When it comes to returns in a whole life insurance policy, there are some misconceptions floating around in regards to guarantees. Often, we’ll hear advisors talk about a “guaranteed” 3.5% or 4% rate of return on whole life insurance, but this isn’t the Whole Truth.
In reality, those rates are a gross return, but we must consider the costs involved with a life insurance policy. By understanding this, we can give clients an accurate representation, which is essential.
So using the Life Insurance Values tool, we’re going to talk about returns and how to analyze them, using the policy of a 35-year-old as an example. First, we’ll look at his policy with a base premium and no PUAs, to analyze his guaranteed cash value with no dividends included.
Then, we’ll see what that same 35-year-old’s account would look like with maximum paid up additions (before the MEC limit). Additionally, we’ll be looking at this account with dividends. Your insurance company may call this non-guaranteed or illustrated.
By doing so, we’ll illustrate how rates can be deceiving, and how to interpret them on your own before speaking with your clients.
Gross vs. Net
These days, guarantees are sitting at about 3.5% or 4%. What they often fail to convey is that the guarantees are a gross value. That means that once costs are considered, the rate will be lower. So it’s not incorrect, but it also doesn’t accurately reflect what a client will see in their policy.
To eliminate the confusion, you have to understand the difference between gross and net guarantees. The net guarantee is the amount left over after:
- The cost of the death benefit
- The cost of our commissions
- The cost of running the mutual company
It may feel counterintuitive to explain these costs to a client, given how people feel about commissions these days, but it’s important they know. Be sure to let them know, in addition, that by owning a policy, they’re a partial owner of the company, and they’re paying for the company to do its job–that’s something to be proud of.
Furthermore, policies cost more up front, which is why the rate of return is lower on the front end of the policy. This is a protection for the company, in the event that they’d pay out the death benefit early. As a result, costs decrease as the policy ages.
Internal Rate of Return
We’ll start this scenario by opening the Life Insurance Values tool, and importing the illustration we want. For help uploading, read our Life insurance Values tutorial.
If we scroll down and assume that there was never ever a dividend paid on this policy, and we look at the 30 year mark, we see that there’s $367,130 of cash value in the policy. The internal rate of return is 0.96%.
To analyze this, let’s pull up a rate calculator. Making sure that the calculator is set to annual, we’re going to copy and paste the payment into the rate calculator, which is $10,510. Then we’re going to copy and paste the cash value from the 30 year mark, with all the decimals included. The period is 30 years. What you see is the same 0.96% that you see in the internal rate of return column.
Yet internal rate of return can be confusing without the proper context. Basically, the way IRR works, is that it calculates what it would take to get that number if you earned the same rate every single year. We know that with a life insurance policy, that simply doesn’t happen.
As mentioned earlier, the policy starts off with negative returns, then it has to catch up so that the results are the same as earning 0.96% each year. So how do you get to an IRR of 0.96% if you started with negatives?
Looking at Annual Rate of Return
This is the reason why Truth Concepts includes an Annual Rate of Return column, which you won’t see on your illustration software. This column measures what happens from year to year. You’ll see in the 30th year, that the rate of return is 2.11%. This 35-year-old had to earn a higher rate of return towards the end in order to have an effective IRR of 0.96%.
So let’s see where that 2.11% comes from. We have $367,130 in the future. And we paid a premium of $10,510, in addition to having a previous cash value of $349,020. That is a critical piece of the puzzle, the previous cash value.
So we started with $349k and added $10k, and ended up with $367k—that’s where the 2.11% comes from. And that 2.11% is what overcomes those negative returns in the early years.
Applying to Client Conversations
If you were to print this illustration, your client would see the negative values up front, and then an IRR of 0.96%. To them, that probably isn’t ideal, but it’s imperative to understand that the IRR is the equivalent of the account earning that amount each year. What other assets are netting 0.96% every single year?
We don’t recommend using this illustration with clients because of the confusion, but it’s crucial that you understand the concepts behind the numbers.
And really, this cash value we’re seeing is just what’s guaranteed. We’re proud of the guarantees of whole life insurance, because no other product or asset comes with guarantees at all. There’s no need to shy away from this talking point, as it makes whole life shine. So building off of the question, “What asset is netting 0.96% every year?” What other asset is guaranteed to net at least that much every year?
And the above also assumes that our 35-year-old never earns a dividend at all—and history is on your side for this one.
Adding PUAs and Dividends
So let’s consider what our 35-year-olds policy would look like with dividends, on a policy that has max PUAs. The base premium is the same as our example above, and with PUAs becomes $28,000. With the dividends, you’ll see that the cash value actually starts at $17,182 instead of zero.
This time, the 30th year illustrates $1,498,673.
Now, we’ve put more money into the policy, yes, and yet the IRR shows 3.51%. And as we know from above, that’s equivalent to the policy earning 3.51% every single year. And just like the previous illustration, the first few years are in the negative. So how does the IRR equate to a 3.51% rate every single year?
The only way is if the policy is earning more on the back end.
Using a rate calculator, we’ll input the previous year’s cash value of $1,415,347 and the $28,000 contribution. In one year, that’s a 3.83% return. So the performance on the end of the policy is what overcomes those first years in the red.
It’s interesting to note, too, that although the policy usually breaks even around the 11th year or so, in this illustration the policy is actually earning a positive return in the 4th year. However, it takes until the 11th year for those positive rates to overcome the negative ones. So even in the fourth year, our 35-year-old is gaining more than he’s putting in—a critical piece when talking to a client.
What’s the Takeaway?
If this is a conversation we advise against raising with a client, because of its complexity, what’s the purpose of getting into it? We’ve heard this question before, and to that end the answer is simple.
Your clients ultimately do business with you for the certainty you provide. That’s likely the reason that whole life insurance appeals to them, and why they chose you to help them.
Understanding concepts like this, and bringing to the table a level of authority, lends to that certainty. By understanding your products and contracts so thoroughly, you’re able to speak about them intelligently. And if the question ever arises, you won’t be thrown off.
When a client asks questions about fees, rates, and other key components, maybe you won’t go into every grueling detail. But the more you know about your products, the easier it is to put those things aside and get to the root of the question. Clients want to experience your certainty of the product as it relates to them.
Be an authority in your field, and when the question about policy rates arises, know that you’ll be able to answer with confidence.