Monday, June 23, 2014

The Whole Life MLM

Warning:  the following is for blogging purposes only.  Those looking to purchase life insurance of any kind should consult a qualified financial advisor.

In reading “the article” on MLMs I cited in my last post, I was disturbed to see one of my own life insurance companies listed among those whose sales practices and treatment of its interns show the same pattern of abuse for which MLMs have come under so much criticism.  Full disclosure:  my father-in-law was a highly successful career agent for this company.  He purchased and initially funded whole-life policies from this company for his children and later sold policies to me.  I can only assume he believes whole-heartedly in their products.

I’m disappointed to learn that this company now requires its interns to attempt to sell life insurance to their pre-existing contacts (a.k.a. “friends and family”).  As my father-in-law described it, his own internship in the early ‘60s required a lot of cold-calling, a soul-sucking enough activity at that.

My own experience is limited to that of a customer.  Based on that experience, I will offer some criticisms of this company, but before that I will offer the following qualified praise:

For a fixed monthly or yearly premium, and over a significantly long policy life, whole-life policies appear to offer tax-deferred returns significantly above most other interest-bearing savings vehicles, the cash values of which is as secure as the company itself.

Let me expand on these caveats.  Whole-life policies are, first, life insurance policies.  Like term life policies, they pay out to your beneficiaries when you die.  Unlike term policies, they accumulate what the industry calls “cash values” (and what other investments call “principal”).  In the first few years of a policy, these increases in cash values (what other investments call “returns”) are some fraction of your annual premiums (what other investments call “contributions”); in later years, they progressively exceed the annual premium.  These cash values do not count as income for tax purposes until the policy is “cashed out”; hence they are tax-deferred.  Like an equity investment, the  returns on the principal are not guaranteed (beyond some trivial level); however, unlike an equity investment, once the cash values increase, they can never go down.  Thus the “principal” is as secure as the company.

Let me give you an idea of what this looks like in practice.  To evaluate the “performance” of my whole life insurance policy, I follow what strikes me a simple formula:  subtract the annual premium from the annual increase in cash values and divide the result by the previous year’s total cash value.

For instance, I have a $100K policy started in 2000 that showed the following yearly increases for the years shown below.  These are representative; you may interpolate for the intervening years.

Year 2003 2004 2005 2007 2010 2014
Increase $1144 $1245 $1356 $1636 $1945 $2377
Premium $1295 $1295 $1295 $1295 $1295 $1295
Cash Value $1991 $3135 $4380 $7232 $12473 $20940
Return (7.5%) (1.6%) 1.4% 4.7% 5.2% 5.2%

Again, while as a matter of law, life insurance is NOT an investment, I will use the language of investment to describe it:  steep negative returns in the early years for which premiums exceed earnings, followed by uninterrupted positive returns.  As you can see, the longer the life of the policy, the more attractive it becomes as an investment; by the ten-year point, they are paying returns that are well above anything else you would get at a comparable level of risk.  For instance, fourteen years in, I have paid $18,130 in premiums; my cash value is $23,317.  Like I said, 3.75% isn’t great, except compared to any other investment with a comparable level of risk.


Now let me share the downside.

It’s not an investment.  By law, whole-life insurance policies are not investments, and are not to be marketed as investments.  This is downright weird:  for their face value, whole-life policies are an order of magnitude more expensive than term-life insurance, and wouldn’t make sense except as an investment.  But because they are not an investment, the insurance company doesn’t report their performance as actual investment companies do.  The customer is left to his own records to this out, as I have done above.

Obscurity.  Because they aren’t investments, there are some things about them that strike me as needlessly difficult to figure out.  For instance, every year, the insurance company reports the increase in my cash values (called “paid up additions” in the industry).  Some fraction of these increases are designated as “dividends”.  So, what is the difference between the “dividend” and “non-dividend” portion of my paid-up additions?  I asked this question years ago, and never did get a satisfactory response.  Indeed, the agent (who took over the servicing of my policy from my father-in-law upon his retirement) seemed not to know.  All he could do was mail me a blizzard of paperwork that didn’t really answer my question.

“It’s tax free!”  No, it’s not.  The policy owner has the option of “borrowing” from the policy up to the full amount of his cash values, and there are no taxes on loans.  But the premiums would still have to be paid, the rate of cash value increase falls, and some amount of interest on the loan has to be paid as well.  On balance, it amounts to a net negative return on the policy.  Now during the ‘90s, it was plausible to argue that you could invest your cash values in reasonably safe equities and still come out ahead.  This was pretty dumb advice then – what investor takes on more risk when he retires? – and utter nonsense today.  But it didn’t stop my father-in-law from suggesting it.

When the policy owner wants his money, he has two choices:  he can cash out the policy and take the entirety of his cash values.  The taxes on the policy are due that year.  I have been given to understand that the taxes only apply to the cash values in excess of the premiums paid, but I can’t claim to have seen this written anywhere, and don’t have any direct experience.  Alternatively, he can buy an annuity from the insurance company.  How taxes are calculated on the annuity, I have no idea.  And the annuity rates, last I looked at them, didn’t seem very good.

So that’s it, or at least as much as I think I understand.  On balance, and given my investment record since 2000, I’m pretty happy with my whole-life policies.


heresolong said...

With no actual evidence to back up my assertion, I would think that any income can be offset by expenses. This almost seems like a capital gains situation where you have spent $xx on a house and then sell it twenty years down the road. You don't pay tax on the value of the house at sale, you pay on the increase. I bet any tax accountant would have a better and fairly simple answer.

Anonymous said...

Ah yes, selling to friends and family. Though it is more accurately described as selling to now-former friends and now-alienated family.

I experienced this during my ill-fated adventure with a very large and well-known life insurance company in 2010. Almost all other companies operate on the same model, so I believe I can speak for the industry as a whole. Upon completion of training, new agents had 60 days to sell six life insurance policies. Commissions earned on these policies would be withheld until the new agent sold the sixth policy by the deadline, when all would be paid. The flip side - and you just know there's a flip side! - is that if the hapless new agent sold, say, three policies by the time the deadline ran out, he or she would be dismissed and the company would keep the commissions on the three policies. The new agent would receive a goose egg.

There was a calculated reason why the new agent had to sell six policies. Based on decades of experience, the company had long since figured out that a highly motivated new agent could sell an average of two or three friends-and-family policies. Sometimes four, very rarely five, and almost never the magic number of six. By hiring large numbers of new agents,* and hectoring them unmercifully to sell to people they knew, the company was able to issue a steady flow of policies on which it would never pay commissions. Needless to say, the new agents usually spent anywhere from two to four months with the company earning no income whatsoever.

* = the company in question hired 25 new agents each month in order to maintain its local sales force at about 250 agents.