A Rapacious Consumer of Cash – Part 1

A peek at the expenses of an IUL contract.

By Bill Boersma

These were the words out of the mouth of an attorney I was speaking with recently. We were on a call discussing the details of a life insurance litigation case.

It’s not uncommon to start trading war stories during conversations like this. One person will say something they’ve recently seen and the other will share another story just as crazy, or worse. Earlier that morning I had been on an introductory call with a client and his attorney discussing potential litigation. It was centered around an indexed universal life (IUL) product sold to the client by an agent who clearly did not understand the policy; he admitted as much.

It’s when I started relating some of the details that the attorney said “These products are rapacious consumers of cash”. To some that might sound like overkill or an exaggeration, especially when you see what the dictionary definition of rapacious is, but trust me, it’s not.

The Transaction

We’ll start with the transaction as issued in 2018. $180,000 (all numbers rounded off for simplicity) was 1035’d into a policy on a gentleman in his fifties. The death benefit is approximately $750,000 and there’s a planned $2,000 annual premium years 2 through 8. The projection the client bought on to shows $27,600 annually coming out of the policy from year 9 though age 100. This was a factor in his decision to retire a little earlier.

Rather than make you wait, I’ll spare the suspense and let you know that in real life the policy now projects to provide no supplemental retirement income and will fail without increasing the premiums. This is the story…

Starting with a few calculations from data in the original sales ledger, the projected internal rate of return (IRR) on the premium to cash value at the end of year 8, when the planned premiums stop, is less than one third of one percent, while the policy has assumed crediting of 6.09%. This isn’t unusual given the heavy front-end expense loading of life insurance, though this is not generally understood by policy owners. The IRR from year 9 though age 85 is 13.39%, quite a change of pace. Remember, the policy crediting is 6.09%, so we’re going from barely breaking even the first 8 years to blazing returns overnight? Nice! If that doesn’t make sense, hang on.

Expenses

Let’s switch to details from the policy expense page. The expense page is from a recent in-force ledger since it wasn’t included in the sales ledger. The policy charges in year 8, the last year cash value the same year is roughly 14%, which would be pretty great if it wasn’t less than the expenses. At age 75 the policy crediting is over 18%, but the policy expenses are almost 25%. The policy is in a death spiral even though the projected crediting is fantastical.

Excuse me, Bill? You said the policy had an initial 1035 transfer of $180,000 plus additional premium for 7 years. How is the cash value tens of thousands less in year 9, before any withdrawals or loans when there has been significant positive crediting? This is where the title of the article comes into play. But first, some more details.

Cap Rates

The original sales ledger shows 100% of the cash value in the one year indexed account with a 10% cap. Today that cap is 7.5%. Currently, the cash value is split between the one-year High Par Indexed account and the two-year Indexed account. At the issue date the caps for those accounts were 13% and 30% respectively and are now 10% and 17%. The original 6.09% maximum allowable illustration rate at the outset is now 4.96% for the same indexed account. Yes, this is going to put a damper on everything.

Regarding cap rates, given the tremendous projected increase in returns in later years, the policy must be crediting very high rates, greater than the cap rates. But how’s it possible for a policy to potentially credit greater than its cap rate of 7.5%. Isn’t that what cap means? Well, kind of. There’s a reason for the unbelievably high internal expenses for the policy and it lies in something called the Performance Factor. When the regulators initially tried to get on top of things and tamp down the unreasonable projections and assumptions, they incorporated some rules and calcs, but many carriers (some to a greater and others to a lesser extent) then went on a hunt to end run the new regs. The introduction of performance factors and multipliers became commonplace. This incorporated an additional policy expense allowing the return (limited by regulation) to be multiplied by the performance factor for an even greater return. The result was a policy return projection following the letter of the law that disregarded the spirit of the law. For this contract, the performance factor to date ranges from 2.27 to 2.93. However, the significant expense behind this crediting is also applied to the policy in down years. In another case on my desk, this expense is $400,000 a year, regardless of the policy performance.

S&P 500 Performance

How has the S&P 500 actually performed while this policy has been in force? 13.44%.* Nice! Though something else few policy owners understand is that the S&P 500 Index isn’t the same as the S&P 500. The S&P 500 Index only returned 11.65%* because it doesn’t include reinvested dividends. None-the-less, that’s a pretty fantastic run. It’s not like the policy was put in force and the market had a bad stretch. The following table shows the 1 year S&P 500 returns with and without dividends reinvested from the date the policy is in force and in the index.

Policy Performance

So, how’s the policy doing, since the actual market return was meaningfully greater than assumptions incorporated in the initial projected crediting rate?

Recall the $27,600 projected retirement income from year 9 on? The current in-force ledger shows that if nothing at all ($0) is taken out of the policy it will lapse with no cash value or death benefit at age 83. Yes, that’s right, a policy in force during market returns better than expected will fail without additional premium going in I nstead of the expected cash flow coming out.

Why?

Because this product is a rapacious consumer of cash. You can’t possibly expect a consistent return great enough to exceed the shockingly high policy expenses. This policy is failing during a fantastic market run. Imagine if the market was doing poorly? Every year the expenses are greater than the crediting so it’s feeding on itself. Mortality charges keep on increasing, both because the insured is getting older and because there’s a greater spread between death benefit and cash value than projected due to a declining cash value. Even though the market has done well, changes in the policy itself, along with policy expenses, are a ball and chain.

The year before it implodes, somehow it’s illustrating better than 25% crediting, but it’s also illustrating an 85% policy expense, so good luck with that.

Sure it’s simplistic showing the table above, but could any policy owner in any conceivable scenario expect the market performing like this to result in a failing policy? Remember “Zero is your hero” so the one down year has a 0% floor crediting that certainly seems like it could be overcome by the other up years.

Contributors

Things that come together to make this happen, in contrast to what is expected and understood by the policy owner, include:

• Lowering of the cap rate
• Sequencing of returns relative to illustrated level returns
• Lack of dividends being included in the returns / What the S&P 500 Index actually is
• Maximum allowable illustrated crediting rates allowed by regs
• Other silly regulation assumptions and allowances

To be continued…

* S&P 500 returns obtained from S&P 500 Calculator on www.DQYDJ.com. Returns are based on policy date and not calendar year returns. Policy date is September 2018.

Securities offered through Valmark Securities, Inc. Member FINRA, SIPC.

Investment Advisory Services offered through Valmark Advisers, Inc. a SEC Registered Investment Advisor.

OC Consulting Group and its affiliates are separate entities from Valmark Securities, Inc. and Valmark Advisers, Inc. Guarantees are based on the claims-paying ability of the issuing company. Indices are unmanaged and do not incur fees. One cannot directly invest in an index.