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Defined Benefit Life Insurance Explained

Clients need to pay attention, because the world has changed.

In my ongoing effort to educate people on how life insurance works, I seek out new analogies and examples on a regular basis. 

Along with others, I’ve written exhaustively about underperformance and management of life insurance. Charlie Ratner is fond of saying it isn’t underperforming, it’s under-explained. I completely agree. If your car runs out of gas and stops along the side of the road, is it really underperforming? Life insurance policies need gas, and if they don’t get it, they stop too. Fortunately, no one at the dealership needs to explain this to society because a critical mass of people understand this and help educate others as they come along.

Most of us understand the difference between defined contribution and defined benefit plans. With defined contribution plans, you put a certain amount in, and it grows depending on performance. With defined benefit plans, there’s a desired goal, and the contributions are dynamic based on past experience and future expectations. Actuaries calculate how much needs to be contributed annually based on these underlying assumptions. 

Shift to Defined Benefit

Before the late 1970s, fundamentally all life insurance was fixed; one knew what was being contributed and what was to be expected. Since then, most insurance is built on a defined benefit model. This isn’t unlike the shift experienced in retirement planning, where the risk has been transferred from the company/employer to the customer/employee. Based on how they’re built and client expectations, even many whole life policies are defined benefit contracts. 

But didn’t I say that retirement plans have shifted to a defined contribution model while life insurance has shifted to defined benefit? How can seeming opposites both shift the risk the same way?  It’s obvious to most of us how the change from defined benefit to defined contribution plans shifts the risk to the employee. With life insurance, the shift in risk to the customer is in the sense that the defined benefit (death benefit) is only payable if the customer funds it appropriately. In the old days, interest, mortality and expense risk was on the shoulders of the carriers. If they got it wrong, they still had to pay the death benefit. Today, interest, mortality and expense risk is on the shoulders of the insurance customers because if they get it wrong and don’t fund the policy appropriately, the carrier doesn’t have to pay the benefit. Very, very different from defined benefit retirement planning. 

Beginning in the late 1970s, with the introduction of universal life, the shift was made to defined benefit life insurance, though the consuming public didn’t fully realize this. Later, variable life policies, blended and non-guaranteed short-pay whole life insurance policies and indexed policies were all versions of defined benefit contracts. Only true guaranteed premium and guaranteed death benefit contracts, such as guaranteed universal life and non-blended whole life policies are defined contribution contracts, as is term insurance. 

Different Role of Premiums

The premiums of these defined benefit policies weren’t tradition premiums, guaranteed like in the past. These premiums are merely suggestions, or point-in-time calculations, of what might be paid to hit a goal given what’s happened to date, what’s happening today and what we think might happen tomorrow. If crediting rates rose and/or the expenses of the contracts declined, the premium might be lowered. What actually happened, crediting rates fell for decades, and now some contract expenses are rising, so the requisite corrections need to be made. Don’t confuse paying premiums with guarantees. This is why pension plan contributions can change regularly. If the plan overperformed or underperformed projections, actuaries calculate the corresponding changes needed for proper funding. 

While your client’s 401(k) may be a defined contribution plan, it’s a factor of his overall retirement planning, which is defined benefit planning. If your client’s original retirement planning assumed an 8 percent return and his experience was off that by a couple hundred basis points, without making changes, could your client still expect to retire on target? If you can usually get to your cottage on one tank of gas but this trip you’re pulling a boat that meaningfully reduces your gas mileage, if you don’t stop for more gas and still plan on making it, I have news for you. 

Since most life insurance is built on a defined benefit chassis, you should advise your clients to manage life insurance like anything in their life that has a benefit affected by environmental factors. I’m not saying policy premiums need to be tweaked with every single crediting or expense change but periodic review is essential or the policies may fail, as they have been for decades. The world changed 40 years ago. I find it difficult to understand why the critical mass of consumer understanding has yet to follow.

 

Bill Boersma is a CLU, AEP and LIC. 

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