Whole Life, IUL, VUL, etc., is it all just a factor of investment risk tolerance? No!
- David H. Kinder, RFC®, ChFC®, CLU®
- Dec 18, 2024
- 4 min read
Updated: Dec 28, 2024
I've been meaning to shed light on this for quite some time because most consumers, let alone most agents, don't necessarily factor in ALL the risks within a life insurance policy's design when presenting it to a client.
I can see it now: the registered investment representative does a traditional risk tolerance questionnaire and determines that a "growth and income" moderate portfolio is suitable for the client's variable universal life portfolio based on their tolerance for investment volatility.
Life insurance cash value volatility has more ripple-effect risks than most account for!
Let's start with the formula for cash value life insurance:
Net Death Benefit = Cash values + Net Amount At Risk - Any Outstanding Loans
Now, that's the formula for any given year, particularly when looking at an illustration's columns of numbers.
What's missing in that formula, is that, depending on the life insurance chassis chosen, there are unbundled costs.
Whole life insurance (including limited pay contracts) MUST, by definition and structure, mature. Maturity age is either age 100 or 121, depending on when the policy was purchased. Maturity means that the cash values must equal the death benefits. This applies for "pay to 100", "10-pay", "20-pay", "pay to age 65", or any other variation of whole life insurance.
Universal life insurance (including indexed, guaranteed non-lapse, and variable contracts) DO NOT have the same requirement to mature (cash values ≠ death benefits at maturity age).
So the definition of policy maturity is different. What difference does that make?
Tons.
The Universal Life insurance policy chassis allows for unbunbled cost structure. It's "off to the races" in your policy.
Which is going to win?
Will your cash value growth (IUL) / investment portfolio (VUL) win over the ongoing costs of insurance? or
Will the costs of insurance win over the cash value growth (IUL) / investment portfolio (VUL) win?
Key question: What happens if the costs of insurance win
over the remaining cash values in any given year?
Answer: Your policy lapses. You (and your family, business, or other intended beneficiaries) lose your entire life insurance policy!
If your policy had a gain (growth above premiums paid), then the entire gain would be taxed as ordinary income in the year the policy lapses. If your policy also had a loan against the policy with a gain, the loan is paid back first, and you STILL owe the same taxes in the year the policy lapses. This is referred to as a Phantom Income Tax where you have a taxable event, but you don't have the proceeds of the gain to pay the taxes.
I doubt even a registered investment rep explained these particular risks in advance of selling a VUL contract. Why not? We're trained and conditioned to just look at investment opportunity and mild portfolio risk, not the risk that the entire policy can dissappear!
Granted, all forms of Universal Life give the policyholder a bit more control! You can always put more money into the policy to help offset the costs of insurance. But are most consumers informed about that? I don't necessarily believe that to be the case.
What is discussed more often is the "premium flexibility" of these contracts.
Premium flexibility is a contract privilege that comes after you 'overfund' the contract. Minimum-funded contracts do NOT have premium flexibility.
Now, you can probably tell that my bias is showing through. I do prefer whole life insurance contracts. Why? It takes much of the guess work out of ensuring that the policy will do what we want it to do.
However, there are places where a UL/IUL/VUL contract are more appropriate. I know that in the NQDC (non-qualified deferred compensation) arena, UL contracts are preferred because they are transparent in their cost structure.
However, just because they are more transparent in their cost structure, doesn't mean that there aren't dangers down the road for the policy.
Wile E. Coyote thought he was a "super genius", but neglected to see the train down the road. While we often equate this to the impending tax policy increase that must inevitably come, it can also be equated to a neglected policy that will require a MASSIVE premium in order to keep it in-force and prevent a huge taxable event should it lapse.
By contrast, whole life insurance is boring, but it flat out works. How do we know it works? Through actuarial math and design. As long as all premiums are paid, it is guaranteed to work as designed - aside from the non-guaranteed dividend elements which may be more or less favorable than as illustrated.
Yes, a whole life insurance policy can still lapse, but that would primarily be a function of missed premium payments and/or increasing loans against the policy, NOT by the policy's investment risk or index performance.
For the UL structures, it requires far more agent expertise to make them work for you through:
Setting proper expectations,
Policy explanations, and
Policy structure.
The oft-cited phrase is "properly structured." (Getting tired of hearing it, but that's the common terminology.) I think I would prefer "properly optimized", but that's just semantics.
The agent makes all the difference with UL, IUL, and VUL,
not (necessarily) the company.
Some may still say "Whole life is still so expensive!" I ask: "Compared to what?" Compared to losing your entire policy due to improperly set expectations, underfunded design, and a possible lack of policy performance due to an amateur agent?
Compared to a term policy? No doubt. Whole life will do MANY more things above what a term policy can do, so it makes complete sense that whole life insurance will have a higher cost structure.
Have your policy's risks truly been outlined to you?
Are those risks still acceptable to you?
Agents: Are you letting an "investment risk tolerance questionnaire" determine acceptable life insurance risks for your client if they don't fully disclose the consequences that I've outlined above?
