Impending Whole Life Insurance Doom

Whole life insurance policies often rely heavily on the issuing company's ability and willingness to pay dividends.  While whole life policies do have considerably strong guaranteed features, the payment of dividends dramatically alters the net value a policy owner can extract from the contract.

These dividends play a crucial role in augmenting cash values as well as the death benefit.  And in some cases, these dividends play a crucial role in the overall viability of the insurance contract.

If you have ever reviewed a proposal for whole life insurance, you likely noticed that all whole life insurance “illustrations” report dividends in an ever-growing fashion year-over-year.  This column in the ledger of projected numbers has subtle but very significant consequences to the assumptions it makes, and sadly these assumptions need some questioning.

Here's an example:

Whole Life Insurance Illustration Ledger

Notice how year-over-year the dividend value continues to climb.

What are the Whole Life Dividend Projections Assuming?

That ever-increasing dividend figure is telling you that the insurance company assumes a constant improvement in the profitability of your insurance contract.  As each year ticks by, the life insurer makes more money on your policy than it did last year.  As a thank you, the insurer shares these ever-increasing profits with you in the form of a dividend.

But is this assumption realistic?  No.

Truth is insurers don't always do better this year than they did every year prior.  Circumstances change, and this can have a direct impact on the insurance company's bottom line as well as the dividends the policy owner receives in any given year.

Throughout history, fluctuations in dividends due to fluctuations in profitability played little more role than a minor annoyance.  Sure it wasn't ideal to receive a lesser dividend in one year versus the last, but it wasn't life-altering.

Current economic trends are creating some headwinds that have a real potential to make declining dividends much more than a minor annoyance for a good number of whole life insurance policy owners.  To understand the situation, we must first understand the balance insurers assume between rising mortality costs and rising investment income on policy assets.

Offsetting Mortality Costs with Investment Income

As you age, your cost of insurance rises.  I know there are some agents who believe whole life insurance possesses some sort of immunity to this reality, but I assure you it's a real cost all whole life policies face.  Insurers are well aware of this cost, and they have a strategy to deal with it.  The really really really short version of this strategy is simple: produce more investment income on the assets accumulated on the behalf of this policy than the outright cost increases of insuring the life of the insured.

Sounds simple enough, and for decades it was.  But current economic conditions (i.e. low-interest rates) make this strategy far less easily achievable and even begin to cast doubt on its likelihood.

So what does this mean for whole life insurance policy owners?  It means dividends may fall in advanced ages, and potentially fall hard.

Now instead of an ever-increasing dividend, we may see a scenario where dividends decline, reaching very low levels if the insured lives into his/her late 80's/early 90's or beyond.

Here is an example from a real in force whole life insurance policy:

Whole Life Declining Dividend Ledger

Notice how dividends peak at age 88 and then begin to decline.  By age 97, they are nearly a third of what they were at the peak.

For those who achieved paid-up status, triggered the reduced paid-up feature, or who plan to continue paying premiums well into advanced age, this isn't much of a problem.  A source of frustration over woeful underperformance versus original expectations quite possibly, but not a game-ending fatality to the insurance policy.

However, for those who plan to use premium offsets, the dividend option to reduce/pay premiums or use blending as a means to achieve cheaper permanent life insurance this situation is a serious potential problem.

Why?  Let's explore why.

Making a Whole Life Policy Pay its own Premiums

Most insurance agents understand that a whole life insurance policy has the capability of potential paying its own premiums.  This means the policy owner does not himself/herself actually pay the premium when due.  Instead, the policy owner directs cash either in or generated by the policy to pay the premium when due.

The two ways one accomplishes this task with a whole life policy is through either

  1.  a premium offset or
  2.  the dividend option to reduce/pay premiums.

A premium offset is simply the withdrawal of cash value from a whole life insurance policy that then uses the cash released from the policy to pay the premium due.  Say for example that you have a whole life policy with $500,000 in cash value.  Your annual premium is $25,000.  You could opt to use some of that $500,000 cash value to pay the premium.

Functionally this involves a partial surrender of cash value created either by the paid-up additions rider or dividend that purchased paid-up additions up to the $25,000 amount.  Instead of receiving a check from the insurance company for $25,000, the insurer will apply the money directly to the $25,000 premium bill.  You as the policy owner pay nothing towards the policy this year.

Many people opt to use this feature to cease premium payments.  Some do it temporarily, while others have a more permanent plan to discontinue premium payments.

Alternatively to a premium offset, some people use the dividends earned on a whole life policy to pay the premium.  If the annual dividend payable is large enough to cover the entire premium, then you as the policy owner will pay no premiums and instead allow the dividend to cover it for you.

Again, many people use this feature to discontinue premium payments.  The majority of people who opt for this dividend option usually have a permanent plan to stop paying premiums.  Now that the whole life policy earns dividends sufficient enough to pay the premiums due, the policy owner can maintain the policy's death benefit without making premium payments out-of-pocket.

In both the case of a premium offset and dividend option to pay the premium, the policy owner has in some sense achieved paid-up status without needing to satisfy the original guaranteed requirements to achieved paid-up status.  There's just one crucial difference, neither the premium offset nor the dividend option to pay premiums is a guaranteed feature.

This means once the policy owner begins using this feature, he/she has no guarantee that the policy will be able to sustain its ability to pay future premiums.  If the whole life policy fails to cover the premium due, the policy owner must once again make premium payments.  This can cause a serious problem for elderly folks who have no plan to use other precious resources to cover whole life premiums payments.

When Whole Life Blending Causes Problems

Whole life blending is a process of taking term life insurance and adding it to a whole life insurance policy.  The term policy is not separate from the whole life policy, but instead a part of the whole life policy.  We use blending all of the time to build cash-rich whole life policies.

And I want to be very clear about something here, what I'm talking about in this blog post does not apply to blending in the context that we talk about it 99% of the time.  There is another application for whole life term blending and that is where this problem takes flight.

Alternatively, agents use blending as a way to make whole life insurance appear cheaper.  In fact, since the 90's blending whole life insurance with term insurance to sell people cheaper “permanent whole life insurance” has been a favorite selling technique of agents all across the country.

If you can't afford traditional whole life insurance, we can set you up with something much less expensive, seems kind of crazy for anyone to buy traditional whole life now doesn't it?  There must be a catch.  The catch is what this dividend debacle is all about.

Whole life blending sold for cheaper death benefit is super dependent on dividend assumptions.  Eventually, the term insurance goes away, and paid-up additions purchased through the dividend take the place of this term insurance.  So when someone buys such a policy, the agent must make assumptions about the dividend and how long the policy owner should reasonably go before dividend paid-up additions replace this term life insurance.

If the dividends payable to the policy owner go down, then this will extend the time that term life insurance remains attached to the whole life policy.  It will take longer to accumulate the paid-up additions necessary to replace the term life insurance.  This fact has a very subtle but potentially deleterious implication that a lot of agents fail to grasp.

If dividends are lower than expected and the policyholder is not accumulating paid-up additions at the same rate originally assumed, the death benefit needed to replace the term life insurance can take many more years than assumed to materialize.  This happens because as the insured ages, the amount of death benefit purchased by paid-up additions goes down. I'll use a very simple (read: not super realistic to any circumstance but more than sufficient to understand the implications of this point) example to help everyone understand.

Suppose you own a whole life insurance policy with the paid-up additions rider.  Right now, for every $1 used to purchase a paid-up addition, you will create $3 in death benefit.  Next year, however, each $1 will only create $2.75 in death benefit.  You plan on putting $1,000 into the paid-up additions rider this and next year which would net create $5,750 in death benefit.  But, an emergency came up and you were only able to put $700 into the paid-up additions rider this year.

Thankfully things turned back around somewhat and you were able to put $900 into the paid-up additions rider year two.  This means you ended up creating $4,575 in death benefit, that's $1,175 fewer dollars in death benefit created.  That's a 20.4% decline in death benefit.  The reduction in dollars you contributed is 20%.  This is the beginning of a troubling divergence.

It happens because as each year passes $1 buys less death benefit than the year before.  Now imagine if this trend continues year-over-year for the course of 20, 30, 40, etc. years.  The problem has the potential to get exponentially worse.

If the problems facing these types of whole life insurance are dizzying already, I have to introduce one more layer of complexity and problematic implication.

Most blended whole life policies direct the dividend first to the payment of the term insurance cost and second to paid-up additions–using whatever is left over after paying the term premium to purchase paid-up additions.  If the dividend goes down, then it buys fewer paid-up additions, this leads to less paid-up additions death benefit reducing term life insurance death benefit, which means next year the term life cost will be higher than originally assumed.

With a higher term life cost, there will be fewer dollars left over to buy paid-up additions which means more of the term life insurance death benefit will remain.  This fact also potentially makes the problem exponentially worse.

There are several factors that can go in the opposite direction of the policy owner's favor and this is exactly what we have seen play out for a number of people who purchased whole life insurance in this fashion.

Blending whole life insurance makes it function a lot more like universal life insurance.  This doesn't make it bad.  The flexibility universal life insurance provides from a policy design perspective is far superior to ordinary whole life insurance.

But with this freedom to control various elements of the life insurance contracts comes the responsibility of properly managing some of its “moving parts.”  Some agents feign apprehension over this when it comes to universal life insurance but then embrace it unequivocally on whole life insurance.  The truth is, there's very little difference so long as you approach both types correctly.

What Can you do if you Own One of These Policies?

I'm not bringing this up to scare people away from whole life insurance.  Purchased under sound assumptions, the product can help you achieve your financial goals in ways you never imagined.

I'm bringing this up to sound the alarm for the thousands of people who likely bought whole life insurance and either plan to make use of a non-guaranteed premium paying feature and/or those whose agent used blending to make whole life appear cheaper against the competition or more budget-friendly.

If you own whole life insurance, it's time to take a look at it.  Call your agent, or find a new one, and take the time to understand what you have.  This problem isn't likely to go away on its own, and as each year goes by the options to remedy the situation become less and less favorable.

2 thoughts on “Impending Whole Life Insurance Doom”

  1. Just to clarify the point you are making here…the issue discussed here is particularly true for whole life blended with term and no PUA payments at all and no plans to drop off the term rider. Policies that are blended with term with the objective to enhance MEC limits and overfund using PUAs and an eventual plan to drop off term after a certain period should not be exposed to the risk you are referring to. They will still be sensitive to dividend reduction, but are not liable to implode like a term blended whole life without overfunding using PUA.

    • Hi Jay, correct with one minor adjustment about blend with no PUA payments. Some blends use a small PUA payment as part of the “cheaper premium” calculation. There is no specific plan to focus on building cash value with that PUA payment, just a need to use some PUA’s in order to eventually replace the term life insurance component. This thin PUA payment could be insufficient and cause a problem.

      But to reiterate and clarify, those who bought whole life insurance to optimize cash value and used blending as a means to load up PUA’s are not at risk of any of the doom and gloom we brought up in this blog post.


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