A few years ago, I penned a series on the innovations that allowed Life Insurance to protect much more than just your family after you have passed. The first of those articles introduced the new Critical Illness riders that more innovative policies began offering. These features allow the policy owner to accelerate the Death Benefit while they are still alive should they have a qualifying medical emergency (ie. Heart attack, stroke, cancer, etc.). In that article we took a deep dive into the gaps in coverage that often still exist for feds utilizing the government’s insurance offerings (FEGLI & FEHB) and how living benefits could help further protect your income / lifestyle both during your career and in retirement.
The second article expanded on the Chronic Illness rider, which acts as a form of Long-Term Care protection that commonly allows the owner to accelerate up to 24% of the Death Benefit each year (for up to 4 years) should they need financial help aging gracefully. In Part 2 of the series, we also compared the Federal LTC insurance program (FLTCIP) and Traditional LTC policies with the more flexible Chronic Illness Riders. Proceeds from a Chronic Illness Rider benefit follow the “indemnity model” which means, once you qualify, a check is written in your name for you to use as you see fit. Conversely, most Traditional LTC policies follow the “reimbursement model” which commonly requires you to receive care from a professional, pay the invoice, submit the invoice to your LTC carrier, have it approved, and then get reimbursed… which can be quite restrictive even after you qualify for LTC benefits. It is also important to point out that the number one concern with Traditional LTC policies applies to the FLTCIP as well. While LTC insurance can be quite pricey (not to mention that the FLTCIP premiums have gone up dramatically over the years), you may be surprised to learn that the number one complaint is actually not the cost. It’s the “use it or lose it” design that could disinherit loved ones!
Life Insurance with Living Benefits enable one policy (and one set of premium payments) to simultaneously address numerous “what if” concerns and these features are available on both permanent and term insurances for those who can qualify through medical underwriting.
But, unlike term insurance, permanent insurance has yet another feature – Cash Value. The Cash Value of a life insurance policy grows tax-deferred, can be accessed for any reason at nearly any time, and can be accessed in a couple of uniquely tax-advantaged ways.
The ability to accumulate and grow cash value within a permanent policy adds another layer of flexibility that simply is not available with the FEGLI. Since entirety of your FEGLI premium is utilized purchasing a Death Benefit, it is not uncommon for a fed nearing retirement to realize that they have paid $50,000+ into the FEGLI and have $0.00 to show for it so long as they have a pulse. Term can be a cost-effective but the coverage term eventually ends and a healthy policy owner would only have fond memories to show for all of their premium payments when it does.
Alternatively, with a Cash Value Life Insurance (CVLI) policy, the first thing that happens is the expenses (such as Cost of Insurance) come out to purchase the desired coverage. Then, after paying for the coverage, the excess premiums go into the policy’s Cash Value to begin growing. Different types of policies offer different Cash Value accumulation strategies with varying degrees of risk, reward, and volatility. There is no single approach that is considered “the best” because of how many different ways life insurance can be designed to blend legacy, living benefits, market risk and reward, and even tax / income planning goals. Each category of CVLI has different pros and cons that must be weighed in conjunction with your needs, health history, and risk tolerance.
Some policies put more emphasis on offering extra Living Benefits but less emphasis on Cash Value appreciation (and vice versa). Think of it like car shopping – if we don’t walk onto the lot with a blank check in hand, then it is important to rank which features are most important to emphasize in our car search. Do you want a muscle car that emphasizes horsepower (like a policy focused on Cash Value growth) or would you rather trade some of that power for a luxury ride with a premium sound system (like a policy offering more robust Living Benefits)? The answer is subjective to you, your needs, and your value system so it is extremely important to discuss your situation thoroughly with an experienced professional who can help you find and design the ideal plan for your hierarchy of needs / goals.
Regardless of whether growing your policy’s Cash Value is a top priority or simply a tertiary benefit of your coverage, it can help fill in gaps in coverage for feds who hit a rough patch – like an additional emergency fund – or it can supplement income in retirement. Let’s look at a hypothetical 52-year-old Federal Employee who suddenly got blindsided by a heart attack requiring a 10-month recovery but who only had the sick leave to replace 5 months of income. If she had to utilize her emergency funds on the added expenses of copays, deductibles, etc. and that well is now dry, then she may find herself in a real pickle. While the FEHB helped her, neither that nor the FEGLI offer additional emergency funds. Long-term disability only starts after first 12 months so she would may very well have to take a Hardship Withdrawal from the TSP to fill in those remaining months of income. That means she would have to take out the funds her budget required PLUS enough extra to pay taxes and the 10% penalty since she is under 59.5 years old.
If this individual had living benefits, then she could accelerate part of her death benefit (tax-free) because a heart attack is generally a qualifying trigger for a Critical Illness rider. If she did not want to permanently reduce her Death Benefit though, she could elect to utilize some of the Cash Value that had accumulated within her policy and treat it like a second emergency fund. Her policy’s Cash Value can be accessed at almost any time and for any reason – not just qualifying medical emergencies – so if it was our Fed’s daughter who was ill or if their roof got blown off or even if they just wanted to take a vacation then they can use the cash value tax-free via withdrawals (up to basis) or through contractually guaranteed policy loans without additional red-tape on how it is used.
Think of Cash Value as being similar to equity in a home. To access that equity, you can sell part of the property but that permanently reduces the value of that property (like withdrawals would reduce a policy’s cash value), or you can take a home equity loan to borrow against your brick-and-mortar, which reduces your equity without impacting the actual value of the home. A Policy Loan works similarly and while Policy Loans do have a cost of borrowing, they allow you to collateralize your Cash Value without actually depleting the account. Collateralizing, rather than depleting, an asset can have some exciting advantages when the time is taken to truly understand the pros and cons of how it works.
As Feds prepare for a retirement where 99% of their FERS pension, 85% of their SS, and 100% of their Traditional TSP distributions are commonly taxable, some view the potential tax-advantages of a properly designed CVLI policy as the most attractive application for their personal situation. They may be worried about future taxes and design their CVLI to work like a supplemental retirement asset with unique tax-advantages. Moderately healthy individuals nearing or already in retirement often consider CVLI in conjunction with Roth conversions to protect their lifestyle from higher future tax rates by shifting money to the Tax-Free portion of their portfolio. Remember, CVLI premiums also purchase a Death Benefit that can simultaneously help address the owner’s legacy goals, Long-Term Care concerns, and possibly even Critical Illness emergencies. This extreme degree of flexibility makes life insurance into a proverbial Swiss Army Knife of planning opportunities – which is ideal for those of us who’s crystal ball is not working!
While there are inherent risks with all types of financial vehicles, CVLI has the flexibility to empower a single dollar of premium to do double and triple duty towards protecting you and your loved one’s retirement lifestyle both during and after your lifetime. Since Cash Value Life Insurance requires applicants to go through underwriting, not everyone will qualify or get approved with cost-effective pricing. Policies that are improperly managed, lapse, or get prematurely closed out can have substantial tax implications as well so be sure to continue doing your due diligence.