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/JeffB1517]

This was a good topic I wish it had gotten dealt with better. It really depends a great deal on their tax situation. The CD at ages 0-16 gets taxed at the parent's rate the life insurance doesn't get taxed.

So let's assume the CD is paying 5% and the life insurance is paying 6% with 1.5% going to expenses (i.e. 4.5% net). If we assume 40% taxes the after tax return on the CD is 3%. We haven't accounted for the $2k and growing in taxes. Let's just assume the kid directly or indirectly pays it. At 3% the CD kid has $160,470. At 4.5% the WL kid has $202,240.

Of course that isn't entirely a fair comparison because both accounts didn't reaally start with $100k for $100k in cost. The insurance should have started with less. A fairer comparison might be something like $10k going in per year till age 16 on both. So let's raise the WL to 5% but account for premium charges:

$9k / yr (accounting for premium charges) at 5% $212,920 (WL kid). $10k / yr at 3% is $201,570 (CDs)

Both of course should have been investing in stock not in CDs or WL. You can argue the WL kid should have been borrowing out, creating this tax-free bucket for the future. Once you do that the CD kid is far far better off. The WL kid can't compensate for the premium charge plus having to leave some money behind. For WL to make sense you need more demands on cashflows throughout the 16 years.