#16 | Insights on IRR
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Internal Rate of Return is, justifiably, a common part of life insurance analysis. Technically, IRR is just a backwards Net Present Value calculation where the discount rate is solved (with NPV=0) rather than a given. But practically, IRR is the tool used by life insurance sales folks to figure out whether or not a particular transaction is attractive from the standpoint of return on capital. A higher IRR is better than a lower IRR assuming a particular year for mortality. Different funding patterns can be readily compared simply by putting their Internal Rates of Return side by side in a spreadsheet. IRR is the Ockham’s Razor for comparing policy designs – and for good reason. It really is the quickest and dirtiest way to pull time value of money information out of a series of numbers. But it’s also quite nuanced and, if used improperly, can lead to some misleading results. This post covers some of the big IRR mistakes that I’ve made and seen others make.
Calculating Policy IRR with a 1035 Exchange
This issue rears its head very often and in many places. The way to correctly calculate IRR with a 1035 exchange is to include the 1035 exchange in the IRR calculation for both the in-force and new policy. The other side of the argument is that the 1035 exchange isn’t technically an “out of pocket” expenditure, so it shouldn’t be included in the calculation. If you go to Vegas and win chips, do you count that as money or chips? Chips instantly turn into money, therefore chips are money. 1035 exchanges readily turn into money, therefore 1035 exchanges are money and count as an out-of-pocket expenditure regardless of whether or not you actually elect to transfer the cash value into liquid cash. Keeping the policy in-force is a decision, every year, that the money is better in the form of cash value than it is in your pocket. That’s the same thing as making the decision to put the money into the policy every year. Hence, 1035 exchange money counts as IRR in every case with basically no exceptions. The only caveat is that policies with big gains (and big taxes) might justifiably use the after-tax cash value as the IRR basis instead of the 1035 exchange because surrendering the policy would have tax consequences.
Calculating Financed IRR with a 1035 Exchange
I’ve fallen victim to this trap – a policy is being financed and has a 1035 exchange, do you include the 1035 exchange in the premium financing IRR (interest payments out, net death benefit after loan in)? I didn’t one time and got high double digit IRRs at Age 100. Julian Movsesian’s spreadsheets do it all the time and get pretty high numbers too. So did ING’s before 2009. But yes, of course you include the 1035 under the same logic as above. The client could have taken it as cash. Not to poke fun at premium financing hawkers, but I’ve seen more than a couple of presentations promoting very high IRR figures on financed policies with 1035 exchanges where the IRR calculation didn’t include the exchange. That’s a simple error with profound consequences. Always (seriously, always) double check a premium financing spreadsheet you receive from a vendor. My experience is that there are usually more than a couple of non-trivial errors that always make things look better than they should.
Calculating Tax Adjusted IRR
There are two schools of thought on this and I don’t think there’s a universal right answer, only an appropriate answer based on how you describe the tax adjustment. The conventional method used by financial planners is to tax adjust the rate of return itself – Tax Free IRR / (1-Tax Rate). That calculation essentially assumes that the tax is applied every year to the whole portfolio. So if you have an 8% tax free return in any given year, the tax equivalent would be 11.43% assuming a 30% tax bracket. The IRR in any given year calculates a continuously compounding return, so tax adjusting it using this method means that every year the portfolio yields are taxed. Is that the right comparison for life insurance, which is non-liquid until death? The alternative method is to tax adjust the death benefit itself (Death Benefit / (1-Tax Rate) and then run a new IRR calculation on the transaction. This answers the question of what the policy itself would have to look like if it was taxable in order to yield the current tax-free benefits. But is that the right comparison? There’s no other asset in the world that pays out like a life insurance policy. My bent is to use the latter calculation if a producer specifically asks to see tax adjusted IRR figures. But usually I just don’t even show any tax adjustment because I know that both methodologies are unrealistic. Besides, I think it’s more powerful to point out the IRR and then just say that there’s no income tax. Any person with half a wit knows that not paying taxes is better than paying taxes. And I never show IRR figures adjusted for the Estate Tax. Avoiding the Estate Tax is a benefit of the planning, not of the asset, and using it to compare to other assets misleads on that crucial point.
Money In, Money Out, Money In
The Excel IRR calculation, which is what basically everyone uses, makes some simplifying assumptions that fall apart with varied cash flows. It assumes that the money going into the transaction is financed at the same rate as the IRR and that the money being received from the transaction is reinvested at the same rate as the IRR. It assumes, essentially, that there’s no such thing as a non-market rate investment. The IRR assumes that you can borrow and reinvest elsewhere at the same rate as the current investment. It’s a fair assumption in theory but falls apart in the way we, as life insurance folks, use IRR. We calculate IRR based on cash flows including the big lump sum of the death benefit. The lump sum is what dominates the IRR calculation. So is it reasonable to assume that because the IRR on the policy is 17% that we could have reinvested all of the returned capital prior to that at 17%, too? No way. That’s why death benefit IRR figures are biased when the policy has had any sort of payment returned to the policyholder in the form of a distribution. Don’t just take what the illustration system says is the IRR as the last word – drop the numbers into Excel and play around with the Modified IRR (=mirr) function.
So, in short, IRR is an excellent short-hand tool for looking at the time value of money. But it’s not robust. It’s actually pretty fragile to correct specification of cash flows and assumptions. If you’re not sure whether or not the calculation was done correctly, build your own spreadsheet and double check the numbers. You might be surprised at what you find.
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