By: Charlie Gipple, CLU,® ChFC® is the Senior VP of Sales & Marketing at Partners Advantage. Excerpt from “A New View on Modern Portfolio Theory: Making the Case for Life Insurance as an Asset Class”
“I understand I get a death benefit with IUL but isn’t life insurance an extremely expensive product for building retirement dollars?”
You can show your client the internal rate of return (IRR) report that many carriers have to demonstrate expenses. Many carriers have IRR reports on the death benefit and there are also carriers that have the IRR based on the cash value.
Cash value IRR
The cash value internal rate of return report basically calculates what the “net” amount of return was on the client’s premium in order to arrive at the cash value that the product generates in year 20 for example. This can be a great tool in demonstrating how the average expenses over the life of the product. This can be done by analyzing the disparity between the actual “internal rate of return” of the policy and the rate in the illustration.
To elaborate further, before we discuss life insurance cash value IRRs, let’s use a simplified analogy. Let’s say that you had a magical “product” that had zero expenses. Assume this “product” was going to grow a client’s deposit by 6% per year from now until say 20 years from now. Without any expenses coming out of this product, what would be the true “internal rate of return” the client would recognize? It is 6%! We know this because, as mentioned, whatever the deposit/ premium is put into this hypothetical “product,” it is going to grow by 6% and not be eroded by any expenses. Therefore, 6% is the answer.
Well, what if we calculated the internal rate of return on the same product with one exception. This time we assume the product had .50% in annual expenses. Well, in this case, the internal rate of return to the client in this product would be 5.5% (6%-.50%)? In other words, if you punched in to your financial calculator what the deposit/premium was in this product versus what the year 20 value was in this product after being eroded by this .50 annual expense, magically the financial calculator would arrive at an IRR of 5.5% per year.
Now, let’s go back to talking about the life insurance illustration to make the point. We know that in our illustration, the policy is going to credit a “gross” 6%. Why? Because we told the system it will by using 6% as the illustrated rate. That does not mean that once you plug the premium payments into the illustration and the 6% illustration rate/gross rate that the cash value will actually grow by 6%, right? No, because there are “expenses” imbedded in the policy and thus the illustration.
The main expenses in IUL are what I call “The Big 3.” They are: 1. Premium Loads 2. Per Thousand Charges. 3. COI Charges. These expenses reduce cash value year after year.
How Large are These “Expenses”?
This is where the Internal Rate of Return calculators can help you put a number on the “expense drag” in the project. Rather than having the actual IRR report on my example, if you otherwise did the math on your financial calculator when I said that the client would pay $16,740 for 20 years then have around $550,000 in cash value in year 20, you would know that the “internal rate of return” would come back at around 4.65%. This is based off a 6% illustrated rate. This means that the “expense drag” averaged 1.35% (6% - 4.65%) per year. In a world where the average A Share Equity Mutual Fund is charging 1.4% (ICI.org), is 1.35% “prohibitively expensive”? It is also important to note that as the policy ages, the “disparity” between the IRR and the illustrated rate narrows. Many times the disparity can be lower than 1%.
Another thing to keep in mind is the tax deferred nature of the growth on the cash value and the tax free nature of loans from the policy. In other words, a tax free rate of return of 4.65% is actually equivalent to an otherwise taxable return of 6.94% (assuming the 33% tax bracket).
Again, these are not investments, but as you can see if optimized correctly the disparity between the IRR and the illustrated rate (expense drag) can be quite reasonable. Especially considering with IUL, you can never lose money because of a stock market decline.
Something you can discuss to rebut an objection is that “cost is only an issue in the absence of value.” Is the 1.35% expense worth the “value” that the client would be able to get out of this policy? The “value” they are getting out of the policy is, almost $1.3 million in distributions (harvest) on a total premium (seed) of $334,795 while in the early years having significant death benefit “leverage.” And again, the client is merely paying taxes on the seed, not the harvest. Note, if the client were to die in the early years, the IRR percentage on the death benefit would be in the hundreds.
In designing the policy with the goal to eventually take tax-free loans against the policy, it is important for the financial professional to be well-versed on how to set up and adjust the policy’s premiums and death benefit in order to minimize the COI charges. If done correctly, the client may find that the cash value in IUL is not only an “asset” that will not drop in lockstep with the stock market like other assets in a portfolio, but also the client may find that IUL can be a very cost-effective and tax-effective “asset class” relative to others.
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