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Dividend recognition deals with how a life insurance company pays dividends to policyholders when they take loans out against their policies. The two options are non-direct recognition (where policyholders receive the same dividend regardless) and direct recognition (where policyholders receive an adjusted dividend when a loan is outstanding).
For years insurance agents argued the virtues of one versus the other, with many favoring non-direct recognition because it had the bonus appeal of giving people access to their money without forfeiting the earnings they stood to gain by leaving their money in the policy. It's like taking your money out for a drive around town and then parking it back in the garage when you are done with it as one example goes.
But this doesn't mean direct recognition lies down and dies next to its competing counterpart. While non-direct recognition has a bumper sticker-like appeal in concept, there's nuance to the discussion that uncovers give and take on both sides of the dividend recognition debate.
We originally published our thoughts on this subject back in 2012. Our opinion hasn't changed. Dividend recognition is far down the list of priority considerations when selecting a whole life policy–especially if the goal for the whole life policy is to accumulate cash value for later use. If you want to see an exhaustive analysis we did recently on the subject, you can check out our dividend recognition webinar.
How does Dividend Recognition Affect Income Projections?
We sell a lot of life insurance to people who want to build an asset for retirement income. So we spend a lot of time evaluating how various whole life insurance features impact a policy's ability to create its owner retirement income. The ledgers that we generate with insurance company software that seeks to explain its product show us projections of values in the policy. These projections assume the current company dividend, which may or may not (probably not) be the same several years from now.
This means we have to make reasonable assumptions about what changes might occur and what impact that will have on the projected values seen in the ledgers. Dividend recognition potentially alters projections and we wanted to know if direct recognition or non-direct recognition is more accurate at projecting the future income potential of a whole life insurance policy.
My hypothesis setting out was that direct recognition would hold the advantage here. Non-direct recognition assumes that loan activity has zero impact on the dividend. So a decline in the dividend should have a larger negative impact on future values when the plan is income production. Because direct recognition adjusts the dividend when a loan is outstanding, and projected values assume this reduction, it's unlikely that a dividend reduction has as much of an impact on the policy's income-producing abilities.
To evaluate this, we looked at a sample policy from Guardian, MassMutual, and Penn Mutual and compared how an income scenario compared comparing three different dividend scenarios:
- The Current Dividend Interest Rate
- A 50 Basis Point Reduction in the Current Rate
- A 100 Basis Point Reduction in the Current Rate
We used these three specific companies because they are very strong in the whole life marketplace for cash accumulation and they represent a good mix of direct and non-direct recognition. Guardian offers both options while MassMutual and Penn Mutual both represent one or the other.
Here are the results of the analysis:
|Current Dividend||Dividend -50bp||Dividend -100bp||Income % Change -50||Income % Change -100|
|Guardian DR||$ 33,033||$ 29,062||$ 26,316||-12%||-20%|
|Guardian NDR||$ 33,215||$ 28,583||$ 25,472||-14%||-23%|
|MassMutual||$ 41,070||$ 33,565||$ 25,593||-18%||-38%|
|Penn Mutual||$ 49,812||$ 43,376||$ 37,819||-13%||-24%|
The results support the hypothesis. Guardian's direct recognition projections were more accurate than its non-direct recognition projections. MassMutual (non-direct recognition) showed the biggest change in projected income with the assumed dividend change. Penn Mutual's (direct recognition) change was more in line with Guardian's change in projected income.
Understanding the Impact Dividend Changes Have on Income Projections
Income projections are a function of assumed cash value accumulation and a spread between the loan interest rate and the dividend rate. This spread can be positive (when the dividend rate is higher than the loan rate), negative (when the dividend rate is less than the loan rate), or zero (when the two are the same). Usually, this spread is positive and larger among non-direct recognition companies than among direct recognition companies. This is certainly the case for whole life policies currently issued among insurance companies.
The spread is larger among non-direct recognition companies because there is no adjustment to the dividend payable to portions of the whole life policy pledged as collateral for a policy loan (a very important component to using whole life insurance for retirement income).
Direct recognition companies, alternatively, tend to have smaller spreads (sometimes even negative spreads) for portions of the policy pledged as collateral for a loan. This is the result of the direct recognition adjustment that takes place when the policy owner takes a loan against the policy. Life insurers that use direct recognition rarely change the adjustment applicable to direct recognition. This means, even as they change their regular (non-adjusted for loans) dividend rate, insurers do not generally change the resulting dividend from the direct recognition adjustment.
Ledgers that project whole life policy values account for the dividend adjustment direct recognition companies use. So as the dividend changes, which does change the cash accumulation assumption on the policy, the spread between the loan rate and the dividend rate does not.
Dividend Increases Should Boost Non-Direct Recognition Income Projections
While decreases in the dividend cause a more substantial decline in projected income from non-direct recognition whole life insurance, the inverse should be true. This means that as the dividend increases, the spread could increase and cause a higher income amount from the policy.
But practically speaking dividend increases aren't likely to take place without pressure for the loan rate to also increase, so the relationship between dividend increases and substantially higher potential income may be limited. This is the case because rising interest rates play the largest role in dividend increases. Rising interest rates would also likely result in higher loan rates as non-direct recognition whole life policies all use variable loan rates tied to interest rates (usually Moody's Corporate Bond Index).
There is a lot to Take In here; We're Here to Help
I realize that this subject is rather deep in the insurance minutia. But I want to emphasize that it has serious implications for your overall financial health if you are considering the addition of whole life insurance to your financial plan.
I strongly believe that whole life insurance can add several critical safety features to your wealth accumulation plans. I also know that it can be done poorly and result in underwhelming results. There are a lot of assumptions being made when you look at projected whole life insurance values. Most consumers (and sadly even many insurance agents) don't fully understand many of these assumptions and how small changes might influence the real value you'll obtain from a policy.
That's why we're here to help. For over a decade I have assisted people with the task of designing and implementing such whole life policies working with them through the marvels of modern technology. We don't need to be in the same room, we simply need to be on the same page. If you think we can help you, don't hesitate to reach out to us.