Another Risky Home Equity Investment Scheme
Q. I have read several of your articles warning about the risks of Equity-Indexed Annuities and have a related question.
A licensed securities dealer, (but not a CFP or CLU) has proposed that I take $300,000 in equity out of my house before home values plummet and invest the entire amount in an "investment grade" life insurance policy, specifically an Equity-Indexed Universal Life (EIUL) policy.
The attractive features of this EIUL policy include: tax-free growth phase (10 year minimum period), tax-free distribution phase (via loans against the cash value), a tax-free death benefit to my heirs (about $1,500,000) if I die before I cash out the policy, and tax-free distribution of any residual cash value to my heirs. The policy would be over-funded as rapidly as current law allows (~ 4 years and 1 month) to ensure this instrument qualifies as a life insurance policy and not as a Modified Endowment Contract (MEC).
The interest rate the policy pays on the accumulated cash value is based on the S&P 500 Index (minus the dividend return!) and has a minimum guaranteed 2% interest rate if the S&P 500 Index average goes below 2% in any year. The interest cap is 11% and the participation rate is 100%.
Negatives include: high cost of insurance (rising from $1,100 in year 1 to $4,000 in year 10 and to $9,500 in year 20), a "premium expense" of 5% (and 5% of $300,000 is a lot of commission to pay), and "other deductions" of $8,500 per year for the first 10 years (really high compared to similar EIUL policies I have researched in the last couple of days).
If I refinance my home with a 10-year interest-only ARM at 5.5% (fixed for the full 10 years), the EIUL will earn enough over the 10 years to pay off the loan provided the S&P 500 Index stays at or above 5.5% for the same 10-year period. But if the S&P 500 Index averages 7.5%, then my total gain at the end of year 10 will be $65,000 (with $16,000 coming in year 10 alone), and if it stays above 11% (after subtracting out the dividend return), then I will gain $200,000 (with $50,000 coming in the 10th year alone).
It sounds almost too good to be true. Is this program too risky, or too expensive, to warrant investing my home equity?
Are we in a long-term period of declining S&P P/E ratios and, therefore, S&P 500 Index valuation?
If the S&P 500 Index stays below 2% for the entire 10-year period of the EIUL, then I stand to lose $85,000 of my $300,000 investment.
A. I am very familiar with this concept. It has been promoted in a book by a guy in Utah...I can't remember his name.
To be frank, this borders on a scam and is not consistent with any good financial planning principles. The 'advisor' should lose his/her license for this.
This is a new scheme for agents to generate additional commissions. For people like yourself, who are not retired, you don't have a lot of investable assets for 'advisors' to go after and earn a commission on. If you are like most people, the bulk of your investable assets are in a 401(k) or other company retirement program.
The 'pot of gold' that pre-retirees have is the equity in their homes. Because home have appreciated, many have significant equity.
This scheme allows the agents to tap that money when they otherwise couldn't. I've also seen variations on this theme where it is recommended that the homeowner invest the money into an equity-indexed annuity. Those agents probably haven't realized that the commissions are much higher on EIUL policies!
That brings me to the commission. You think that the 5% premium has to do with the commission. It doesn't. The 'other deductions of $8500 per year' give you a better idea of the commission.
Yes, the agent could be making $85,000 off of this transaction. Knowing that will help you recognize the greatness of the conflict of interest on the agents part.
All that being said, this doesn't make sense from an investment standpoint. Like you say, it is very expensive insurance. In fact, it is being sold as an investment instead of as insurance and the fees are very excessive.
Even if you wanted to invest the equity in your home for a period of 10 years or more, it would make more sense to buy a low-cost, no commission term policy to cover the death benefit and then to invest the money either in tax-free municipal bonds or in index-tracking exchange-traded funds (ETFs). The municipals would provide a more stable return that can be in the range you are talking about or the equities can provide the growth that is taxes at capital gains rates.
Moreover, investing on your own will give you the flexibility to make changes if and when needed. It will allow you to participate in the full growth of the indexes without any premium charges, etc. The chance of seeing a negative return over 10 years is very low.
The bottom line is that I don't see where it makes sense to tap your homes equity. It has probably been the best investment you have ever had. You are earning a guaranteed 6% or so (the interest rate on your mortgage) while increasing equity at the same time.
There is too much risk mortgaging it to the hilt for an investment.
Run like the wind from this advisor. He/she does not have your best interest at heart.
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posted by Jeffrey D. Voudrie @ 8:09 AM
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