While there are various reasons that a consumer would be interested in equity indexed insurance plans, the primary reason would have to be as a method of saving. One might argue that if this is so, then other types of insurance products may be more attractive, particularly annuities. For instance Variable Annuities provide a method of savings, particularly impressive for a source of retirement funds, but it has its limitations—particularly in the fact that it is regulated by the Securities and Exchange Commission which is notorious for the amount of rules and regulations it enforces.
Conversely, traditional life insurance products afford the type of long-term protection that is needed in many circumstances, and as a general rule, the "traditional"—meaning not tied to outside investments—insurance can serve most of life's purposes. The problem has always been that life insurance companies are strictly regulated as to where they can invest their funds (read, your premium), and these investment vehicles are necessarily extremely conservative as they hold the policyowner's money. If they were allowed to invest in more "risky," and therefore more productive, investments, "bad things" can happen—remember Executive Life?
Indexed insurance products are touted (and rightfully so) as the best of both worlds. They offer the solid financial beings of insurance company along with the ability of the policyholder to share in the earnings of a healthy and vigorous economy. Consumers like variable products for this very reason, but again, there is a downside—if the market tumbles, there goes the savings element that has been built on the growth of the market. Along comes the indexed products that says, "Hey! Use me and you will share in the returns of a booming market, but if the market plunges, you will always still have growth in your investment. Win-win situation!"
Investors have a savings dilemma when they attempt to create a sufficient inflation-protected income stream in the future. Besides the purchase of specific types of life insurance, usually for specific purposes such as estate planning to pay estate taxes, for family protection against premature death, to use as collateral for a loan or mortgage, etc., investors need to take into account their initial accumulation and ongoing withdrawals in order to meet their goals for future income.
Because variable contracts, and their subcontracts, as well as mutual funds and individual stock investing are subject to market risk, their value can fluctuate. Therefore, their performance is not guaranteed and the investor may receive more or less than the original investment amount as a result. Similarly, the interest-bearing element of traditional whole life insurance fluctuates just like traditional investment vehicles. There is simply no way to guarantee that cash accumulation in the whole life account will adequately compensate for all of the life insurance premium contributions made. Regardless of the types of investment involved, financial goals and willingness to accept risk must be considered when choosing investments of any kind. Also, any withdrawals from variable products prior to age 59 ½, may additionally result in tax penalties—another item to be considered. It could be said that there is no one strategy to a secure retirement withdrawal plan.
Therefore, the practicality of most life insurance policies is influenced by the performance of stocks, bonds, and other investments. Before determining as to how life insurance can serve as a valuable tool for future income, the effects of investments on other types of savings portfolios need to be considered. Before investors can make an informed decision about the type of life insurance policies they should purchase, the diversification of their portfolios and their financial strength should be considered.
One basic method that helps to determine the impact of inflation rates and interest rates on the performance of life insurance policies, is by using illustrations of various scenarios. This will point out to the consumer how important it is to use realistic projections of interest rates and inflation rates in determining the practicality of different life insurance products.
There have been, and always will be, very sophisticated studies on investment rates of return, starting as early as 1926. These studies may take into consideration a plethora of factors, such as a variety of mixtures of equities and fixed income port-folios, the difference in returns between every type of investment vehicle known to man, future inflation adjustments based on past history, etc. These studies are worthwhile in some respects and worthless in other respects. The problem is that agents often have no idea as to where the statistics are coming from and whether they are reasonable or not.
In the not-too-distant past, insurers were furnishing their agents with computerized projections of the growth in the cash value or investment fund of various insurance products, using interest projects of 10% annually or higher. For those who do not remember, there was a "vanishing premium" policy wherein the growth of the investment "fund" would pay for future premiums, and it grew at such a rate that the policyholder would (theoretically) never have to pay another premium as long as they lived! Of course when interest rates tumbled there were unhappy policyholders who found premium notices in their mailbox for a life insurance policy whose premiums did not "vanish." Needless to say, Insurance Departments took unkindly notice and these plans are not available today, but perhaps the biggest impact on today's plans where premiums are invested or where the savings element (cash value or whatever it is called in the plan) is projected when "making the sales pitch." The result is that most projections used in marketing insurance products today, take rather conservative approaches.
Indexed products are protected somewhat from such scrutiny when showing projections as to the buildup of cash values as the internal fund is guaranteed by the insurer. Still, mention "illustration" and the red flags pop up in regulatory bodies.
Many potential life insurance policyholders who are confronted with the computer-generated illustrations and figures presented by insurance agents are often overwhelmed by the multitude of figures that all predict a very lucrative financial future. For the agent, it is important to understand the methods that the insurers use in order to calculate these projections and to recognize the problems with such calculations.
Some insurers use the portfolio method to credit interest to a book of business and generate illustrations that are based on current interest and inflation rates—the most common method of illustrating future wealth growth. The insurer calculates the dividends of a block of policies based on the average earnings of all of the investments involved. This means—and it should be so explained—that the calculations are based on current experience and the projections may be accurate only if the economic conditions remain the same in the future. If the economy suffers a decreasing interest rate, or if inflation should start to climb, such illustrations are, in effect, worthless.
An officer for a large insurance group recently stated that "An illustration is not useful for anything more than wrapping fish."
A comparison of illustrations support this statement, where one illustration shows that for a $250,000 policy, age 50, male, non-smoker, the policyholder would be expected to pay only $5,427.50 annually for a little more than 11 years. The cash value would have grown by 6.25% to $172,681 in 30 years.
A similar policy on the same individual offered $90,000 more in the cash value within the 30-year period than the above policy within the 30-year period. In effect, then second policy would offer a 8.12 % rate of return, plus the policyholder would stop paying premiums one year earlier than the purchaser of the policy above.
Based upon this comparison, the second policy would appear to be a much better policy, so the consumer would probably decide on that plan. However, a closer look at how the second policy became so superior reveals that the illustration is based on four implied assumptions:
It is abundantly clear that an accurate value of policies must incorporate realistic calculation of interest and inflation rates. It was not long ago that agents generally used a 12 percent rate of return for the investments! We wish! The results over the past 20 years have shown that these double-digit interest projections are highly inflated (to say the least) so the end result has been that the life insurance industry has lowered expectations to more conservative rates. Considerable pressure from the regulators had quite a bit to do with these more realistic assumptions.
So, what could be a reasonable and realistic projection of interest rates in today's market? While it may be a shock to many, legitimate and scholarly studies—such as those conducted by contributors to the Journal of the American Society of CLU and ChFC (1995)—indicated then (1995) that an interest rate of 5.01 percent might still not be considered an accurate projection within a long-term historical context. Now, it is not such a shock as that is pretty much what is happening to conservative investments today, 12 years later.
As discussed earlier in this text, and frequently preached from the highest rooftops (so to speak), diversification is generally necessary in order to gain the highest rate of return from a portfolio, and is considered to the be the most important technique for alleviation of risk. Diversification, by itself, does not really guarantee against a financial loss, ergo, there is no guarantee that a diversified portfolio will outperform a portfolio that is not diversified.
This is not to say that allocating investment across a number of asset classes (stocks, bonds and cash) will not help to cushion the investor's portfolio against an isolated downturn in any one particular segment of the market, without losing the returns from cash investments or bonds.
It should be kept in mind that everything in insurance valuation is tied in some way with the mortality of the individual. For instance, annuity prices are determined by statistical projections based on mortality tables, as are, obviously, life insurance prices (but different mortality tables). A portfolio that accomplishes what the policyholder wants to accomplish, can be considered as "successful" and such portfolio mixes depend upon the degree of risk that the investor chooses as well as his age and goals.
There is no doubt that diversification is an effective method of alleviating the risk for the simple reason that different segments of the equity markets and different types of fixed income behave differently, often in a manner that offsets the behavior of each others. Plus, the rates of return among the various segments change radically from year to year. Therefore, the goal of diversification is to take advantage of the best opportunity that that market has to offer, and at the same time, moderating volatility and risk.
But, and it is a big "but," if the investor switches back and forth among various investment styles and allocations in an attempt to time the shifts in leadership in certain areas of the market, this has been proven to lead just to more volatility of the portfolio and the investor will suffer poorer results in his return on investment.
It is outside the purview of this text to discuss investment approaches to any degree, however, there seems to be some competition for the investment dollar between Variable Annuities and equity index funds. It is accepted that Variable Annuities provide a higher rate of return than CDs (Certificates of Deposit) or mutual funds because of the higher-yield assets that are available to the investor. It was noted in the previous discussion of the performance of Variable Annuities, that Variable Annuities are similar to mutual funds as they both invest in stocks and bonds. Variable annuities are similar to mutual funds in the area of investment perils. If a mutual fund has the same level of risk as a Variable Annuity, the rate of return of a Variable Annuity is (theoretically) higher than that of the mutual fund because of the compensation for probability of death. If the annuity contains survivor benefits, the rate of return of the annuity may be somewhat higher or lower than that of a mutual fund with similar risk, depending upon the commission and management fee charged by the insurance company.
Also, it is important that the annuitants not confront short-term liquidity problems. Early withdrawal from the annuity account requires payment of high back-loading charges as well as, importantly, high income tax. It is also preferable to have group annuities (rather than individual annuities) as group annuities normally have lower premium rates.
Earnings from a variable life annuity contribution is income tax deferred. No income tax on interest earnings or capital gain from the assets in the life annuity account is required. However, for a mutual fund, income tax on any earnings from the assets in a mutual fund must be paid. On the other hand, income taxes must be paid on the earnings on the annuity whenever benefits are received from the life annuity account.
Many financial experts have contended that index funds make better investments than Variable Annuities because they have shown higher rates of return over the past 20-or-so years.
The negativity of Variable Annuity investing are, actually, several:
Studies, of all kinds, by various organizations for various purposes, all show one inalienable fact:
F It is critical that consumers be suspicious of those insurance agents who present illustrations using only high interest rates and promises of high rates of return.
However, one should not blame agents for all of the problems with the marketing or servicing of the modern type of annuities and insurance. Insurance companies must contend with many more technical and individual investor problems than those discussed in this text. Still, this discussion should provide a better understanding of these products from the standpoint of the insurers. All things being equal, consumers should understand that their own desire to generate high income from their policies must be balanced with the abilities of the insurer to produce acceptable profits for themselves. After all, and a point not to be lightly taken or ignored:
F Insurance companies are not eleemosynary institutions!
The duration for fixed income for retirement withdrawals reaches its peak overall strategy at the five-year period. It is also obvious that mutual fund bond funds are not the best vehicle for a retiree's fixed income portfolio as they have many fees and besides, the control of the portfolio is no longer in the investor's hands.
Fixed income mutual funds are generally "institutional funds" and have smaller fees, but since they target institutions and require a large commitment they are beyond the reach of most investors.
When there are mixed allocations, there really seems to be more than asset allocation in retirement planning. The ideal would be an ever-moving target that has the flexibility to change annually. For long-term strategies, more volatile investments with decreased initial withdrawals appear to be the best. Also, the flexibility of mandatory withdrawals rules is very important, as this allows for the flexibility during asset value decreased and erratic cash flows.
There really is no single strategy for analysis and selection of the optimal life insurance policy and program, regardless of the decision as to whole life, term, traditional or innovative insurance strategies.
F Life insurance strategies are best tested regularly and reviewed on an annual basis in order make sure that the security and flexibility needed is being achieved.
Obviously, consumers benefit from a diversified portfolio but the ideal investment portfolio is clearly dependent on the unique resources and needs of each individual investor. The objective, strategically, when insurance is used as an investment tool, is an ever-moving target that still has the flexibility to change annually to fit the changing needs of the individual.
Individuals should be prepared to accept more risk as a tradeoff against loss of return, and even for long-term strategies, slightly more risky investments with decreased initial withdrawals may be the best approach. Again, the latitude that is provided regarding mandatory withdrawal amounts may be, in most cases, highly important.
For insurance companies and their agents should remember that consumers shopping for life insurance policies, annuities, or investment options, should always be educated about the features of the policies, the charges involved and the risks that they will undertake by putting their money with insurers and other companies. By making well-informed decisions and ensuring that they are able to support their investments without needing to make large withdrawals that will jeopardize their policies, agents can pretty much guarantee that policyholders will benefit from the wide variety of financial options and products that are available on the market today.
There are certain salient points that a professional agent will pass on to the policyowner or prospect, which they should take into consideration.
The first, and perhaps foremost, point is to make sure that the policyholder understands how to check on the financial standings of the insurance company, primarily by a visit to their library and looking up on the company in the AM Best guide. Obviously, insurance is a long-range partnership and if the company is not financial stable, they may not be around to provide service to the policyholder when the account value falls below expectations.
Chartered Life Underwriters (CLUs), chartered financial consultants (ChFCs), or certified financial planners who are dedicated to their profession would be the ideal source for providing objective and quality advice and answering questions. Beware of many "designations," such as CFA (Chartered Financial Advisor), Certified Elder Planning Specialist, Certified Retirement Financial Advisor, etc.
Specifically, there are certain areas that should be taken into consideration before purchasing a life insurance policy or an annuity. Following are some of those areas:
STUDY QUESTIONS
1. While there are various reasons that a consumer would be interested in equity indexed insurance plans, the primary reason would have to be
A. its overall cost.
B. the 3-year return-of-premium feature.
C. as a method of saving.
D. that the rates are guaranteed by the FDIC.
2. Because variable contracts and their subcontracts can fluctuate in value, as does mutual funds and other savings devices, therefore
A. their performance is guaranteed in order to maintain persistency.
B. whole life insurance has made a giant comeback.
C. their performance is not guaranteed and the investor may receive more or less than the original investment as a result.
D. insurance companies invest heavily in volatile "junk" bonds to keep earnings up.
3. For any prospect for any investment vehicles, the type of investment involved and financial goals must be considered, but primary consideration must be given to
A. the willingness to accept risk.
B. the amount of spendable income the prospect has.
C. the value of the home or other major property investment.
D. the amount of commission.
4. Indexed products are protected somewhat from the scrutiny afforded by illustrations and projections as to the buildup of cash value because
A. the internal fund is guaranteed by the insurer.
B. the SEC has certain requirements for information to prospects, including a
prospective.
C. the buildup of cash values in EIUL policies are inconsequential.
D. they are not really insurance products.
5. When the portfolio method of crediting interest to a book of business and the generation of illustrations based on current interest and inflation rates are used,
A. it must be explained that the interest rates will not change for at least 10 years.
B. the calculations and projections, it must be explained, are accurate only if the economic conditions remain the same in the future.
C. history has shown that over a 15 year period, such illustrations are extremely
accurate.
D. the EIUL automatically becomes an investment security under the jurisdiction of
The SEC.
6. In order to gain the highest rate of return from a portfolio, and considered by many to be the most important technique for alleviation of risk, it is generally necessary
A. to have sufficient funds so that a typical loss becomes inconsequential.
B. for the majority of the funds to be invested in mutual funds.
C. to use offshore banks.
D. to have diversification.
7. Many financial experts have contended that over the past 20 or so years,
A. index funds have shown higher rates of return than Variable Annuities.
B. index funds have shown higher rates of return than any mutual funds.
C. investing in only one stock will always provide the best return.
D. the sales loads of annuities are higher than those used for index funds.
8. It is critical that consumers be suspicious of those insurance agents
A. who show illustrations using only high interest rates and promises of high rates of return.
B. that show illustrations using current interest rates and conservative forecasts.
C. who do not show their securities license when they start discussing policies.
D. that represent large, financially secure insurance companies.
9. Mutual fund bond funds are not the best vehicle for a retiree's fixed income portfolio because
A they have many fees but the investor controls the investments.
B. they have many fees and the investor has no control over the investments.
C. they have the lowest growth percentage of any investment.
D. they are excluded from SEC regulation.
10. A purchaser of an interest-sensitive insurance product
A. will never have any influence as to the yields in their policies as they are
assuming no investment risk.
B. must never be in a decision-making position in respect to investments.
C. will lose most of their investments, without fail.
D. must be able to adjust their expectations about the yield of their policies,
particularly since they are assuming some risk by investing in interest-sensitive
life insurance products.
ANSWERS TO STUDY QUESTIONS
1C 2C 3A 4A 5B 6D 7A 8A 9B 10D