Demystifying universal life policies

IN MY previous article dated Nov 28, 2020, I wrote about universal life policies (ULPs) being touted as good instruments that allow the affluent to free up more cash for their retirement while still leaving a significant legacy.

But ULPs are not the holy grail to legacy planning as there may be a more cost-effective alternative found in a simple term plan. ULPs are expensive due mainly to three big costs:

1) Premium charge, estimated to be between 7-9 per cent of initial premium;

2) Policy fee which consists of a monthly deduction, the mortality charge, as well as huge surrender charges especially in the first year; and

3) commissions which can be as high as the premium charge.

As a result of these costs, upon inception of a ULP, the cash value will typically start at about 70 to 80 per cent of the initial single premium. You have effectively lost 20 to 30 per cent of your money immediately on day one. So, is the humble term plan a better option?

Take this example:

Peter, a 45-year-old high income earner would like to buy a traditional ULP with a sum assured of US$5 million. The premium amounts to US$1.33 million. He takes a premium loan of US$900,000 and pays US$430,000 cash up front. Based on an average 2.5 per cent per annum (pa) interest across the loan period, Peter needs to pay interest of US$22,500 pa. Alternatively, Peter can opt for term insurance with the same sum assured that covers him up to age 100. He pays a premium of US$38,537 pa instead.

Looking at the scenario holistically, If Peter had bought the term plan, he would have avoided paying US$430,000 cash upfront and can invest it instead. If he had chosen to go for the ULP, he would not have the US$430,000 to invest. But his annual cost is smaller by US$16,037 pa (term plan annual premium less ULP's annual interest cost), and hence he can invest this amount. The table shows the outcome of his choices.

There are a few observations we can make:

1. If death occurs anytime between age 85 to age 100, the total payout from the term option is better;

2. When term insurance ceases at age 101, the ULP total payout exceeds the term option;

3. Assuming death occurs at age 120, the term option beats the ULP solution again, thanks to a higher investment value. But, the question is, what is the probability of living beyond 100 years old? A difficult question to answer, I know.

Also, we did not include the growth of cash values of the ULP. If it exceeds the sum assured, that will be the payout instead and the ULP option may be better.

I did a simple calculation based on 70 per cent of the initial single premium invested upon inception of the ULP and found out that for the ULP total payout to be at least equivalent to the term option:

1. At age 85, the ULP's cash value needs to be at US$7.3 million and thus, the ULP's ROI needs to be 5.28 per cent pa;

2. At age 100, the ULP's cash values need to be at US$8.6 million, and thus, the ULP's ROI needs to be 4.13 per cent pa;

3. At age 120, the ULP's cash values need to be at US$7.9 million, and thus, the ULP's ROI needs to be 2.73 per cent pa.

For traditional ULPs, it might be difficult to achieve this kind of ROI at age 85 but the ROI seems realistic for age 100 and 120.

But if you buy ULPs which have a lower front load cost or use a wealth adviser who rebates you the commission, the ROI needed can be lower.

Note that we have not considered the premium loan interest rate which can be different from what we assumed and also currency risk of the US dollar.

In the case of the term option, there are fewer moving parts. There is no currency and interest rate risk as term plans are denominated in Singapore dollars and you do not need premium financing.

Also, with the term option, you have the option to terminate the plan early whereas with ULPs, high surrender charges may mean losing a substantial amount of your premiums paid. You can also customise the investment portfolio of the term option according to your risk appetite, and you cannot do the same in traditional ULPs.

So, there is no clear conclusion to whether ULPs or term insurance is better. But I hope this discussion has shown you that there is much to consider and ULPs are not the only way.

One thing that is certain is that legacy planning is not about buying ULPs. Legacy planning is about developing a strategy to define, reflect on, and express what wealth really means to a family. This refers not just to financial wealth, but also the family's core values to be passed on to future generations.

For business owners, financial wealth could even include passing on the business and therefore business exit and succession planning are important. ULPs are just one of the many instruments a wealth adviser can suggest to a client to create and transfer financial wealth to his loved ones.

So, before you buy your next ULP, first have a deep conversation with your trusted adviser.

• The writer is CEO of Providend Ltd, Singapore's first and probably sole fee-only comprehensive wealth advisory firm. He can be contacted at chris_tan@providend.com