#41 | The Dividend Dilemma
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For Whole Life companies, a dividend rate is way bigger than just a number. It’s a point of pride, tangible evidence of the benefits of mutuality, an indication of corporate efficiency and investment savvy and, maybe more than anything else, the easiest and most public benchmark for comparison. But for exactly those same reasons, dividend rates are almost necessarily less than straightforward. Carriers have an incentive to maintain the rate itself while using other, less public means to adjust policy performance.
So if you’re looking to dividend rates as any indication of relative product performance, chances are pretty good that you’re missing something. The carrier with the highest dividend rate doesn’t necessarily have the most competitive product. Run a few illustrations and you’ll see that story pop out pretty quickly. MassMutual doesn’t necessarily have a more competitive product than Northwestern Mutual even though Mass’s dividend rate is higher than NML’s. The reason, of course, is that a dividend theoretically returns excess premiums paid. The baseline premium is predicated on highly conservative interest rate, mortality and expense assumptions. Premiums are refunded in the form of a dividend if the real world is better than the baseline assumptions. But we don’t know which category dominates the actual dividend payout because we don’t know what the original assumptions were or what the current experience actually is. Fortunately, we have three ways to actually look at the economics of the dividend.
First, we can look at the cash-on-cash rate of return in the illustration. The cash return in the long run usually trails the dividend rate by something like 100-150 basis points (more or less, depending on cell, funding and carrier). Given that dividend rates are more than 200 basis points over current long term interest rates, only clients who were primed to believe that the dividend rate is a reflection of the policy’s cash-on-cash yield will be disappointed. The illustration also gives us insight into how long it takes for the dividends to actually start accruing in a meaningful way. Whole Life companies divide the dividend across policyholders based on their contribution to the overall pool. As such, products that are overfunded and mature receive higher paid dividends than new contracts. So even though the long-term trend moves towards the dividend rate less 200 basis points or so, the difference can be dramatically larger in the short term. Universal Life products perform similarly. A crediting rate of 5% sounds nice until you look at the short term net return after policy charges. The difference is that the charges are clearly stated as different from the interest credit in UL but the two are essentially intermingled in Whole Life. This isn’t to say that UL or Whole Life returns aren’t attractive. I’m simply pointing out that the illustrated returns will differ from the declared dividend rate and that Whole Life should be compared and positioned on the former, not the latter.
Second, we can look at the statutory filings to get an idea of the dividend paid as a percentage of the total block of business. Section 29 of the Notes to the Annual Statement covers Participating Policies and the company has to state the percentage of its business that is participating and the total dividends paid to participating policyholders. For example, 69% of MassMutual’s reserves and liabilities for deposit type contracts ($33.28B) were participating and Mass paid dividends of $1.313 billion in total in 2011. Quick and dirty division tells us that Mass paid a 3.94% dividend in the aggregate. Other mutual companies report similar numbers. But this is an oversimplified measure for a couple of reasons. First, it doesn’t capture the difference between reserves and cash value (which is usually small on Whole Life). Second, and more importantly, it doesn’t reflect the value of the underlying contract guarantees. A Whole Life policy with heavy guarantees will have a lower dividend payout and vice versa. Third, dividend payouts are divided amongst policyholders based on contribution so using average numbers misses the fact that some policyholders get more than others as a percentage of account value. So while I admit some inaccuracy, this metric is a fairly revealing measure of the actual return driven back to the average policyholder. The simple fact that the actual paid dividend is always lower than the declared dividend rate is evidence that the declared dividend rate is only one of a variety of factors.
Third, we can look at the carrier’s net investment yield as an indication of roughly the ceiling of possible actual dividend yields. No major mutual company or stock company with a large WL portfolio broke 5.25% in 2012 for the full general account. We’re also assuming that mortality and expense improvements offset acquisition expenses and corporate overhead so that the pure yield is fully transferred. Reasonable assumption? Probably not, considering that commissions and general insurance expenses tend to run between 1-2% of general account invested assets. I also think it’s interesting to look at the carrier’s net investment yield and its dividend payout. Not surprisingly, the companies with leaner commission and expense structures also seem to have a smaller spread between the two figures. This is a somewhat intuitive result because the only theoretical drag on returns in a mutual company is related to expenses.
In short, actual Whole Life returns are not equal to the stated Dividend Rate and tend to lag it by some material amount. But does that mean that Whole Life returns aren’t attractive? Absolutely not. Whole Life returns are more or less in-line with other general account life insurance products that use the portfolio crediting methodology. It’s also arguable that Whole Life will outperform UL because it offers a more predictable premium flow to the insurer, which helps with bond duration matching and will generally produce better yields. But we shouldn’t buy into the idea that Whole Life produces 7% returns in a 3% interest rate environment based solely off of the stated Dividend Rate. Instead, look at the illustration, the cash dividend credited and statutory earnings. You’ll end up with a much clearer picture of how the product will actually perform.
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