If you like risk, then you will love owning a minimally funded variable universal life (VUL) policy!
Look at this protection-oriented scenario that is quite common: 45-year male in good health wants $1 million of level death benefit coverage for life and would like to fund the policy before retirement (20 years). A no-load policy with an 8% gross return assumption shows that 20 premiums of $6,648 will sustain $1 million of death benefit all the way to age 121.
The mortality-adjusted return of this illustration (which reflects the probability of death at each age) is a decent 6.80%, which would be quite an attractive after-tax return in a world where the gross earned rate is 8%. However, this is an illustration that assumes that the earned return will be 8% every single year. Adding volatility to the equation tells a much different story.
If we assume that the true investment mean is in fact 8%, and we just add historical equity volatility to the monthly returns (along with randomly generated dates of death from an appropriate mortality distribution), then a Monte Carlo analysis reveals the following:
- 18% of the time . . . jackpot! In these scenarios, the death benefit grew to be greater than the original $1 million at the time of death due to investment performance.
- 45% of the time . . . you get what you bargained for with a death benefit of exactly $1 million at the time of death.
- 37% of the time . . . the policy was worthless at the time of death because the policy had already expired due to a zero cash value.
A 37% chance of the policy expiring worthless is a mind-blowing result. Recall that the original assumption was an 8% return and the Monte Carlo testing assumed a true investment return of 8%, so the only thing that was introduced was volatility. This isn’t a case of markets performing worse than expected – this is simply markets performing the way markets perform. If things go as they are expected to, the policy blows up up more than 1/3 of the time due to the inherent risk in the VUL policy structure.
Many people erroneously apply the same “buy and hold” or “set it and forget it” mindset to VUL that they use with their investment portfolios. This approach is incredibly dangerous.
There is a poorly understood phenomenon that occurs with VUL that involves a synergy between investment performance and cost of insurance charges. When the markets do better than expected, the so-called net amount at risk (difference between the death benefit and the cash value) shrinks and the cost of insurance charges are proportionately reduced. But when markets do worse than expected, the net amount at risk increases, resulting in higher cost of insurance charges than expected. The downward pressure of these cost of insurance charges is very difficult to overcome without some type of policy management. Policies left unattended can completely cannibalize themselves.
Shockingly, this cannibalization can even occur in scenarios where the death benefit has been pushed up due to outstanding investment performance. In almost 20% of the scenarios (that all ended up as failures), the cash value and death benefit both grew to be above $1 million (and were almost equal to each other) at an advanced age, but then some kind of market correction occurred. Left to its own devices, the death benefit will remain at the higher level while the cash value drops, introducing crippling cost of insurance charges due to the high mortality risk at advanced ages. In one extreme example, I saw the cash value and death benefit grow to more than $6 million at age 93, only for the policy to fall apart completely at age 100 due to cost of insurance charges that created a downward spiral and ended up consuming all the cash value before the insured passed away.
What’s the moral of the story?
- For some, the takeaway is that they should stay away from minimally funded level death benefit VUL policies.
- For others, the takeaway might be that they need active management for these types of policies on an ongoing basis – and those actions could include additional premiums, lowering the death benefit, and/or taking investment risk off the table when the insured gets to a ripe old age.
- For everyone, it should be apparent that simply putting your VUL policy in a drawer and believing that “buy and hold” will work out because that same strategy might work with a mutual fund is a disaster in the making.
If you own or are in charge of a VUL policy on behalf of someone else – particularly one that is protection-oriented with minimal funding – then you might be totally unaware of the huge gamble that you are taking. And perhaps more importantly, are you prepared to mitigate these risks with corrective actions?
Does your client need a policy review?
I am an Actuary and a Consumer Advocate (not an insurance agent) who helps high-net-worth individuals with $100,000 or more invested in cash value life insurance or annuities to maximize the value of their policies.
High-net-worth individuals and their advisors hire me to help:
- Analyze existing life insurance policies and annuities to provide customized recommendations for optimizing value
- Consider impact of objectives, longevity, tax considerations, and opportunity cost on life insurance and annuity decisions
- Access/design life insurance policies and annuities that eliminate (or reduce) agent compensation and maximize policy value
- Provide an unbiased perspective free from any conflicts of interest
- Avoid making critical mistakes and provide peace of mind
- Provide a qualified appraisal on life insurance policies
To learn more, please contact me.
Disclaimer
Witt Actuarial Services does not guarantee any specific level of performance, the success of any strategy that Witt Actuarial Services may use, or the success of any program. Information contained herein may become out of date; Witt Actuarial Services is under no obligation to advise users of subsequent changes to statements or information contained herein. There is no guarantee that the information contained herein is accurate. This information is general in nature; specific advice applicable to your current situation is only available through an engagement. Any perceived similarity with persons living or deceased is entirely coincidental.