Illustration Rocket Science
As I sit here, I am looking at an indexed universal life (IUL) insurance illustration that is 56 pages long. The “Tabular Detail Ledger” is eight columns wide.
To the untrained eye the details of an illustration can be very daunting to look at because…where does one start? It’s a very important stack of papers, but yet the risk of “analysis paralysis” is high when the agent or client looks at it. The agent may think, “Where do I start to explain the illustration? Do I discuss every single value, every single year? Why does one column increase while the other columns decrease? How are all of these numbers arrived at?” Etc.
And ever since I mentioned IUL illustrations about 20 seconds ago—depending on how fast you read—I know what has probably entered your mind as the elephant in the room. That elephant is the controversy around IUL illustrations and max illustration rates. To be clear, the “proper” illustrated rate to use is not a topic of this column. Nor is the recent product developments that have proliferated since the AG 49 regulations. I have already written on those topics and you can email me if you would like me to send you those past columns. Rather, this article is about using the illustration for educating the client on cash value life insurance, whether the illustrated rate is one percent or six percent.
My opinion is, we need to be able to explain the illustration contents to our clients effectively. After all, depending on the state the case is being sold in and the insurance company being used, the client is usually required to sign the illustration!
I am a believer in disclosing everything, but I am also a believer in being able to explain everything in a simple manner so the client understands everything. To me, the last thing an agent needs is for the client to completely disregard those pages and sign the illustration because it is just too daunting. To that end, if you have taken out a mortgage lately did you read all of the documentation that you signed? I didn’t think so.
So, over-disclosure and over-illustration can present a risk in that it can completely dissuade the client from even paying attention to the illustration when the client would have otherwise paid attention if the illustration were shorter. It’s a balance.
In the wake of a lot of controversy around unrealistic illustrations, I have had some folks suggest that the illustration should not even be a part of the sales conversation and almost suggest that by doing so the agent is acting in an unethical manner. That is going too far in my opinion. My response to that has always been this: “So you suggest that the client sign something that the agent did not even discuss?” In other words, if in most states with most companies the illustration is required to be a part of the sale, then I believe you cannot ignore the illustration.
Even if an illustration is not required, I am still a proponent of using them. The illustration is a visual representation of how the values act year after year, how the columns (Cash Value, Surrender Value, Death Benefit) react to withdrawals and loans, etc. It can be an educational tool if used correctly!
So, what if there was a roadmap as well as a method to explaining the illustration in a simple manner so the client can actually understand it? This may sound like a lofty task, but it can be done. Again, this is not about fluffery, this is about education.
The Most Common IUL Illustration is the Most Complicated
Many times, the most complicated illustrations can be those where the client wants to maximum-fund the policy over X years, then take tax-free loans out against the policy to supplement their retirement income. These types of illustrations are actually the most popular type that are run when IUL is being considered. As a matter of fact, Wink’s Sales and Market Reports quarter-by-quarter will tell you that 80 percent or so of IUL sales are of the accumulation design—versus other objectives like guaranteed death benefit, wealth transfer, etc.
So we are going to use a “max fund” scenario where accumulation then loans are illustrated. We will simplify this conversation into four very simple points. I will also educate on those points as we go through them. (Disclosure: The following demonstration is not all encompassing of the discussion of caps, spreads, expenses, etc. that should be incorporated into the agent’s conversation with the client.)
We have Bill, a 45-year-old male in good health, who needs life insurance and has $10,000 per year to utilize for an IUL policy. He wants to maximum-fund this policy because 20 years from now, at retirement, he would like to begin taking loans against the policy as retirement income. With my favorite IUL we will assume a five percent illustration rate and solve for a loan amount that can be taken against the policy from age 65 until age 85.
Note: For this unnamed product, five percent is a conservative illustrated rate that is well below the AG49 rate. I use this number for two reasons: 1. I believe the illustration should be about explaining the policy, not hyperbole. 2. Because of the time value of money with these policies, even at five percent, these policies still work great in many scenarios!
In this scenario we chose an increasing death benefit (Option 2 Death Benefit) switching to level (Option 1) after the premiums are paid. This death benefit option will allow a lower face amount versus a level death benefit. What this does is it decreases the net amount at risk (death benefit minus cash value) in the policy which, in turn, reduces the cost of insurance charges. The face amount on this policy, per IRS regulations, is approximately $239,000.
Four Points on the Illustration
Illustration Point #1: The Seed
If the IUL is designed properly, one of the benefits of those retirement distributions (loans) is that they are potentially tax free to the client. Yes, the premium that Bill put into the policy has already been taxed, but, if the policy is set up correctly, the distributions are not. I like to say that with IUL you are paying taxes on the seed but not on the harvest.
The first of the four points on the illustration is to point out what the premium/seed is going into the policy—not just the annual premium/seed, but the total of those 20 premiums. In this scenario Bill would be putting in $10,000 per year, or $200,000 over the 20-year period until age 65.
The “seed” is the first point on the illustration to emphasize.
Now, what can Bill potentially get in return for that “seed” of $200,000?
Illustration Point #2: The Potential Harvest at Retirement
The second crucial point on the illustration is the year in which he would like to retire, which is typically age 65. In this year you want to discuss a couple different points:
- Death Benefit. What does the death benefit look like in that year of retirement before the loans begin? In this scenario Bill’s death benefit has increased to a little more than $546,000. This is a point that presents an opportunity to discuss why you illustrated an increasing death benefit—the fact that it decreases internal expenses in the policy and it also offers the ability for the death benefit to offset inflation.
2. Surrender Value. At age 65 Bill’s surrender value is $315,129. This warrants a discussion around the fact that he put in a “seed” of $200,000 and is able to, at that time, take out a “harvest” of $315,129. That is, assuming the illustration is 100 percent accurate—which it never will be.
This is where you discuss the fact that the illustration was assuming five percent, which is merely a projection and not guaranteed. Also, a conversation around the “guaranteed values” is important at this time. CG Financial Group provides agents with pieces on discussing the “Power of Indexing” and also the guaranteed columns.
As you discuss the “projected” $315,129 in surrender value in that retirement year, you can tell Bill at that point that he could request that money to be sent to him and the insurance company will send him a check. He could cash out that entire $315,129!
However, the check is not the only thing the insurance company will send out in this scenario. They will also send out a 1099 for the difference between what he put in (basis) and what he took out. Any time a life insurance policy dies before the client dies, it is taxed like an annuity! Thus, he would get a tax bill on $115,129 ($315,129 minus $200,0000) in income. Clearly, we do not want this. So, this is where you tell Bill how he can get access to that “harvest” without the 1099 coming. This is where you move on to point #3.
Illustration Point #3: The Loan Amount
In the first year of retirement for Bill (age 66) he can take loans against the policy of $26,218 in this example. As you point this number out you want to explain two different things to Bill:
- Again, the loan is typically not taxable. Why not? Because loans generally are not taxable! When he goes to the bank to get a mortgage or a loan those transactions are not taxable to Bill, correct? This situation is no different, assuming it is a non-MEC contract of course!
2. You projected the loans to run until age 85. If he wanted the loans illustrated longer—age 100 for example—you can run it that way as well.
When I am training agents, I like to point something else out: Have you ever been asked by the client, “Why do I have to take a loan from myself? That is my money I am taking out!” Here is my explanation which we have a separate tool for:
The client is not taking anything out of their policy. What is happening is the client is going to the insurance company and the insurance company is making a loan to the client, in this example to the tune of $26,218 per year. These loans are not much different than Wells Fargo giving the client a loan. However, how does the insurance company guarantee they would get their principal plus interest back should the client die or surrender the policy? This is where the insurance company collateralizes the surrender value (second column) and the death benefit (third column) of the client’s policy year by year as those annual loans are taken.
This is a very risk-free loan for the insurance company because the principal—plus interest—are fully protected by the policy. This is why you see the “Surrender Value” and “Death Benefit” columns on the illustration decreasing once loans are taken. Not because money has been taken out of the policy, but because a portion of the surrender value and death benefit is being used as collateral!
Furthermore, this is also why the accumulation value, also known as cash value, is not decreasing—because the client did not take one penny of their cash value out of the policy. The client merely got a loan from the insurance company and the insurance company used the surrender value and death benefit as collateral. Again, on the illustration the accumulation value usually continues to grow while the surrender value and death benefit decrease.
Illustration Point #4: Life Expectancy
Although Bill, as a 45-year-old male, has a life expectancy of slightly less than 80 (per the Social Security tables), I will generally use age 85 as a rough life expectancy for simplicity.
This is where I summarize everything. Here, I will reemphasize the fact that he would be putting in a “seed” of $200,000, but in exchange for that “seed” he would be allowed total loans over his lifetime that add up to $524,360 ($26,218 times 20 years) that will not be taxed. The illustrations will generally add these numbers up for you in five-year increments. I then point out that the $524,360 was not the total “harvest” the policy would have generated in our example. Why not? Because, if Bill happened to pass away in that year (age 85) there is also a death benefit that is passed on to the beneficiaries that is tax free. The death benefit in this scenario is $112,814.
So, in this scenario there is a total “harvest” generated from the insurance policy of $637,174 (total loans + death benefit) versus a “seed” of $200,000. Again, this is based on the projection of five percent, which is just that—a projection.
And that is how you discuss the illustration in a simplified manner.
Internal Rate of Return Reports
At this point in time, especially if the client is more on the analytical side, the client may want to discuss the costs in the policy. In other words, is putting in $200,000 into something that generates a value of $637,174 forty years later a good value? Unless the client is savvy with the cash flow functions on a financial calculator, that can be hard for them to quantify. This is where I like to utilize the Internal Rate of Return Report that usually can be included in the insurance company’s illustration.
To me, the IRR reports are invaluable when it comes to quantifying the value of the policy, and also in quantifying the expenses embedded in the policy. For instance, the IRR in this policy between the cash flow and the death benefit was a tax-free IRR of 5.55 percent.
At CG Financial Group we work with a lot of IUL agents and I personally do a decent amount of personal production with IUL. With that, I have an observation: I have never had a client say, “Charlie, the amount of the retirement distributions on your illustration are five dollars less than your competitor’s.” Never!
Again, it shouldn’t be about fluffing up the illustrations because these products just work! If the clients aren’t forcing us to illustrate higher rates, then why do we as an industry continue to wage illustration rate war?