Vol 12 No 2		February 2010

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Options for Replacing VUL Used for Retirement Income

"The differences between the deferred fixed annuity to income annuity and NM approaches are: 1) annuity has more annual income for life than NM approach; NM has tax-free death benefits; and overall financial performance with NM should be better taking into account the value of the death benefits"

Phil acquired a variable universal life (VUL) policy in 1994 to provide a supplement to his retirement income. Recognizing that his cash value was below his premiums paid and sensing the unneeded life insurance costs were far more than he bargained for he asked me to assess his options. To follow is my report to Phil. After considering these options he decided to replace the VUL with a Northwestern Mutual (NM) whole life policy as described in the report.

Inherent Deficiencies of VUL

VUL insurance has various equity and fixed-income sub-accounts from which policyowners select for the investment of their policy's cash values. Because VUL policy expenses are high compared with whole and universal life (WL and UL) it makes sense to predominately select equity sub-accounts to reach for higher investment returns to recoup the higher expenses. A life insurance policy investment strategy that uses primarily fixed-income instruments is better done via WL or UL. Therefore the appropriate investment for VUL is equities, whose results are volatile and unpredictable with years of large gains and losses. This presents a serious problem. Simply, equity volatility and life insurance are a very bad mixture, especially when the intent is to fund the VUL and then count on withdrawals and loans for retirement income.

Insurance agents and buyers get their primary understanding about life insurance from illustrations provided by the insurance company. Illustrations show how a policy is projected to perform based on the premium and withdrawal patterns shown and pricing factors that remain constant throughout the illustration. The most important pricing factor is investment results and equity volatility is simply not picked up in these illustrations because they require the use of constant yields. I have backed this up by doing considerable Monte Carlo testing on VULs. The results are always disappointing for policyholders.

When VUL is used for retirement income another dangerous element is introduced. If after years of loans another market decline occurs the policy could terminate without very large premiums being paid. When this happens all of the gains withdrawn or loaned are immediately taxable without any surrender value from the policy to pay this tax.

Given the nature of VUL and this design I do not recommend that this approach be continued.

High Cost of the Existing VUL

Phil's VUL has surrender charges for another six years. The cumulative insurance costs are high at $130,760 over the next six years. Compared to the current surrender charge of $21,177 Phil would have $109,583 of additional retirement funds if he switches to the annuity option discussed below and terminate this policy.

Another option discussed below is to replace this VUL with a low-expense Northwestern Mutual whole life. The insurance costs for NM over the six year period, and taking account the surrender charge, are about $30,000 less.

Whether the annuity or NM option is preferred there is no reason to wait due to the surrender charge because the insurance costs are of more consequence.

Deferred Annuity Option

Phil can exchange this VUL for a fixed or variable deferred annuity. The exchange is tax free, although I doubt there is a taxable gain anyway. The exchange under IRC Section 1035 also transfers the cost basis that I believe is higher than the current VUL surrender value. This is helpful because it allows for more tax-free income later. The deferred annuity can be exchanged for an income annuity when Phil retires.

Using a fixed deferred annuity (fixed-income rates), Phil retiring at 65, transferring VUL cash value of $343,414 and continuing VUL premiums of $32,453 the accumulated annuity balance would be around $830,531. At retirement with conversion to an income annuity and assuming current rates, I estimate that Phil could have tax-free annual income of about $47,300 for life. At Phil's death there would be nothing left. The tax-free yield based on current fixed annuity rates for this strategy is 3.2%. In a 45% marginal tax rate this is a pre-tax yield of 5.7%. This calculates monies funding an annuity and monies paid out. 3.2% is the overall yield on this financial option.

Other deferred annuity options are variable annuity (selecting the type of investments you already have for the VUL) with or without guaranteed living benefits (GLB). A non-GLB deferred variable annuity will have lower expenses. GLB's have higher expenses. GLB promises a heads-you-win, tails-you-break-even proposition. Phil gets most of his gains, but if losses are suffered Phil can annuitize to guaranteed living benefits. GLBs are complicated and in my judgment not without risk. Several companies that sold them ran into financial trouble during the last downturn in the stock market. None of them tipped over, but several received TARP funds. GLB sales pitch sounds good, but as a natural-born skeptic I am not a fan.

I can't calculate a yield for a variable annuity approach because of the volatility of the equity investments used.

Of course the difference between fixed-income backed fixed annuity and equity based variable annuity is like the race between the hare and tortoise. Slow and steady versus reaching for hoped for large returns to fuel larger retirement income.

If variable annuity is used the strategy would be to take the balance at retirement and purchase a fixed income annuity for lifetime income.

Whole Life Option

NM is an excellent company. It has the highest financial strength rating from the four major firms. It has produced excellent value for policyholders for 150 years. Based on their current dividend rate of 6.15%, transferring $343,414 VUL surrender value and premiums of $32,453 to 65 the death benefit is $1,423,000. Beginning at 65 it is illustrated that Phil could withdraw $40,200 for 15 years to 80 with the death benefits declining. All withdrawals are tax-free return of cost basis. Phil's life expectancy is age 86. The illustrated death benefit is $763,113 at 86. The overall yield for this option, based on NM current pricing, is tax-free 4.1%. This is a pre-tax equivalent of 7.5%. (Actual values depend on non-guaranteed dividends).

The differences between the deferred fixed annuity to income annuity and NM approaches are: 1) annuity has more annual income for life than NM approach; NM has tax-free death benefits; and overall financial performance with NM should be better taking into account the value of the death benefits.