Many of my prospective clients want to see a report showing the Internal Rate of Return or IRR. I do not believe that the IRR, or the payback period, for that matter, provides any useful information for analyzing a maximum over-funded policy design. When we are thinking about The Double Play, we simply want a policy with as much cash value as possible.
Goal
The goal of this post is to show you why the IRR is not a useful metric when evaluating maximum over-funded policy designs. I also want to explain what metrics that you should be looking at instead.
I’ll start off by defining the Internal Rate of Return (IRR). Then we will dive into policy design so that you can see for yourself why the IRR is a useless metric. And finally, I’ll show you what metrics you should be looking at when you evaluate a policy design.
So if this sounds interesting to you, keep reading.
What is an IRR?
The IRR is the annualized rate of growth that an investment is expected to generate. It is typically used in a business case analysis where there would be an initial lump sum investment and lumpy or growing revenues over time. The IRR smooths out the lumps and shows you what the annualized rate of return would be at any given point in time. It takes into account the variable nature of the actual returns to give you that rate of return which would have got you from point A to point B on your investment if it were growing at a constant rate.
Why is the IRR a useless metric for Maximum Over-funded Life Insurance?
First, it is clear from the definition above that the IRR is intended to evaluate an Investment. Life insurance is not an investment. It makes much more sense to evaluate the IRR when analyzing the death benefit relative to the premiums paid and treating the premiums as the investment.
Second, and much more important, it is important to realize that the IRR will significantly and dramatically change based upon the life insurance policy design.[1] Here’s what I mean by that. Two policies with the exact same growth rates and the same premium can have vastly different IRRs. In a minimally-funded policy design, we are trying to get as much death benefit for the premium as possible. In a maximum over-funded policy design the focus is on maximum cash value.
In order to illustrate this, I created 2 illustrations based on $20,000 of annual premium for a 45-year-old male, non-smoker. One of the designs was minimally-funded and the other design was maximum over-funded. Let’s take a look at how two polices with the same premium will have a different IRR.
IRR in a Minimally-funded Policy
A typical life insurance policy with a $20,000 annual premium will have the least amount of cash value necessary to sustain the internal cost of insurance over the life of the insured. Anyone purchasing a minimally-funded life insurance policy is trying to maximize the amount of death benefit protection they can get for their premium. We can look at the IRR from the perspective of the Death Benefit, which is what the insurance companies intended. Or we can look at it from the perspective of the Cash Value.
This table shows us the IRR for both the surrender value and for the death benefit of our Hypothetical case.[2] Notice that the IRR is negative all the way out through the 19th year of the policy. For anyone that cares about the cash value, this is a horrible return.
But now let’s turn our attention to the IRR on the Death Benefit. Because we have designed the policy for as much death benefit as possible, we should expect the IRR to be very high. And that is, in fact, true. If the insured were to die during the first policy year, that would be a 1,000% IRR on the premium.
IRR in a Maximum Over-funded Policy
In a maximum over-funded policy design, we are trying to get as much cash value as possible. In order to accomplish this, we are paying the absolute legal maximum for the death benefit received. It’s important to recognize that a maximum over-funded policy design with the same $20,000 annual premium will have a much lower death benefit than the minimally-funded policy. When looking at the cash value, this means that the policy will have a much higher IRR even though it is the exact same premium.
And because the death benefit is held to a minimum, the internal charges are also held to a minimum. This means that we should expect a much higher IRR on the cash value. Its still going to be negative in the first few years, but it is going to turn positive much sooner. The IRR should also begin to approach the interest crediting rate on the cash value over time. You can see the surrender value IRR increasing every year.
In this table we can see the IRRs for a Maximum Over-funded Policy design.[3] You will notice that the IRR for the surrender value starts off negative, but it turns positive by the 7th year. And because the fees are lower, more of the premium dollars make it to the cash value and this results in a higher IRR.
That last sentence is key: because more of the premium dollars make it to the cash value, the IRR is higher. Policy design is the key factor! You want, and need, a policy with the most cash value so that you can put your money to work in two places at one time. You want a maximum over-funded policy design.
You have seen that you can compare two policies with the same premium and they can have a significantly different IRR. The key is to have a policy design with the most cash value and lowest expenses. The IRR is meaningless.
Side by Side Comparison
Before we close out this topic, it might be more helpful to look at the numbers graphically. This graph combines the key data from the two tables shown above:
The warm colors show the death benefits for these two policies. The minimally-funded policy resulted in a death benefit of just over $2 Million (Red Line). The maximum over-funded policy design resulted in an increasing death benefit starting at only $304,293. It is important to note that the death benefit on the maximum over-funded policy design crosses over and exceeds the death benefit of the minimally-funded policy design after age 78
The cool colors show the accumulation (cash) value. The rapidly increasing blue line is the maximum over-funded policy design. The Green line is the minimally-funded policy design.
I want you to notice the gap between the death benefit and the cash value in each design. The Green line is growing very slowly because the policy must support the much higher death benefit. Much more money must be taken from the reserves and put into a pool to pay claims. This is the cost of insurance.
Notice that in the maximum over-funded design, the gap between the death benefit and the cash value remains constant. The cost of insurance each year is the amount necessary to cover that initial $304K risk of payout. Notice that by Age 89 that the cash value represents most of the death benefit. The annual growth of the cash value far exceeds the premium contributions at this point in time.
Now that you can see the significant differences between two policies with the exact same premium, you should understand why the IRR is a meaningless metric. Policy design plays a much more important role. A minimally-funded policy has less cash and will earn less in dividends. A maximum over-funded policy will have more cash and will earn more in dividends.
The key to a well-designed, maximum over-funded policy is minimizing the internal expenses. This means more of the premium is available to serve as collateral for a loan. And it means more in dividends/interest-crediting. It’s important to understand that The Double Play is all about how much money we can put to work in two places at one time. Remember that the life insurance is not the Investment. Your real estate investments are what matters. So now that we know why the IRR doesn’t matter, what metrics should you be looking at?
What metrics should you evaluate?
The ratio of cash value to premium is the most important metric. As stated in the previous paragraph, you want a policy with as much cash value as possible. You get this by designing the policy at the Guideline Level Premium in the case of an Indexed Universal Life or as close to the 7-Pay Limit as you can get on a Whole Life policy. You’ll know you have a good design when the ratio of the cash value to the premium in the first year is 85%+/- before dividends or interest crediting.[4]
If you are looking at a policy illustration and the cash value is 65% of the premium, you should realize that IS NOT a maximum over-funded policy design. Understand that while the premium may be the same, the resulting cash value is much lower. This means that more of the premium dollars are going towards the fees and expenses of the policy… and the agent’s commissions.
The next best metric is the dividend or interest-crediting rate assumption. Remember that the agent is usually using current dividend rates to project forward for the rest of your life. If you’ve lived on this planet for more than a few years, you know that interest rates are not constant. Since the dividends and interest-crediting rates are highly dependent upon the returns on the insurance company’s reserves, dividends will rise and fall over time as well.
What this means is that you should simply try to hold the growth assumptions constant across all the policies that you are evaluating. Make everything an apples to apples comparison. It is important to realize that the real world and the illustration are not going to be the same. If you are holding the growth rates constant and one policy still has more cash value than another, then you can assume that the fees are lower in the policy that performs better.
Conclusion
The goal of this post was to show you why the IRR is not a useful metric when evaluating maximum over-funded policy designs. I used the examples of a minimally-funded policy and a maximum over-funded policy to show you that two policies with the exact same premium and same growth rates will have significantly different IRRs simply due to the policy design. Understanding life insurance policy design and how it impacts cash value is crucial.
I also explained that the best metric to evaluate policy designs is to focus on the ratio of the cash value to premium. A properly designed, maximum over-funded policy should have about 85% cash value to premium.[5] I also showed that it is best to make the assumed dividend or interest-crediting rates the same across all the policies you are comparing. This way it is obvious which policies have lower internal charges.While I showed you extreme examples to illustrate this, it is still important to understand that when you are looking at two similarly designed policies that it is still the cash value that is most important. When you can leverage more cash for your real estate investments, you will make more money.
[1] We’re going to dive into the weeds on policy design. You can learn more about the differences between minimum and maximum funded policies here:
Minimum and Maximum Over-funded Policy Design
[2] Note: the surrender value is not the same as the cash value. The Surrender Value represents how much you would get back if you were to surrender the policy. The cash value is how much cash is actually in the policy. in this illustration, the surrender charges disappear after the 10th year. At that time the surrender value and cash value will be the same as long as there are no loans against the policy.
[3] Please note that I did NOT include the early values rider, which waives the Surrender Charges, on this example. A policy intended for The Double Play would an even higher IRR in the first 10 years.
[4] Realize that other factors impact this ratio. This is the case for a healthy, fit, non-tobacco user. Tobacco usage, Health, and Age can adversely impact this ratio.
[5] Before dividends or interest-crediting.
