The estate tax exemption recently was raised to a level that diminishes the necessity for life insurance to solve liquidity problems for most consumers. As a result, we have seen an increased focus on sales of whole life, variable life and indexed universal life (IUL) purporting to be the “retirement income” solution.
Every insurance carrier illustrates some form of Life Insurance Retirement Plan (LIRP). I think there are many benefits to using traditional life insurance policies to solve income-based needs, if those products are responsibly managed and if the purchaser truly understands the risks.
Lately, carriers have been very creative with product designs that require a Ph.D. to understand; they have rosy illustrations where interest rates are linear and dividends always meet expectations, and unicorns roam the forest. And I wonder, “How many of these policyowners will realize all of the benefits the illustration shows?”
Will interest rates have a positive or a negative effect on the final outcome? Will IUL owners understand how the pattern of returns affects their income options? Will the owners of whole life be prepared to deal with the economic drag created by interest on loans? Will they understand how to change dividend options when necessary to achieve the best results? Will they know they can’t lapse the policy without suffering adverse tax consequences?
Because all these scenarios require decades of accumulating cash, your clients most likely will be dealing directly with the issuing carrier to manage the distribution phase of the plan. Regardless of your carrier affiliations, you must admit this is a scary thought. It can be frustrating to try to untangle contract language many decades after the sale.
I bring this up because I think we need to look not only at the validity of the illustrations we use, but also the expectations we create in clients’ minds when selling these products for this purpose.
Clients Must Understand Costs, Risks
Clients who are overfunding insurance contracts with the expectation of receiving very specific benefits in the future may not understand all of the costs and mechanisms that the illustrations assume.
With whole life, IUL and variable universal life (VUL), clients are assuming risks that they may not understand and will likely not be able to articulate to a carrier robot in the future. This is a real problem that must be addressed at the inception of any life insurance-based income sale.
In our practice, the typical broker request for client illustrations includes using either the carrier’s highest allowable interest rate, a guess at market returns or the carrier’s current dividend scale to project cash values at the insured’s anticipated retirement, usually age 70.
These illustrations show income coming from accumulated cash value that will last for a specified number of years. None of these projections will be correct. Most will be different by orders of magnitude based on the type of policy, the level and pattern of premium contributions, interest rates, options pricing (by the carrier), market performance, and most importantly for IUL and VUL, the pattern of returns.
Many of these products, specifically the participating carrier’s 10-pay whole life contracts, are sold as being essentially guaranteed. After all, the premium, base death benefit and the cash value of the base benefit are guaranteed. That leaves dividends and variable loan interest rates as wild cards. And, while I have a lot of faith in the ability of the major mutual carriers’ ability to deliver dividends, the dividends are not guaranteed and will vary over time.
The same can be said about IUL and VUL. Both products are market-driven, with substantially more moving parts than whole life contains. Cash values projected at retirement are subject to the volatility of the markets, nonguaranteed mortality costs, the decisions of carriers’ pricing actuaries (who determine the option pricing, caps, participation rates and bonus interest where applicable) and, again, the pattern of returns.
From a planning perspective, are your clients helping or hurting themselves by contributing significant dollars into products like these? Are these products really the best companion to the more traditional retirement accumulation strategies?
How GUL Can Help
In a previous article, I described a guaranteed universal life (GUL) product that offers three key riders:
1. Return of premium.
2. Chronic illness/long-term care.
3. Ten-year income guarantee (based on death benefit) starting at age 85.
Most pertinent to this discussion of retirement income is the income rider that pays out the death benefit in 10 equal installments commencing at age 85.
Recently, we were asked to compare the benefits of this product to a 10-pay whole life product offered by a mutual carrier, and the results surprised us. The prospect, a 50-year-old physician (non-smoker preferred) had been sold on the idea of using the whole life policy for retirement income. The policy would be a supplement to the already significant amount of money he was setting aside in qualified plans, and he anticipated starting the income stream from the policy at age 70.
No discussion of this type of supplemental retirement planning would be valid without a full analysis of the client’s needs, risk profile and retirement plans. But, as is so often the case, the agent asked us for a simple comparison of policy results in a vacuum. In this instance, the results were overwhelmingly in favor of the GUL with the riders I have described. In this instance, the rider delivered the highest income with the least economic or administrative friction.
It’s too easy to conclude from this result that, in all situations, clients should favor this specific GUL product over whole life when considering their retirement income needs. But an agent in this situation needs to consider whether or not this is an anomaly or a legitimate planning opportunity to be broadly applied. We decided to research the results using a more robust set of data. We started by asking ourselves the following questions:
1. How would the use of any life insurance product enhance or detract from a client’s opportunity to receive maximum income at retirement?
2. Given the choice, which of the most popular policy solutions has the highest probability of success?
3. When a client decides to access retirement income, which of their assets should they use first, and why?
4. What are the benefits of each potential product recommendation?
5. Which life insurance products produce the best income potential, and why?
6. What are the advantages of one income stream over another?
There is a plethora of carrier-designed sales materials that espouse the use of permanent life insurance products to balance the effects of volatile markets on a long-term investment/income portfolio. Most seem to make the argument that insurance policies are uncorrelated to the markets and therefore should act as a balance against the effects of a down market. Or, in the case of IUL, that the interest rate floor protects the policyowner from loss. In essence, the argument for these sales scenarios is to take income from the policy when markets are down and use other assets when markets are up.
While this idea may seem logical, I would suggest that even with the use of whole life, promoters of this idea intentionally inflate the positive aspects of this strategy while ignoring several key risks.
For example, the age at which a client first begins to take income, actual dividend crediting, the client’s risk tolerance and the ultimate age to which that income will be required are all factors that can influence whether a life insurance policy adds real value to the income derived from the overall plan.
Clearly, over time, accumulating cash in a tax-deferred vehicle has economic advantages over taxable investments. But this is true only if the internal rate of return on cash (on a tax-adjusted basis) is equal to or greater than that of more traditional stock and bond portfolios. And life insurance in its most typical form has lots of economic drag. Some of that drag is dependent on age and ratings, and some is in the form of options pricing (which determine caps and participation rates), carrier administrative fees, fund-related management fees, and loan interest types and costs.
All of these factors are important to the outcome, but one other item may be more important than all of them combined: the client’s ability to manage the changes the illustrations reflect. By that I mean:
1. Changes to the death benefit options from B to A at specific points in the contract.
2. Changes in variable loan interest rates and/or the choice to make a change to participating versus traditional loans.
3. Market volatility in an IUL or VUL contract.
4. The decision to make withdrawals to basis and then loans.
5. The decision to take only loans and no withdrawals.
6. Dropping or retaining term riders.
7. Making sure the contract does not become a modified endowment by virtue of a change to any of the aforementioned factors.
To measure the effects of what I refer to as illustration noncompliance, we constructed a chart showing variations in income results that could be expected based on a variety of potential outcomes, some of which (such as switching to a nonparticipating loan) must be determined by the policyowner.
Keep in mind, these are the best possible scenarios based on the way illustrations operate today. That means that the results could be better or worse depending on actual policy performance accounting for fluctuating dividends, gap-toothed patterned interest credits, market volatility, actual fees and expenses, and actual versus projected net amount at risk. The products we used in our analysis are some of the industry’s best in their respective categories and fairly represent other similar contracts from the top-selling carriers.
What should you take away from the data in this chart? First and foremost: whole life, IUL and VUL are complicated products and policyowner compliance with the illustrations will have a significant impact on the end result.
If, for example, you or your client forgets to change the death benefit option from B (increasing) to A (level) in year 10, the resultant income flows at retirement would be very negatively impacted. Same goes for loans versus withdrawals. Making the wrong decision could result in either negative tax consequences, lower income or both.
Second, although IUL illustrations project the highest income opportunities, even a small misstep, like forgetting to change the death benefit option from B to A, can cause that potential income to drop (in our example) from around $248,195 to $98,527, a 60.3 percent variance. And these numbers do not accurately reflect the pattern of returns, which could easily cause that number to be zero!
Third, with the exception of the GUL with the lifetime income rider, all of the other income amounts are projections and the actual results are not determinable in advance. That means you and your client must be vigilant and the carrier must be capable of making the changes required to stay on track as markets fluctuate.
To me, this is a practical matter of utmost importance. Do you place your clients on the Good Ship Lollipop, push them off from shore and hope they arrive safely with all of their assets intact? Or do you encourage them to purchase the more conservative policy that guarantees everything, assuring them safe passage regardless of the waves and headwinds?
There are as many product solutions as there are clients to buy them. It is certainly possible that well-managed IUL and VUL products will meet or beat the assumptions made here. It is also possible that whole life products will outperform today’s assumptions. The real wild card is whether or not carriers will be able to make the illustrations a reality by building better tools to manage them.
Value and Future Income
Based on the data we’ve been accumulating about this specific use of life insurance for retirement income purposes, two things have become quite clear: IUL accumulation products illustrate greater income than any other product, with arguably the most moving parts and the greatest potential for losing that income due to illustration noncompliance. And the guaranteed rider to pay the death benefit in 10 equal installments offered by the GUL product I have described provides the best guarantee of future income.
Whole life and VUL are outliers in my mind because they have too much economic friction in the form of fees and/or expenses, or they require too high an interest rate to succeed (a direct result of the fees and expenses). In addition, they both require entirely too much engagement with the insurance carriers where the cost of illustration noncompliance far outweighs the potential benefits.
As is the case with all financial products, the key to success is active management and client engagement. For clients who are active asset managers with a deep understanding of options and market performance, a well-constructed IUL product may deliver the best long-term value.
For everyone else, for whom the task of constant policy management is unreasonable, and who look to insurance as a simple way to protect against risk or as a guaranteed backstop for their other retirement income planning, I am inclined to recommend the GUL with a guaranteed income rider, or maybe a combination of GUL and IUL.
With the GUL/lifetime income rider, I know that it will do exactly what is illustrated and there is very little required of clients to achieve that result. This is the type of anchor that all retirement plans need, and it does not introduce other elements of risk into the overall plan. More importantly, it requires only one contact with the insurance carrier to turn on the income, and it’s smooth sailing from there on.
Another key takeaway from this data is that your clients would be better off waiting until age 85 to take the income from a life insurance policy. This is based on the idea that the policy is a retirement backstop, not the cornerstone of the plan. The extra 15 years of accumulation produces significant cash benefits and increases the probability that the client never runs out of income.
I have focused on the practical aspects of policy management. I believe the results are compelling in and of themselves. However, I haven’t addressed some of the more detailed and thorny issues of standardizing the returns between VUL and IUL and the probability of those returns actually happening.
What the IUL and VUL numbers in our charts represent is a linear return, which overestimates the real returns and, in the case of IUL, allows the carriers to illustrate rates that are significantly above the advertised AG49 maximums. To do that, we need much more sophisticated software than the industry currently makes available.
It doesn’t take a rocket scientist to understand that if the internal rate of return on cash is greater than or equal to the maximum illustrated AG49 rate, the carrier has essentially charged zero for mortality and expenses, or they are making some very aggressive assumptions that they are not disclosing. I’m not an actuary, but I am pretty sure insurance carriers do not survive and thrive by giving anything away.
Sy Syms famously coined the phrase, “An educated consumer is our best customer.” I could not agree more.