Is what I’m about to describe the next great life insurance sales opportunity? Is it possible to successfully market a life insurance policy designed to act as a personal defined benefit plan? Will individuals for whom limitations on retirement plan contributions make it impossible to fund adequate retirement incomes flock to a life insurance strategy that provides income at retirement that is tax-free?
In describing DB-by-INS™ I’m providing a framework for life insurers to look anew at the issue of retirement income funded by life insurance. I’m obviously not suggesting a replay of past initiatives, some of which were ill-conceived and misleading to consumers. That’s ancient history. Rather, I’m suggesting a way for life insurance to play a unique role in strengthening retirement security- for the right market segment: Affluent, aware of their future retirement security challenges and ready to try to meet them:
The belief that life insurance could be an extraordinarily attractive strategy for boosting personal retirement security may strike many as unreasonable. Yet a critical analysis reveals that for a number of reasons it may be highly desirable. These reasons include…
• There is no cap on annual “contribution levels”.
• Myriad investment choices within the life policy create substantial accumulation potential.
• Pre-retirement, self-completion benefits are inherent, and,
• At retirement the money comes out income tax-free…
These advantages should lead us to consider life insurance as potentially valuable to those who want to give their future retirement security some turbo-charging. Oh, did I mention that it can also serve as your personal DB plan?
Let’s analyze these claims to help you decide whether I’m describing the future “must have” of personal retirement security, or, if I’ve just plan flipped-my-lid (I’m confident I haven’t).
What’s in a Name?
Let’s call this personal retirement security strategy DB-by-INS™ (Defined Benefit by Insurance).
Defined Benefit because a specific retirement income objective is defined
By Insurance because the funding vehicle used to provide the retirement income benefit is Variable Universal Life insurance (VUL) or Indexed Universal Life insurance (IUL).
When thinking about the potential value of DB-by-INS™ it’s wise to have an open mind. Why?
1. It’s become clear to most observers that the massive shift to DC over recent decades has diminished the retirement security of millions. Retirement security is clearly strengthened when a pre-determined level of retirement income is defined and funded for.
2. The introduction of the Roth IRA and subsequent expansion of the concept validates the Roth-like income tax treatment of DB-by-INS™: Contributions (premiums) are paid-in after-tax, they grow tax-deferred and are received income tax-free (via loans against the policy’s account value).
3. There is no cap on the amount of money than can be allocated to DB-by-INS™. This is important to employees with higher incomes for whom limitations on pension plan contributions make it impossible to fund an adequate post-retirement income.
4. DB-by-INS™ offers an income tax-free life insurance benefit. This protection mitigates the risk to an employee’s family when an individual’s future earning capacity is lost due to untimely death.
5. DB-by-INS™ is not tied to an employer or plan sponsor; it is personal, flexible and custom-tailored to meet individual needs.
6. The VUL policy funding DB-by-INS™ offers numerous investment choices and significant growth potential. When IUL is used for funding, accumulation potential is achieved through linking cash value growth to an external index (i.e. S&P 500).
7. Unlike typical interest-sensitive life insurance policies, DB-by-INS™ has a higher probability of delivering on projected benefits. Why? It is linked to an administrative system that not only monitor’s annual investment performance, but also informs the policy owner annually over necessary adjustments to the annual contribution (premium) which will keep the policy on-track to deliver the desired retirement income benefit.
The mechanics of DB-by-INS™
When applying for the life insurance policy that will fund the DB-by-INS™ strategy, the applicant must make three decisions.
1. Identify a desired annual retirement income,
2. Select a retirement age, and,
3. Select an Assumed Investment Return (AIR).
Let’s look at an Example:
Ed Smith is a 45 year-old sales executive with an annual salary of $220,000. Ed and his wife Susan, a stay-at-home mom, realize that, due to the cap on how much of Ed’s salary may be deferred, his 401(k) plan is unlikely to provide sufficient retirement income.
Ed and Susan understand that their future retirement security is uncertain unless they supplement Ed’s 401(k) deferrals with additional after-tax savings.
Ed and Susan like the fact that DB-by-INS™ offers income tax treatment similar to Roth plans. They also like the strategy’s inherent ability to be flexible as their needs change over time.
They place a high value on the life insurance policy’s death benefit; Ed is underinsured and the additional coverage creates more pre-retirement financial security for Susan and their kids.
Ed and Susan also appreciate the admin system that wraps around the life insurance policy and is designed to keep them on-track to realize their defined retirement income benefit. They understand that investment performance varies and that the money paid into the policy must be adjusted downward or upward as often as annually.
How Much Life Insurance?
The purpose of DB-by-INS™ is not to maximize the amount of life insurance someone purchases based upon a given annual outlay. Rather, we would seek out the minimum (or very close to the minimum) amount of life insurance that would be required based upon the insured’s age and annual outlay.
Although it is easy to determine the minimum amount of life insurance needed to comply with tax guidelines that define the amount of insurance needed to preserve favorable income tax treatment, it is not a good idea to focus on the absolute minimum. The reason is that if the policy is issued at the minimum insurance amount, there will be no leeway to increase outlays in the future- a capacity that must be preserved when increases in outlay are needed in response to investment performance that is less than the AIR.
A good approach is to issue the policy at the minimum life insurance amount + 20%. This opens up a corridor to take in additional contributions in the future when they may be needed.
The Application Process
Issuance of a life insurance policy is not automatic and starts with a lengthy application. Information on the application, supplemented by reports from attending physicians, leads to an assessment of the applicant’s health status. There may be additional underwriting requirements such as a blood test and, or, a medical exam.
In addition to completing the life insurance application, an additional form must be completed related to the ongoing administrative oversight of the policy. The insurance company (or TPA) must know the income objective, the projected retirement age as well as the AIR.
Annual Monitoring & Compliance
The DB aspect to DB-by-INS™ stems from the annual monitoring and reporting functions that turn a life insurance policy into what is effectively a personal, defined benefit retirement program. I cannot stress strongly enough how important this characteristic of DB-by-INS™ is in achieving good compliance and quality sales in the context of the past, the present and the future of “real-world” sales and sales practices.
Since my first experiences with universal life insurance in 1980, I’ve seen the product consistently sold to thousands of consumers on the basis of policy performance projections made far into the future. I believe it’s a pretty sure bet that not a single policy sold over the past 27 years has performed exactly as it was projected to perform.
A steady downward trend in interest rates has wreaked havoc on fixed universal life insurance projections that were based upon 30 to 40 year interest assumptions as high as 12%.
Similarly, variable universal life insurance policies were often sold based upon projected investment results of 12% annually. Market downturns in recent years caused a large segment of VUL policies to under perform their projected results resulting in a plethora of negative consequences including policy premiums that didn’t “vanish” as they were projected to, investment losses on 1035(a) cash value rollovers, complaints against advisors, broker-dealers and insurance departments, litigation, arbitration awards to policy owners, etc.
Virtually all of this unpleasantness was a product of poor sales practices (and poor communications) including having no system to provide ongoing monitoring of life insurance policy performance. A characteristic of universal life insurance that is both important and inadequately understood is that when performance lags behind the projected level, immediate action to adjust premiums makes up for the underperformance and avoids a cascading multiplication effect that can overtake the policy entirely.
Just as compound interest works to our advantage, it also surely works to destroy universal life policies when the small annual adjustments needed to keep the policy in balance are neglected. This is because there are inherent costs in the universal life insurance policy in terms of “risk” charges- the actual costs for insurance deducted monthly from the cash value- as well as administrative charges. When the policy is in balance, when interest is being credited at its projected level, these costs are relatively inconsequential. However when interest crediting falls behind, even modest costs can consume the remaining policy cash value. Just a little bit more premium can make all the difference.
Speaking of Costs
The DB-by-INS™ strategy is all about balance. The amount of life insurance cannot be too high because the costs implied can become a drag on cash value growth. Neither can the life insurance amount be artificially minimized due to the need to maintain flexibility in being able to raise and lower outlays in response to varying investment returns.
As a general rule, properly designed DB-by-INS™ plans have modest costs for insurance and expenses. In addition, there should be no additional cost assessed to both monitor the policy annually and report on its investment results.
That said, DB-by-INS™ has costs. And these must be assessed in the context of overall goals for future retirement security. Some important questions:
Are the costs acceptable given that I will be able to access my money at retirement income tax-free?
The policy may have surrender penalties that may reduce liquidity should I need to reach my cash value before retirement. Is this an acceptable risk?
Is the ability to put away larger amounts of money inside DB-by-INS™ than would be allowed in qualified plans important to me?
There are critical questions that must be answered before starting the DB-by-INS™ strategy?
The Target Market for DB-by-INS™: Affluent Builders and Pre-Retired
For millions of American workers employee-sponsored retirement plans are insufficient to fund their income needs in retirement. According to research published in 2006 by the Retirement Income Industry Association, there are 5,590,000 households in the US categorized as Affluent Builders (ages 35-49) and 4,695,000 households categorized as Affluent Pre-Retired (ages 50-64).
Together these market segments make up 15% of households and control $5.8 Trillion in assets. The Affluent Builders and Pre-Retired stand above the Mass Market and below the Wealthy in terms of financial assets. Approximately 70% of Affluent Builders and Pre-Retired agree with the statement, “I am concerned about having enough retirement income.”
In terms of premium patterns that life insurance companies can expect from this target market, younger purchasers (35-49) will tend to favor annual or monthly outlays while older individuals (50+) will be inclined to supplement systematic premiums with lump sums. Of course, only after-tax dollars may be placed in the DB-by-INS™ strategy.
Marketing the DB-by-INS™ Strategy
The marketing of DB-by-INS is fraught with challenges that can be successfully overcome. As mentioned above, twenty years ago some agents and companies abused a similar concept and sold universal life insurance policies to individuals allegedly without mentioning to them that they were purchasing life insurance policies. Such actions led to expensive litigation, financial penalties, and regulatory reform. Moreover, a series of legislative actions systematically eliminated abuses of the favorable income tax treatment accorded life insurance. .
State insurance regulators developed a view that consumers must be provided a “balanced” view of what they are being asked to purchase. Consumers must understand that life insurance is an integral part of the concept, that it costs money to have life insurance, and that there may be limitations on liquidity. Insurance companies have created their own rigorous compliance standards which seek to ensure that purchasers understand what they are buying.
Following the abuses of the 1980s, I would argue that the industry over-corrected; it became afraid of the “retirement sale” for life insurance. Let me suggest that this was a mistake.
Over the past two decades the life insurance industry would have been better served if it kept its focus on retirement. It could have linked its universal life insurance policies to an easy-to-create administrative capability that would have provided the key piece of value policy owners needed in a declining interest rate environment: information. Insurers do issue an annual report to each policy owner that projects policy performance into the future. But they do not tell policy owners on an annual basis what changes to premium patterns would keep their policies on-pace with originally projected results. Adding this additional information would make all the difference.
Today’s web-based technology allows for DB-by-INS™ to be distributed in a way that assures consistency of message across multiple channels of distribution. A combination of streaming video, personalized advisor micro sites, real-time monitoring and dynamic disclosure generation create a capacity for large numbers of advisors to convey the “story” in a compliant manner.
Advisors/RIAs have the customers for DB-by-INS™. What they need is a marketing ecosystem that will allow them to effectively extend their influence into this new opportunity.
Conclusion
Twenty years ago retirement security in the US was more predicable than it is today. With the benefit of hindsight we now understand that the loss of “defined benefits” is sure to exact a cost to Americans’ retirement security. That cost may be exceedingly high.
Workers need to take stock and begin to focus their attention on creating their own “defined benefits.” The DB-by-INS™ strategy is one way that offers real attraction when retirement income predictability is what’s desired.
©Copyright 2007 David A. Macchia. All rights reserved.
François Gadenne has written extensively at this blog on retirement income issues including essays addressing the present and future activities of the Retirement Income Industry Association (RIIA).
Retirement Income Industry Association (RIIA) Executive Director, François Gadenne, contributes regularly to this blog. Francois writes about retirement income-related issues as well as RIIA’s role in helping its members navigate through a variety of complex issues. Today he explains RIIA’s various membership categories and the benefits accorded to each.