The circle of life insurance underfunding: Where we are in the food chain
By Kevin Startt
A better educated consumer lies at the foundation of the agent’s first responsibility in “doing no harm,” but illustrating policies at zero over common time periods is a viable solution as well. Policy performance hyperbole by some agents is the bigger problem.
Who profited the most from Black Friday? The one who was smart enough not to camp out the night before for that $25 espresso machine. I am reminding you of the one who profits most from the sad chronicles of the circle of life insurance and the continuing saga of policy underfunding that has now created barnacles on the cash values of many a contract since EF Hutton bought the first universal life insurance contract in late 1970s.
I remember as a young Hutton broker looking at the early dinosaur- like computers spit out illustrations showing 11 percent returns. I remember the chants of paid-up premium (PUP) from paid-up additions providing short pay premiums that, at exorbitant interest rates, would easily pay a policy off forever with just a few premiums. Right. And pigs can fly over ocean-front property in Kansas. That never happened, unless a policy was juiced with sky-high funding.
My father-in-law bought one of those in 1984 for my now 28-year-old son and just paid off the premiums about four years ago with considerably less cash value that anticipated. The siren songs of variable universal life in the mid-90s were illustrated at 12 percent, and I asked a group of agents why they were illustrating an unsustainable rate that would require a gross rate of return of 16 percent for a standard 45-year-old non-smoker to sustain the policy. I remember asking these agents how many 20-year periods there had been since 1926 that produced that rate of return. Their answer? Zero. The number of 10-year return periods since 1926? Out of 80-plus 10-year rolling periods, there were two, and we were living in 1998 during the tech run-up in one of them.
The "bank on yourself," "tax-free retirement income," and “new insurance adviser” books have been rebutted except in the realm of policies that are grossly over-funded because of low equity returns and interest rates. I was not surprised when I read that today’s all-time low interest rates are killing life insurance policies once again. This is the great insurance policy circle of life that has pervaded the sales of UL-VUL and now FIUL. I was therefore not surprised when a recent large life carrier provided warnings of knowing who you are doing business with and chronicling Baldwin-United Piano-turned-annuity-seller from 1983, when in fact they themselves were regularly illustrating 8.5 percent on their FIUL contract as late as 2009. Now, many of these policyholders will be facing the shock of additional premiums unless they find a retirement savior. Many times, that will involve keeping the policy, much to the chagrin of cash-strapped consumers. If policyholders next year do not kick in additional life insurance premiums, they will be getting a notice that they must add additional premiums to the contract to keep the policy in force or face the prospect of lower death benefits. As the Wall Street Journal mentioned last month, this is a “life insurance ticking time bomb” again. There is no doubt that life insurance as a potential tax-advantaged income source is a powerful concept if its illustrated right and if it performs properly. The life insurance illustration is still a shell game, and until agents under-promise and over-deliver, it will remain a shocker for savers and a reminder that life insurance performs a number of potential beneficial functions, but remains a death benefit solution or final expense solution first and foremost. Many advisers are reporting that on pre-2008 policies, 70 percent of policyholders are facing out-of-pocket costs and jeopardizing the tax-free retirement income story they were pitched.
In the meantime, authors who pitched these concepts — some of whom do not even maintain a life and health license — are laughing all the way to the bank after millions of book sales. Although agents are required to show three different scenarios in illustrating a policy, many policyholders are led to the current performance scenario based on past performance which has been heavily geared to the good old 60-40 allocation of stocks and bonds in the case of VUL and FIUL, while UL illustrations are plagued by historically low rates. The good old 60-40 Modern Portfolio Theory illustration has been a dud for 13 years. However, a broader allocation has actually performed at a clip of 8 percent plus with small caps, real estate and hard assets added. Most agents, though, still use MPT.
In summary, how many different policy designs and illustration regimens must we go through to get this right? A better educated consumer lies at the foundation of the agent’s first responsibility in “doing no harm,” but illustrating policies at zero over common time periods is a viable solution as well. Policy performance hyperbole by some agents is the bigger problem. When the policyholder asks which policyholder wins, we can’t be like the jockey who looked glum and said, "The horse was so slow, I had to carry a saddle.” That saddle will be in the form of additional premiums that many policyholders can’t afford or a lower death benefit that many beneficiaries can’t afford either.