Whole life insurance – classic, traditional, boring, old-fashioned whole life insurance – is perhaps the most misunderstood and under-appreciated financial product in the advisor’s arsenal. That is until recently, when persistent low interest rates and the maturity of competitive enhancements combined to create the perfect storm.
Many advisors, and the clients they serve, are taking a second look at the powerful role that whole life can play within the modern asset allocation grid and risk protection profile.
Inflexible No More
Whole life has not simply become the best-looking horse in the glue factory. True, much of the recent resurgence in whole life’s popularity has come as other products, such as universal life, have suffered from crediting rates at or near stated guarantees and price increases resulting from stiffened insurance department reserving requirements. Riders such as one-year term, enhanced paid-up additions and critical care all have helped to brighten up what many see as yesterday’s news.
But the backbone, and therefore the underpinning upon which whole life has been built, remains the same – steady predictable returns with base guarantees. (Of course, guarantees are based on the claims-paying ability of the carrier.) Whole life is typically a product issued by mutual carriers. So, profits are returned in the form of dividends, which are not guaranteed. I will present more information on dividends later in this article, but dividends remain tax-deferred when left in the policy to buy paid-up additions. This is a provision that adds an element of inflation protection to the product.
The Ultimate Utility Tool
Whole life insurance is the Swiss Army knife of the advisor’s tool kit. Insurance is a contingency asset. It protects you “in case:” in case of death or disability or in the event one needs access to safe, conservative savings.
Insurance company actuaries are smart people operating in a complex world, but they do favor a certain type of simplicity. Whole life is intended to be an asset that you use and maintain for your whole life. To quote the tag line of a popular carrier, it is intended for the “if” in life.
Whole life features what one would expect from a life insurance policy, solid death benefit protection. Thanks to extended life expectancy tables, the modern policy is now designed to provide base coverage to age 120. Enhanced loan features (variable loan rates or decreased loan interest rates in lower policy years) all allow the policy owner to “unlock” the death benefit prior to the insured’s death.
Features such as living benefits and accelerated death benefits riders have provided even greater access to the cash value. Even properly structured life settlements provide for favorable access to policy values before contract maturation.
Disability waiver of premium, which is a relatively low-cost rider, remains a distinguishing facet of a well-constructed whole life plan. Savings alternatives such as 401(k) plans, individual retirement accounts and 529 plans do not provide a method for the funding to be completed by a third party.
Of course, policy cash values still accumulate (yes, on a tax-deferred basis) and are accessible in the traditional manner (surrender or loan).
Policy benefits would be reduced by any outstanding loan, loan interest or withdrawals. Dividends also are affected by policy loans and loan interest. Withdrawals above the cost basis may result in taxable ordinary income. If the policy lapses, or is surrendered, any loans considered as gain in the policy may be subject to ordinary income taxes.
But, unlike other permanent products such as secondary guarantee universal life, accessing the cash value will not necessarily reduce the underlying policy provisions and erode the death benefit any more than by the amount of cash removed.
Any advisor with more than a decade in the business undoubtedly has experienced how cash values have helped to keep a business afloat, pay medical bills or purchase a vacation property. Volatile market performance, along with the high fees associated with 529 plans, have encouraged many to favor using a well-funded whole life policy as a way to fund education.
In the current low-interest rate environment, the stability of guarantees has buffed the luster of a product that is getting a second look from many potential buyers. Describe a financial vehicle with underlying guarantees that provides support in the event of disability, at retirement or upon death, and the uninitiated (including many legislators) will assume you are describing Social Security. Add the financial stability of a well-regulated and properly funded system of reserving – and you are describing whole life. Imagine that!
Finally, it is important for an advisor to recognize why cash value is important to a life policy. Mortality is graded on a curve. The older one gets, the more likely one is to die. This is a primary reason why so few term policies result in a claim. The cost of transferring the risk of death becomes too great when it becomes more likely. Consider two policies with $1 million of death benefit. The universal life or term policy with no cash value represents a full $1 million of risk to the carrier. The whole life policy with $350,000 of cash value represents $650,000 of risk. Carrier costs are lower at that point, and so are policyholder costs.
Bells and Whistles
So what has changed with whole life? There have been some improvements and modernization, mainly in riders that have helped to enhance the product’s flexibility and make it more like the “pay what you want” universal life alternative.
The most significant of these is the one-year term rider. So called “blends” of whole life and term insurance create the ability to increase policy death benefits while not necessarily growing cash values. Add in the paid-up additions (PUA) rider and you have virtually the same “pay what you want” flexibility as universal life. (One caveat: the net effect of paying less premium – a lower death benefit – may be more rapidly evident in a whole life blend. Maybe that’s not a bad thing.)
With the advent of the computer, policy illustrations now can accommodate term riders that increase, decrease, keep the overall death benefit level, etc. Only denizens of the nostalgic days of projections based upon rate book calculations can truly appreciate just how valuable a time-saving tool computer-enhanced ledgers are.
The flexibility that this brings is quite significant. It has also provided a “testing laboratory” to model the effect that skipping premiums, adding in PUAs or making withdrawals will have on a policy’s long-term performance. So, in a certain sense, although riders have opened up the world of whole life to enhanced performance and greater policy owner control, it is the modern computer program that truly unlocks these features. Now we simply need to have an environment where the product can clear itself from the clutter that so often permeates the world of financial instruments. And so that environment has appeared in a long period of low interest rates and an unusually volatile long-term investment market.
Portfolio Rate Crediting
Predictable returns and relatively blended performance associated with the portfolio-crediting rates make up the dividends declared by whole life carriers. Start with the concept of averaging. The dividends paid by the whole life carrier are essentially an allocation of the profits generated by the issuing carrier. Those profits are the result of three factors: investment earnings, expense savings and mortality gains.
The investment earnings piece is where the blending comes in. Insurance companies invest primarily in bonds and fixed rate instruments. Clearly, these are often longer-term investment contracts, particularly in periods of relatively higher returns. When the company determines what their investment yield is in any given year, it is typically combined throughout the entire company.
This is called a portfolio rate, because the entire portfolio is considered for purposes of the calculation. So, a three-year policyholder is placed into the same bucket of assets as a 10-year policyholder. Conversely, most universal life policies simply provide a new money-crediting rate, often in parity with more stable instruments such as Treasury rates. Obviously, in times of low nominal rates, this blending of returns tends to average to a higher return than a new money rate. Should interest rates increase gradually, both products will experience similar growth patterns, whereas should rates spike sharply higher, a new money rate will outpace a portfolio rate.
The expense savings element of the dividend is reasonably self-evident. Carriers routinely evaluate various cost savings methods and service enhancements that will reduce the countless layers of costs that the modern carrier undoubtedly is presented with.
Mortality gains pose an interesting aspect of whole life. When pricing the product, actuaries assume that a certain number of insureds will die, becoming claims paid. When fewer people than projected die – based upon actual underwriting standards, naturally improving mortality and initially conservative assumptions – the result is fewer claims and that leads to excess reserves on hand. These mortality gains become a part of the dividend. This can be a significant component, but more importantly, it is non-correlated to any other asset available in the marketplace.
In summary, what we now have is a financial product that has gained flexibility, is operating within a sweet spot based upon competitive market pressures and is truly a non-correlated asset. And you thought it was boring old vanilla whole life.