The premise of "Missed Fortune 101", a popular insurance book, is that all of us would be better off with no equity in our homes and no money in traditional IRA's or 401(k) plans. We can do a whole lot better, the book asserts, by putting lots of cash into a life insurance policy so we can take it out later, tax-free.

As much as I would like Douglas R. Andrew's idea to work, it doesn't survive testing in the Reality Lab.

I really wish it did work. Like most of the people who will respond to the seminar advertisements appearing in major newspapers, I'm older and have some money. My wife and I have money tied up in IRAs, SEP-IRAs, and a 401(k) plan. It's enough money that withdrawals will trigger full taxation of Social Security benefits. That means our effective federal income tax rate can be as high as 46.25 percent on money that was put aside at 25 to 33 percent.

That's not the way qualified plans were supposed to work.

So I read "Missed Fortune 101" full of hope.

In a very lucid explanation of the different types of life insurance policies, Mr. Andrew eliminates variable universal life because of its expenses and volatility. He settles on two choices:

•  Traditional cash value life insurance with returns based on what the insurance company earns on its portfolio.

•  Equity index based policies. Throughout the book, he uses a 7.75 percent return assumption on equity index policies.

In fact, I have a universal life policy. I have owned it for 13 years. While Mr. Andrew routinely assumes that you can earn more in a life policy than you will pay on a mortgage, that isn't the case with my policy. It's paying 4.50 percent plus a 0.75 percent bonus for those who have held their policies at least 8 years.

So I'm earning 5.25 percent. That's less than current mortgage rates. Yes, some policies pay more. But others pay less.

So I responded to a mailbox flier that offered an interesting booklet: "Minimize Taxation of Your Social Security Retirement Benefit." I met with the insurance agent who sent the booklet. A week later he offered a $494,000 life insurance policy with 5 premiums of $50,000 that would go into an equity index life insurance policy. The money would be allowed to grow for an additional 10 years. In the 16th year (at age 80), I would be able to borrow $25,000 a year for the rest of my life, tax-free, even as the death benefit increased.

All this was based on an equity index return assumption that was about 8.6 percent.

If the policy performed at the guaranteed rate of 2 percent, however, the outcome was very different--- the policy would exhaust my $250,000 of premium payments in the 12th year. There would be no lifetime income of $25,000. The only way to benefit in any way would be to die within 12 years--- before the policy collapsed--- so my family could collect the death benefit.

High taxes sound pretty good compared to that.

If you examine recent equity index returns (the return on large common stocks excluding dividends), that 8.6 percent index return looks pretty reasonable. From 1991 through 2000, according to Ibbotson Associates, capital appreciation of   the S&P 500 Index was 12.2 percent a year, compounded. Even burdened with an annual cap or limited to a percentage of the gain--- as most equity index policies are--- 8.6 percent looks very likely.

Unfortunately, the '90s were an unusual period.

While equity appreciation (excluding dividends) was over 10 percent through the '80s and '90s, it was under 3 percent in the '60s and '70s. In the 78-year period from 1926 through 2003, according to Ibbotson Associates, index appreciation ran at a compound annual growth rate of 5.9 percent. About 1 percentage point of that came from rising price-to-earnings multiples.

Bottom line: With P/E ratios at relatively high levels today, future index appreciation is likely to be closer to 5 percent than 6 percent--- if the policy has no cap or participation limit. If earnings multiples decline, it could be closer to 4 percent.

That's better than the 2 percent guarantee--- but far below the 8.6 percent assumed and projected. Mr. Andrew uses a 7.75 percent assumption that is nearly as unrealistic as what I was presented.

Then there are the last two burdens: commissions and life insurance costs. These can be devastating. After 5 years and $250,000 of premiums the cash value of the policy I was offered would have been $140,000 at the guaranteed 2 percent. That's a loss of $110,000. At projected returns it would have been worth $220,000, a loss of $30,000.

No doubt some can do better, and the actual result would be somewhere in between. The only thing certain is that most people will be disappointed, perhaps disastrously, with the consequences of exchanging home equity or tax deferred retirement accounts for life insurance.  

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Personal finance writer Scott Burns is syndicated by Universal Press. His twice weekly column appears in newspapers from Boston to Seattle. He is the Chief Investment Strategist for AssetBuilder, Inc. Readers can register at www.scottburns.com. Questions/comments can be posted directly. They can also be sent, without registration, to scott@scottburns.com. Questions of general interest will be answered in future columns and on this blog.

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