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The Problem with Dividends

Updated: Dec 12, 2023



One doesn't have to step very deeply into the infinite banking footprint to learn that dividends are a pretty major part of the concept. Unfortunately, they are also one of the most misunderstood--by agents and clients alike. If you'd like to follow along for a bit, I want to unpack what dividend is, how elusive comparing them across companies can be, and the impact of the economic environment on dividend performance.


Most people are familiar with the concept of a dividend-paying stock company. If you own shares in Coca-Cola, Fed-Ex, or Exxon-Mobil, you'll receive a taxable dividend when the company makes a profit based on the fact that you have an ownership stake in that company. This is similar to a dividend from a mutually-owned life insurance company. When the company is profitable in a given year, a share of that profit goes back to, not the shareholders in this case, but the policy holders. In a mutually owned company, the policy holders ARE the owners, so the very purpose of the company is to benefit them.


Some critics of dividend-paying whole life would argue that the only reason a policy holder receives a dividend is that they were overcharged for their premium in the first place. After all, the reason the dividend is tax-free is that the IRS actually classifies it as a "return of premium." While this is technically true, the tax-free status is more of an accounting classification than an actual reality. These types of policies will eventually grow dividends that exceed the annual premium. How is it possible to be "overcharged" and refunded an amount that is greater than you paid in the first place? To think about it a different way, would you say that Coca-Cola only pays a dividend because they overcharge for their drinks? Of course not! Companies are in business to make a profit. Dividend-paying whole life just puts you in the position to benefit from that profitability.


Another misunderstanding is that a dividend rate is not the same as a rate of return on the policy. Most companies will publish their dividend rate for the year. The problem is that the rate is just one variable in a formula that is used to calculate the actual dollar amount that is paid out. The formula takes into consideration several factors: the performance of the company's investment portfolio, their mortality expense (in other words, how many death claims they have paid), other company expenses, and even how long a person has paid into their policy. Every company has their own formula, and to cloud the waters even more, it's all proprietary information. So the uneducated advisor will often talk about the dividend rate in terms of a rate of return on the policy. Nothing could be further from the truth.


As if that wasn't confusing enough, trying to compare dividends across companies is next to impossible. The deck is stacked against you in that endeavor. Not only is each company's formula proprietary, but even the published rates are not apples to apples. Some are net numbers while some are gross. However, there is one comparison that can be made, and that is in the volume of dividends paid. As Nelson Nash famously said, it's not the rate that matters, it's the volume.


In the chart below, I've taken information from two identical policies from two well-known companies. These policies are both on a 35 year-old male paying $10,000 a year in a policy split 40% to the base and 60% to the paid up additions (PUA) rider.



Table 1


The obvious assumption is that the company with the higher dividend rate would pay a higher dividend by volume, but as you can see from this chart, that is not the case. Now, to be fair, Company B did have a much higher initial death benefit than Company A. Remember that each company is trying to do the best for the policy holder, but they put the emphasis in different places. There isn't really a right and wrong, but there are always trade-offs. We would say that Company A is more dividend dependent on meeting its illustrated non-guaranteed values. Company B is less dividend dependent, and puts more of an emphasis on its guarantees. So which is better? Well, that answer might depend on each individual's preferences and goals.


Table 2, below, shows the initial emphasis on the death benefit of Company B. However, you will notice that the closer we get to natural mortality, Company A gets closer and closer and eventually overtakes Company B in the death benefit column as well. Why is that? It's simply because a larger dividend is buying up more paid up additions each year. It's not as large from the start, but *if nothing changes* on the illustration, it catches up eventually.


Table 2


If nothing changes...It's impossible that nothing will change, and herein we find another mistake well meaning people make. Illustrations are just snapshots in time...liar's poker, if you will. The only guarantee is that your policy will not perform exactly as illustrated. Dividends go up and dividends go down over a lifetime. Premium payments do, too. By now I can guess that your head might be starting to hurt. But humor me for just a bit longer.


Right now, nearing the end of 2023, we find ourselves in a rising interest rate environment. Rates are higher than they have been for over 10 years, and since dividend rates tend to trail behind interest rates, we also see insurance companies starting to announce that their dividend rates will be increasing for 2024. Why does that matter? Well, let's go back to this concept of dividend dependency. While at first glance that might seem like a bad thing (after all, dividends are not guaranteed, even though they've been paid every year for over 100 years by some companies), it also gives you more of an advantage as dividends go up. Let's say, for example, that dividends increase over the next 5 years by 10%. Well, in year 5, that would be an extra $228 into your policy with Company A, vs. only $89 with company B. That goes to purchase more paid up additions, which increases the death benefit, which increases all the numbers in years following. The sooner this happens, the greater the compounding. As dividend rates go up next year, the policies with the largest volume of dividends will see the greatest volume of increase. That increase will cause all the numbers in every year following to go in one direction. You guessed it, UP.


Many well-meaning consumers try and evaluate which policy design or company to go with based solely on the illustrations with which they are provided. While that seems logical, it's just not telling the whole story. We have to do a thoughtful analysis that is not in an economic vacuum. Do you believe interest rates will stabilize at a higher rate than they have been over the past decade? Do you believe they will continue to rise? If the answer to either of these questions is YES, then maximizing the dividend component of a whole life insurance policy is something to consider, even if it doesn't show up on an illustration.


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