Should Premium Financing Be Used In Retirement Planning?

One of the most abused areas of Premium Financed Life Insurance over the last decade has been using this arrangement to generate a retirement income stream.

The concept is valid, however there are several ways to cheat the system and lead a client to believe they can put very little dollars in (sometimes even zero), and magically generate a large income stream that will last them their entire lifetime.

I’ve seen so many ridiculous Free Insurance / Free Retirement programs out there, it boggles my mind that anyone would even fall for this.

The biggest problem I have with this concept (and believe me, I have a laundry list of criticisms about this this proposition), is that it attracts the type of client that wants something for nothing, and typically the type of people that want something for nothing aren’t very liquid.

They may have high incomes, but without liquidity, if their income dries up in the future due to market conditions, industry changes, or any business cash flow challenges in general, the client won’t have the ability to weather the storm, even if it is a short-term storm.

They may be able to make the interest payments today, but they don’t have the liquid to make the payments if they lose their income temporarily.

In my younger years – back when I was full of ego – I bought a two-year old Ferrari 458. The down payment was $79,000 (which I could afford) and the monthly payments were $3,100 (which I could also afford). My income could easily support the expense, however I wasn’t incredibly liquid at that time. After a year of ownership, the warranty expired, and the dealership offered me an extended warranty. The cost of a one-year extended warranty was $10,000.

Ouch.

I acquiesced and bought the extended warranty for $10,000 because the Consequence Of Risk could have resulted in a five-figure repair expense. Then a few months later, Ferrari announced they were releasing the new 488, which was going to be Ferrari’s first twin turbo. I realized my car may greatly appreciate in value because it would be the last naturally aspirated Ferrari model, but I also realized that if the new twin turbo version became more desirable, the value of my car might plummet.

If I were truly wealthy back then, and I had a fleet of exotic sportscars in my garage that I was collecting (not flipping), if the market value of my car dropped off a cliff temporarily, it wouldn’t have been that big a deal. The problem was that I was not wealthy enough (at least not by my standards) to absorb a loss because I was planning on flipping the car within 2-3 years. Long story short, I sold the car after only owning it for only a year and half, and that pride of ownership cost me $144,800 to drive my Ferrari for only eighteen months ($79,000 down payment + 18 months of $3,100 monthly payments + the $10,000 extended warranty). That doesn’t even include the annual service, which I believe was somewhere between $7,000 - $8,000.

In my opinion, I was not a suitable Ferrari owner at that time – I was just a braggadocious idiot with a high income. I’d like to think I have matured since then – that I am wiser and less of an egomaniac where I don’t feel the need to show off anymore – but I learned a great lesson from that mistake. You see, I could afford the payments, but I wasn’t liquid enough to afford the risk… and risk mitigation is what a properly designed premium financing arrangement is all about.

Now, there IS a method of premium financing that CAN be responsibly designed to generate retirement income, and the client doesn’t necessarily need to be wealthy where their net worth needs to be above $10 million. If their income can support it, and they’re in an industry that is semi-recession proof, and they have enough liquid to weather a storm or two… a Third-Year Financing (3YF) may be appropriate for them.

Personally, I own a premium financed policy on my life, and my wife owns a financed policy on her life. I’ll explain why we chose to invest in these assets, and perhaps you will glean some perspective on the value of using Premium Financed Life Insurance in this capacity.

We chose this asset class for several reasons. I’m not worth $100 million, but I have a relatively high income, and being in the top income tax bracket living in California, I love the idea of parking money in a tax-free asset that accumulates with a stop-loss feature (the 0% floor in my IUL policy). When I assess whether or not premium financing is suitable for a client in my situation, I break down my adult life into three different stages:

1. My Income-Earning Years.

2. My Retirement Years.

3. My Twilight Years.

During Stage I of my adult life – My Income-Earning Years – I have a substantial personal overhead with a $2.1 million mortgage on my primary residence, another mortgage on my vacation home in Hawaii, lifestyle expenses, etc. My family relies on my earned income to facilitate our lifestyle, so I need to insure the loss of my earned income in the event that I die unexpectedly early. It may sound morbid to think about, but if I fall victim to a fatal car accident tomorrow, or if I die of cancer during my income-earning years, or if my life is ended by some other common tragedy, my family would not be able to maintain their lifestyle and pay our current expenses without my earned income.

The purpose of my policy’s death benefit is to provide my family with the liquidity they need to keep our family home and maintain the comfortable lifestyle they enjoy now. I don’t plan on dying early, but I’ve never met a cancer victim who planned to die early either.

Now, if I am blessed enough to live a nice long healthy life, I will enter Stage II of my adult life – My Retirement Years. By that time, my mortgage will likely be paid off, my son will be a full-grown independent adult, and my overhead expenses may be lower than they are today. At that point, perhaps I will not need as much death benefit as I need today, so I have the option of drawing down a tax-free retirement income stream from my policy. All the while during My Income-Earning Years, the cash value is accumulating tax-free, and is also protected from market crashes due to the 0.00% floor.

These tax advantages and downside protection are extremely appealing to me, and I have found that many clients, CPAs, and estate planning attorneys share a similar perspective on these matters. I don’t know anyone that thinks income tax rates are going to go down. Given this belief, the tax-free growth and tax-free income drawdowns from a Premium Financed Life Insurance policy are of tremendous value. From a tax standpoint, it is like a Roth-IRA-For-The-Wealthy… with a 0.00% floor… with the ability to use leverage in the form of bank capital.

That’s one heck of a powerful combination.

I have a website/microsite – Rothish.com – that explains this concept a series of educational videos. It’s not a Roth IRA, but it's taxed like a Roth, so it’s kind of Rothish.

Then if I’m extremely blessed, I will one day enter Stage III of my adult life – My Twilight Years. If things go moderately well, even after I take substantial tax-free income drawdowns from my policy, there will still be a death benefit that I will leave behind for my son (and my future grandkids, if I’m so lucky to have them one day). I chose to use our Second-Year Financing (2YF) loan design for my policy and my wife’s policy wherein we paid the first year premium out-of-pocket… started financing in policy year two… and we pay the interest due each year.

Back then, I had not developed the Third-Year Financing (3YF) yet. If I was to start a policy from scratch right now, I would absolutely use the 3YF design, hands down. For someone in my particular financial situation – mathematically speaking – it is the most efficient loan model. The chances for outside collateral are perhaps even slimmer than the Second-Year Financing (2YF) design that I elected back when I put my policy in force (and my wife’s policy). It is built so efficiently, and during high interest rate environments – mathematically speaking – it is superior.

I realize that was the second time I used the term mathematically speaking within two paragraphs, and that is intentional. At the end of the day, premium financing should be a mathematical decision based on indisputable backtesting and stress-testing, comparing every other viable estate planning option, as well as all alternative retirement planning options.

Of course every client is different, so our proprietary backtesting software seeks to uncover the indisputable mathematical truth about what asset construction is the most effective for each specific client. But like most high-end solutions, it is not just the product chassis or the bank’s loan terms wherein the proper due diligence needs to be done.

The technician – in this case, the premium financing intermediary – is an integral part of making sure this solution is appropriate and masterfully designed. There are certainly an abundance of bad actors in this industry, and it is hard for most advisors and consumers to know who they should trust. Gimmicks and financial magic tricks can mislead clients (and advisors) into believing all that glitters is gold… and sometimes, the sparkle is coming from fool’s gold.

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