Faceoff: Whole life or universal life?

This month’s features an insurance debate between whole life or universal life. The debate was moderated by Dean DiSpalatro and Vikram Barhat.

Universal Life

Subject: Brett Simpson, chairman of Rogers Financial Group and a trustee for the Institute for Advanced Financial Education

What is it and who is it for?

The easiest way to describe a universal life (UL) policy is as a combination of a term insurance policy along with an imbedded investment account that allows for different investment options within it. It’s like a bucket where clients can pour in or deposit a flexible amount. There’s not a contractual premium the way there is with whole life (WL). Instead, there is a maximum and minimum deposit range.

Picture a tap at the bottom of the bucket, out of which is coming the mortality costs, or the amortized term insurance cost. You can choose whether those mortality costs are on a level cost-of-insurance basis or whether the premium increases annually as the client ages. If you have a level cost of insurance, you’d have that cost leaving the bucket each year.

This level cost for life is similar to a non-participating (no dividend) WL contractual premium. Under either level or increasing mortality cost structures in a UL policy, you could pour more in the bucket in a given year than what comes out of the cost taps, thereby building a surplus for future years. Clients should always be contributing at least the cost of the insurance that’s coming out the tap at the bottom of the bucket to ensure sustainability, unless there is a surplus.

A surplus allows you to skip deposit years in the future, or create an additional flow into the bucket from the investment return on that surplus that can be enough to subsidize the outflow from the bucket, which is mostly the level, or yearly renewable, cost of insurance. So the two things that go into the bucket are the deposit the person wants to put in and the investment return that gets recycled back into the bucket.

Does that make UL a better option than WL insurance?

It really depends on the need. UL is good for a person who doesn’t have any trouble with the discipline of saving. For somebody who’s not disciplined, a contractual premium [as in WL] that forces them to put in a certain amount at any given time is good. But flexibility, [as with UL], is always a nice thing. In corporately owned situations with uncertain corporate requirements, or variable cash flow requirements, the flexibility to put in excess deposits in some years and skip deposits in other years ends up being useful.

One of the advantages of UL is accountability. You can get a contractual guarantee on each of the components of UL, such as administrative costs, policy fees and mortality costs, whereas WL is all bundled together. You can get a guarantee on the overall bundle in WL, but not on the contractual components of the bundle.

UL separates those contractual pieces. You can see each of the pieces and isolate choices with each of the pieces with very specific contractual guarantees that vary between different insurers. Personalized choice and linked returns make it more accountable and less opaque in terms of investment performance.

There’s more room to customize the parameters of the UL chassis to the particular needs of the client. A WL plan, which has the same components — the mortality cost, the administrative cost, and the return that the insurance company is generating — guarantees the premium that is charged for a guaranteed amount of death benefit, but the premium they’re charging is an overcharge.

They’re charging what they need to in order to fund the policy if they’re going to make only a rate of return of about four percent. So if the insurer makes more on the overall participating portfolio, which is invested in mortgages, bonds, real estate and stocks, say a return of six to eight percent, then they didn’t really need to collect as much in premium to fund the mortality cost at life expectancy.

The excess rate of return is then credited back to the client in the form of a dividend. And that dividend is really a refund of the overcharged premium. So it’s not a taxable dividend in the way that we would think of a dividend from a stock. It’s really a refund of their excess premium.

A WL participating investment portfolio would be like a cruise ship ploughing through the waves, very stable because of its length and its girth, whereas a UL investment portfolio may be more like a small sailboat. It’s going to go up and down with the waves of market cycles because the investment horizon is generally going to be tied to something shorter-term.

A UL policy can be more flexible, and can be adapted more to somebody’s specific risk tolerances. Sometimes higher-net-worth individuals may feel they need or want to customize [the policy] to their particular tastes or tolerances. They may not want something as mass market as WL.

Whole Life

Subject: Jan Russel, CLU, CH.F.C, CFP, president of Russel Financial Services Inc.

What is whole life insurance?

Whole life (WL) insurance is a life insurance product that lasts your entire life.

WL plans can be both participating and non-participating. If it’s participating, the policyholder receives a dividend each year. This dividend can be reinvested in the product, increasing the cash value on a tax-deferred basis over time. When the insurance company collects a premium, the company first uses it to cover all the mortality and administration charges [associated with the policy]. The remainder goes into the par account, which is then invested. Dividends are allocated each year from the earnings of the par account.

[Unlike universal life (UL) plans], the client isn’t involved in the management of the portfolio — it’s done strictly by the insurance company. Generally it’s invested in things of a long-term nature — a portfolio of government and corporate bonds and loans, mortgages, real estate equities, and cash. The equity portion is usually much lower than you would see in a balanced mutual fund, for example, and because of this it’s a very low-volatility account.

As a result, WL policyholders will generally see their cash value rise every year, though the dividend may vary from one year to the next. When they get reports from their insurance company, they’re never seeing their cash value go down.

In the past, insurance companies got into a lot of hot water because they made projections on the level of future dividends, which could be used to pay future premiums, without enough disclosure. They didn’t provide enough information to policyowners that these projected dates on which policyowners could stop paying premiums were not a guarantee. Companies are now required to inform their clients that dividend projections are subject to the economics of rate of return on investments, mortality rates, and things of that nature.

The dividend can be used in a number of ways. For example, you can use it to buy additional insurance, so your protection grows over time. It can also be used to cover future premium payments, which means, at some point in the future, the values in the plan plus the continuing dividend would cover the premiums, although as mentioned before, this is not a guarantee. Nowadays, WL plans can be set up so there is a guaranteed date when no future premiums are required.

Who should buy it?

Generally WL products cost more than a minimum-funded UL product, [and are most suitable for people who have some financial latitude]. You certainly wouldn’t pick this kind of product if it meant you had to sacrifice paying down your mortgage, saving in your RRSPs, or putting money towards RESPs.

There are a few different profiles that fit the WL option. A good profile would be someone from 45 to 60 years of age who has done well financially. They may have paid down their debts, and no longer have a mortgage. And they may even have available assets beyond their RRSP to put away for their estate. [WL insurance is] a great estate planning tool because the dividend can be used to purchase additional insurance protection over time.

This increases the estate value of the policy, and it’s a great way of leaving money tax-free to someone you care about. WL insurance can even work well for a business owner who has excess cash and wants to put it into a policy. They can have the corporation own it, and still be able to access those cash values and have an estate value later on. The policy also works well for a younger person who doesn’t yet have dependants or a lot of debt. When you are younger, the cost of the policy is lower and you may have the affordability to put something away without it being a drag on your RRSPs and other savings. So that might be someone who has just come out of school, and they haven’t yet got a family or a mortgage — someone in the 25-to-32 age range.

Everyone can use some permanent insurance — whether it’s WL or UL insurance — because some day we’re all going to die, and cash is always needed when that happens, even if the person didn’t get married and had no dependants. There’s funeral and other expenses that have to be taken care of. You can cover this off with a small WL policy, and then add a larger block of term insurance.

Combining WL and term

Having a part WL, part term insurance arrangement makes sense because the term portion will be low-cost. You’ll then be able to convert the term portion into a WL policy in the future when your needs change. Say you’re 55, and you want to start thinking about providing money for your estate. You can simply say to the insurance company that you want to switch over part of your term insurance to WL, and you won’t need to go through a medical exam.

If you have a serious medical issue at the age of 55, for example, and you already have a big block of term insurance, you can convert to WL and the insurance company can’t refuse — they would have to give it to you at standard rates. If you were to first apply for the insurance after having a heart attack, you would either be turned down or you would have to pay onerously high rates. Buying the block of term insurance is a small price to pay to have the option to convert later on. So you could be young and with no mortgage, but it still makes sense to protect your ability to get it in the future when you’ll really need it.

Some will say there’s so much more flexibility in UL because they can manage their investment options themselves. But it’s hard enough to manage your portfolio of securities in your RRSP, your non-registered account, your TFSA and your RESP. What I find is it’s not managed well most of the time within a universal life policy. And it’s not done proactively, because a lot of agents are just not wealth managers or don’t have the time.

So why not hand it off to the insurance company? Yes, you do have to pay a fixed premium and you can’t choose your investment mix. But if you look at the return on the par portfolio for the last 25 years with Sun Life, it’s 9.3%, [which is quite good].

I’ve also seen cases where people will fund a universal life plan with very little, and because of volatility they actually have to put up extra money at the end of the year. The cost of the insurance is deducted monthly, and all of a sudden the account value has gone down and there’s not enough money in it to cover the cost. But you never have to worry about that with [WL].

Good advisors design programs that match the client’s cash flow and needs. And they’re always given options. When I see clients, if I feel their [ability to afford insurance] and their life stage matches a term [product], we’ll show them term. We may not show them any WL at all. We just educate people, and in the end it’s the client’s choice. It’s really no different than the suitability requirements that you have to meet when helping people to invest.

Are there situations where a UL policyholder should also hold a whole life policy?

Simpson: Sure. I have both types of coverage myself. But it’s not a should, it’s a can. The two of them are similar and so part of it is diversification of strategy. [With the WL policy,] I’m going to use the duration-averaged return of the participating portfolio of the insurance company. I’m going to tie my returns to the insurance company, and I’m going to have an increasing death benefit if I’m going to use that participating WL system to reinvest my dividends in paid-up additions.

[With the UL policy,] I want to be able to customize my rate of return to my own risk tolerance. If I want an equity-like return, then I want to be able to invest in a diversified portfolio of businesses, through a stock type of mutual fund investment within my insurance policy portfolio.

What are the odds of an advisor making an unsuitable recommendation?

Simpson: They’re much higher in UL insurance because of the [possibility of a] combination of too low a premium with too high an investment return assumption. In that case, the policy actually can’t fund itself, forcing the client to put in a higher premium later than what was planned. In a WL, there’s a contractual premium that does not vary. The risk in WL coverage exists when using the non-guaranteed dividend to subsidize the contractual premium or pay for extra term coverage. This is where a lot of insurance companies were sued in class action suits in the late 1990s and early 2000s, when dividends decreased and could not meet expected uses. (Editor’s note: Agents selling universal life insurance in the 1990s defended high premiums by saying they would disappear after a few years. However, the premiums would only disappear under unrealistic rates of return.) Subsidized premiums didn’t vanish and the growth of policy benefits did not meet expectations.

Is there a clash of interests?

Simpson: I don’t think you can isolate the clash of interests between advisor and client to one product type. There’s always a conflict of interest in managing a client’s needs, and the advisor is expected to put the client interest first. There’s no right kind of insurance for everyone. Anybody that says there’s only one right kind is showing they’re really not that knowledgeable about insurance and its uses. Each one of the tools, each one of the insurance products has been designed for particular needs.

There’s no shortage of people that are licensed but not fully knowledgeable about the different products out there. Sometimes those products are being applied in ways that are not appropriate. And that’s the part where we have a responsibility as an industry to raise the level of knowledge of advisors around these kinds of tools.