Dirty tricks financial advisers play

Question: I'm 29, make about $260,000 a year and am thinking about purchasing a house. I was approached by a financial adviser who wants me to invest in an equity indexed universal life insurance policy, which he called a "surefire" way to develop a sizable nest egg that grows tax-free and can also be tapped tax-free via a loan. He suggested that I purchase a house using an interest-only mortgage, which would have lower payments than a regular mortgage, and then invest the difference into the life insurance policy. He also suggested I take out a home equity line of credit on the home and invest the loan proceeds in the insurance policy. He threw around claims like "do what the banks do" and "make money off of borrowed money." I would like to get an unbiased second opinion, so any advice you could give would be greatly appreciated. --Randolph, Northampton, Mass.

Answer: Sounds to me like you're dealing not with a financial adviser, but a man who has a powerful urge to sell life insurance.

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Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005).

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I can't say whether this person is motivated by the substantial sales commissions such policies can pay, by a true belief in the value of these policies or something else.

But I can definitely say that I don't think you should take him up on his offer for a couple reasons.

For starters, I have some fundamental reservations about using equity-indexed universal life (EIUL) and similar life insurance policies (variable life, or VL, and variable universal life, or VUL) as vehicles to accumulate retirement savings.

In theory, such policies appear attractive. You're getting life insurance protection at the same time that a portion of your premium (often a sizeable portion) goes into the investment component of the policy known as cash value. In the case of an EIUL policy, the investment part of your premium earns a rate of return that is tied to a value of a benchmark or index such as the Standard & Poor's 500 index. Typically, you are also assured a modest minimum rate of return, say, 2% or so.

But while that arrangement may give the impression of an all-upside-no-downside proposition, the fact is that policies usually impose a ceiling on your potential gain, whether by crediting your policy with less than the index's actual total return or by setting an outright cap.

So in a year like 2009 when the S&P 500 earned just over 26%, you might receive, say, just 15%. Some of the crediting formulas can get pretty complicated, making it difficult to gauge just how the policy might perform.

Aside from investing issues, I also have doubts about touting tax-free withdrawals via policy loans. True, these policies are designed to allow loans, and proceeds from policy loans aren't taxed. But once you go down that path of borrowing from the policy for tax-free income in retirement, you're likely locking yourself in to keeping the policy going for the rest of your life. The reason is that if the policy lapses, you'll owe income tax on the investment earnings you've pulled out. If that tax liability occurs late in retirement and you're not flush with cash from other sources, you could have a nasty problem on your hands.

For these reasons alone, I'm skeptical of using EIUL or any other type of life insurance as a way to build one's nest egg. I think you're better off sticking to regular tax-advantaged plans like 401(k)s, IRAs and, if you're self employed, SEP-IRAs and even solo 401(k)s.

If you've still got money to save and invest after maxing out these plans, I'd focus on tax-efficient investments in taxable accounts, by which I mean anything from index funds to ETFs to tax-managed funds.

But what your adviser is suggesting makes me even more wary. An interest-only loan so you can plow more money into the policy? Borrowing against the equity in your home and then investing the loan proceeds into the policy? (I'm not sure how much equity you'll even have at least initially to do this, but that's beside the point.)

These sound like the kinds of schemes people hatched during in the heyday of the real estate bubble. The fact that someone would be out there pushing this kind of strategy now boggles the mind. Did this guy learn nothing from the financial crisis about the dangers of leverage and investing borrowed funds backed by real estate?

I can't divine this person's motivation or competence based on what you've told me. But phrases like "do what the banks do" and "make money off of borrowed money" sound more like the patter of a flim-flam man to me than dispassionate advice from a financial adviser.

My advice is that before you do anything with this adviser, you first check out his credentials with the Securities and Exchange Commission, FINRA, state securities regulators and your state's insurance department.

Next, I suggest you read this piece on VULs, EIULs and other insurance products by James Hunt of the Consumer Federation of America.

And if after doing that you're still considering investing in an EIUL or similar policy, I suggest you gather all the policy illustrations, brochures and other info the insurance sales person has given you, take it to a fee-only financial planner -- i.e., one whose livelihood doesn't depend on commissions -- and ask that person to analyze how it stacks up vs. other alternatives.

If you decide to go ahead and "do what the bankers do," fine. I just hope the bankers this person is referring to have a better track record than the banks that needed a government bailout.