August 17, 2011

Life Insurance Product Wrongly Sold as Income Generator

 On a recent episode of the Suze Orman show she had a guest on who had bought a permanent life insurance as a retirement income investment.   The woman had bought an Eclipse indexed life insurance policy.  I'm generally not a fan of investing in life insurance bit this policy in question really doesn't seem like a bad policy as far as cash value life insurance goes.   In this case the real problem with the insurance was how it was sold by the salesperson.  The womans main goal was to have retirement income and that is not what the life insurance policy in question is designed for.   The salesperson sold her something they shouldn't have. 

Here are the basics of the policy that the salesman was going to sell her: 

Initial Investment : $125,000
Female Age 53
Death Benefit  : $600,000
Expected Annual Income in 10 years as claimed by salesperson: $18,000
Sales commission : $7000
Surrender charges : $25,000

If you could invest $125,000 at age 53 and then get $18,000 per year for life 10 years later then that would be a pretty good deal.     First of all you have to figure out how much $18,000 per year at age 63 would cost.  You can get that by buying an annuity. has rates for annuities.   A single life annuity paying $1500 per month ($18,000 per year) for a 63 year old woman would cost about $256,000 and change.    Therefore the $125,000 would have to about double in 10 years for the policy to be able to pay out that much for life guaranteed.    And thats not even taking account for the cost of the life insurance death benefit, the sales commission, other fees and the surrender charges.  Its hard to say how the salesman claimed she'd get $18,000 income since that return doesn't seem to match reality for such a plan.

The documentation for the plan was shown briefly on screen and I copied down some figures.  

If you assume that your investments grow 8% over time based on the performance of the indexed fund then you would see a cash value growth like the following:

8% return assumed
Year 1 = $3,771
Year 2 = $27,674
Year 3 = $53,354
Year 4 = $80,946
Year 5 = $110,596
Year 10 = $160,808

So in 10 years your $125,000 would potentially be worth over $160,000.   Thats equivalent to a 2.5% compounded annual growth rate. 

When the woman was sold the policy the salesman used the predicted or assumed earnings growth to forecast the future value of the investment portion of the insurance.  Insurance plans generally have a guaranteed return as well as higher potential return.   A mutual insurance company's plans may pay a certain fixed amount and then offer dividends in addition to the fixed guaranteed amount.   The dividends would not be guaranteed and would vary depending on how well the insurance company performed financially.  With this universal indexed plan the variable amount is based on the performance of stock market indexes.   For the plan in question it is indexed to one of three index choices.  Each index has a minimum return of 0% and a cap of 16%.    Its not really unreasonable to assume that such an indexed investment would return 8% annually.   In fact if you had such an investment fully invested with the S&P 500 index option over the past 40 years you'd have averaged around 9% annual returns.  BUT the problem is that there is no way to predict the return of the indexed investments in the future.   There is absolutely no guarantee that you'll get 8%.   In fact its purely a guess to assume 8%.   This is a key detail about cash value insurance that people need to understand.  If a projected rate of return is not based on guaranteed returns then it should be clear that you're just looking at possible growth based on guesswork.   

If you're buying an investment in an insurance policy and you want guaranteed safe returns then you should primarily look at the guaranteed growth rate for the investment.  

The Eclipse policy has a 3% guaranteed growth rate for a fixed investment.   If you go with that 3% guaranteed minimum then your cash value would grow as follows

3% guarantee
Year 1  : $1,266
Year 2 : $21,400
Year 3 : $41,914
Year 4 : $62,808
Year 5 : $84,076
Year 10 : $83,477

Thats not extremely good growth since your $125,000 ends up worth $83,477 over 10 years.   That works out to -4% compounded return.   Of course you would have a large death benefit for those 10 years so  we should figure the value of that in.   If you account for spending $1500 a year on a term policy for a woman the same age then you'd be looking at -3% growth of your investment value.

Long story short... The woman was sold insurance as a retirement plan.   The insurance product in question wasn't designed as a retirement income vehicle.   She was told by a salesperson that her $125,000 investment over 5 years would get her $18,000 of income after 10 years.  That growth was not guaranteed in anyway and appeared to be an overly optimistic return for the policy.    Suze Orman ended up talking to the insurance company that issues the policies and the company refunded the woman's money.   I'm not sure if the company would have done so if a major TV personality was involved or not.   Even so, the fact that the insurance company did refund the money without charging surrender fees seems to be an emission that there was wrong doing on the part of the salesman.

Bottom Line : If you're looking at a cash value insurance policy then make sure the rate of return you're looking at is a guaranteed rate and not just a "forecast" or "projected" rate of return.

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