We have Calculators….(part 2)

When I previously wrote on life insurance based accumulation planning and the actual IRR on premium to cash value relative to projected dividends, I promised a part 2 focusing on non-whole life products.  I wasn’t specifically picking on whole life but was focusing on it for that piece.

When we look at the offerings of non-whole life cash value products, we have the Universal Life family of products which includes Guaranteed UL, Current Assumption (traditional) UL and Indexed UL.  We also have the Variable Life products, which are securities based contracts, and this category includes Private Placement Life Insurance.

Something very important to understand is that most modern life insurance products, Whole Life, UL & Variable, can be “built” in almost innumerable ways.  This allows significant flexibility regarding putting together a policy which best fits the needs of a particular individual but it can also make things so complicated that it is difficult, if not impossible, for consumers and advisors to understand.  It also makes insurance a bit of a black box which can be manipulated.  In many situations, there really isn’t such a thing as sitting down at a computer and inputting basic data to see what a million dollars of insurance on a given individual costs.  There are numerous decisions to be made before the computer starts calculating.  This is about as different from the “rate book era” as we can get.  What is fixed and what is variable and what is built on assumptions is very different from the old days, even in “fixed” products.

This is also why the modern game of spreadsheeting and commoditization can be so dangerous relative to making insurance decisions.  For most modern life insurance, a mindset of trying to pay the least possible will often have unintended negative consequences.

It is important to understand that a single contract can be built many different ways resulting in many different outcomes concerning the return on premium relative to cash value or death benefit.  A given contract could be sold for death benefit purposes or cash value purposes with the same death benefit having very different premium structures.  Someone utilizing a particular product primarily for death benefit will likely realize a different IRR on premium to cash value than someone using the same product predominantly for cash value accumulation.  This is something that should always be clearly explained in the sales process but it often is not.

I am focusing on this because as soon as I relate the financial dynamics of a particular transaction, someone will inevitably state that theirs doesn’t work that way or it can be built much better.  I know that.  However, I am trying to make a point about the all too often insinuation that A plus B equals C when it doesn’t always add up.  Realize that often this rub is not as much about what is said as it is about what is not said.

I will not relate any examples of Guaranteed UL because GUL is not generally meant to accumulate cash value and calculations to that end wouldn’t make sense.  GUL is pretty much a death benefit transaction, period.

The point of the following examples is to calculate the actual IRR on premium to cash value and gauge it relative to the quoted crediting rate.  As an example, I recently looked at a traditional UL policy with a 3% crediting rate.  At the 30th year the IRR on premium to cash value was 1.6%.  That’s not good or bad.  It just is.  A traditional UL isn’t really built for accumulation like some other products.  It could also likely be funded differently to potentially improve the IRR.

In the same vein, I reviewed a very large IUL policy which was purportedly sold specifically for accumulation purposes.  It was illustrated at 7% and “returned” a half of one percent at year 10, 1.5% at year 15 and 3% in year 20.  I am familiar with what happened during the sales process and these numbers are vastly off what was clearly insinuated.  By the way, by tweaking how the policy was built (which would substantively reduce commissions) the 10 yr IRR jumped from 0.5% to 4.25%.  Same product, same death benefit and same premium.  This is important to understand.  That isn’t an anti-commission statement but rather a pro-transparency statement.

A variable case recently on my desk assumed a 7% return which returned 2.5% at year 10 and 5.7% at year 30.  We all know that investments have expenses which are netted out but the consumer needs to understand that less than half the projected earned return would be credited 10 years into the deal.  That is exceedingly different than more traditional investments, as would be expected if clearly understood but, incredulously, that is not clearly understood by a preponderance of consumers and advisors.  Another VUL showed $100,000 a year going into a $10,000,000 death benefit at a 9% crediting rate.  20 years into the contract it projected a seven figure cash value, which is certainly a lot of money, but it represented a 3% IRR.  Again, that might be fine if this was predominately a death benefit transaction but the consumer thought he was having his cake and eating it too. He thought he was getting a death benefit and making the better part of the projected return on his money.  Yes, that is a ridiculous notion but that was the set up.

Both of these transactions were projections of what would happen in the future, not what actually happened in the past.  More commonly, I am reviewing policies which were put in force years ago.  Maybe it was a policy implemented in 1999 assuming a 10% or 12% return (which unfortunately was common).  Maybe the actual return averaged 6%.  If so, the policy is underperforming expectations and the cash value is lower than expected so the mortality charges are higher than anticipated and the policy is trending very poorly and the actual return on premium to cash value may be negative and getting worse.  Without intervention the transaction may easily be on its way to a negative 100% return.  Does everyone realize that this is how it works?  Do most consumers even realize this is possible?

The newly popular Indexed products tout the inability to have negative crediting rates and maybe even minimums of a couple percent.  However, this is entirely different than not having a negative return.  Yes, positive crediting can very easily result in negative returns.  Don’t believe it?  If you have a 3% return and a 5% expense, what is your net?  It is almost never postured that way during the sale.  Soooo…. yes, guaranteed positive returns can result in losing your ass.  That’s why I state that it is often more about what is not said than what is said.

The bottom line is that there are always expenses associated with life insurance and depending on how the contract is built, they may be modest or they may be significant.  Either way, this is important information to be extracted from the numbers for decision making purposes.  Here is a great example which highlights the importance of understanding expenses.

I was working with an individual who was utilizing a VUL contract for supplementary retirement funding purposes.  In fact, next to his 401(k) it was his single largest asset.  I helped him do some analysis and we made some assumptions as follows.   At that point the cash value was $400,000.  We decided to assume he continued funding it as planned until retirement and then let it set for 5 more years.  We assumed an 8% gross rate of return, though we agreed this was aggressive for his planning, for evaluation purposes.  At age 70 the cash value was projected to be $700,000.  We then asked the insurance company to calculate how much he could withdraw for the 20 years between 70 and 90 with reckless parameters of targeting cash value at age 100 just enough to keep the policy in force assuming the 8% returns continued straight line forever.  Of course we would never do this but we were simply assessing the transaction.  Can you guess what the maximum annual withdrawal was calculated to be under these aggressive parameters?  $250.  A year!  In other words, it basically took the entire $700,000 to pay the mortality charges for the balance of the individual’s life.  Using realistic parameters, the policy may have collapsed on its own without ever taking any money out!

Even when we made substantial changes to the policy design to improve the situation, the amount available for retirement funding was only a portion of the cash value he started with.  This means that though he was taking an 8% market risk, he was realizing a negative return.  I realize he had the perk of a death benefit, which may be valuable, but that was ancillary to the fundamental purpose of the transaction and certainly not worth enough to justify the economics of the deal.  Upon learning this he bailed on the transaction and put his money to better use.  He had simply assumed some things based on his limited understanding and what he had been told and had never had his assumptions validated by performing objective calculations.  What if you thought you were earning 8% in your 401(k)  based on what you were led to believe and then discovered you were earning 4% or 2% or negative 5%?

This is why understanding the expense structure of contracts is so important.  Whatever one is spending money on needs to be understood and a decision needs to be made that it is worth it.  I don’t think that any torturing of the cost/benefit analysis would have made this last example worthwhile.  However, getting $10,000,000 of insurance for $100,000 a year while projecting a net 3% on a gross 9% return may be fantastic…  if understood.

Transparency is of utmost importance and every pragmatic effort to pierce the black box nature of life insurance should be made.  Private Placement Life Insurance (PPLI) is a product class which puts a premium on that.  If you have ever reviewed a PPLI proposal you will likely see multiple columns segregating and identifying the fees and expenses much more cleanly than others along with various expense ratios.  Even the annual IRR on premium to cash value may be included right in the ledgers.  (Many products I reference above have an expense page which provides much of the same information but is seldom provided as it is not a mandatory part of the sales ledger.)

I was always taught to run towards potential objections or suspicions rather than away from them and that is what PPLI and these optional expense pages do.  There is still a spread between crediting and earnings but it is laid out very clearly and is putting it into context relative to one’s objectives, whether that be income tax savings or death benefit protection.   Of course, many of our clients don’t have the millions of dollars necessary to get over the PPLI threshold but the concept of transparency should be emulated in all products if crediting rates continue to be a central tenant of the sales process.

I realize that income tax planning is a big driver in many of these transactions and I have not touched on that and it needs to be incorporated into the discussion.  However, these numbers are important on their own as many consumers and advisors I meet with still believe the touted gross crediting/market return/dividend rate is being applied to their money and the tax saving are on top of that!

Pull out your calculator or call me for a customized spreadsheet.  This isn’t an attempt to kill deals (unless the process highlights malfeasance).  Quite the contrary; it’s an attempt to make everyone comfortable and to mitigate objections.  If a salesperson is worried that the real IRR coming to light will tank a deal, there were bigger issues from the outset.

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