In this outlet, I often explain that at infineo we help households and businesses set up customized Whole Life insurance policies. When tailoring such a policy, it’s not enough to know how much the client wants to pay in premiums each month (or year). Even after pinning down this number, we have to go further and ask how to split it up between the contractual base premium and the optional Paid Up Additions (PUA) rider. In this post I’ll give a primer on what this distinction means for the policyholder.
The base premium is what most people probably have in mind when they ask, “What’s the premium on this life insurance policy?” It is the contractual amount the policyholder owes each month (or year) in order to keep the policy in force.
Even if we are considering plain vanilla Whole Life insurance policies—which are quite “old school” and conservative, relative to some of the more exotic products tied to the stock market and such—there are different policy designs regarding the contractual base premium. For example, a person might take out a “10-pay” policy which requires only ten annual premium payments after which it is “paid up.” Or there could be a “Paid Up at 65” design, or even an L121 design (in the United States) that means there is a level premium charged for the entire life of the insured, up until age 121 at which point (if the insured has beaten the odds and is still kicking) the policy would mature and the “death benefit” would be paid to the owner of the policy.
Also keep in mind that even if a policy isn’t yet “paid up” contractually, so long as it has been sufficiently funded, it’s possible that the owner doesn’t need to kick in out-of-pocket contributions to keep it afloat. For example, if a healthy man at age 20 takes out a “Paid Up at 90” policy that requires $10,000/year in base premium payments, he won’t have to actually put in $700,000 of his own money to keep the policy in force. No, at some point (perhaps when the man is in his 50s, depending on the specifics) the annual dividend on the policy will be higher than $10,000, so that if the man so chooses he can elect to have his dividend cover his base premium. This strategy keeps the policy in force but doesn’t require him to keep coming up with a fresh $10,000 each year (from outside sources) to keep feeding the policy. (To be sure, the growth of the policy’s Cash Surrender Value and death benefit would be stunted if he makes this choice, relative to a continued funding of the policy from outside sources.)
In contrast to the base premium, another method by which to flow outside dollars into a Whole Life policy is via a Paid-Up Additions (PUA) rider. This is typically an optional feature, carving out extra capacity for the policy to accept premium payments. There are tax considerations (which lie outside the scope of this post) for how long of a window a new policy might have for such PUA contributions. Generally speaking, if a policy has a very long horizon of base premium payments, at an earlier point in the life of the policy, the ability to also supplement them with PUA payments will drop away.
A PUA payment is a one-shot affair (as opposed to the contractual base which puts the policyholder on the hook for many future payments). For example, a 30-year-old woman might take out a Whole Life policy that is a Paid Up at 65, where (say) $5,000 is owed annually as the contractual base. So she is on the hook for the next 35 years to make at least that $5,000 payment. However, her policy design might also allows for her to put in up to $5,000 additionally as Paid Up insurance, in the first ten years of the policy. Yet after she turns 40, the woman only has the option to keep making the $5,000 base premium payments.
With Paid Up Additions, you are effectively buying a small “one-pay” insurance policy, where you make a single payment to lock in death benefit coverage for the rest of the insured’s life. Such a “one-pay” policy will immediately have its own Cash Surrender Value, which will then grow over time as the policy ages, marching steadily upward towards the death benefit.
In practice, rather than separately showing all of the “mini” one-pay policies that each burst of a PUA contribution buys, a home office illustration will combine all of the values and simply report the total Cash Surrender Value and Death Benefit in a table based on the year and the presumed payment history. But again, what’s happening under the hood is that on top of the original base chassis, each instance of a PUA contribution is effectively buying more paid-up insurance that carries no further obligation on the part of the policyholder.
In the “infinite banking” community (inspired by the pioneering work of Nelson Nash), the trained financial professional will often suggest to the client using a policy design that involves a sizable percentage of the projected cash inflows in the form of a PUA. This is because, other things equal, a PUA payment boosts the available cash value (which can be borrowed against) more than the same amount in the form of a base premium would.
However, the downside is that the PUA payment won’t boost the death benefit as much as the same dollar amount in the form of a base payment would. In order to see specifically what I mean, consider the following excerpts from real-world home office illustrations. To keep things relatively simple, in this exercise, we are only focusing on the guaranteed values, so we can set aside the influence of projected future dividends. I think this is the best way to isolate the essential difference of a base vs. PUA payment:
To get a baseline, start with the illustration on the left. It shows a policy with a contractual base premium payment of $5,000 annually.
Next, the top right illustration shows the same individual and policy structure but with a $10,000 annual base premium. As you can see, it basically doubles the numbers from the original illustration.
Finally, the bottom right illustration shows the same individual but with a policy that has (a) a $5,000 contractual base premium and (b) an optional $5,000 PUA rider that, in this illustration, we assume is fully exploited each year. Thus, in the bottom right panel, the individual is pumping $10,000 per year into the policy, just as in the top right.
However, close inspection reveals that even with the same out-of-pocket payments, the resulting policy values evolve quite differently. In particular, if the entire $10,000 is concentrated fully in base payments (top right), then there is no available cash in the first two years, and thereafter the cash accumulation is a small percentage of the annual $10,000 payments. Even by the 10th year, the increment in the cash value isn’t quite $10,000 (going from $53,767 to $63,255 from Year 9 to 10). On the other hand, the death benefit right out of the gate is an impressive (yet constant) $1.05 million.
On the other hand, if we look at the bottom right example, we see that implementing a 50/50 base/PUA split means that $4,914 of the first $10,000 payment is available in Year 1. By Year 7, increment in the cash value is higher than the $10,000 paid into the policy. So the same flow of annual $10,000 payments has a much better cash value for any given year (particularly early on), relative to the 100/0 split in the top right. But the downside is that the 1st year death benefit is only slightly more than half of the death benefit in the top right. Additionally, the death benefit grows each year with the 50/50 option. (To avoid confusion: In the real world, if the dividends were rolled back into the policy to buy additional paid-up insurance, then the death benefit would increase in both policy designs.)
There is a raging debate in the infinite banking community about the ideal tradeoff between base and PUA. In this introductory post, I am not taking a stand on such controversies. Here I just want to give the foundation so that readers can better understand what the combatants are even talking about.
As I wrap up, let me mention that for a given amount of money paid into the policy, the life insurance agent who sells the policy gets a smaller commission on the PUA portion. So even though cynics often accuse financial professionals of pushing Whole Life because it has a higher commission than term policies, the fact that those trained in the principles of infinite banking often suggest some role for a PUA rider, means that they are deviating from what would earn them the highest commission.
Finally, since I’m talking about commissions, let me emphasize that when it comes to life insurance policy illustrations, what you see is what you get. Yes, agents earn a healthy commission on Whole Life products, but all of that is already reflected in the values being shown in the illustration. That’s partly why the early years of the policy have such meager growth in the cash value.
So the reader should keep this in mind, if he’s comparing the implicit internal rate of return on a Whole Life illustration with the prospectus for a mutual fund, where the earnings might be reported in gross figures while not reflecting the (say) 1% management fee for the fund.
NOTE: This article was released 24 hours earlier on the IBC Infinite Banking Users Group on Facebook.
Dr. Robert P. Murphy is the Chief Economist at infineo, bridging together Whole Life insurance policies and digital blockchain-based issuance.
Twitter: @infineogroup, @BobMurphyEcon
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