The Practice Management Minute...
Demystifying IUL Illustrations (Part 2)
Charlie Gipple
December 2017

In last month’s part one of Demystifying IUL Illustrations, I made the point that the risk inherent in illustrations (that are typically 30 to 50 pages long) is that the consumer never even pays attention to the content of the illustration. I likened it to the documentation that one signs while getting a mortgage. I would tell you that I read everything in the fine print before I signed for my mortgage but that would be a lie! Thus the mortgage documentation becomes a moot point for disclosure purposes similar to what can happen with indexed universal life insurance (IUL) illustrations. Clearly, we do not want that! 

I then went on to elaborate that the IUL illustration can actually be used as a great tool as long as the agent knows how to explain it in a simple manner. However, in order to explain something in a simple manner, one needs to understand the content, the numbers, and why the numbers behave the way they do in the illustration. As Albert Einstein said, “If you cannot explain it simply, you do not understand it well enough.”  

I also stated that the agent must understand that caution needs to be exercised, because the only guarantee the illustration offers is the fact that the illustration will be wrong. We just want the illustration to be wrong on the conservative side. 

Then I explained that illustrations that are maximum funded, with loans coming out in later years for retirement income, can be some of the most complicated to understand and explain. However, these are the most common illustrations when IUL is being used.  I then used an example scenario of Jill, our 45-year-old client, to demonstrate how to simplify the IUL illustration conversation. This is where I laid out a track for the financial professional to go down. This track is five specific points on the illustration that are great places to stop and emphasize for the client. Below are the details of the scenario followed by the five point track.

Scenario: Jill, a 45-year-old female in good health, has a life insurance need of $500,000. She wants to maximum fund this policy because, when she retires in 20 years, she would like to begin taking loans against the policy as retirement income. We assumed a six percent illustration rate and solved for a fixed/wash loan amount that can be taken against the policy from age 65 until age 100. In this scenario we chose an increasing death benefit (option 2) switching to level (option 1) after the premiums are paid. This death benefit option allows more premium to be paid into the policy, versus a level death benefit which decreases the net amount at risk (death benefit minus cash value) in the policy, which, in turn, reduces the cost of insurance charges. The five points of emphasis on the illustration were:

Point 1:  What is the total premium (seed) going into the policy over the funding period? $358,443 ($17,922 over 20 years).

Point 2: The year that the client would like to retire—20 years from now in my example.  

What has the death benefit grown to?  $1,121,000.

What is the cash surrender value?  $621,700.

(Note: There should also be a discussion around the assumptions used in the illustration and the fact that they are not guaranteed. This is usually the point where I have this discussion.) 

Point 3: The loan amount in the first year of retirement—$41,283.

This warrants a discussion with the client about the loans that allow them access to that cash surrender value (harvest) without the 1099 coming.

Point 4: Approximate life expectancy—age 85 in my example.  

At this point, I emphasize the total seed that we discussed in Point 1 and compare that to the total nontaxable harvest.  Total premium ($358,443) vs. total loans ($825,660) plus death benefit ($477,348) which totals $1,303,008.

Once finished walking through the first four points, at that point the client may ask questions such as:

  • How much does all of this cost?  
  • What are the expenses?
  • Is putting $358,440 into something that generates a value of $1,303,008 between loans and death benefit a good value?

Point 5: The aforementioned questions bring us to the main content of this month’s column, where I discuss the internal rate of return (IRR) reports that many carriers have as supplemental outputs for their illustrations. 

Based on Jill paying one premium of $17,922.16 and having a death benefit of $516,013 in year one, that is an IRR of 2,779 percent should she pass away in that year. However, suggesting death in the first year is a ridiculous scenario that will rarely happen, but I show that to make a point. My goal is to demonstrate that, from purely an IRR  standpoint, dying young with life insurance is the best case financial scenario and that the IRR on the death benefit tapers off as time goes by. Clearly, dying young is not ideal! 

If dying young is the best financial scenario, then what would the worst case financial scenario be from purely an IRR standpoint? It would be that Jill dies very old.  This is due to the fact that the leverage power of life insurance burns off as the policy ages because of the time value of money, and also because the loans, plus the interest that Jill is taking, goes against the death benefit. In other words, the worst case for Jill and/or her beneficiaries from a IRR standpoint is that she lives so long in retirement and takes so much in loans for her retirement needs that she spends the death benefit down to almost nothing.  

Again, in our scenario with Jill we illustrated the loans coming out to age 100, at which point there is almost nothing left in cash surrender value and death benefit. So, back to the questions our hypothetical client may ask about costs and charges. What was the cost to Jill in the case that she lives until 100?

To answer that, let’s look at the IRR that Jill would have at age 100 after she put in $358,443 of premium ($17,922 x 20 years) and took out $1,444,905 ($41,283 x 35 years) in loans. Because I optimized the policy’s death benefit for distributions to compress the cost of insurance (COI) charges, the IRR would be quite attractive. It would be 5.57 percent or a taxable equivalent of 7.43 percent assuming she was in the 25 percent tax bracket. But if we illustrated the policy at six percent, why is the IRR only 5.57 percent and not six percent? Because of expenses. Therefore, what would be the total expense drag on this policy over the life of the policy? It would be 43 basis points (six percent minus 5.57 percent) per year!  

Many would argue that this level of expense is not astronomical, especially considering that the 0.43 percent was buying life insurance over Jill’s lifetime so that, if she were to die young in those early years, her beneficiaries get multiples of what she put in—i.e. leverage! But even when that leverage has burnt off, it still was not a bad proposition for Jill because it cost her only 43 basis points.

Another method for looking at expenses is to look at the cash surrender value IRR in year 20, 30, etc., and check the disparity between that IRR and the illustrated rate. If you can get the disparity to around one percent or lower you have an IUL with low internal charges.

Again, these are not investments, but as you can see, if optimized correctly, this disparity between the IRR and the illustrated rate can be quite reasonable.

The value of putting in $358,443 of premium and taking out $1,444,905 is significant. Cost is an issue only in the absence of value, and nobody can argue that there is an absence of value with cash value life insurance if the policy is designed correctly based on the client’s needs.

And remember, with IUL you are paying taxes on the seed and not the harvest.

 

The information presented is hypothetical and not intended to project or predict investment results.  The numbers cited in the illustration are based on the Builder IUL 8 issued by North American.

The net cost of a variable interest rate loan could be negative if the credits earned are greater than the interest charged.  The net cost of the loan could also be larger than under standard policy loans if the amount credited is less than the interest charged. In the extreme example, the amount credited could be zero and the net cost of the loan would equal the maximum interest rate charged on variable interest loans.  In brief, variable interest rate loans have more uncertainty than standard policy loans in both the interest rate charged and the interest rate credited.

Indexed universal life insurance products are not an investment in the “market” or in the applicable index and are subject to all policy fees and charges normally associated with most universal life insurance.

Income and growth on accumulated cash values is generally taxable only upon withdrawal. Adverse tax consequences may result if withdrawals exceed premiums paid into the policy.  Withdrawals or surrenders made during a surrender charge period will be subject to surrender charges and may reduce the ultimate death benefit and cash value.  Surrender charges vary by product, issue age, sex, underwriting class, and policy year.

Neither North American nor its agents give tax advice. Please advise your customers to consult with and rely on a qualified legal or tax advisor before entering into or paying additional premiums with respect to such arrangements.

Builder IUL is issued on policy form series LS172 by North American Company for Life and Health Insurance, Administrative Office, Sioux Falls, SD 57193. Product, features, riders, endorsements or issue ages may not be available in all jurisdictions. Restrictions or limitations may apply.


Author's Bio
Charlie Gipple
CLU, ChFC, is the vice president of Life Insurance Sales for North American Company for Life and Health Insurance. He is chiefly responsible for managing and expanding sales and providing strategic direction in the distribution of life insurance products. Prior to North American, Gipple was the senior vice president of Sales and Marketing at Partners Advantage Insurance Services, one of the largest IMOs in the country. He managed all sales, distribution and marketing support activities across the company. Gipple has also worked in leadership positions with large insurance companies like ING and Genworth, where he gained experience in expanding multiple product lines and multiple distribution channels. He holds a Bachelor of Arts degree in Finance from the University of Northern Iowa. Gipple is well known in the industry as a keynote speaker on life insurance, annuities and behavioral finance as he has been asked to speak at NAFA, NAIFA and the MDRT Top of the Table meetings. As a life insurance and annuity thought leader, Gipple has also made media appearances on AMBest TV and thestreet.com. Charlie is a monthly columnist for Broker World and also regularly authors articles for LifeHealthPRO, Investment News, Financial Advisor Magazine, and numerous other media outlets. Gipple can be reached via telephone at: 515-330-8068. Email: cgipple@sfgmembers.com.















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