#379 | Whole Life as a Fixed Income Alternative – Part 2
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If we go back through the 5 key tradeoffs and decision points in fixed income investing, Whole Life – a participating all-base Whole Life – makes a uniquely compelling case. It is the only product with tabular guaranteed cash values that eventually equal the death benefit, essentially reducing the protection element of the product over time in favor of the accumulation element. It is the only product with guaranteed cash value growth year over year. It is the only product that earns non-guaranteed interest that cannot later be forfeited.
A Universal Life policy can have similar attributes but only when funded at or near the maximum non-MEC premium, but Whole Life is the only product that builds those attributes literally into the structure of the contract through the guarantees and participating nature of the policy. It is, by its nature, a product built on and for cash accumulation. Out of the box, Whole Life is the most fixed income-like of any permanent insurance product. Here’s how it looks on the 5 key decision points in Fixed Income:
Credit – A highly-rated mutual life insurance company with a surplus ratio that usually exceeds top-tier commercial banks despite having virtually no liquidity risk from a run, as discussed in a post earlier this year. On top of that, mutual life insurers have essentially no business risk, unlike traditional corporate fixed income, because the worst-case scenario is putting the company into run-off. Risk for life insurers always comes in the form of bad investments or aggressively priced liabilities. Pick a mutual company that doesn’t delve into either of those and the chances of a credit catastrophe are vanishingly slim.
Maturity – Unlike traditional fixed income, Whole Life doesn’t have a maturity date where the cash value comes due and must be reinvested. A Whole Life buyer doesn’t have to make the decision about how to ladder maturities. Instead, the life insurer makes that decision for the block as a whole. In the same way that life insurers use risk pooling for mortality risk, life insurers arguably use risk pooling for liquidity risk as well, building a large and diversified maturity portfolio to handle any liquidity scenario. As a result, policyholders reap the yield benefit of the diversified portfolio without having to build it themselves.
Liquidity – Life insurance cash values are available immediately* at par. They do not have a fair market value adjustment. The impact to the fair market value of the underlying assets from the credit quality and maturity date of the assets are borne by the life insurance company. There is no way to pass those gains or losses through to the policyholder. As a result, Whole Life has the liquidity benefits of a ultra-short, ultra-high quality fixed income portfolio without actually having to invest ultra-short or ultra-high quality.
Tax – Whole Life allows the policyholder to control tax incidence. Whole Life is not “tax-free.” Fixed income coupons are typically taxed at ordinary income rates. Whole Life gains are also taxed at ordinary income rates but only if the policy is surrendered. The worst-case scenario is that Whole Life allows for tax deferral relative to a traditional fixed income portfolio. But the best-case scenario is much better – the policyholder takes loans from the contract and eliminates tax altogether because the tax-free death benefit ultimately satisfies the policy loans. The choice of tax incidence is up to the policyholder.
Complexity – Whole Life isn’t complex, but it is opaque, and the two are often confused. The actual mechanics of the product are pretty simple. Premiums are paid, expense and mortality charges are deducted and interest is credited. The net result at the end of the year is the cash value. To the extent that expenses, mortality and interest are better than the guarantees, the policy earns a dividend that is (usually) used to buy additional death benefit with its own cash value. It’s not complicated. The problem is that none of these mechanics are made visible by the insurer. Mutual companies could go a long, long way in building credibility by being more transparent. But opacity is not complexity – and compared to structured credit and other non-traditional fixed income alternatives, Whole Life is a piece of cake.
Through the lens of these five decision points, Whole Life written by a top-tier mutual life insurer is a nearly perfect alternative to traditional fixed income investing. It offers Treasury-like credit quality, returns like corporate bonds, tax treatment on par or better than muni bonds and liquidity like a money market fund. There is simply is no other asset class with those attributes. Whole Life is in a category of its own. Literally.
Manufacturing Whole Life
Consider that typical individual investing is essentially the assembly of raw materials – mutual funds, fixed income instruments, other investments – into a personalized portfolio that, in aggregate, is supposed to have certain risk and return characteristics that meet the needs of the individual. Whole Life, by contrast, is a manufactured financial product. The life insurer repackages the raw materials into a polished product that has its own risks, return profile and tradeoffs that are independent and distinct from the raw materials themselves. The raw materials have been transformed into something new.
The manufacturing process for Whole Life involves three key elements – risk transfer, capital and mutuality. Mortality risk transfer is always and inextricably at the heart of Whole Life because the entire structure of the product is designed to ultimately support (and endow) a death benefit. A more subtle point, however, is the fact that mortality risk transfer also facilitates other types of risk transfer. Liquidity, for example, can be managed across the whole block, thereby allowing life insurers to invest longer and potentially riskier than they otherwise could, because buyers of Whole Life usually want to preserve their death benefits and don’t see their cash value as purely liquid in the same way as they see their savings account at the bank.
However, risk transfer only works if the life insurer has the capacity to take on the risk. Risk is measured by the four Cs of Risk Based Capital – C-1 for asset risk, C-2 for biometric risk, C-3 for liquidity risk and C-4 for “business” risk, an extra layer of conservatism. A company with a 400% RBC ratio holds 4 times the basic RBC factors in capital. It takes a lot of capital to run an insurance company. The more capital a company has, the more capacity it has to write new business and take on risk.
Capital is the unheralded but absolutely essential secret ingredient in life insurance. Capital is what allows the life insurer to transform raw investment materials into a packaged product. Capital is what allows the life insurer to invest in a diversified portfolio with real volatility but to present to customers the smooth and stable returns in a Whole Life contract. Capital is the transformation agent. Without it, a life insurer can’t exist. And neither could Whole Life.
This leads us to the third point – mutuality. Who owns the capital of a life insurer? In the case of a stock company, the shareholders own it. The goal of a shareholder is to maximize the value of the investment. In the context of life insurance, that means delivering a high return on capital that can either be reinvested or extracted. Because life insurance is a highly competitive market where margins are generally tight, increasing the numerator of the ratio (distributable earnings) is difficult. It’s much easier to reduce the denominator, which is capital. Little wonder, then, why stock life insurers have gone to great lengths to engineer their capital through reinsurance arrangements. These arrangements amount to filling a room with balloons – lots of volume, but very little strength or substance.
By contrast, policyholders own the capital of a mutual insurance company. Return on capital in the context of a mutual company is about which policyholders benefit. Writing a new life insurance policy requires a slug of capital that has to be essentially allocated away from existing policyholders and towards new policyholders. The new policyholder, then, has to pay back the existing policyholders with a return on capital over time. In this way, the capital stock of the mutual life insurer consistently grows along with block of business and, ultimately, the amount of distributable earnings available across all policyholders – the dividend. That’s the magic of mutuality. It’s a self-contained, self-perpetuating system where (theoretically) all interests are aligned. It’s volume, strength and substance.
But mutuality is also about the ideal of equity for all policyholders and, on that score, not all life insurers see it the same way. The management team of a mutual insurance company are the stewards of the business. Some stewards see their role as continuing the franchise as efficiently as possible. Other stewards see their role as investing to grow the business so that current and future policyholders will benefit. Other stewards see the opportunity to take capital that might otherwise be deployed to policyholders and, instead, to redirect that capital to investments and non-participating lines of business that will hopefully turn a profit for the benefit of policyholders, as long as those businesses are priced prudently and conservatively. And still some stewards have notoriously seen it differently – as a means to primarily enrich themselves at the ultimate expense of policyholders.
There are real implications for the policyholders of mutual companies from the differing visions of the stewards of the firm. Mutuality is not a protection unto itself. Stewards who don’t steward well are arguably more problematic than shareholders at a stock company, who at least have some level of ownership and management has formal accountability. If participating Whole Life is going to work well, then it’s going to work well because of the interpretation and execution of mutuality built into the operations, culture and management team of the company. When you buy participating Whole Life, you’re buying the company, not the product.
The Costs and Tradeoffs of Whole Life
The fact that Whole Life is a manufactured product means that there are some tradeoffs and costs unique to the product itself that are not found in the raw materials used to construct it. Chief among them – initial policy values. After you pay your first Whole Life premium, there is very little to show for it in the policy cash values. If your time horizon for thinking of Whole Life as a fixed income alternative is 10 years or less, then Whole Life ain’t going to work. It takes 10 years just for a typical policy to break even.
Whole Life only shows its advantages compared to traditional fixed income once it has had time to mature. Buying Whole Life requires a long-term perspective. Heaped commissions are a big reason for reduced initial values in Whole Life, but they are far from the only reason. Reducing initial policy values allows for some of the premium to be used for capital rather than reserves (cash value), which makes for a more efficient contract over its life cycle. Lower initial values also allows the life insurer to invest in longer duration assets with the initial premium, therefore enhancing the yield that can be credited over time.
Whole Life is rightly calibrated to deliver long-term performance. That’s where it works best – a long-term product delivering long-term performance. Isn’t that what long-term financial planning is all about? But there’s a nuance that I think often goes unnoticed. Whole Life requires a long-term perspective to buy, but a short-term perspective to hold. A mature Whole Life policy has cash values that grow much faster than the amount of the required premium, if there still is one. After 10 years, you don’t need anything more than a 1 month time horizon to justify keeping or surrendering the policy because the cash values are fully liquid and have gains. As they say in weightlifting – no pain, no gain.
The particular way that Whole Life is manufactured also exposes it to criticism about embedded fees. Unlike a mutual fund, fees in Whole Life aren’t transparent and disclosed. They’re embedded in the guaranteed values and partially reimbursed through the dividend. The only thing that is easy to see is the difference between the headline Dividend Interest Rate and the actual policy cash value IRR. For the MassMutual 10 Pay, for example, the cash value IRR tops out at around 4.55% for a 45 year old Ultra Preferred Male for a $1M DB, which is 1.45% less than the headline 6% Dividend Interest Rate. In early years, it’s obviously much worse, but it’s accurate to say that the fees in the product tally up to an annualized cost of 1.45% over 40 some-odd years. Compared to retail mutual funds, that’s a lot.
Let’s break it down. Somewhere around 0.25% of the 1.45% is directly related to providing the death benefit which is a benefit, not a cost, and to cover state premium taxes. That leaves 1.20% left over. We know a fair bit of that is related to compensation. How much? That’s hard to say because compensation for Whole Life isn’t based on AUM. But if we consider that Whole Life is being positioned by an advisor as a fixed income alternative within a broader portfolio, it seems reasonable that the advisor would charge 0.8% (on the low end) to advise on the portfolio. That leaves 0.40% left over for general expenses at the life insurer and return on capital. Seems pretty reasonable.
Another way to approach the question of fees and commissions is by looking at statutory filings. As of 2019, life insurers have to break out operational results by product line, which means we can actually see what expenses are allocated to the Whole Life product line. We can also see total commissions paid. The results are pretty interesting. Expenses as a percentage of assets are on the left axis. Blue is statutory operating expenses, yellow is total commissions. The dots are for the right axis, which shows the total size of the block.
In aggregate, general expenses account equal 1.11% of total assets under management. Commission tallies up to 0.52% for a grand total of 1.63% in fees based on statutory data.
How do we square that with what we see on the illustration? Most expenses aren’t allocated at the life insurer based on AUM. Typically, expenses are front-loaded based on premium and face amount. As a result, a company that sells more new policies as a percentage of their overall block is going to have much higher expenses as a percentage of AUM simply because they’re growing. We can see that playing out at Penn Mutual and Mass Mutual, both of which have grown quickly in recent years. Penn Mutual’s ratio of premiums to cash value, for example, is 19%. MassMutual is at 11%. It’s not a surprise, then, that these companies are incurring higher expenses because they’re rapidly growing their blocks.
Based on Thrivent, Northwestern and MetLife, life insurance companies can operate Whole Life blocks with expense ratios of 0.6% or below. MetLife has the largest and most efficient closed block, by a country mile. That’s probably not a coincidence. Northwestern has far and away the largest Whole Life block of any insurer and they’re also the 2nd most efficient operator, but their ratio of premium to assets is just 7%. Thrivent rings in at 6% on the same ratio. These companies show what expenses for Whole Life look like on a marginal basis and are much closer to what we actually see in the illustration over time.
But another issue, I think, is just that some companies don’t really spend a lot of time focusing on expense management – and why would they? There is essentially no accountability for expense management at a mutual company. Policyholders don’t bang on the doors demanding expense reductions, although they should, especially for closed blocks of business. Prudential, John Hancock and Brighthouse seem to able to get away with allocating relatively large expenses to their closed blocks. And who is going to complain about that? No one. The only thing stopping a company from frivolously wasting money is the corporate culture and the desire to show a consistently growing dividend.
Making the Leap
This, then, is the push and pull of Whole Life. As a packaged product, it makes an incredibly powerful case as a fixed income alternative with characteristics that combine the credit quality of Treasuries, the yields of corporate bonds, the tax treatment of muni bonds and the liquidity of money market funds all in one svelte package. As a participating product, it is a fundamentally different offering than Universal Life, despite the fact that a fully funded Universal Life policy written by a well-managed company can deliver similar benefits. For Universal Life, the benefits are discretionary. For Whole Life, the benefits are structural. They are literally built into the product itself and the ownership structure of the company issuing the contract. Whole Life fundamentally takes raw materials and turns them into something beautiful.
Beautiful, but not perfect. The packaged product has its own set of tradeoffs. It’s opaque. It requires a long-term time horizon. It has fees that are hard to quantify and, at first blush, look pretty steep. There is very little accountability for expense management that will directly impact long-term policy performance. Ultimately, the performance of the product is contingent on the company and, as an outsider, it’s really hard to know what the corporate culture is at these firms. Buying Whole Life is about understanding the product – and making the leap of faith that the company will prove to be a good steward for generations to come. Good agents help clients make the leap.
Once you make the leap, then a properly configured and fully-understood Whole Life can serve as an incredibly powerful long-term fixed income alternative. And curiously enough, Whole Life makes its most compelling case in the context of the holy doctrine of traditional investment management, the model that systematically turns raw investment materials into personalized portfolios – Modern Portfolio Theory. Stay tuned for next week.
