Submitted by Brian Fechtel, CFA, agent and Founder of BreadwinnersInsurance.com
Brian Fechtel, CFA, agent and Founder of BreadwinnersInsurance.com, was one of the contributing authors to the NAIC’s White Paper on the State of Life Insurance Industry, having written a section advocating the importance of drastically improved policy disclosures. The Journal of Financial Planning in September 2012 published his article, “Bringing Good Disclosure of Cash Value Life Insurance to the Marketplace.” Breadwinners’ Insurance is known for not only helping individuals and businesses obtain exceptional value on their policies but also making sure that its clients truly understand their policies so that they can confidentially make smart decisions. Recently, Breadwinners’ Insurance has recently introduced truth in life insurance policy disclosure, combining its pioneering policy analysis approach – presented more than 20 years ago in Best’s Review - with its proprietary financial analysis of life insurers’ annual statements. Fechtel received the National Underwriters’ 2012 Award for Regulatory Advocacy.
AD: Why should people consider purchasing permanent life insurance products?
Brian: The tax advantages and the permanence of cash value life insurance are the product’s primary advantages. A permanent policy’s cash values grow tax-deferred, and in fact, such appreciation is never taxed when a policy is held until death. These growing cash values can be accessed during one’s life without incurring taxes – either by withdrawing, surrendering, or taking a loan. A second tax advantage of cash value policies is that, even if the coverage is not desired on a permanent basis, the cost basis includes all the premiums paid, even the portion that essentially went to pay the term costs. Consequently, with the right policy design, and even when only wanting coverage for a limited duration, a cash value policy, despite its greater annual costs, can sometimes be a more tax-wise and cost-effective alternative than buying term insurance and separately investing the difference because of its tax privileges.
While mentioning the rationale for purchasing such policies, it is important to give equal mention to an important caveat: these policies typically pay sales commissions that no informed consumer would accept. Everyone seems to have heard at one time or another something about the huge sales commissions agents are paid for selling these policies, but industry sales data shows that almost all of the policies sold still continue to pay huge sales compensation. Consumers would be well to recall Plato’s words: “All that deceives can be said to enchant.” Agents have many ways of misrepresenting the costs of cash value policies, of selling the sizzle while it is laden with excessive fat. Anyone considering purchasing one of these policies – as, again, the industry sales data shows – ought to be very leery of sales presentations where the annual costs (of which sales commissions are the largest total component over the policy’s first three or four decades) of a policy have not been completely presented. Very briefly, there are ways to minimize or to only pay appropriate sales compensation, and any consumer would be wise to find a genuine expert about such when purchasing a cash value policy. Bottom line: Beware becoming enchanted with a product you don’t sufficiently understand.
AD: What are the key benefits to consider?
Brian: As mentioned above, a cash value policy can be an attractive supplemental savings vehicle. Premium dollars that are not used by the insurer to pay expenses grow tax-deferred, and yet can be accessed, largely for any reason and at any time. Many find it makes sense to view the cash value in a policy as a source of emergency funds for such a possible short-term need. Others significantly fund these policies, planning to access the policy’s cash values during their retirement. Another key benefit of these policies is that they enable one to pay for the cost of coverage with the untaxed appreciation that accrues when a policy has built-up a large cash value. In contrast, term premiums need to be paid with after-tax dollars. Being able to pay for such costs with what is essentially a pre-tax, rather than a post-tax, dollar can be a most important benefit for those who want coverage for a long time or on a permanent basis.
AD: Which products make the most sense in the current environment?
Brian: Cash value policies are, by their very nature, intended to be long-term contracts which span 30, 40, or 50+ years. Consequently, the choice of a good product, I believe, depends more on the individual’s preference for a particular type of long-term investment than on any considerations regarding the current financial environment. The performance of traditional cash value policy, such as whole life or universal life, is driven by the investment performance on the insurer’s own general portfolio. In contrast, a variable policy or an equity-indexed policy is driven by the nature of those investments.
AD: How important are fees and expenses?
Brian: Very, very important; in fact, most permanent or cash value policies have excessive expenses that, again, probably no informed consumer would accept. Sales commissions and sales related costs routinely exceed 150% of the a cash value policy’s annual premium – which, as you know, given the investment nature of the product - is many times larger than a term policy’s premium. Such costs can, however, be dramatically minimized, thereby providing the policyholder and beneficiaries significantly greater value. The failure of life insurers and their agents to provide appropriate disclosure of cash value policies leads to the all too common bad experience that so many individuals have suffered from being sold (or unwittingly buying) unattractive policies. (More on this subject in Question #5 below.)
AD: How does a potential buyer understand costs and compare products?
Brian: There is not a short, three sentence answer to this question. First, everyone ought to know that policy illustrations do not provide a good basis for comparing policies. Sadly, however, although the Society of Actuaries actually said that over 20 years ago, comparing policies by comparing illustrations is still a very common and widespread mistake.
Given that cash value life insurance policies are a combination of an insurance component and an investment component, to compare such products, one naturally must understand both components. For example, the performance of a whole life policy is driven by the insurer’s financial performance. With regards to the investment component one should purchase a policy which provides the type of investment management and performance that one finds acceptable and attractive. Very briefly, one should seek the type of information similar to what he seeks on other investment products.
With respect to a product’s costs, one needs to obtain information regarding the costs of the policy’s various components: sales, administrative, claims, investment management and capital costs. Given that sales costs can often be very large – they can easily be twice as large as claim costs over the policy’s first 20 years - it can be most important to find a product with low or acceptable sales costs. This is especially true given the industry’s experience that perhaps not even a third of purportedly permanent or cash value policies are kept in-force for more than 20 years. Claim costs are largely a function of how carefully the insurer underwrites its applications.
Clearly every prospective policyholder should seek information regarding the insurer’s claim costs, its reinsurance costs, and the competitiveness of such vis-à-vis its competitors. If an agent, adviser, or life insurer can’t provide you with satisfactory answers to your important questions, it’s probably worthwhile to explore finding another agent, adviser, or insurer. Finally, while administrative and investment management costs can be of secondary significance because of their relatively small size, the profit an insurer realizes from its life insurance product line (the charges policyholders bear to grow its capital) and how such profits are possibly distributed are factors that every policyholder – and especially any prospective new policyholder – must clearly understand.
AD: Is it important to work with a mutual insurer that pays dividends?
Brian: Let me be very clear. 1) There are good mutuals and not-so-good mutuals. 2) There are also well-regarded mutuals that issue lots of unattractive policies (and lots means more than 90% of the policies their agents sell are unattractive, that is, pay excessively high sales compensation that no informed consumer would accept). And, 3) focusing upon dividends can be a real distraction, as there are significant differences between dividends and performance, the latter being what truly counts.
Regarding the choice of insurers, of buying from a mutual versus a stock company, policyholders need to understand the unique challenges mutuals face because they cannot raise capital as stock insurers can, and yet they have an ever growing need for capital to preserve their financial strength ratios. Consequently, a mutual policyholder can face significantly greater capital costs in the policy’s early years than a policyholder with a stock company. Moreover, if one for some reason finds the touted allure of mutual insurance so appealing, a policyholder with a stock company can, in essence, make the relationship akin to that of a mutual policyholder by also buying the stock of the company, thereby creating a synthetic mutual – with quite possibly even greater value than what could be obtained from an original mutual.
Regarding evaluating dividends and/or being swayed by an agent’s touting of dividends, prospective buyers need to know that dividends are comprised of both mortality and expense refunds and better-than-guaranteed investment returns, and can be confusing unless one completely understands such matters as: how they are calculated, how they will vary, and how they can be misused by agents either when recommending or when disparaging a mutual insurer’s dividend-paying policies. In essence, dividends unfortunately can be an invalid and misleading proxy for finding exceptional value.
AD: What are your thoughts on paid-up additions riders?
Brian: A paid-up additions rider is a good way to get dollars into a policy because the typical commission rates on these riders are much lower than normal, typically a small fraction of standard first-year commissions. It is important to realize that using paid-up additions riders is perhaps not even half of the secret to obtaining good value from a policy. Another significant factor in obtaining good value can arise from properly designing a policy so as to reduce or minimize the sales compensation paid on the base policy, that is, the portion of coverage provided by parts other than a paid-up additions rider.
AD: What is a policy’s loan provision, and how does it work? How important is the ability to borrow from the cash value of the policy, and are there interest payments associated with these loans?
Brian: The loan provision enables a policyholder – for any reason – to access the policy’s cash values. Typically, one can borrow up to approximately 90% of a policy’s cash value, so the policy can provide a good source for funds needed during a short term emergency. When one borrows from a cash value policy, there is an annual interest charge that can be either at a fixed interest rate (i.e., 5, 6, or 8%) or a variable rate. These interest payments from the policyholder become investment earnings for the insurer and are used as the insurer uses its other investment earnings: to grow the policy’s reserves and cash values. Consequently, the actual economic cost of borrowing from a policy is different from the interest paid because the insurer returns part of the loan interest in growing the policy’s cash values. There is, unfortunately, widespread misinformation regarding policy loans. In particular, the advantages or disadvantages of different insurers’ loan management practices (i.e., direct recognition or not) are often incorrectly presented. Also, while policy loans can provide the policyholder with tax-free funds over many years, such as during retirement, excessive borrowing can cause a policy to lapse and create a large unpleasant tax bill. These subjects, however, require a more detailed explanation than is possible in this short Q&A. But in summary, the capability to borrow substantially from a cash value policy (again, typically up to approximately 90% of the policy’s cash value and at any time and for any reason) is one of the primary reasons so many individuals find cash value policies an effective financial tool in their own personal financial management.
AD: What happens with whole life if interest rates increase dramatically? Are owners of existing whole life policies locked into lower rates?
Brian: No, whole life policyholders are not locked into the low rates being earned today on the insurer’s large portfolio of investments that support their policies. But their insurers will not be able to immediately provide a dramatically higher dividend rate as rates rise because only some (not all) of the insurer’s investments will be earning that higher rate. Life insurers manage their investment performance to provide a competitive return over the long run, so there are always times when the rates they credit will be either slightly higher or lower than rates currently being paid on a single fixed income asset. Over the past four or five years (2008-13), many whole life policyholders have received a dividend interest rate that is higher than what would have been available on fixed income assets in the recent marketplace. But again, if interest rates increase dramatically, it is likely that insurers will temporarily pay dividend interest rates that lag. Given that a cash value policy is intended to be a multi-decade investment vehicle, though, it is sensible to not attach great significance to a whole life policy’s current dividend interest rate, but rather look at its performance over multiple past decades. Admittedly, as we all know, past performance is not a guarantee of future performance, but it does provide a better way for assessing the attractiveness and competitiveness of an insurer’s investment management practices.
AD: Do alternative products such as equity indexed life or variable universal life help to address the interest rate risk issue?
Brian: Yes, and no, are the two correct short answers. Certainly, equity indexed and variable policies can avoid the direct impact of interest rate changes. But such products are not immune from interest rate repercussions in the fixed income marketplace. For instance, if interest rates increase dramatically, equity prices would likely decline (either directly from the higher borrowing costs businesses would incur or the reduced value investors would attach to the business’ stream of anticipated future profits). While equity-indexed policies might not suffer directly, their performance during a multi-year period when equity prices fall is unlikely to be deemed truly attractive, and given the pricing discretion that these insurers retain, their ability to change the participation rates and annual caps on the policies, the fact is that these products are actually priced after, rather than before, they are purchased – a situation that potentially could prove to be unsatisfactory to policyholder.
AD: Are there any interesting hybrid products on the market or in development?
Brian: While there always is some new or hybrid product in the life insurance marketplace, we find that these products seldom have any broad appeal or fulfill any real need. It is quite often difficult to analyze the competitive value of such hybrid products because of their multiple potential benefit streams. By individually combining separate products, we have found products whose value can be better measured, and we’re more comfortable recommending – and our clients seem to also appreciate – products that are more transparent.
AD: What is the general profile of the ideal candidate for permanent life insurance?
Brian: An ideal candidate has to: 1) have sufficient current and likely future income (or other investable cash/assets) to afford the policies’ larger premiums, 2) have typically already funded other tax-advantaged savings vehicles, 3) be concerned about taxes (in other words, have a high marginal tax rate), 4) understand the living benefits of life insurance that arise from accessing the cash value, and 5) appreciate the benefits of having some life insurance coverage for multiple decades, or on a permanent basis, recognizing that the income tax-free rate or return on the policy’s proceeds from a good policy that performs well will likely exceed the risk-adjusted returns of many, many commonly-held alternative investments. That is, that the insurance costs – for which the policyholder receives a direct benefit – can be less than the tax costs on alternatives.
AD: How should buyers think about purchasing permanent life insurance? For example, what portion of assets should be dedicated to permanent life insurance? Should purchases come after 401k and IRA contributions and after term life purchases?
Brian: Only after one has an appropriate total amount of coverage, should one evaluate whether it makes sense to obtain a portion of that total coverage via a cash value policy. And, generally, it makes sense to fund a 401k, IRA, or other tax-qualified retirement savings program before purchasing a cash value policy; but there are exceptions to this rule, such as a much younger, dependent spouse – whose financial security might best be secured with the eventual and inevitable untaxed proceeds from a life insurance policy, rather than having funded an IRA. The portion of assets clients choose to dedicate to permanent life insurance varies quite significantly, there’s really no valid rule-of-thumb. A good cash value policy provides competitive financial performance, that is, its ongoing annual insurance costs are competitive, and its investment returns are competitive. Admittedly, finding such a policy can be very challenging for an ordinary consumer, given the inadequate information generally available from agents, but a good cash value policy provides good performance.
So the answers to your final questions are really driven by a client’s response to: 1) How much coverage does he/she need/desire for a good long duration or on a permanent basis? 2) Has one found an insurer and a policy that truly offer the prospective for attractive competitive financial performance? And 3) does one have the capability to fund such a product – with its given investment characteristics and likely performance – sufficiently on an ongoing basis?
At Breadwinners’ Insurance, we find that it is only when an assessment for a client begins with such an unbiased perspective and then continues with the necessary useful information regarding the product and the insurer’s financial performance that clients not only obtain exceptional value but actually find the process itself genuinely pleasant and truly helpful. Our work is a service not a sales business.
AD: Thanks so much Brian.
