Life insurance proposals: vapor on paper
By Steve Savant
Life insurance proposals are a form of advertising. Nowhere is this more evident than when a carrier proposal illustrates supplemental retirement income scenarios.
The proposals are now larger than the applications — dominated by disclosures, disclaimers and caveats. I can’t remember the last time I closed a sale on the basis of reading the proposal caveats to the client. The numbered pages don’t even show up until deep into illustration.
When you finally arrive at the premium contribution page displaying the numbers, they look great — sometimes spectacular. But most of the time it’s just vapor on paper.
Hopefully by now, it’s common knowledge that proposals from the late 1980s to present rarely accumulate the projected cash values or distribute the income stream illustrated. Here’s how to add substance to your quotes and give your income proposals a fighting chance at reality.
Now, you don’t have to drink my Kool-Aid, but it’s fortified with facts. But first let me confess, I’m a narrow minded premium purist. I generally use indexed universal life for supplemental retirement income scenarios and guaranteed level term life and guaranteed universal life for indemnification planning.
There are rare exceptions to my indemnification rule: For a small increase in premium over a carrier’s GUL premium, their IUL can generate similar guarantees. But I generally don’t use IUL for indemnification planning, which is almost always a commodity sale where the premium price tag wins the case and not based on cash value accumulation.
Before moving on to tax advantaged income through IUL, I want to acknowledge all the life insurance funding chasses for supplemental retirement income: variable universal life, IUL, current assumption universal life and participating whole life.
VUL policies offer access to equity and bond market returns for long-term hold positions of investors who understand principle risk. IUL policies offer access to indices, domestic and global for long-term savers. CAUL polices offer long-term savers access to current interest rate crediting with a guaranteed interest rate credited throughout the life of the enforced contract.
Whole life polices offer long-term savers guaranteed premiums for the life of an enforced contract with dividends, comprised of earned interest from dominate holdings in investment grade U.S. bond portfolios and the return of unused premium through expense management. They all have their strategic space in life insurance income scenarios, but I’m addressing IUL because of its current popularity.
Keep in mind that all four funding chasses have policy expense loads, the largest being the cost of insurance and the only expense you can regulate in your design of a proposal illustrating supplemental retirement income. The following design tactics will reduce the COIs, increase the net rate of return and greatly mitigate the negativity that comes from suggesting life insurance as a supplement retirement income strategy.
Over the last decade I have not written a life insurance case for a non-qualified supplemental retirement income scenario on a male — only females within the family. All things being equal, female COIs are considerably less when compared to their same age male counterparts. But with married couples, the majority of sales scenarios, all things are not equal. Females are statistically younger and are more likely to secure a better underwriting offer than males. Female COIs just cost less. Therefore, the female is the insured.
The next step is designing your proposal at the onset with the minimum non-MEC death benefit and reducing the death benefit to the DEFRA corridor as soon as the TAMRA guidelines allow, generating an improved net rate of return during the accumulation period.
The tactical use of level or increasing death benefit depends on the scheduled annual premiums; seven years or less — level death benefit and 12 years or more — increasing death benefit. You’ll need to beta test both death benefit options between eight and 11 years to determine the lowest COIs. There are reasons for this, but not for this article.
Indexed universal life has four fixed or variable policy loan options: zero net cost loans, wash loans, spread loans and arbitrated loans (participating.) I try not to use the phrase participating loans because of the confusion with participation whole life policies and especially direct recognition loans.
My first choice is always zero net cost loans — the charging and crediting of the same rate generally 30- 60 days apart. But I’m often forced by competition to use arbitraged loans. In that case, I insert a huge disclosure that caveats the worst distribution scenario of the last decade — where the S&P was in 2001-2003 and 2008 — to illustrate the real loan impact, whether you use variable or fixed policy loans.
This really matters during the income years. We all use look back crediting rates for our proposals. You better start looking back at the last 10 years for distribution scenarios. I’ll elaborate on that shortly.
Many non-FINRA producers illustrate the worst 10-year period in the S&P 500 at 5.85 percent, but that’s with dividends. So without dividends, the S&P return would be lower.
For my FINRA sophisticates I use the historical returns of the one year point to point at 5.5 percent. Historical returns for the 20-year holding period based on over 40 years (285 periods) of rolling monthly index segments, with 20 years of S&P 500 return data in each segment starting January 1968 through September 2011.
If you run any of the real IUL income players at 5.5 percent, managing the death benefit as I suggest, they beat the best current dividend paying par whole contract — not by much, but it does. At a crediting rate of 5.5 percent — a tax-free crediting rate using withdrawals to basis and policy loans of gain on an enforced non-MEC policy — the taxable equivalent is 7.85 percent in a 30 percent blended tax bracket.
Think about the market risk to generate a 7.85 percent return. After 2008, most baby boomers wouldn’t take the risk. One last thought here: Tax-free income as described in this article will not be included in the provisional income test for Social Security benefit taxation. This is huge if you believe that net spendable income is the goal.
Indexed universal life was constructed to perform around 200 basis points above the current interest rate environment. I’m right at the edge of comfortability showing a maximum rate of 7 percent, but no look back numbers beyond that. If a producer wants the 20 or 30 look back rate, fair enough, but my proposal will include a memo of caution from me.
Now, are you willing to examine the look back scenario of a retiree, who scheduled his life insurance income to start in 2001 and has been receiving income through the end of last year at 2011, the worst decade in modern times?
Four out of the 10 years were non-crediting years. If I had an arbitraged fixed loan rate at 5 percent, in any of those years, I’d be forced to punt and use available withdrawals to basis because it costs me nothing. Otherwise the arbitraged loans cost me 500 basis points.
In years 2001-2003 that adds up to a compounded loss. Withdrawals of basis can help salvage non-crediting years when using arbitraged policy loans. One proviso: I don’t withdraw to basis in the first 15 years of the contact so that I don’t create a potential triggering of the force out rule, which in turn, may expose a contract to a tax liability with gain in the policy.
Now keep in mind none of this includes the policy expense loads, so those bad boy years of the S&P may not credit lower than zero, but I have policy costs to pay nevertheless and maybe loan costs if I run out of basis.
If you’re going to use the carrier look back history for accumulating crediting rates, then you better use the look back at history for the last decade for income scenarios to test your loan policy strategy. Otherwise, it might just be just vapor on paper.