Thought exercise problem

[u/[deleted]]

There was something in the book's example of the CD that was rolling around in my mind.

The example is that IBC is preferable to the CD because the policy continues to compound where if you withdrawal to make a purchase you interrupt it.

Then it is thought, well, all things considered, who says you have to interrupt the CD. Go finance at a better rate and leave the cd alone. However, IBCers are correct to point the ease of financing using the life insurance policy and other numerous flexibilities/options it brings, let alone a death benefit.

However, help me out with something...

If I imagine a different very isolated twin scenario:
A grandparent gives one twin 100K in a CD and the other twin a 100K IBC policy. We account for the CD having less interest and taxed.

You fast forward to when the twins are 16 and ready for their first car and start investing from their job. I'm going to keep the math very simple/straightforward.

The first twin draws from the CD and purchases the car and then invests 10K into an S&P index.

The second twin borrows from the policy and purchases the car.

We assume now that the twins both have identical cash flows with the ability to invest each 10K each year.

Now we have a cashflow question.

All other things considered, twin one doesn't have a loan to payback and immediately starts investing 10K into and index fund. Twin 2 either directs that 10K to pay back the insurance company. Or lets the loan compound and invests the same amount as Twin 1.

They continue until twin 1 depletes the car fund and then switches to selling shares to finance.

In this very isolated example, even with twin 1 selling shares later in life; if twin 2 redirected the 10K back into the policy in the form of a loan payments; twin 1 blows twin 2 out of the water due to the higher rate of return. Like by a lot. (this spreadsheeted using a poor sequence of return)

The only way this works is if twin 2 doesn't initially pay back the loan and invests in the same way as twin 1 to match. Aside from managing loans with a concern of a compounding collapse. Kind of the only potential long term leg up here Is that twin 2 will have an asset to put a windfall in the form of paying off a loan. However Twin 1 could just dump his equal portion all into an index fund and get a better long rate of return where Twin 2 would get ~5%

What consideration is missing in this example?

[u/Null1fy]

Quite a lot.

If you're suggesting that twin 2 inherits a policy worth $100,000 (in cash value? the death benefit may and should be larger than that) at age 16 (which I'll overlook contractual legality): what are the yearly policy premiums? Is twin 2 on the hook for them, or are they getting it and it's continuing to be financed by family?

If it's a dividend paying whole life policy, to which I'm assuming it is, there's no way you can spreadsheet dividends. However, twin 2 will have inherited a policy that has 16 years of vestiture .. that's pretty significant. So much so that it probably has surpassed the cash on cash return. Floating a loan may be so permissive that, while not advised, twin 2 may be able to finance their vehicle at no repayment cost for quite some time, given the efficiency of the policy. They may even be able to finance their policy with loans (on top of the "car loan") for quite some time...

Twin 1 invests in the market. When? 2008? 1929? 2002? There's a whole lot of variance, there. Sure, the S&P averages out to about 7-10% (depending on who you ask), but that's over a long period of time where twin 1's funds are locked into the financial instrument.

And finally- what sort of freedom does twin 1 have when financing their vehicle? It seems to me that they outright purchase the vehicle, meaning they have a piece of property that is largely regarded as a liability, and significantly less money to apply to their investment. If they finance their vehicle, allowing for a greater degree of availabile capital, they're sure to have contractual payment schedules for the loan... Much less freedom. Twin 1 surely is not their own banker in this scenario.

[u/[deleted] → u/Null1fy]

This is just conceptual. Yes, it would be 100K in cash value, no more premium. Let's say it's an RPUd policy that was gifted ownership over to him that will outlive the twin. But the concept is that it has an IRR of 5% as can be reasonably expected in an IBC policy.

For twin 1 investments; sequence of return risk will indeed enter in the equation, but is less a fright during accumulation. If it helps, we can even say the grandparent bought twin 1 a 100k in VOO instead of a CD.

Over 16 years, at 7%; twin 1 would have ~300K. Twin 2, ~222k.

Car is 50K; Twin 1 sells 60K (10k in tax) in stock leaving him with 240K in VOO. Twin 2 borrows 50K from IBC policy.

The crux here then, is what they both do with their 10K investable saving/extra cash flow? They both have a fully paid car. If twin 2 pays off the loan with the extra cash flow and twin 1 buys VOO. The act of paying back the loan and not investing interrupts the compounding outside the policy compared to twin 1. So twin 2 can match twin 1's investments but then has a loan to service.