How To Create A (Nearly) No-Risk Fixed-Income Portfolio That Won't Go Down


Bond investors are facing the potential for the first bond bear market in many decades.

There is a way to sock away significant amounts of cash, tax deferred, and earn 4% to 7% annual returns.

That capital never goes down and is completely uncorrelated to the stock or bond markets.

The flexibility of the structures provides significant liquidity that can be used in down markets, allowing your stock portfolios to recover without having to sell at low price.

The traditional paradigm for life insurance and annuities stem from the historical sales tactics including high commissions and questionable features of the products. But given the paradigm shift that has started in the fixed income markets, we think life insurance and their related products are essential for retirement income and planning.

For younger investors (less than 50 years of age), life insurance should be an essential part of your retirement planning. Most independent financial advisors ignore life insurance as a planning tool and regard it solely as a means of protecting families from the loss of earnings power from one or both of the parent-workers.

However, life insurance can be much more - it can be a great tool for retirement. In addition to being the financial protection in the case of earning power loss, the structure is a great bucket as a non-correlated asset class.

Let's walk through something for a moment. If you are a high income earner life insurance is the only place with virtually no contribution limits for after-tax dollars. Some insurance agents recommend having approximately $1,000,000 of death benefit for every $50,000 in after-tax annual income. So if you net about $250,000 in after tax income (~$450,000 gross salary per year), they recommend having about $5,000,000 in death benefit.

In terms of using life insurance for a planning tool, there are several ways it can be used:

1. As an inheritance tool

Many retirees do want to leave their children, grandchildren and/or their favorite charities a sum of money once they are no longer here. The problem for people is they do not know their own longevity, meaning without a definite end-date of their need of the portfolio, they will not know how much they can spend per year and leave that specific sum to heirs.

The death benefit on a second to die policy can be used for this end. With this kind of policy in place, once the spouse passes, the beneficiary of the policy would receive a defined sum. That way, they can spend their portfolio down without the fear that there will be nothing left to leave to those loved ones or charities.

2. As an emergency fund

We have highlighted this before but will continue to highlight it again until it sinks in. So few buckets allow the kind of liquidity that the cash value of life insurance does. A life insurance policy that builds cash value has just about daily liquidity. With a whole life (or variant) policy, you can take a loan against it and pay it back later. This can be used as a low-cost mechanism for short-term borrowing, especially now that margin borrowing costs on investment accounts have risen so much.

Another advantage is that the money goes to your account tax free and you have more flexibility than with margin on an investment account. While it varies by insurer, most allow cash value borrowing of up to 90% of the cash value. Lastly, another attractive aspect of borrowing against the policy is that you do not even have to repay them. If you do not pay it back, the death benefit is reduced by the loan amount at death. One caveat is that the loan accrues interest and the rate is typically fairly high, above 7%. That is both a positive and negative since if you do pay it back, you can park more capital into the cash value.

3. As a down market buffer

As a retirement planning tool, cash value that can be tapped in an emergency can offset the withdrawal from an investment portfolio. For example, if you retired in 2006, and were taking out 4% of your capital each year from your portfolio, and in 2008 the portfolio fell by half, your withdrawal rate just doubled. That capital being pulled out is thus not there to participate in the rally of 2009 to the present, resulting in a permanent impairment of your portfolio. If instead you withdrew your living expenses from your cash value life insurance for 2008 and even 2009 and 2010, you did not have to liquidate positions in your portfolio at depressed prices. The amount that this can help protect your portfolio is immense.

The cash value of a life insurance policy never goes down. The policy is credited with the dividend rate and is completely uncorrelated to the market. Many cash value dividend rates were in the high single digits in 2008 so for many investors, it was the only asset that increased in that year. Having this non-correlated asset class during a downturn can be immensely beneficial, especially when you are in the distribution phase.

4. As a bond surrogate

Given the typically higher dividend rate that many of these life insurance companies offer. The cash value of your policy is invested in the insurers general account according to the risk guidelines of life insurance laws. As we noted above, in 2008 many of these companies paid out 7-9% dividend rates with no decline in principal. This is starkly different than dividend paying stocks which may have been paying that much but lost 30% or more in value.

Today, the dividend rates of the top companies are still between 4% and 7%, again completely uncorrelated to the equity or even bond markets. The rates are adjusted annually (typically in December for the following year) and usually only see small adjustments. The dividend rate is correlated to the long-term trends in interest rates which is why they have generally been falling over the last two decades.


Source: Northwestern Mutual Life

If you have an insurance need already, you can create what is called an overfunded policy. This is where you pay more premium than needed to support the death benefit. That added premium payments go directly into the cash value of the policy and immediately begins earning the dividend rate. In other words, you can stuff additional after-tax dollars into your "account" and earn a "risk-free" 4%-7% rate of return. In a 2% interest rate world, generating that mid single digit return, tax deferred, is extremely powerful.

Many use the life insurance policy as their fixed income surrogate instead of investing into a intermediate term bond fund. Given we are in a rising rate environment, bond funds are going to be lower return vehicles. For example, YTD, PIMCO Income (PONAX) is down over 1%. While not a lot, investors are unaccustomed to their fixed income ever dropping.

Imagine for a moment that over the next ten years your fixed income allocation earns 4% or 5% annually, tax-deferred, compared to what is likely a low-single digit regime for core bond funds. That 300-400 bps of outperformance plus the benefit of tax deferral which adds another 200 bps is extremely powerful.

5. To help with tax planning

The cash value of a life insurance policy has been paid using after-tax dollars and grows tax-deferred. Not having to pay taxes on earnings each year makes these structures more similar to an IRA than non-qualified account. When that money comes out, it is paid as basis first. This is another powerful tool as it allows you to take money out tax-free. The only time you pay taxes on your money is when you distribute more than the basis which are taxed at ordinary rates. In terms of a tax planning tool, the tax code gives life insurance significant amounts of latitude.

Tax alpha can be a key planning tool. For example, if you need $175K for living expenses, with $50K coming from Social Security, which is taxable, we can utilize cash value so as to not push you up into higher marginal brackets. Our progressive tax system means that the more need from the portfolio (especially from qualified buckets), the more taxes you will pay.




Most advisors simply ignore the benefits that a life insurance policy can provide investors. The cash value grows 5%+ in an equivalent to a AAA-rated security. Those securities today yield less than half of that rate. Add in the tax benefits of tax-deferred growth, and the yield is closer to 7-8% annually. While the rates are falling slowly in conjunction with the long-term trend of interest rates, they are still significantly above market rates.

Most working-age earners have a need for life insurance, especially if they have school-age children. Piggybacking on that need by overfunding a whole life policy can build a significant nest egg for retirement planning purposes.

Investors today are likely to generate very little over the next few years from their bond portfolios. Non-professionals spend 99% of their time analyzing stocks but then simply stick their bond allocation into a core bond mutual fund. Well, that works in a 35-year bond bull market characterized by falling interest rates. We appear to have entered a rising rate environment and YTD results on bond funds are likely to be repeated for the next several years.

Instead, investors can place some of their capital into their existing life insurance policies to "overfund it." That cash value starts earning the dividend rate without ever going down. That non-correlated asset class is often ignored by investors and advisors alike. However, given the current state of the markets, we think will be more important than ever.

We have found that an overfunded policy complements our closed-end bond fund strategy very well. The standard deviation of returns for cash value life insurance is about 0.30% with a yield around 5%. The standard deviation of returns for our Core Income Portfolio is about 5% on NAV and 9% on price with a yield over 8%. A 50/50 split between the two nets the investor a standard deviation (risk level) that is lower than the Barclays U.S. Aggregate Bond index and a yield that is over three times large.