I had a mentor many years back who had done very well in financial services and had made a great deal of money. While I was talking with him one day on the phone, he brought up that he had just purchased a Ferrari. At this point, me being fairly frugal and understanding there is no worse “investment” on earth than automobiles, I said, “what are you thinking buying a $200-$300k car? How can any car be worth this much money?” After firing back with a couple of choice words which I cannot put in this article, he told me a phrase I will never forget. He said “Charlie, cost is an issue only in the absence of value. Is this car costly to me? Yes. However, if to me the value eclipses the cost, why would I not buy it?”
The issue of cost is brought up very frequently during conversations around life insurance and especially permanent life insurance. Of course this is perpetuated by the pundits such as Suze Orman and Dave Ramsey who consistently make the blanket statement that permanent insurance is too costly and one should buy term and invest the difference. So, as I do indexed product boot camps across the country, my job is to educate the agents on why IUL is not so expensive if designed correctly and how the agents can explain this to their clients.
IUL has what I call “The Big Three” of expenses. These are the largest and most prominent expenses which the naysayers like to probe. Yes, there are typically additional expenses like rider charges, admin charges, etc. However, the bulk of the expenses come from three different areas:
• Premium Loads. When the client puts in their premium, there is usually a premium load which comes off the top of the “gross premium” to arrive at the “net premium.” For example five, six or seven percent.
• Per Unit/Thousand Charges. These charges are a factor of the face amount, which is usually deducted monthly from the policy over a period of time. The duration and severity varies by product, but a typical period on the per-thousand charges is the first 10 years.
• Cost of Insurance (COI)/Mortality Charges. These are usually the most significant charges over the life of the policy and are deducted monthly. The good news is that we can affect these charges by optimizing the death benefit for low COI charges. How? By using strategies including minimum non-Modified Endowment Contract (MEC) death benefits or option two death benefit switching to option one in the optimal year. By doing this, one is able to compress the net amount at risk as much as possible, thus minimizing COI charges.
Now let’s take an unnamed IUL and look at a hypothetical scenario. Let’s say we have a 45-year-old male (Bob) who is going to pay annual premiums of $10,000 to age 65. I am assuming a minimum non-MEC death benefit in this scenario in order to reduce COI charges and thus generate as much cash value as possible. This is because Bob is looking for maximum distributions/loans* once he retires at age 65. This initial non-MEC death benefit is $211,000. For purposes of the loan duration, I will assume retirement will last from age 65 until age 100. I am illustrating only five percent on this IUL and guaranteed wash loans. With the five percent illustrated rate, a zero-interest net “wash” loan, and loans to age 100 it is difficult to label this an inflated example.
In solving for the loan amount Bob can take, the illustration says the annual loan amount is to the tune of $17,998. In this scenario, a common conversation looks like the following. If Bob lives to life expectancy (age 82), he would have gotten seventeen years of tax free income—approximately $305,966. His beneficiaries would get approximately $275,397 of death benefit. This is a total of more than $580,000 tax free to him and his beneficiaries. Seems good, right? But what were the costs?
Since diving into the itemized expense ledger which most companies have with their illustrations would be like explaining how to create an atom bomb, here are my thoughts on explaining IUL expenses. This is where I love to use the Internal Rate of Return reports which many insurance companies have available in their illustration printouts. With life insurance from purely an internal rate of return standpoint, what is the best case scenario for the client and/or beneficiaries? They die young or they die old? Again, from just an internal rate of return standpoint, it would be if they die young, right? For example, with Bob’s life insurance policy, if he dies in year two, the internal rate of return is 330 percent ($227,953 death benefit to his heirs). This is because of the death benefit and the leveraging power of life insurance! As the late, great Ben Feldman would say, you are buying dollars for pennies.
So, if dying young is the best case scenario from purely an internal rate of return standpoint, what would be the worst case scenario from an IRR standpoint? Worst case scenario—Bob dies very old. The leverage power of life insurance burns off as the policy ages because of time (premiums paid), and the loans plus interest Bob is taking count against the death benefit. In other words, the worst case for Bob and/or his beneficiaries from a return standpoint is that he lives so long in retirement and takes so much in distributions for his retirement needs that he spends the death benefit down to almost nothing. Again, I usually use age 100 as the example. In this case the policy would have behaved very similar to an investment vehicle which only gave Bob the retirement distributions of $17,998 per year and very little death benefit. So back to the question: “How significant are those charges in this ‘worst case’ scenario?”
In this example, I look at the IRR Bob would have at age 100 after he put in $200,000 of premium (20 years times $10,000) and took out $629,930 ($17,998 times 35 years) in loans. Because I optimized the policy’s death benefit for distributions to compress the COI charges, the internal rate of return would be 4.56 percent or a taxable equivalent of 6.81 percent assuming he was in the 33 percent tax bracket. But, if we illustrated the policy at five percent, why is the IRR only 4.56 percent? Because of expenses. Therefore, what would be the total “expense drag” on this policy over the life of the policy? It would be 44 basis points (five percent minus 4.56 percent) per year. Many would argue that this level of expense is not astronomical, especially when the average A-Share equity mutual fund in the United States charges 1.5 percent in “management fees” (ici.org). Additionally, the expense of .44 percent was buying life insurance over Bob’s lifetime, so if he should die young in those early years, his heirs get multiples of what he put in, i.e. leverage. But even when this leverage has burnt off, it still was not a bad proposition for Bob because it cost him only 44 basis points.
Another method for looking at expenses is to look at the cash surrender value IRR in year 20, 30, etc., and check the disparity between the IRR and the illustrated rate. If you can get the disparity (expense drag) to one percent or lower, you have an IUL with low internal charges.
Again, these are not investments—but as you can see, if optimized correctly, the disparity between the IRR and the illustrated rate can be quite reasonable.
Remember, with IUL you are paying taxes on the seed and not the harvest. The value of putting in $200,000 which has been taxed and taking out $629,930 which is not taxed is huge. This cost is an issue only in the absence of value, and no one should be able to argue that there is an absence of value with IUL, even when utilizing a conservative example.
*Both loans and withdrawals from a permanent life insurance policy may be subject to penalties and fees and, along with an accrued loan interest, will reduce the policy’s account value and death benefit. Assuming a policy is not a Modified Endowment Contract (MEC), withdrawals are taxed only to the extent they exceed the policy owner’s cost basis in the policy and usually loans are free from current federal taxation. A policy loan could result in tax consequences if the policy lapses or is surrendered while a loan is outstanding. Distributions from MECs are subject to federal income tax to the extent of the gain in the policy and taxable distributions are subject to a 10 percent additional tax prior to age 59½, with certain exceptions.
The information contained in this article is not intended to serve as tax or legal advice and does not address individual circumstances. Pursuant to IRS Circular 230, Partners Advantage Insurance Services and their representatives do not give tax or legal advice and cannot be used to avoid tax penalties or to promote, market, or recommend any tax plan or arrangement. Encourage your clients to consult their tax advisor or attorney.
