In MAP, the role of life insurance is to accumulate sufficient cash value. The cash value is meant to be used to generate retirement income for the primary purpose of deferring social security to age 70. To accomplish this goal, we use a specific type of Whole Life (Limited-Pay Whole Life Insurance) to provide for a higher rate of cash value accumulation. Some advisors have questioned why we are not recommending Universal Life. We explain why below.
Why We Use Limited-Pay Whole Life
Like other Whole Life products, limited-pay Whole Life policies guarantee tax-deferred cash value accumulation and a guaranteed death benefit. Premiums are level and are guaranteed never to increase (with rare exceptions, generally not applicable when the policy is issued by a highly rated, reputable insurance company).
The premium-paying period is shorter than other Whole Life policies and cash value accumulates much faster. Once the premium payment period ends, no additional premiums are required to keep the policy in force but the cash value will continue to increase. These policies are very easy for the consumer to understand and implement.
Additionally, many Whole Life insurance policies pay dividends. These dividends can support a higher internal rate of return to the policyholder. The Whole Life dividend paying history among insurers is very strong. A strong dividend paying history is an important sales strategy. The dividend strategy is so important to insurers, that many will support the Whole Life dividend by requiring a higher rate of return on their other lines of business. These “subsidies” help to prevent future dividends declines.
What is Universal Life?
Universal Life is a much more complex product, not easily understood. Unlike Whole Life policies, they do not pay dividends. They also introduce a number of new variables, and additional flexibility with regard to making premium payments.
A traditional Universal Life policy includes a Target Premium, a Cost of Insurance (COI) rate, a fixed crediting rate, and other policy charges that may apply. The Target Premium is a level premium amount, and represents the minimum amount needed to fund the policy such that the policy will grow sufficient Cash Value to keep the policy in force until maturity.
COI charges are assessed at each policy anniversary and reflect the probability of death of the policyholder. These COI rates increase as the policyholder gets older to reflect a higher likelihood of death.
The Target Premium is level, so in the early policy durations, it is significantly higher than what is needed to cover the COI charges. The excess premium is used to fund the Cash Value accumulation. As premium payments are made each year, the Cash Value grows with interest. At some point the COI charges will rise to a level where the Target Premium will not be enough to cover them, and the Cash Value will be drawn down to cover the difference. If the policy is funded at the Target Premium, the Cash Value will be exhausted precisely when the policyholder reaches the maturity date.
Perhaps the most unique feature a Universal Life product provides is the ability to alter the premium payments. Premium payments do not have to be equal to the Target Premium amount. The policyholder can over-fund the policy to accrue more Cash Value, thereby maximizing the accumulation benefits of the policy. Alternatively, the policyholder can skip premium payments all together, provided there is sufficient Cash Value to cover the COI charges.
Universal Life can be attractive because of the premium funding flexibility. This can be particularly beneficial when money is tight for the policyholder. However, under-funding a Universal Life policy can quickly lead to unintended consequences.
The UL Death Spiral
The Cash Value in a UL policy is not just for accumulation. It also becomes a factor in determining the cost of insurance charges. COI charges are based on the COI rate, and the Net Amount at Risk (NAR). The NAR is equal to the death benefit on the policy less the Cash Value. This dependency creates an interesting dynamic between the COI charges and the Cash Value accumulation.
If the Cash Value accumulates at an adequate level, the COI charges can become more level over the life of the policy. This is because as the COI rate increases with age, the NAR decreases, and offsets the final COI charges assessed on the policy. In contrast, a minimally funded policy will produce much lower Cash Value resulting in a higher NAR. This will result in COI charges that grow to be much higher as the policyholder ages.
“Under-funding a Universal Life policy can quickly lead to unintended consequences.“
Here is the irony: Maximizing the Cash Value accumulation in the policy results in lower COI charges even though there is more than enough Cash Value to cover higher charges. In contrast, a policy funded at the minimum level, having very low Cash Value, will incur higher COI charges. These charges will gradually erode the Cash Value, further magnifying the COI charges. This scenario creates a death spiral that can quickly get out of control. The policy will eventually lapse once there is no longer enough Cash Value to cover the COI charges.
Other UL Risks
Universal Life provides a fixed crediting rate. The rate can change at the insurance companies’ discretion. Fluctuations in the crediting rate can affect the accumulation of the Cash Value. This presents another risk that the Cash Value will not be sufficient to cover COI charges, even if the policy is funded consistently at the Target Premium level.
Indexed UL and Variable UL further magnify this risk. The crediting rate associated with these policies is derived from an indexed-based crediting strategy, or from the underlying performance of a group of investment funds. These products provide upside potential for higher Cash Value growth by participating in the market. However, the crediting rates will be more volatile than a Fixed UL product. The variability in the crediting rate creates more uncertainty with regard to whether or not the policy will be funded adequately to cover the COI charges.
This quote by Simona Botti, from the London Business School, gets to the heart of MAP:
Freedom of choice is alsoSimona Botti, London Business School
freedomto decide when you do not want to choose.
The goal of MAP is to provide a guaranteed stream of income in retirement. We view it as a glidepath. Once the insurance products are purchased, involvement by the policyholder is minimal.
While Universal Life may be suitable for some, we believe the majority of our demographic will be better served by a more straightforward policy. One that helps the policyholder avoid making choices that could lead to devastating consequences.