David H. Kinder, RFC®, ChFC, CLU
Stock Market Risk vs Index Performance Risk: Is Zero YOUR Hero?
Last month, I had the privilege to be invited and flown to the corporate office of a prominent insurance company to learn about their contracts, internal workings, tools for their consultants, etc.
This particular company is very well known for their fixed indexed annuity contracts and is the #1 sold company right now. (For more about how indexing works in life insurance contracts, see my blog post here.)
We got to the part in the program were we discussed Index Segment allocation for a given parameter of 'risk'. However, it's not a discussion of risk... at least in the traditional sense.
Typically speaking, when financial consultants talk about risk, we talk about the risk of losing money due to stock market forces. In essence, risk is a measurement of pain. How much 'pain' can you endure for your portfolio? These contracts don't have that kind of risk because they are fixed indexed insurance contracts.
What kind of risk is it? It's performance risk. In essence, how will your plan work out if your contract does NOT earn a return in a given year? How about two years in a row? Three? Or would your plan be just fine? One prominent annuity promoter discusses with people what annuities WILL do versus what they MIGHT do. If your plan is based on what they WILL do, you'll probably be just fine with your annuity plan. If your plan is based on what they MIGHT do, then you need to look at the risk of having low or no performance based on the index segment allocation.
Please note that I'm using the term 'segment' as opposed to fund. The term 'fund' implies that you are invested directly in the index. That is not so. You have allocated all or a portion of your contract balance to track a given index, so it's segmented (like an orange) as opposed to directly invested in that index.
The image to the right here... is an example of an asset allocation based on the Efficient Frontier Theory. (Don't try to over-analyze it - it's just an example.) With the Efficient Frontier theory, the idea is to get the optimal return for a given level of risk. Again, these contracts do NOT have stock market risk, but they do have performance risk. So there are some sample allocations to help bring about either more consistent returns (conservative) to more aggressive and volatile returns.
In the title of this blog, I pose the question: Is Zero your Hero?
Here's the general answer. For Fixed Indexed Annuities: Yes, generally speaking, annuities will perform just fine even if you got zero return for a year, two, or three. You might not like it... but you didn't have any money at risk in the stock market.
For Fixed Indexed Universal Life insurance policies: While these policies do not have stock market risk... they do have an increasing cost of insurance on the net amount at risk (the amount between the cash values and the total death benefit). The cost increases as you age... because you're getting older and that much closer to the risk of passing for the insurance company.
That being said, the performance risk (the risk of having zero returns in the contract for an extended period) can put these contracts at risk to lapse, depending on how they are structured and if they may have other provisions in the contract. Even with other provisions, the contract has to stay in force for the provisions to be honored.
What can be done for these life insurance contracts? Several options, depending on your situation.
1. You can allocate more of your cash values and premiums to the fixed interest allocation. Now, you still have interest rate risk (it may not keep up) and increasing costs of insurance... but at least you won't earn zero.
2. You can opt for a level death benefit as opposed to an increasing death benefit. A level death benefit means that the total amount of insurance will not increase as the cash value increases. In fact, it will decrease over time. Notice in the diagrams below how the insurance protection gets smaller on the left side, while it increases on the right side.
Now, it's also very common for policies to be set up with the increasing benefit at first to maximize cash values in these policies. Switching from Increasing (Death Benefit option B) to Level (Option A) is very easy to do by simply notifying the insurance company of what you want to do. (I wouldn't do it until you were finished funding it though.) 3. In addition to the first option, you can also reduce the death benefit. These are flexible premium contracts and you can reduce the death benefit at any time. You will want to wait until at least 7 years have passed to satisfy the MEC guidelines. You don't want to lose the tax status in this contract if you can help it. When compared to whole life insurance, this simulates a "Reduced Paid Up" policy where the net amount at risk is very minimal, so the costs are very small compared to the volume of cash values that can earn indexed interest in the policy. This does NOT eliminate the costs, but it does greatly reduce them because of the new lower benefit. 4. You can replace the policy with a new one - either a new life insurance policy OR an annuity contract. For a new life insurance policy, you may need to be insurable. For annuity contacts, generally you don't. It will depend on your new goals and objectives to determine which path will suit you best. You may want to review my post regarding 1035 exchanges for other considerations.
5. Ask if your policy has an overloan protection rider. These are riders that are often included with these IUL policies (and a small number of whole life policies) that, if certain conditions are met, the policy will stay in-force, even though you have a large loan balance against it, it didn't perform as well, or other considerations. The conditions are usually a given minimum age of the insured (often at least age 70), the policy has been in-force for a minimum number of years (such as 15 years), there is a sizeable loan balance (such as 95% or more of the cash values), and there may be other factors. See your contract for details.
6. You can sell the policy to a life settlement company. This is an option for people who are older and may not be in the best of health. You can sell your policy and get an advance on the total benefits of the policy. There may be some tax consequences to this, but it is certainly an option.
7. You can simply surrender the policy. Granted, I generally don't like this idea, but it is an option. You can simply cancel out the policy and take all the proceeds in cash. However, if you have any loans against a life insurance policy, and you surrender it, it can cause a phantom tax situation in that year. This can also happen if the policy lapses, either by lack of premium payments, lack of paying policy loan interest out of pocket back to the policy, OR lack of performance to sustain the policy. It could even (and most likely) be a combination of all three factors.
So, is Zero YOUR hero? It can be! But depending on your objectives, the kinds of contracts we're talking about, and how long the zero returns last... it could become a problem.