#43 | Accumulation Funding: Less Is More?

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The premium level for a life insurance policy designed for accumulation should almost always be right at the maximum non-MEC limits. That’s easy. But how many premiums should the client pay? The answer isn’t intuitive or universally applicable. Efficient funding has more to do with each product’s individual pricing structure than any absolute maxim about the premium duration. Different policy charges react differently to parameters. Premium loads are related to premiums paid, COIs to net amount at risk, fixed charges to base face amount and asset charges or credits to the account value. Fortunately, these differences allow for ways to add meaningful value to clients by tailoring policies to particular accumulation needs. I’ll use two real, live case studies as examples.

The first is a client looking to put $100,000 annually for 16 years (his age 70) into a life insurance policy to fund his retirement. He figures he has enough in other retirement vehicles to provide income from age 71-73 but wants to use life insurance thereafter. I proposed that he diversify coverage between two companies and ran the illustrations at 5%. My assumption was that he’d split the premiums 50-50 between the two, but what I found when I tinkered with the illustrations sent me back to the drawing board. For Company A, the IRR on the distribution stream using a 16 pay at 5% was 4.54%. Not too shabby, but the IRR using a 7 pay clocked in at 4.50%. For Company B, the IRR on the 16 pay was 4.51% and a meager 4.26% on the 7 pay.

The reason is pretty intuitive. Company A’s product has very low early charges in exchange for high late tail mortality and Company B has in the inverse. In other words, Company A’s lower charges mean that funding it at high levels doesn’t confer much of a benefit because the ratio of charges to account value is already very low in the early years. Company B, on the other hand, has much higher early fixed charges so the product is most efficient with higher funding that offsets the fixed charges.

So what? Well, as the client said, Company A’s product delivers the same financial benefits with less up-front cost. We modified the case design to a 7 pay on Company A and a 16 pay on Company B. This allows his premium commitment to drop in year 7 without losing policy efficiency, an important consideration if his income goes down (which he says is highly probable given his profession) or he wants to use other retirement planning vehicles in the future.

The second is a company looking to fund distributions to a key executive in years 11-25 of a new policy. The company wants to set aside $100,000 per year for the first 10 years. I was brought into the case after the initial design, which was essentially to specification – a 10 pay IUL policy with roughly $93,000 distributions from years 11-25. The IRR on the distributions was 2.79% against an assumed 5% crediting rate. Not particularly compelling and the reason, again, is fairly intuitive but not obvious. Each premium has a load of 6% attached to it. Premiums in the later years are essentially docked 6% and don’t have time to build value inside the policy before they’re withdrawn.

I recommended switching to a 7 pay design and starting distributions in the 14th year. The client could allocate the premiums that would have been paid in years 8-10 to a side fund (with no premium load, obviously) and those funds could be used to pay distributions in years 11-13. The net result is that the policy IRR jumps from 2.79% to 3.02% and the side fund payments to the trust in years 11-13 are $109k assuming a 3% after tax return. The total return for the transaction is 3.02% versus the original design of 2.79%.

There are some other benefits as well. Setting aside the premiums allows for the policy to ride out any potential negative experience in the market that would translate to zero credits in the IUL contract. I also pointed out the downsides of using IUL in a rising interest rate environment. The side fund would provide a partial hedge against lackluster IUL performance. And, finally, I pointed out that 200bps for tax advantaged accumulation is pretty pricey and largely driven by the client’s needs for quick liquidity after distributions. Other vehicles would likely work better.

Both of these examples highlight the potential benefits of using shorter rather than longer premium durations, but what about a situation where the converse is true? Because the MEC rules are based on 7 years of premium, it’s usually true that any policy with less than a 7 pay maximum non-MEC premium is not efficient for two reasons. First, the face value is higher than it needs to be because the minimum non-MEC face will be based on a 7 pay of a given premium, not a 5 pay. The NAR will be higher and consequently so will COIs. Second, and more importantly, the weird world of life insurance dictates that higher face amounts mean higher commissions. Higher commissions mean higher fixed policy charges and less efficient accumulation.

My experience is that the most efficient payment period in the majority of accumulation cases is 7 years. Some clients want to pay longer, and that’s fine, but don’t be afraid to recommend a life insurance policy portfolio for the first 7 years and then other assets thereafter. Diversification is usually a good thing and allowing clients to shift assets in the future hedges many of the risks in using a life insurance policy for asset accumulation. However, if your client views death benefit as an important part of the policy, then you may need to fund beyond 7 years because the costs of maintaining a meaningful death benefit will be higher.

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