The cash accumulation method works like this:
1. Equate outlays (much in the same manner as the equal outlay method) for the policies being compared.
2. Change the face amount of the lower premium policy so that the sum of the side fund plus the face amount equals the face amount of the higher premium policy. Note that this would yield the same result as where it is possible to set both death benefits and premium payments exactly equal—in flexible premium policies.
3. Accumulate any differences in premiums at an assumed rate of interest.
4. Compare the cash value/side fund differences over given periods of time to see which policy is preferable to the other.
The cash accumulation method is ideal for comparing term with permanent insurance. But planners must use this analysis with caution; the use of the appropriate interest rate is critical because, as is the case with any time-value measurement, a higher assumed interest rate will generally favor a lower premium policy/side fund combination relative to a higher premium policy.
We suggest a two-part approach:
1. If planners perform this comparison without regard to a specific client and merely to determine the relative ranking of the policies, the planners should assume a relatively conservative risk-free, after-tax rate comparable to the rate that one would expect to earn on the cash values of the higher premium policy. This will more closely equate the combination of the lower premium/side fund with the risk-return characteristics of the higher premium policy.
2. Alternatively, if the comparison is being conducted for a specific client, the planner should use that individual’s long-run after-tax opportunity cost rate of return, which may be considerably higher than the rate of return anticipated on the cash value of the higher premium policy.
A full and fair comparison is made more difficult because of the impact of death taxes, probate costs, and creditor laws. This is because the cash accumulation method uses a hypothetical side fund to make the comparison. But money in a side fund—if in fact it were accumulated—would not be eligible for the exemptions or special rate reductions afforded to the death proceeds of life insurance. Therefore, each dollar from that side fund would be subjected to a level of transfer tax that life insurance dollars would not. Likewise, the side fund would be subjected to the normal probate fees and attorney’s costs to which cash or other property is subject. Furthermore, this method does not consider the value of state law creditor protection afforded to the death benefits in a life insurance policy, but not to amounts held in most other types of investments.
The bottom line is that the side fund money may appear to have more value than it actually would have in the hands of those for whom it was intended. It is therefore apparent that, while the cash accumulation method has strengths that overcome many of the weaknesses of other comparison methods, it also has weaknesses that prevent it from being the single best answer to the financial planner’s policy comparison problem.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM