There has been a lot of discussion about the lawsuit filed by stock car racing driver Kyle Busch against Pacific Life Insurance Company regarding the millions of dollars in premiums Pacific charged for its indexed universal life policies.
Filed in Lincoln County, N.C. state court, where Busch lives, the complaint accuses Pacific and its appointed agent of designing and promoting a series of complex IUL policies as “tax-free retirement plans,” which were misrepresented as safe, self-funding investment vehicles.
According to the filing, Pacific used misleading illustrations, undisclosed costs and false promises of guaranteed multipliers and controllable charges to induce Busch to pay more than $10.4 million in premiums, resulting in net out-of-pocket losses exceeding $8.58 million.
An Analogous Situation
Like many others, I read through the complaint and picked out the important information. Rather than surmising about the details of Busch’s policies, let’s look at what we know from public information and compare it to a similar situation I handled.
That situation involved $10 million of premiums in a single policy over a handful of years. The policy had a cash value at the 10-year mark of less than 50% of the premiums contributed over the first five years, and it went down from there, showing that expenses were outstripping the crediting, even with meaninglessly low early mortality charges. Even at the point when the projections were showing income starting, the cash value was significantly less than the cumulative premiums, meaning there was a negative rate of return on premium to cash value over multiple years from policy inception to the income years. Imagine starting retirement distributions from your Internal Revenue Code Section 401(k) plan when your balance is less than your contributions.
It’s not uncommon to see insurance ledgers where the policy expenses over the first 10 years are greater than the entire premium. Cash value at 10 years is often less than cumulative premiums, even for accumulation-focused policies.
Purported Returns
The projection showed three decades of a million dollars annually coming out of the policy as retirement income. In traditional financial planning, there’s an often-used 4% income rule. In this case, the income was 15% of the cash value in the first year.
If the early years are negative but the overall return is close to the gross crediting rate, this suggests that the rate of return during the income distribution years must be quite steep. As ridiculous as it sounds, the policy with a 5.67% crediting rate is reflecting a return in the policy over the income years of 20%!
This is an important thing to note. If an advisor took the time to run some numbers and saw a return manifested in the illustration that made no sense, hopefully they’d call a time-out and urge some further analysis and explanation.
Performance Factor and Charges
That high crediting is driven by something called the “performance factor” that comes with a hefty charge, roughly 3% to 7% of the cash value annually. It’s hundreds of thousands of dollars a year, projected to grow to millions a year. The charge ends up being 75% of the crediting annually.
A problem is that the projection assumes level positive crediting every single year, and that won’t happen. In down or flat years, the expenses still come off the cash value. This significant expense doesn’t include commissions, policy fees and mortality charges that add millions more.
In a recent case where I served in a litigation support capacity, the crediting was a fanciful 15% but the policy was falling apart because the expenses were 20%.
The Loans
The retirement income consists of loans from the insurance company collateralized by the cash value of the policy. To be clear, a policy owner isn’t borrowing their own money. These loans are referred to as alternate loans, indexed loans or participating loans. There’s some slight of hand permitted by the regulations. The carrier is allowed to assume perpetual positive arbitrage between the policy loan and crediting of the cash value collateralizing the loan. The bigger the loan, the better the projections look, and some agents use this to make projections look better When the loans grow to tens of millions of dollars, the projections are assuming hundreds of thousands of dollars of arbitrage crediting. While Busch’s transaction wasn’t premium financing, in a way it does incorporate arbitrage financing where success depends on a perpetual positive spread.
Buried deep in the ledger is “This causes Alternate Loans to be significantly more volatile than Standard Loans.” How often is this pointed out to policy owners? This arbitrage credited interest pushes the projected return on the cash value over and above the multiple credits referenced earlier.
The details show a loan growing to $100 million! That’s not a typo. What are the chances the policy owner would have moved forward with the transaction had they known it would have put them a hundred million in debt? If things don’t pan out as expected and the policy collapses, the $100 million in loans comes crashing down with $90 million in phantom taxable ordinary income.
Product Build and Commissions
Much of the conversation now centers on how the policy was developed. The anti-IUL crowd is using this as an example of how bad IUL is, while the pro-IUL crowd is focusing on the importance of building a policy right.
There are many ways to run a policy. Most people have no idea how many choices there are to be made when you open the software for a product. Because of all this optionality, it opens the door to manipulation. These policies are so complicated, so many policy owners don’t understand the machinations of the build.
It’s widely agreed that this case was manipulated in several ways to maximize the compensation for the agent at the expense of the clients. This contributed to the massive expenses that the policy couldn’t sustain.
The Bottom Line
A policy like Busch’s is effectively impossible to accomplish. If his policy is like the one I’ve related here, none of this is a surprise. If an advisor involved knew what to look for, like how a policy with less than a 6% crediting rate can show a 20% return, something that outlandish would certainly (hopefully) drive some tough questions.
Imagine if you saw some 401(k) modeling that showed a loss over all the contribution years but somehow ended up showing a competitive equity return over the entire period from plan inception to participant death. Would you ask questions? What if you then calculated the return from the first income distribution at age 65 to death at age 95 at 20%? You would laugh out loud and question the hypothetical return calculation of approximately double what the historical averages have been?
How Can the Advisor Help?
This begs the question of how an advisor can help their client keep from being taken advantage of. Analyzing life insurance policies can be very complicated and beyond the capabilities of most consumers. Though the advisors are educated in their fields, they have little ability to independently and objectively produce effective analysis. Guidelines exist in the insurance and investment markets based on state regulations, licensing and professional credentials, though consumers and advisors wouldn’t know if they’re understood and being implemented.
A big red flag is when an agent sells off a life insurance projection, or is comparing projections from different carriers, which has been proclaimed as fundamentally inappropriate by organizations such as the Society of Actuaries. Digging deeper to analyze policy expenses, crediting methodology, non-guaranteed factors, etc., is crucially important. Simply using a financial calculator for spot checking to highlight questionable numbers, as discussed above, is critical but rarely done.
Very few agents bring the available independent and objective tools and analytics to bare to properly analyze a policy and to determine which ones have lower expenses and which may be playing games. Bringing an independent consultant familiar with the various types of life insurance, the reputations of various players in the market, and access to the analytics that allow true research may be the only way to confidently move forward. Such a consultant is generally paid a consulting fee and not compensated by commissions.
