Most athletes will tell you that the pain of losing is far greater than the joy of winning. Pat Riley, the legendary coach and team executive, said it even more succinctly: “There’s winning, and there’s agony.” This is a psychological concept called loss aversion that was first posited in the 1990s by Nobel Prize winning economist Daniel Kahneman and his research partner, Amos Taversky. Kahneman used to do an experiment with his students called the Coin Flip Scenario. He asks a student if he or she wants to flip a coin. If it lands on tails, then the student pays him $10. If it lands on heads, how much would he or she have to win to make it a worthwhile gamble? For most people, they would have to win at least $20 to make the bet. In short, the pain of losing $10 can only be offset by the possibility of winning an amount much greater than $10. This is because, for most of us, pain is more acute than pleasure.
This same result plays out over a wide variety of situations, including personal finance decisions. This is why diversification is so important and a core part of every good financial plan. However, even in something as seemingly straightforward as diversification, there are differences of opinion. For some diversification is finding a good potential return and layering it with a great potential return. This is the “if some is good, more is better” approach. This can work in some situations, but, if the two options are closely correlated, you’re really not protecting against the downside risk. You’re really just trying to maximize the positives and hoping to weather the storm when things don’t go your way. However, if we believe that diversification is more about risk management, then our approach should be one of mitigating negatives rather than maximizing positives. In life insurance, I would suggest that putting all of your client’s money into one type of product is closer to the former than the latter, even if you have multiple index options from which the client can choose. To truly diversify your client’s plan you need to look at more than one product. Much has been written in these pages and elsewhere of the power of indexed universal life, so for this article I’m going to talk about the benefits of looking at whole life, not as an alternative, but in conjunction with an IUL.
The First Day is the Worst Day
A whole life policy provides guaranteed cash value growth each and every year. That means that regardless of market conditions, interest rates or company decisions the client sees an increase every year. In addition to the guaranteed cash value growth, whole life also provides a non-guaranteed element—dividends. While dividends cannot be guaranteed to be paid, the impact that they have on the policy, once paid, is guaranteed. If the client elects to use dividends to purchase paid-up additions, then both the guaranteed cash value and the guaranteed death benefit of the policy increase. That means that those increases can never be taken away. In an IUL the potential for increases in cash value is potentially significant, but it is not guaranteed and can be more or less than what is illustrated. If the return is less, or potentially zero, the cash value in an IUL can also potentially decrease as cost of insurance charges are applied. For a client that is concerned about seeing her values potentially go down or even stagnate for a period of time, whole life can be a solution. If a portion of her money goes into whole life, then that portion will either grow exactly as illustrated on the guaranteed side, or if a dividend is paid, will look even better. In short, with whole life the first day is the worst day her policy will ever have. If anything changes, it changes for the better.
The most important part of any financial plan is the money that goes into it. That is especially true for insurance. If the client can’t pay the premium, then the plan won’t work as promised regardless of interest rates or market performance. So what happens if your client becomes disabled and can’t afford to pay their premiums? Most IULs offer a Waiver of Monthly Deduction rider, which is valuable, but doesn’t guarantee that the premium is paid. Rather, it waives the costs that are deducted, so while the cash value won’t decrease due to cost of insurance charges, it also won’t grow as planned because the premium isn’t being paid. Again, for a client who is concerned about seeing her values stagnate in a vehicle that she planned to use for retirement income, whole life can be a solution. With the Waiver of Premium rider on whole life every dollar of the client’s premium into their base whole life policy continues to be paid. Many companies also have a Disability Benefit rider that will waive some or all of the additional premium being paid into a paid up additions rider. This means that, if a client becomes disabled, the portion of her retirement savings that she allocates to whole life continues to be contributed just as if she were paying it herself. In short, with whole life you not only guarantee the cash value growth, you also can guarantee the contribution.
The moral of this story is that our conversations should not be whole life or IUL. The choice shouldn’t be binary, especially when we consider the concept of loss aversion—the pain of losing is far greater than the joy of winning. Whole life ensures that some portion of your client’s plan is guaranteed to grow, even if the client becomes disabled. So to truly diversify your client’s plan and mitigate those negatives, we should be talking about whole life and IUL.