This year Ernst & Young published a study that speaks very positively about permanent life insurance and annuities. TL: The DR version of the 18-page reports is that when they incorporated entire life insurance and annuities into a pension plan, they increased both pension income and "older value" for the hypothetical pensioners. So should we hurry to our nearest insurance saleswoman or women and ask for full life insurance and annuity? Maybe not so fast. There are a few things to unpack on this one.
Augmenting Pension with Insurance Products
The report, which you can download here, analyzes three hypothetical families and considers five scenarios:
- Only investment (ie equities and bonds) plan
- Investments with forward insurance
- Investments with full life insurance
- Investments with deferred income interest rates
- Investments with full insurance and deferred income interest
It is not surprising that the term insurance with investment models went worse than the scenario with only the investment (ie sans term life insurance). This is quite intuitive. If we have to distribute some of the money we intend to save for the pension at some other cost, we will save less money.
What is worth at least a moderate increase in eyebrows is their result that full life insurance up to 30% of the money saved results in both an increase in estimated pension income and older value (they defined older value as the balance of the portfolio measured in USD at the end of their income analysis – age 95). Here is the chart from the report:
This increase is not only above the term insurance mixed with a traditional investment strategy, it is also above the income forecasts from the investment scenario where the couple did not own any life insurance at all.
Does this mean that whole life insurance somehow beats shares in a magical way? No.
The portfolio based solely on investments is a 50/50 mix of equities and bonds. When Ernst & Young added full life insurance to their portfolio, they did so by subtracting some of the money allocated to bonds. So the whole life policy worked well against bonds in the portfolio.
There is another element that comes into play, which will also affect how annuities affect this analysis. The entire life insurance lacks volatility. When markets go down – and bonds tend to correlate moderately with broader stock indices today – losses created by the down market lead to a reduced income generation potential. The entire life insurance is mostly affected by these events. Its complete lack of downward movement during market contractions usually results in a higher overall income level.
The increase in older value is not surprising. The whole life insurance provides a death benefit and this can increase what actually remains when the hypothetical couple dies.
Adding annuities to the analysis
What happens if we replace the entire life insurance with annuities? We get these results:
Annuities provide a more significant increase in pension income. Perhaps even more surprising is the positive effect that annuities have on older value. This is again due to the subtraction of bonds and the limitation of volatility exposure that these insurance products produce.
Using both full insurance and annuities in the pension plan
Now that we see how the entire life insurance and then the annuities had on income and older value created, what happens if we use both as part of the pension plan? Here are the results:
According to this research, there is a trade-off between income maximization and older maximization. The entire life insurance can increase the income, but it significantly increases the older value. The reverse is true for annuities. So from here, it is essentially up to the individuals to decide what is most important and how they want to prioritize goals.
Criticism of this research
The authors of this report noted that this is more of a starting point for a broader discussion of how insurance products can help increase pension accounts. It is a bit too easy to draw certain conclusions from data that I think would be urgent and suboptimal. Here are some thoughts on where this data might go wrong.
First, the investment profile seems overly conservative at a younger age. The 25-year-old couple used the same asset allocation for the 35- and 45-year-old couples in the investment scenario. Although I believe that the effects of owning cash value insurance as part of a portfolio even as young as 25 years old can have its benefits, I see no reason to further handicap the portfolio with bonds and a large equity position on the broad US stock market. Greater risk can and should be taken at this stage in sectors with higher growth potential and risk – they can afford this. that's the point of incorporating full life insurance into the plan.
The concept of insurance example used the annual renewable term (ART) life insurance to calculate the impact the ownership insurance has on the end result. The authors further noted that they used an "industry representative" analog to calculate values. ART is an almost extinct insurance product offered by about a handful of insurance companies. It is certainly not representative of how people buy life insurance today, and it has not been representative for many decades. This mistake is unlikely to change the results much, but it is a significant mistake when it comes to carefully modeling investor behavior.
The report probably used standard participatory full insurance to calculate the permanent life insurance impact on the portfolio. This is by no means an optimal way to approach the entire life insurance as part of one's pension portfolio. Research also completely ignores the use of universal life insurance products. While I certainly admit that the majority of whole life policies purchased are more in line with the theoretical policy used in this analysis, if they were not concerned about the correct modeling of life insurance, it should not have hurt the analysis to examine how tweaking whole life insurance to more optimally producing cash value – and very likely death benefit – results affected the results. The good news here is that there is a very good chance that the results of integrating full life insurance into a pension plan – when done correctly – will yield even better results.
The report is short on details about the annuity used. It also fails to address a common problem that many people have when it comes to the income function of annuity products. This is the fact that most contracts require someone to effectively hand over their money in exchange for a guaranteed income stream. Although I do not suggest that this should be an obstacle to owning an annuity, it is a common trade-off and it can also have consequences for dying earlier than expected. How well Ernst & Young examined these considerations is not explained at all accurately in the report.
This said that it is always nice to see someone take a look at how insurance products will affect pension preparedness. This report is favorable to the idea and opens the door for more discussion.