From the November 2002 issue of Investment Advisor • Subscribe!

The Plight of a Trough

In a seemingly bottomless market, one of VUL's chi

Variable universal life insurance, or VUL, has a dual nature: it consists of life insurance with an investment component. It has a dual image in the market, too. During the 1990s the market loved VUL: sales of variable life products grew at a compounded rate of 21% annually between 1990 and 2000, according to a study just released by Tillinghast-Towers Perrin. Now that the market has turned sour--sales declined 15% in 2001 and will drop an additional 25% in 2002, according to the same study--it's hard to find someone, outside the companies that sell it, who doesn't hate it.

This love/hate relationship is quite extreme, and the industry is experiencing troubles that aren't due solely to the drop in policy sales. Many companies' ratings have been downgraded--Fitch Ratings in September released a study of the life insurance industry in which it downgraded 35 life insurance groups comprising approximately 42% of its life insurance universe. The companies soldier on, some doing reasonably well as assets pour into the fixed-income side of their products, but VUL itself remains a flashpoint. Most advisors contacted for this article say it's a bad product or that it's sold inappropriately. If you ask the companies, they say it's a good product that's often not being used properly.

Perhaps the truth is somewhere in between.

One unhappy customer is Roland Shankles, who cashed in his policy earlier this year. Shankles, a CPA with Summit Accounting Services in Knoxville, Tennessee, is upfront about giving his opinion that VULs offer "high fees and low returns," and figures that he's lost a minimum of $14,000 on his VUL policy over the last several years. Shankles, who bought a Western Reserve Life VUL policy in July 1995, put in $200 a month for seven years on the $200,000 policy. He bought it from someone he trusted, and did what the agent recommended. "He [the agent] always said, 'Stick with me four years,'" says Shankles, who adds that he figured he could easily do that because "most people say 20." In fact, he stayed for over seven years.

"The thing I did not consider was maintaining a diversified portfolio throughout. From 1995 through '99, the thing grew rapidly and I just had no idea that" the market would take such a severe downturn. He adds that if you had asked him if he was ready for a market downturn, he would have said that he was. But "Nasdaq is down 75%-80% from its peak," he points out. "If you had asked me if I was ready for an 80% decline? No. I don't know who's ready for that."

In fact, he called the home office about it after talking to the agent and not accomplishing much. "The fellow at the home office commented, 'Well, you've been pretty aggressive with subaccount selection.'" Shankles concedes that his subaccounts were not sufficiently diversified, but points out that his agent had recommended the investment strategy he followed. Shankles finally decided to cash in the policy after analyzing it--something the average consumer is probably not in a position to do.

In his calculations Shankles included the cost of a term life policy. He says he asked himself how much he had put into the policy in total premiums over the last seven years, "at $200 a month from July 17, 1995, to August 30, 2002." That totaled $17,200. From that he deducted the cost of a comparable $200,000 term life policy. "I didn't know what a term policy would have cost in 1995, so I used the numbers for 1998," he says. That "would have been more expensive than a comparable Western Reserve policy," he adds, since he was using figures calculated on his age in 1998 and not in 1995 when the policy would have cost less. The cost for the term policy came to $424 a year, or $2,968 for seven years. That left a net investment, says Shankles, of $14,232. "The surrender value was $7,762," he says--leaving him with a net loss, as he calculates it, of $6,470. He hazards a guess that at a 4% rate of return, an income stream of $200 a month from 1995 till now would have totaled closer to $16,000.

"There were so many fees," he says, "that it's like your subaccount is walking down the hall in the insurance building, and everyone reaches into your pocket and takes something out." Fees did take a good chunk of money. Including a surrender charge that phases out over 15 years, the cost of Shankles' policy in fees and charges over the last five years were: 2002, $1,030; 2001, $969; 2000, $925; 1999, $901; and 1998, $830.

Cost Basis

Shankles, while a CPA, is neither a financial planner nor an insurance salesman, so perhaps he didn't understand the policy he was sold. But many planners who do understand the policies still criticize VUL, and one of the biggest reasons is fees. Harvey Ames and Carl Johnson, of Ames Planning Associates, Inc. in Peterborough, New Hampshire, are opposed to the use of VUL in their clients' portfolios. Johnson points out that many clients do not realize all the charges involved, such as the sales loads of the funds within the accounts, and that they do not realize how much of an effect those charges will have in a down market. Their firm, says Johnson, has used "insurance for insurance purposes and investments for investment purposes; when the two come together it's poor on both ends."

Ames, a CLU and fee-only planner, says that the upfront commissions and trails can amount to such a hefty portion of the policy that they eat up too much of the possible return. He relates the case of a doctor client he picked up in 1989; the doctor had been sold VUL policies on each of his two children to fund their education. The policies had been in place for four years, and the investments had grown by "a grand total of 10.2%, and it was a relatively good time in the market," says Ames. He replaced the policies, bought low-commission straight life, which he placed into an irrevocable life insurance trust (ILIT), and invest in other arenas. The money that Ames invested on behalf of his client paid for "six years at Northwestern [for the daughter] and the son is now graduating from a school of equal quality." Ames says that agents are selling this insurance for "10-year-olds. [My client's children] wouldn't have gotten the education they got" without the change he made, and there is still money left in the portfolio. There simply isn't time for a VUL policy on a child to bring in returns that will meet the expenses of that child's college education. Ames is adamant: "They keep coming up with these false constructs that show VUL with high commissions are able to beat straight investments. That's intellectually, rationally, and intuitively incorrect. If it was so good, every dollar in the universe would be in it."

Using It Right

Tom Orecchio, of Greenbaum and Orecchio in Old Tappan, New Jersey, says that "agents tend to sell VUL as the Swiss Army knife of financial planning. It fixes every problem you could possibly have." Orecchio does have one client whose experience with a VUL policy was positive. The client, he says, was a business owner who was not able to save a significant amount of money for retirement. He'd maxed out his SEPs, his Keogh, and his SIMPLE IRA, says Orecchio. The client was pitched the idea of saving in a VUL policy for retirement, but he had an insurance need anyway, Orecchio says; "first and foremost it's used for his insurance needs." He also stresses that a conservative estimate was made on the return from the policy, and it was overfunded--"which is key." This client didn't run into the problems others had, Orecchio says; the insurance agent "had structured the choices so as to minimize income taxes, and was putting high-income-tax vehicles inside the variable policy. That's rare. It's appropriate." It was also used, he said, as part of an overall financial plan. Even some fee advisors, he warns, tend to regard VUL as a separate entity and don't allocate among the subaccounts in the policy in accordance with the client's overall financial plan.

Orecchio is not a big fan of VUL, though. He also has clients such as the 72-year-old woman with a 78-year-old husband who was told she needed to fund the policy or it would lapse. "The projections were too high," he says. "You have a year or two of bad performance and then they tell you it's not properly funded." VULs in general, he says, have "no disclosure, [are] not properly funded, [and] don't properly allocate assets."

John Ryan, an independent insurance consultant in Highlands Ranch, Colorado, stresses that policies must be overfunded to be effective. "If the minimum premium is $5,000, I would suggest at least a $7,500, if not $10,000, payment to the policy," he says. Further, he argues that it should only be bought when someone has a long-term need for death benefit protection. "By long-term I mean 30 years plus," he says firmly. If it's less than a 30-year need, he suggests term insurance. Once a policy is bought, Ryan points out, its investments must be tracked to ensure that performance is adequate; sometimes, he says, clients will be told to deposit additional funds.

There are advisors who use and even like VUL. But it has to be carefully managed. Ted Dougherty, a financial advisor with American Express Financial Advisors in Woodbury, Minnesota, says he is not surprised by the current attitude toward VUL and blames it on advisors. "Too often advisors follow the leads of their clients," he says, "as opposed to providing leadership to their clients. Right now because markets have dropped so much, clients want to be in conservative positions."

According to Dougherty, advisors don't spend enough time checking out clients' "risk temperament" and clients don't know themselves how much risk they can tolerate. The positive outcome of a down market, he says, is "the opportunity to touch base with clients and find out where they are." Where he used to ask of his clients whether they were conservative, moderate, moderate aggressive, or aggressive in their investing temperament (a scale of 1-4), now he asks where they are on a scale of 1-10. "I prod further," he says. He will ask clients where they were two to three years ago, and says many of them who now say they're in the six or seven range will admit that they used to be "nine to ten." Dougherty doesn't stop there. If a client tells him he's a six or a seven, then Dougherty asks, "What rate of return do you want with that?" If they say they want a 9%-10% rate of return, he says, "I know we're in trouble and we have to spend more time talking about risk in the market."

If clients dislike VUL, he says, he assumes it's because they have an improperly structured policy.

However, in the already prevailing attitude of distrust in the marketplace, the current poor image of VUL, whether justified or not, affects advisors in more ways than one. First there is the job of repairing the damage for a client who has been sold an unsuitable VUL. Then there is the matter of trying to attract and retain clients who have had a bad experience with VUL. Often such clients tar the entire financial community with the same brush.

Johnson relates the story of a prospective client who came to his office with a SunAmerica VUL policy as his "singular investment." The man had "no idea of the commission he'd paid, and no idea of the surrender charge he'd have to pay to get out of the investment." His portfolio had been valued at $1.5 million but it was down to $800,000 because of losses in the VUL policy. The policy, says Johnson, was pitched to the client as ideal for funding an ILIT. But the agent had the policy written before the trust was created, and then did not follow through to make sure that the trust was created; it never was. This would not have happened, theorizes Johnson, had the policy been part of an overall financial plan. To the best of his knowledge, he says, the man has neither returned nor contacted any other advisor to help him with his situation.

Shankles would agree with the client's sentiment. "My respect for people who sell whole life and annuities has diminished," he says. Ames, who has himself sold life insurance, is more harsh about his former colleagues. "Those who are really into sales are true believers; unfortunately, for every one of them who are what I consider to be legitimate, honest, honorable, straightforward agents who really have their clients' interests in mind, there are eight or ten who are just looking to move policies."

Jackie O'Leary, VP in product management at New York Life, agrees that in determining candidates for VUL, "the fit has to be correct." New York Life agents, she says, "sell [VUL] with the understanding of a very long time horizon. If clients have been with their agent/advisor for 20 years," she says, "they understand 'flexible' means both up and down; they see illustrations that show a zero rate of return before they even buy it."

Ruth Manka, senior VP at GE Financial, stresses the prerequisite of ascertaining the client's needs. The client should be asked if he is looking for a wealth transfer vehicle, for insurance alone, or to provide for another individual or charity. Furthermore, the client's risk tolerance should also be determined. There's the time horizon to consider as well. "Make sure you're not putting them into a VUL with the false expectation that in five years you will get money out with a great return," she says.

Double Whammy

Jim Peavey, head of media relations at A. M. Best, reports that VUL sales declined 27% in the first half of 2002 compared to the same period last year. "Virtually every company has suffered some sort of decline," he says. In fact, some companies selling VUL have suffered doubly, seeing their ratings decline as the markets have pummeled their investments. The ratings decline is not related to the sale of products, and indeed, not all companies have seen their ratings head south with the market. But Peavey says capital losses and lost fees have combined to create a difficult situation for many insurers.

Peavey thinks insurers' own portfolios must be scrutinized. "Which companies will fail because they hold bonds and stocks in the next Enron?" he wonders. He points out that companies now need to consider their exposure in many areas they probably didn't before: geographically--"If the worst possible happened, what would their exposure be like in a nuclear [disaster]?" or financially--"What is the next company that is going to implode?" Insurers are getting a lot better, he says, at trying to "manage around the unknowable and profoundly severe."

As a greater awareness is focused on the suitability of various products and behaviors within the financial services industry, and as people educate themselves on more aspects of their finances, will there still be a place for VUL? The companies that sell the products emphatically answer yes, and at least one study bears this out.

John Fenton, a principal at Tillinghouse-Towers Perrin, says a recent study confirms that sales of VUL have been down this year, but it also found that there is still tremendous potential for the product. One way to increase sales, he says, is to reach people who do not even sell insurance: people like financial advisors. "'Sell' can mean different things," says Fenton.

According to Fenton, advisors who have little or no experience selling VUL would be able to "call in the cavalry" in the form of a wholesaler from an insurance company or a managing general agent (MGA), or "have an official partnership." This, says Fenton, would allow the advisor to "still pay attention to his client's needs and get paid part of the commission." That, he feels, would be the most common approach, since VUL is a complex product.

Another alternative companies have is to simplify policies, since underwriting in its complexity requires a life expert (which adds to the cost); in addition, it can be intrusive and turn off prospective clients. There is also the option of reducing the number of loads attached to a policy. "Instead of having six or seven loads, they could have three," says Fenton.

There are, however, drawbacks to such changes. Less intrusive underwriting, says Fenton, could possibly lead to higher losses as actuarial risk might be less carefully assessed, so companies would have to "build the price into the product" to avoid lower profits. Lest one think that simpler loads might lead to lower policy expenses, however, Fenton hastens to add, "Simple loads don't mean low."

Regardless of whether you sell VUL or your clients come to you with portfolio messes to be cleaned up, one thing is sure about the VUL market. It is a complex product with many factors to be considered. Make sure you consider them all so your clients have the protection they need.

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