Vol 5 No 7		September 2003

Katt & Company is a fee-only life insurance advising firm. We work with clients throughout the U.S. - primarily by phone, mail, email and telecopy. Typically, we assist clients buying life insurance and those who need existing policies reviewed and managed. We also assist clients with disability income and long term care insurance. The June 2002 Forbes magazine, and a July 16, 2003 Wall Street Journal article, name Peter Katt as one of only four nationally recognized advisors. The Forbes article states that, "…advisers are well worth the money… These savants are working for no one but you…" For references please contact us.

"My Stocks Averaged 4.1% But My Variable Life Account is Down 40%"

This is a client's situation seven years into his variable life policy that is being used for the dual purposes of family protection and tax-deferred investing to enhance his retirement resources. We did everything right for Dr. Smith. He has a pure defined-contribution design with maximum premiums relative to very low initial death benefits while maintaining it as a non-MEC policy. He was shown simulations showing the difference between volatile variable life equity returns versus far more tranquil whole life returns over his lifetime, the-hare-and-the-tortoise of life insurance comparisons. We used a low-load policy. He put 100% of his premiums and cash values into Vanguard's growth fund (sic) where he intends to let it ride until retirement. None of that risky market timing going on here. The arithmetic average for this fund has been 4.1% with yields in consecutive years of 18%, 33%, 24%, 20% [43%], [36%] and 13%. The arithmetic average is the sum of the year-to-year results divided by the number of years. But the actual result has been a compounded negative 12.5% yield that has produced 40% less value than what he put into the policy. This is due to two things. First, the timing of gains and losses can have a tremendous effect on actual performance, which is by far the most important cause of Dr. Smith's result. The second, and much less important cause of Dr. Smith's decreased values, are the expenses associated with variable life. It is possible that the actual result could be better than the arithmetic average, but no one would be disappointed with that outcome.

Dr. Smith's defined-contribution design had an Option B death benefit (which provides for a specified death benefit plus the policy's cash value). Because he really doesn't need increased death benefits at his current age of 61, we have changed his death benefit from Option B to Option A (where the cash values do not increase the death benefit). This decrease in death benefits will lower the premium costs. Over his lifetime this change from Option B to Option A will reduce his costs by about the amount of his equity losses and it is possible that future investment results could put his actual yield on the plus side.

Dr. Smith's situation is well worth remembering the next time your client is shown arithmetic average results as a way of promoting variable life as the preferred insurance asset. The arithmetic average is visually supported by variable life illustrations that must show a constant yield. Variable life illustrations create the illusion of predictability. A 4.1% yielding illustration to demonstrate safety to Dr. Smith would have been very misleading. And if Dr. Smith had been sold a defined-benefit design with large level-to-maturity death benefits relative to some known (sic) premium cost his policy would be insolvent right now and he would be facing the equivalent of a margin call. (See my November 2001 AAII Journal column, Variable Life Insurance Policies and Stock Market Volatility, about the horrors of using variable life for defined-benefit life insurance designs). The volatility of equity returns can produce results that may appear unexpected but are actually natural due to the unpredictability of equity gains and losses.

As an aid to your clients' deciding between variable and participating whole life for their defined-contribution type policies the following data may be helpful. Generally, variable life's expenses are higher than participating whole life by an equivalent of 65 to 90 basis points in yield. That is, variable life has to earn 65 to 90 basis points more than whole life to be even. Since 1926 large cap equities have had an arithmetic average of 12.2%, but a geometric average of 10.2%. Bonds, on the other hand, have had an arithmetic average of 6.2%, but a geometric average of 5.9% (the smaller spread due to less volatility). If we factor in that the best participating whole life companies (e.g., Northwestern Mutual and Guardian) have the liquidity ability to commit up to 25% of their general portfolios to private and public equities, but protect their policies from year-to-year losses, the real historical difference between a long-term investment in participating whole life and variable life is closer to 170 to 200 basis points, not the 600 basis points derived from simply comparing the differences in the arithmetic averages between stocks and bonds since 1926. This is especially important for older clients whose time horizons may make variable life far more risky because they may not have the time to earn back their investment mistakes. A long-term difference between variable life and participating whole life of 200 basis points is probably much more accurate than believing this gap is 600 basis points.

Because of unpredictable and volatile equity results, and high policy expenses, we can fashion three rules about variable life insurance. One, never use it with a defined-benefit life insurance design that has large level-to-maturity death benefits and the fantasy of knowing the amount of premiums. Second, never use the tranquil illustrations showing constant equity results as a guide to making a decision between variable and participating whole life for defined-contribution life insurance designs that have minimum initial death benefits relative to expected premiums. And, never buy variable life with visions of huge equity returns and then chicken out and select fixed-income investments because those higher policy expenses will make this a sure loser compared with using participating whole life.

Two other articles on variable life that may be of interest include my July 2000 AAII Journal column, Using Variable Life Insurance As an Investment Alternative, and my July 1999 AAII Journal column, The Do's and Don'ts of Buying Variable Life Insurance Policies.