substantial asset protection to life insurance cash values.
12. You want your assets to bypass probate at your death.
13. You may have a substantial estate tax liability at your death, or the death of your spouse (whichever comes later), and your heirs will need substantial cash liquidity to pay the tax rather than liquidate assets in a hurry.
14. You can do it and still get the death benefit you need to provide adequate protection for your loved ones (very important).

Important: Bank on Yourself and similar programs are not for you if you have trouble swallowing a term life premium to protect your family. Premiums on these whole life policies, when properly funded, will run thousands of dollars every year. You need to contribute to these policies at the same level you might fund a big 401(k).

It’s probably not for you if you consider yourself very risk tolerant, and you think you would prefer a bumpy 8 percent return to a smooth 6 percent.

So this isn’t a very revolutionary idea or anything. It’s really reverting to an older concept, and it’s pretty easy to do: You just need a highly rated whole life policy from a dividend-paying mutual life insurance company (stock companies won’t work) that does not practice direct recognition. (This means you still earn interest and dividends on all your cash values, even if you have borrowed against them. For example, you have $100,000 in cash value. You borrow $25,000 to buy a car at 6 percent interest. But the insurance company still pays you interest and dividends of, say 5 percent on the entire $100,000 you started with – not just on the $75,000 remaining.) Not every company does this. Two obvious examples of companies that do – that are excellent candidates for this kind of planning, include New York Life and Northwestern Mutual.

Downsides: While NYL and NM are both solid, proven dividend payors – as are most mutual life insurance companies, they can’t get blood out of a stone. They rely on treasuries to drive their returns, and yields on treasuries are extremely low. Current policyholders are benefiting from past higher yields. New policyholders should not expect to see the same level of dividend payouts as past generations of policy owners have seen.

I should quibble with some sleight of hand on Yeller’s part, too: She uses the fact that treasuries have outperformed stocks over the last 20 years, when that has nothing to do with expectations of future returns. You cannot expect treasuries to continue their past performance over 20 years if the same 20 year treasuries started 20 years ago with yields of 8 percent and now have yields of 3 percent.

Furthermore, Yellen uses the DALBAR study, which we refer to in a recent update, to note that the average investor only saw a return of 3.49 percent annually, for the last 20 years, once you took investor behavior into account. But this is sort of a cheesy metric: The 20 year returns on stocks are much better than what the typical investor will experience – and if you’ve made it this far into the article, and you use a financial planner (like me) you probably aren’t the “typical investor.”

The bottom line: This kind of planning has its place. But it also banks on Congress continuing to grant life insurance the same benefit of tax-free buildup of life cash value and tax-free withdrawals of dividends and tax-free loans. If the rules change, this is going to be tough to unravel.

Our approach, as with everything else, is to balance and diversify. I like this concept for the right people, with a portion of the portfolio – and frequently the portion you devote to safety. Whole life cash value is very stable.

But I don’t advocate using this concept for everything you do. Hold an IRA. Get some money in equities, annuities, and your own small business. Diversify, diversify, diversify.

Index Funds … to Index? Or not to Index?

I’ll tell you flat out, I like index funds. I think they are an appropriate holding for nearly any investor who can tolerate a reasonable amount of risk. So let’s take… a closer look!

What’s an index?

An index is simply a selection of stocks, bonds or other securities that represent a given market. For example, the Standard and Poor’s 500 (S&P 500) is simply the 500 largest companies on the New York Stock Exchange, as measured by the total value of all their outstanding shares. And it’s a very good benchmark for measuring the success of large U.S. corporations. It’s weighted by market capitalization. So the largest company in the S&P 500 (currently Apple, with Exxon-Mobile close behind)

Similarly, the Wilshire 5000 is an index comprised of the 5000 largest companies on the NYSE. The Russell 2000 is a proxy for the fortunes of small cap stocks. There are indexes that measure the bond market, the treasury market, the real estate investment trust (REIT) market and the high-yield bond market. There are indexes for Europe, Asia and South America and just about every individual country in them. There are indexes for gold and precious metals, and for separate industries, like utilities, telecommunications. There’s an index that theoretically, if imperfectly, represents just about any asset class.

So what’s an index fund?

An index fund is simply a mutual fund (or exchange-traded fund) that tracks a given index. Meaning, they hold the same stocks or other securities in the fund that are in the index, and in the same proportion – almost always weighted by market capitalization.

Why index funds?

Well, to understand why people use index funds, it helps to understand a little bit about the theory of markets and investing. Index funds are based on a couple of postulates:

1. Markets are efficient. That is, the securities markets factor all known and knowable information about a security into the price of a security very quickly. News is “baked in” to the price of a stock before the news even becomes widely known.
2. It is therefore very difficult for individual investors to find bargains at any kind of advantage.
3. Money managers, in the aggregate, will tend to underperform their benchmark indexes by roughly the amount of their expenses.
4. You can increase your returns, therefore, by decreasing your expenses.
5. If you simply have a portfolio that replicates an unmanaged index, you don’t have to pay a professional money manager or a staff of overpaid research analysts to pick what securities to buy and sell.
6. Index funds tend to be more stable than actively managed funds – with fewer trades and lower turnover.
7. They therefore incur fewer internal trading costs, such as commissions to brokers and bid-ask spreads.
8. Because index funds have low trading activity compared to most actively managed funds, they also rack up fewer capital gains distributions. They are therefore more tax efficient than most similar actively-managed funds in the same categories.
9. The combination of lower management fees + lower trading expenses + higher tax efficiency is a compelling advantage, over time.

And so, led by a Princeton graduate named John C. “Jack” Bogle, who came up with the concept (though building on some other theoretical work by Harry Markowitz and Eugene Fama), a company called the Vanguard Group rolled out the first index funds.

Now you can buy index funds from just about any major mutual fund company with a fully diversified line-up, and you can buy ETFs via any brokerage company.

Does it work?

Yes. The concept works extremely well. Indeed, in 2011, 84 percent of actively-managed funds underperformed their benchmark indexes, according to a recently released study by Standard & Poor’s. That means that if you picked an actively managed fund to hold for the year, it only stood a 16 percent chance of being a good idea. After all, if your active manager can’t beat the index on a risk adjusted basis, over time, there’s absolutely no sense in paying the manager to do something you can do better on your own, by investing in index funds.

Does indexing always make sense?

No, not for everyone. Index funds are also risky – in that you can lose money in index funds, like with any mutual fund. Some people just cannot tolerate the prospect of losses at all. In these cases, you may be better off in risk free products, such as fixed annuities, GICs (guaranteed investment contracts), money markets, and CDs.
In other cases, an active manager may have a specific strategy that you cannot replicate in an index fund. For example, funds that specialize in arbitrage situations or turnaround situations.

In most cases, though, we do lean towards creating an index fund core to an investment portfolio, and building out from there, depending on the client’s individual situation and risk tolerance.

Obama Supports Same-Sex Marriage Rights. For What It’s Worth.

The move was hailed by supporters of the GLBT community. Previously, Obama had been on record as specifically opposing same-sex marriage, though he demurred on the issue by ordering his Solicitor General not to defend the Defense of Marriage Act  from constitutional challenges before the Supreme Court. (Judging by his Solicitor General’s recent performance defending the Patient Protection and Affordable Care Act last month, however, it could hardly have made a difference!)

While the move provides some moral support to same sex marriage advocates, though, it changes nothing. While the President could have used the bully pulpit in 2009 and 2010 to push a repeal of the Defense of Marriage Act when he had Democratic majorities in both houses he did not. And he cannot repeal it now.

That’s key, because from a financial planning perspective, the Defense of Marriage Act is a huge factor. Let’s take a look at the current state of same sex marriage and what is likely to happen (or not happen) from a financial planning perspective.

The Defense of Marriage Act specifically prohibits the executive branch from extending any benefits of marriage to same-sex couples. This means that even if they are recognized as married under state law, same sex couples do not qualify for the tax breaks normally awarded to traditional marriages.

This brings up an interesting point: Rick Santorum, the former Senator from Pennsylvania who until recently challenged Mitt Romney for the Republican Presidential nomination, was an outspoken opponent of same-sex marriage. When pressed on the issue, Santorum once argued that all the financial and legal benefits of marriage could be obtained under contract law. And it was therefore unnecessary for the government to formally recognize same-sex marriages in order to grant these important benefits to long-term, committed couples of the same sex.

This, however, is not quite true. Contract law does not supersede the Internal Revenue Code, for example, nor state tax codes. Regardless of what the President wants, the IRS cannot, for example, allow same sex couples to claim spousal tax exemptions, because of the Defense of Marriage Act (which was signed into law by a Democrat, by the way).  Nor can they contribute to an IRA in a nonworking spouse’s name.

Same sex couples also cannot, no matter how hard they argue, qualify for the unlimited spousal exemption from estate taxes normally granted to traditionally married U.S. couples – and no contract between two adults can supersede that.

The U.S. military now allows gays to serve openly in uniform. But because of the Defense of Marriage Act, the military cannot grant health insurance to same sex spouses of service members, nor allow them to stay in military housing.

What’s more, the President has thus far refused to make the repeal of the Defense of Marriage Act part of the Democratic Party platform. It’s easy to see why: Localizing the issue does not work well, as same sex marriage has failed in referendum after referendum across the country – most recently in the swing state North Carolina, but also in the reliable Democratic stronghold California. But until there is a critical mass of voters willing to push Congress to repeal DOMA (or at least not put DOMA opponents’ heads on pikes outside of the city gates after the next election), then nothing changes for same sex couples.

It’s not that same sex couples need to do anything different than straight couples do regarding financial planning – it’s just that the basics are much more vital for same sex couples. It’s vital that same sex couples take care of all their basic end of life care documents, like a health care power of attorney, and limited powers of attorney that take effect when one party is disabled. Gay couples should also not count on spousal Social Security benefits in the event one is widowed. They need to have solid life insurance planning in place. For details, see my article on financial planning for same-sex and unmarried couples here.

So while the President has “evolved” to the same states’ rights position concerning same-sex marriage that Dick Cheney held, it’s too late for that to do any good for same-sex marriage advocates. And when he declined to push to repeal DOMA, while it would probably cost a lot of downticket Democrats their elections in 2012, it reminded me of nothing so much as Charlie Brown running up to kick the football – only to have Lucy pull it away again.