Comments on: Life Insurance: What to Buy

By: Peter S.

Peter S. — Fri, 30 Sep 2011 20:55:59 +0000

@TFB – If you got your insurance license, I would not become your client until you satisfactorily answered my last question…

By: Peter S.

Peter S. — Fri, 30 Sep 2011 20:45:51 +0000

@TFB – I had little choice but to spend a lot of time, effort and IQ trying to figure out how EIULs work because I was literally unable to find an agent that FULLY understood them. Even agents that sold EIULs since they were introduced some 15 years ago had huge holes in their understanding of even the basic concepts, let alone the contract fine points. To make matters even more challenging, I found carrier illustrations in many instances to be incomplete, materially misleading, or flat wrong. Doesn’t say much about regulators.

If one doesn’t understand all the policy fine print (and how those provisions can affect performance), most illustrations are a minefield that can later tear off one’s financial limbs… Agents tend to lead one to believe carrier-issued illustrations are projections when, in reality they are nothing but a meaningless snap-shot of the present, mindlessly extended for as much as 100 years with NO changes to ANY variable during all that time!

Adding to the due diligence burden is the fact that the actual amount of future fees and cost of insurance charged to the policy holder will be a function of the carrier’s actual and PROSPECTIVE investment returns, expenses, mortality rates and lapse rates. Similarly, future cap rates will be a function of market interest rates and the carrier’s hedging prowess. Lastly, the projected claims paying ability of the issuing carrier is a major risk factor that can’t be assessed without underwriting the company, relying on a rating agency, or both. Unfortunately, agents are almost useless in this endeavor.

Having said all that, EIULs are really no more complex or “complicated” than any other investment, especially where principal is at risk. Things only seem complicated until the “Aha!” moment of understanding is reached. Then, the most complex financial instruments become really simple. Some good, some bad.

Madoff’s regulators, investors, bankers, auditors and lawyers all thought he operated a proprietary, ultra-sophisticated, stunningly successful, complex investment scheme. Once understood, it magically morphed into a simple Ponzi scheme every 5th-grader can understand in five minutes. With due diligence, there are no shortcuts. One should never invest without ACTUALLY understanding. Meanwhile, assume all “facts” to be fairy tales until verified.

Clearly, EIULs are a complex product, designed for a potentially lifetime commitment to the contract and the carrier – definitely not for everyone (not that any financial product is). Though EIULs passed my DD, It may not be for me IF there are alternatives to the cash value component that have historically been able to match or exceed EIUL crediting rates over the long term. That is the last, still missing part of my DD. I was hoping you might be able to provide some impartial, objective insight or point me in the right direction for further DD.
Thanks again.

By: TFB

TFB — Fri, 30 Sep 2011 18:50:12 +0000

@Peter – I don’t have anything else to add beyond what I already wrote. It sounds like you are already convinced that an equity indexed universal life insurance policy is the best fit for you. Go ahead then. It’s your money.

I also want to commend you for being one of the most knowledgeable equity indexed universal life insurance prospects. Your agent should be very happy. Too bad I don’t have a life insurance license. Otherwise I would want you to be my client.

By: Peter S.

Peter S. — Fri, 30 Sep 2011 05:09:46 +0000

@TFB – Well, we agree both we prefer to live longer than shorter! But, my point was, the death benefit component of an EIUL is not “expensive” – as measured by the IRR. In fact, the premiums are comparable to term policies of same duration (as they should be – the same mortality tables are used).

We also agree, Roth style plans may address some of the tax rate risk, and we agree all other options require risking the principal. But, my point was, investments in 401k and Roth plans SIMPLY DO NOT PERFORM WELL ENOUGH for their participants, considering the risks taken. I don’t know of any principal-risking investment option within 401k/Roth style plans that ACTUALLY delivered returns exceeding the EIUL over the long term. The Dalbar‘s new QAIB 2011 study is quite revealing: long term investor returns suck. Seems to me, higher risks warrant higher returns. I was hoping you might point out a few alternate options? Otherwise, the EIUL seems like a wise choice for me (even if it doesn’t share in dividends), at least for some of my money.

You raised lack of diversification. Ironic, because TOO MUCH diversification may be a major contributing cause of the dismal long term performance of funds in which 401Ks invest (wasteful fees and turnover are some others). The winners in those crowded funds simply do not have the impact they should – severely chopping off the upside, and disproportionately so. After all one can only lose 100%, but the upside can be 400,000% (Berkshire Hathaway).

Yes, we agree that EIULs are intended for long term holding, but they are no more “irrevocable” than any other investment designed for holding. It is their long term nature that creates the advantages, not unlike those of bonds, CDs and even some mortgages. Of course, there is always a price for “early withdrawal”. But, that is not the issue, as I am prepared for long term holding.

The unresolved question is, has any other investment vehicle, principal-risked or not, short term or long term structured, indexed or not, dividend sharing or not, taxable or not, diversified or not, performed as well or better than an EIUL with crediting formulas as I described – OVER THE LONG TERM – as measured by its annualized return or IRR. Thanks again!

By: TFB

TFB — Fri, 30 Sep 2011 01:45:34 +0000

@Peter – It doesn’t surprise me you would get a huge IRR with life insurance if you die early. I just prefer to live longer.

If you are concerned about the tax rate increase you can use Roth 401k, Roth IRA and convert your Traditional accounts to Roth, although I’m not as concerned or a big fan of using Roth accounts.

You are correct that all other options require risking the principal. I still think not getting the dividends is too big a cost for cutting off the down years. So is lack of diversification. If the US market becomes like Japan in the last 20 years, this EUIL will do poorly.

Also, isn’t this pretty much an irrevocable deal? Once you start it, you will have to continue until you die. If your plan changes for whatever reason, the costs of insurance are gone and all credited earnings become taxable.

By: Peter S.

Peter S. — Fri, 30 Sep 2011 00:15:46 +0000

Typo in my previous post: correct Death Benefit at age 55 is $622k, not $222k. The corresponding 13.1% IRR is correct.
Sorry

By: Peter S.

Peter S. — Fri, 30 Sep 2011 00:05:04 +0000

@TFB – Thank you for your thoughtful suggestions. I have not found any carrier that does not exclude dividends from the S&P 500 index. I have confidence in the S&P 500 simply because of what it is. I have not back tested the 0% floor / 12.5% cap crediting formula against other indices to see if they beat the S&P. Have you or anyone else? What caught my attention about the EIUL was not its great upside potential (the cap limits it), but its APPARENT ability to very effectively protect against the downside AND STILL OUTPERFORM all indexed and most mutual funds. If my back test calculations are correct, for the past 10 and 15 years, I would have LOVED to take a 6.3% and 7% return, respectively, vs. what any fund did, except maybe Warren Buffet’s.
If the latest Dalbar report is to be believed, the actual historic net return realized by individual investors for the past 20 years was a little over 3% vs. about 8% returned by the S&P 500 (including dividends) and about 7.5% under the EIUL crediting formula. I doubt Dalbar’s explanation of bad investor timing fully accounts for their shortfall, but, for whatever reason, the chances of my 401k even approaching the S&P 500 seems remote, at best. Except to the extent my company matches contributions with what amounts to additional salary, I am questioning the wisdom of putting more money into the 401k when (1) my principal is fully at risk, (2) I bear full volatility risk, (3) I risk increases in the tax rate as will be applied to deferred income, and (4) the historic net returns after all fees, commissions and yet unknown taxes don’t seem to adequately compensate for these very real and significant risks.
I understand I am effectively prepaying taxes if I pay into an EIUL, but, a future (and in my opinion very likely) increase in tax rates could easily turn that into an advantage.
As for the PURE life insurance component, at an assumed annual 6.5% crediting rate (120 bp under the back tested results for the formula), the internal rates of return (after all fees, charges and cost of insurance), seem reasonable even in the later years (I don’t expect to last past 85…):
Age 55 $222K Death Benefit – IRR 13.1%
Age 65 $717k Death Benefit – IRR 9.7%
Age 75 $829k Death Benefit – IRR 6.4%
Age 85 $779k Death Benefit – IRR 4.5%
Age 90 $500k Death Benefit – IRR 2.8%
The earlier I go, the higher the tax free IRR. The later I go, the lower the IRR, but I would continue to realize what seems like relatively high returns if I overfund the policy to build cash value. And if I die early the cash value from over-funding will be added to the death benefits, paid tax free to my family. Any holes in this thinking?
Bottom line: a 4.5-5% tax free IRR on the DB at age 85 is not bad; and I don’t know how to beat a concurrent 6.5-7.7% tax free IRR on the overfunding.
Based on past performance of different options, I don’t know what else to place money into for comparable returns without risking principal and, in my opinion, inevitable tax increases. Additionally, inflation will likely rise as the money supply is expanded to pay for debt, so outpacing inflation will be another major issue. Any suggestions?
I especially value your opinion after having read just about all your posts – I am very impressed with your intelligence and unbiased, clear thinking.
Thank you.

By: TFB

TFB — Tue, 27 Sep 2011 19:51:01 +0000

@Peter – Excluding dividends is a big deal. Don’t under-estimate its effect, especially if the returns will be low as some pundits say (“new normal”). In a low return environment, dividends are a large contributor to the total return.

Linking strictly to S&P 500 is also a problem. If you otherwise would invest in a diversified portfolio with small caps, emerging markets, commodities, etc., and those investments would do better than US large caps, you won’t be able to benefit from the higher returns.

Comparing tax free loans and inheritance with 401k being taxable at the time of withdrawal is not taking into account the tax exclusion on 401k contributions. Suppose you stop contributing to your 401k now and start paying into this EIUL, you lose the exclusion and your taxes will go up. You are basically prepaying the taxes for your future tax free loans and inheritance. If I buy an EIUL, I would do it in addition to contributing the maximum to my 401k, not in lieu of.

For many others, the cost of insurance is an extra cost. If they didn’t want the investment features of an EIUL, they don’t need and wouldn’t buy life insurance year after year into their 70s, 80s and 90s, which costs a lot of money. You are saying you want it anyway. Are you sure? If EIUL isn’t available, what and how much life insurance would you buy?

By: Peter S.

Peter S. — Mon, 26 Sep 2011 22:35:16 +0000

TFB – I have been examining the investment component of equity indexed universal life (EIUL) insurance policies (within MEC limits) as an alternative or supplement to investing in more mutual funds within my 401K. Some insurance companies offer interest crediting formulas linked to 100% participation in the S&P 500 Price Index (dividends excluded), currently subject to a 12.5% cap and a 0% floor, as measured point-to-point, credited annually. In other words, whenever the Index rises during a measured year, the carrier credits the cash value account by the percentage increase of the Index, up to 12.5% (some carriers offer 15%). If the Index falls, the interest credited is 0% – regardless of the amount of the fall (some insurers offer a 1or 2% guaranteed floor). The interest so credited is compounded and is tax deferred.

To “back test” the formula, I applied it to the published monthly historical change of the Index starting the first trading day of August, 2011 and going back 60 years. Assuming such a contract was always available and the cap and floor remained constant, the compounded annual crediting rate would have been 4.74% going back 3 years vs. 2.95% change in the Index. Corresponding figures for going back further are, 5 yrs – 5.27% vs. 2.1%, 10 yrs – 6.29% vs 0.34%, 15 yrs – 7.07% vs. 3.99%, 20 yrs – 7.49% vs. 5.59%, 30 yrs – 7.49% vs. 7.81%, 40 yrs – 7.13% vs. 6.37%, 50 yrs – 6.91% vs. 5.86%, and 60 yrs – 6.96% vs. 6.75%.

I know such back tested past “performance” can be unrealistic and does not guarantee future returns, but it is indicative in some ways. I am reluctant to keep putting more into my 401K (now unmatched by my employer) and subject it to the continued risk of principal loss and the vagaries of the stock market (my net compounded in return in the 401K over the last 11 years was actually negative).

Should I die, my family would collect the accumulated cash value, also tax free. I doubt that would be the case with my 401K. I can borrow against the cash value at a net cost less than 0.25% – also tax free as long as the policy is not a MEC (and without any obligation to pay it back while I am alive).

Yes, I know I can't do this without paying for the cost of coverage under the death benefit component, but I do need and want permanent life insurance and the cost of that is acceptable. The principal risk I see is whether the carrier will still be around when I need them. I intend to bet on a large carrier that is among Weiss Ratings' admittedly thin A list – a group that has weathered many storms. The secondary risk is the insurer's ability to change the cap (up or down), albeit they have to do it consistently for all policy holders in the same risk class. The carriers I am considering have a good history in this regard, though not more than about 15 years.

Does the concept and my logic make sense to you and your readers? Am I missing or ignoring some key element?
Thank you for any insight!

By: David

David — Mon, 04 Apr 2011 20:54:49 +0000

It appears there was an error in my illustration. According to the analyst I spoke to today, the N/A is supposed to be an actual number. Apparently, I’m the only one who caught it. The number would be either positive indicating an actual cost or negative indicating that you made money on a per thousand dollar basis. I also confirmed with him what I previously told you which is that all policies carry the same guaranteed mortality costs. If mortality experience is lower than expected, then the insurer has effectively overcharged you and subsequently refunds the difference in the permanent policy and adds it to any guaranteed cash value amounts in the policy. For policies with assumed costs (i.e. ULs), the insurer charges an amount lower than the guaranteed mortality costs, never overcharges you, so there’s nothing to refund. If costs are higher than expected, you simply pay the extra out of the cash value or out of pocket. But, either way, the guaranteed mortality costs and actual costs are the almost the same for all policy types. One thing I was potentially mistaken about was level term policies. This is where the difference in mortality costs would come into play. The insurer keeps any overage for term policies, since there are no non-forfeiture options on term, meaning you might end up overpaying for term, ironically, where that will never happen with whole life. But, there’s not usually much overage, so I wouldn’t feel so bad about anything you don’t get back. He also mentioned that less than 1 percent of term policies ever pay out a death claim making it a pretty decent money maker for insurers (which didn’t surprise me). I guess that explains why lots of companies push term.