Gross Retuns vs. Net Returns – Episode 051

This transcript was auto-generated and may contain errors.

[00:00] Welcome to the Prosperity Podcast, fresh alternative personal finance talk for independent thinkers who prosper outside of Wall Street. Here’s your host, best-selling author, Kim D.H. Butler, and No BS Money Guy, Todd Strobel. Hey, everybody. Welcome to another edition of the Prosperity Podcast. This is No BS Money Guy, Todd Strobel. Once again, I have my co-host and best-selling financial author, Kim Butler, with us. Welcome, Kim. Thank you, Todd. Looking forward to our conversation today. We’re going to hit a subject matter that some may find boring, but everybody needs a place to store cash, so it’s a good thing to know about. We’re going to be talking about life insurance, and specifically, we’re going to be talking

[00:47] about gross returns versus net returns. Well, there’s a lot of times that we fall into the sexiness of a gross return, but those of you who know the money that you can spend is the net. So really and truthfully, you need to compare net returns because that’s the money that goes in our pockets, and Kim, I’ll let you take it away from there. Well, this came up because of a couple different phone calls that I had last week with clients that have this question, and these were existing clients that had owned life insurance for quite some time and were unclear on this. In fact, one of them I think has owned it over 20 years, so please don’t feel bad with your questions. Sometimes we just have to ask those what may seem dumb or stupid or silly questions.

[01:41] They’re never ever dumb or silly or stupid. It’s a completely legitimate request, and our society does not favor learning about life insurance. So how are you supposed to know this stuff? Because we don’t talk about it often as a society, even if you learned it once, sometimes that gets forgotten and you have to learn it again. So the idea here is to have a comparison between the various life insurance policies that are out there and the terminology that is used in terms of a gross return versus a net return, and then also to mix in the dividend word that, of course, is associated with whole life insurance that is also very confusing to people. Now, if you would define what is included in the gross return, and then we’ll talk

[02:33] about what’s included in the net. Okay, I want to actually peel away the onion first. So it’s important to understand, first of all, that when we speak gross and net in today’s conversation, we’re not talking about taxes. So taxes are off the table. This is life insurance, and it doesn’t really matter what kind you buy as long as it’s not a modified endowment contract. In other words, as long as it’s actual life insurance, there are no taxes on the growth at all. So we’re not talking gross and net as it relates to taxes. We’re talking gross and net as it relates to the expenses of the life insurance company and consequently your life insurance policy. And that’s what we mean by the difference between gross and net.

[03:18] And then on the other side, the term dividend, which gets very confusing to people because gross and net implies an interest rate, and we talk about them as interest rates. Dividends, however, are technically dollar figures, though they’re expressed as interest rates, and that’s somewhat helpful because that’s how we understand how things grow is the function of interest. But a dividend is not really a function of interest. It’s more a function of a dollar figure. So as we get into it, hopefully, that will be more clear. And if not, please, as you’re popping onto iTunes to rate our show or comment on our show, if you have additional questions, please send them our way because we’re more than happy to help make this clear.

[04:05] It is actually fairly simple. And once you really get it in black and white, it doesn’t need to be fuzzy. There doesn’t need to be this lack of clarity out there in the marketplace around whole life and universal life. And then some of the hybrids like the index policies, etc. Super. So back to the original question. When we talk about gross return, what what numbers are we specifically talking about that’s added in to that figure? OK, so on the whole life side, if you go look up Guardian or Mass Mutual or Mutual Trust or New York Life or Ohio or Penn Mutual or Northwestern Mutual or any of those companies that say that they’re a mutual company and they have a dividend paying or sometimes you’ll hear the term participating life insurance

[05:00] policy. If you look up on the Web, you’re going to see gross returns of around six point five percent in today. So this is late in the year, 2015, and most insurance companies are going to have high sixes, low sevens. So let’s just use six point five as the example. And you’re going to see a six point five percent gross return. You’re also going to see that in the dividend area if the company chooses to put this information on the Web site. And some of them don’t, because, as I said earlier, technically dividends or dollar figures, not interest rates. But if there is an interest rate there, it’ll it’ll be a gross interest rate six point five. So what’s included in that is everything. It’s the it’s what gross means.

[05:47] It’s the entire amount before expenses that is contributed or paid into a policy. And again, from a whole life company, that is actually a function of dollars. So when an insurance company declares a dividend, it’s a function of dollars. It’s X millions of dollars. But we can calculate it backwards and determine the interest rate. And they, too, can do that, which is why they will sometimes put an interest rate on their Web site. So the whole life environment, when you see a gross dividend rate or when you see a dividend rate really anywhere on the Web, that is a gross dividend rate. And that means it’s before expenses. Now, when you see the universal life types of policies or the index types

[06:38] of policies, when they list a gross interest rate, it doesn’t have anything to do with the dividend. It’s literally guesswork. It’s purely a function of guessing how much their index, typically stock market based index, is going to earn in a particular year. Now, again, back to the whole life side, that’s not involved in the stock market at all. That’s another question I get a lot. Well, what if the stock market goes down? Doesn’t affect whole life at all. If the stock market goes down with index, universal life or index life, then you’re going to have that guess that they put forth as the gross interest rate is going to go down right with it. And again, this is before costs. So once I’m clear that we’ve laid out the before part, I’ll cover the

[07:28] costs. Are we clear so far, you think, Todd? Yep. I think we’re good on gross. Now let’s start peeling back those expenses to get us to the net. OK, so on the whole life side, it’s very straightforward. There are three expenses and that is the first is to run the company because, as you may know, the mutual companies that offer whole life products with dividend participation are owned by the policy holders. That’s an important distinction. And there are definitely some stock companies that are owned by stock holders that do provide whole life insurance as a product and it may or may not be participating. If you can get it to be participating, that’s better. But the typical whole life product is owned by a mutual company.

[08:14] And so one of the costs of running the company is borne by the policyholders. So literally all the administrative costs, the electricity at the home office, all the salaries of the key players, et cetera, et cetera, et cetera, the cost to run the company. Those are one of the costs. The second cost, of course, is mortality. That’s your actual death benefit costs and mortality experience plays a role in that mortality costs. That’s the second part between the gross and the net. And then the third is typically the commission to the agent. There’s nothing wrong with salespeople earning commission for helping you get results. That’s all it is, especially when they’re more than happy to disclose it. And in all whole life illustrations, it’s very clear

[08:58] what it is because you can see how much you put in the first year and you can see how much you have the first year. And the difference between those two numbers is the gross and the net. And the difference between those two numbers is those three things. Again, administrative expenses, mortality costs, and the costs of commissions doing business with that person, whereas the administrative is doing business with that company. We just got a great question and it’s on number two, mortality. And does that expense represent the death claims that they’ve paid or the expense of insuring all of the insureds? That’s a great question. If I understand it correctly, I’m actually going to answer it as both. It’s a combination of the two because insurance

[09:52] companies now remember all these companies been around 150 years or so, they obviously analyze their results in terms of death claims paid. But they also are looking forward and trying to figure out what death claims they are going to pay. And if we have time today, maybe we can get into talking about the reserves that a company sets aside to pay those death claims. But what’s most important, I think, in answering the question is that mortality expense is a combination. The best that I understand it, and I absolutely could be wrong, but the best that I can explain it is a combination of experience and ongoing costs. So there is a mortality cost ongoing in your life insurance policies. And I don’t know that we want to get too far into this

[10:45] distinction today, but in a whole life product, that is a guaranteed and or a fixed, if you will, expense. Super. So we started with a six and a half percent gross. What would a typical net look like? Great question. I want to cover one more expense item before we move in. Yeah, no problem. Before we move into the net. And it’s an expense that is on the index universal life side that is not on the whole life side. And that, of course, is running the index. And the way that the insurance companies do those are typically they purchase options. So options have a cost and that cost is borne by the policyholders to a certain degree. And so the difference between the gross and the net has a fourth expense level, if you will, on the universal life

[11:35] side, especially when it’s an index universal life of the stock market and running the index options that are there. Of course, if it’s just straight variable universal life, then you’ve got money manager costs like a mutual fund would. So that that’s the fourth expense on the index side. Now we can go to the net. Super. So you mentioned six and a half percent on the gross. What could we expect on the net? So in the year 2015, late in the year, the net is around four and a half percent. And that, again, after the costs is a net net net, meaning that’s an actual internal rate of return that occurs. That is after all the expenses. And, of course, after tax, like like we said, we’re not really involved in a tax discussion here today because

[12:24] it’s all life insurance and none of its tax as long as that policy stays in force. But you can look for around a four and a half percent return. And this is why cash value of whole life insurance is so much better of a place to store cash liquid cash than a bank account or a CD or a money market account, because it’s going to have that dollar figure that’s there. Now, I want to bring up something that people will often read about on their policy illustrations. And this is true both in whole life as well as in universal life. And that is that there’s often a guaranteed interest rate of four percent listed literally in the product, in the illustration that exists and that guaranteed interest rate of four is a gross interest

[13:18] rate, in other words, before costs. So in actuality, that’s netting out to around two percent. The same difference for minus two is two that we have in the six point five minus two is four and a half. So not to confuse here, but our gross dividend rate is at six point five. Our net is at four point five. And then dividends are not guaranteed, though they’ve been paid every year for many, many, many years. They are not guaranteed. And so we have the other side of the table that is guaranteed with a gross of four netting down to two. But then these two numbers are not added together. In other words, bottom line, what is your cash value earning? It’s around four and a half percent today, late 2015 on a whole life policy on an index

[14:19] universal life. Who knows, because it’s going to be earning whatever the stock market is. Now, some index universal life policies have floors, have reported floors, and they do use the term guaranteed. But again, I reiterate, those are before costs. So if you look in your illustration and you have a universal life policy and it says in this particular index universal life policy and it says something to the effect of a two percent floor or sometimes it’s even a zero percent floor. Understand that that is before expenses. That’s before the cost of mortality, the administrative expenses, the cost of the commission and the cost of either running that particular mutual fund sub account or that particular index strategy, which again, has

[15:10] options and premiums and all of those things that go along with that cost. If this is confusing to anybody, I guess I would recommend two things. Number one, go to Amazon and buy live your life insurance by Kim Butler. I think that would be an excellent way for you to get a better understanding of what we’re talking about today. And the second thing would be to contact partners for prosperity and ask them to just go ahead and run an illustration for you. And you can actually see these numbers. And I think they become much more real, whether you could use you, your spouse, your children, whatever. But these numbers become a lot more real when you can actually see hard numbers. Wouldn’t you agree?

[15:55] I do agree. And on that note, let’s cover different ages because I used 4.5 as a net net rate of return for our discussion. That’s going to be from basically age zero up until probably around age 45 or 50. You know, a lot of people think that buying a policy on a child is going to get them a much higher rate of return. And it will slightly by one or two basis points, literally like 0.1 percent. But not by a lot. But it does go a little bit lower as you get a little bit older. And I think people understand this inherently. So it is a rule of thumb in the year 2015. And I keep making that calendar notation because dividends are declared every single year. And so every single year, though they don’t move around a lot, your dividend

[16:47] is going to be different. So when you look at one of these illustrations, they’re all based on the 2015 return and the 2015 dividend, which means in 10 years we have to throw that piece of paper away. It’s not accurate anymore anyway. But if as a rule of thumb, if somebody is in their 60s, it might be around 4 percent, maybe even three and a half. Depends on your approval rating. If you’re in your 70s, you’re definitely down into the 3 percent range. But again, you have to remember compared to what compared to cash compared to liquid cash of the bank, which of course is earning less than 1 percent these days and is taxable. Super. Yeah. One more point that I want to make back to the illustration that you

[17:28] suggested, which is a great idea. If you’ve never seen a life insurance illustration, particularly a whole life one, the product’s been around for a couple hundred years, then get one, get one on yourself, get one on an adult child. If you like, please, we’re happy to help you with that partners. Number four, Prosperity dot com. Contact us via the web form. And we are happy once we have a birthdate and a state of residence to send you an illustration. If you already own life insurance, something that you can ask for and if we’ve helped you buy it, of course, we’ll get it for you. And if not, you can often get it by calling the 800 number of your insurance company. And this is important whether you

[18:08] own whole life or universal life is something called an in force illustration. The word is in force. I N F O R C E. So I N as in Nancy. And an in force illustration actually shows your policy as it exists today. And that’s a very reflective picture of the policy today going forward. If you bought it five or 10 years ago, it’s going to look different than the illustration that you got five or 10 years ago. Again, as I’ve indicated, the dividend does change every year and you don’t need to look at an in force every year, but every two or three years is a good idea. So that’s an in force illustration. Our tip for you today, is call your life insurance company or call us if we’re helping you with this area

[18:53] and get an in force illustration. If you don’t understand it, send it to us. I’m more than happy to spend the literally two minutes that it takes since I look at so many of them to give you a in English interpretation of what that document reads. Super. Well, Kim, that’s a very generous offer and I would encourage our listeners to take advantage of that. This is No BS Money Guy Todd Strobel for the Prosperity Podcast. Once again, thanks so much, Kim Butler, and we look forward to talking to y’all again real soon. Thank you for listening to the Prosperity Podcast. To take control of your money and have it work for you, visit us at partnersforprosperity.com. If you liked this episode, make sure you subscribe and

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