There is such a lack of understanding about how life insurance actually works, not conceptually, but really works, that sometimes it is difficult to have a meaningful conversation because you have to back up so far to establish a point of commonality that it is difficult to do so. Even when people understand that they don’t fully understand it, they still think they have a fundamental, base level understanding but even that is generally wrong. It is not easy to destroy a foundation that someone believes is sound.
It is difficult to explain how difficult this is to explain to some people which is why it is so important for Advisors to have a working knowledge of Life Insurance so they can help lead their clients through the process. When I am working with someone who has a policy which is dramatically underperforming and I explain to them how the policy works and the drastically reduced interest rate market will cause their policy to collapse when the cash value is exhausted, they will nod dutifully as though they understand. Until I see a visceral reaction, I know they don’t really get it. They will look at me and say, “We get that but our death benefit is still there so do we really care?” See what I mean? Until their face turns red and they start yelling about the crooked industry and that their agent should be in jail I have to keep pushing and prodding because telling someone that even though they dutifully paid their premium out of pocket each and every year as illustrated on the original sales ledger does not translate into actually getting a death benefit, or said more simply, faithfully paying your premium doesn’t always mean your policy will stay in force, is not an easy message to internalize. By the way, most permanent insurance works this way, even most of the whole life policies I see.
I have tried to come up with an analogy which almost anyone can understand as to why most life insurance acts the way it does. Following is my best stab at it. I am sure others have the same or similar stories, I just haven’t heard them.
Let’s look at your retirement planning. Hypothetically, as the plan is visualized, when you are working, you are earning more than you are spending. Earnings over and above living expenses are put into a side fund which earns a return and grows over time. Then, in the future when you are retired and your living expenses exceed your earnings, expenses are subsidized by the side fund so you don’t starve to death.
If you understand this, you can understand modern life insurance. Here we go: with life insurance, your premiums today are more than the actual cost to insure you. The excess is put into a side fund which earns a return over time. Then, in the future when the cost to insure you is greater than the premium, expenses are subsidized by the side fund so the policy doesn’t starve to death.
So far so good? Let’s go a little further. Your retirement funding is based on some assumptions and expectations. In order to know how much to put away into your retirement plan side fund every year, you have to make decisions regarding your expenses in retirement and what your investment earnings are going to be over the coming decades. Sometimes this works out and sometimes it does not. Sometimes your expenses are going be greater than you thought. Sometimes your aren’t going to earn as much on your investments as you expected. When this happens, you intellectually know that the formulas you originally worked by aren’t going to pan out and you have to adjust. Sometimes the adjustment is putting more in the side fund and sometimes the adjustment is reducing expectations regarding what you can live on later.
With life insurance, the funding is also based on some assumptions and expectations. In order to know how much to pay in premiums for a certain number of years, you have to make decisions. These decisions include how much insurance do you want in force and for how long as well as your expected earnings over the coming decades. Sometimes this works out as expected and sometimes it does not. Sometimes your expenses are going to be greater than you thought. Sometimes you aren’t going to earn as much on your cash value as you expected. When this happens, you intellectually know that the formulas you originally worked by aren’t going to pan out and you have to adjust. Sometimes the adjustment is putting more in the side fund and sometimes the adjustment is reducing expectations regarding the death benefit that can be supported later and for how long.
Are your retirement earnings guaranteed? Generally no. Is life insurance guaranteed? Generally no. Are retirement expenses guaranteed? Not usually. Are policy expenses guaranteed? Not usually.
If you don’t earn what you expect in your retirement plan you know things will not magically pan out per your expectations. If policy owners truly understood life insurance and they realized the projected crediting wasn’t being realized as expected, they likely wouldn’t expect their life insurance to magically perform as expected.
What’s the difference? Lack of understanding. Prior to, let’s say, the 1970s, life insurance was a fixed product. There were rate books and an agent could take out a slide rule and calculate the premium, cash value and death benefit for any given year for someone. There weren’t any moving parts and things were guaranteed.
In the seventies, with the advent of the computer, everything started to be modeled. This modeling incorporated assumptions. Furthermore, these assumptions were variable. The modeling also had a fatal flaw, which continues to this day, in that whatever assumptions were input into the computer were expected to stay exactly the same forever. Forever is a long time by the way.
Most of us are generally aware that when something is based on assumptions, management becomes important. However, the consuming public never really made that jump with regards to life insurance. I can assure you that today, most policy owners mistakenly believe that their life insurance is as guaranteed as it was back in the old days when it actually was. Of course there are guaranteed policies today but even they don’t always work as understood. Also, many people will tell me they intellectually understand this but that their policies are in the realm of the guaranteed. Many of them are woefully mistaken. “But my agent told me so.” I don’t really care. Until I see it, I’m going to assume it is not.
What do we know about retirement planning today? Better yet, what did we “know” about retirement planning in 1999? Blind monkeys throwing darts could get 20% a year in the stock market, right? People were doing conservative planning assuming 10%. When exceedingly high returns are projected forever, the required contributions are very low. Assumptions were dashed. Corrections were made. Those who didn’t suffered.
What you we know about insurance crediting? In the eighties, permanent life insurance policies were crediting double digits, even conservative whole life policies. When policy owners calculated required premiums to fund their insurance assuming an exceedingly high rate of return which was assumed to stay high forever, the required contribution was quite low. Assumptions were dashed. Corrections needed to be made. Those who didn’t suffered.
Think about it. For a 25 years old to have $1,000,000 at age 65, assuming a 10% rate of return, she would have to put away $2,054 a year. If she woke up at age 65 and realized she had “only” earned 8%, she would have $574,000, only a little more than half of what she expected as a result of only a 200 basis point reduction in earnings. 5% brings it all the way down to $260,000.
What about a 1980s era life insurance policy. 12% wasn’t out of line at all, even with whole life. 4% isn’t uncommon today. With a traditional investment, for every $1,000,000 you want in 40 years assuming 12% you have to put away $1,164. At 4% that payment is $10,119! Here’s the punch line; if you were paying $1,164 in insurance premiums for your policy incorporating 1980s era assumptions, what do you expect to be happening when you now plug in 2016 assumptions? A 35 year continuous decline in the interest rate markets which drive most life insurance policies means something. If consumers truly understood their insurance, they wouldn’t expect their 1980s and 1990s and even their earlier 2000s life insurance policies to be supportable in today’s interest rate markets. They would be making the requisite corrections.
This is as clear as I can make it. It doesn’t solve anything but the first step to recovery is admitting there is a problem. Policy owners who understand the financial dynamics related above still have to internalize that what they expect and understand to be true simply may not be. Sometimes that is as difficult to accomplish as convincing a believer there is no God or an atheist that there is one. At least with life insurance there is an obtainable understanding and faith has little to do with it. I didn’t say that it was easy to get there.