Author: Matt Haid
When it comes to funding split-dollar plans, life insurance is often the clear front-runner due to its inherent longevity, tax advantages and dual-purpose benefits. But while the decision to use life insurance may be straightforward, choosing the right type of policy is anything but. Two products typically rise to the top: whole life (WL) and index universal life (IUL). Each offers distinct advantages, from the flexibility of market-linked returns to the rock-solid stability of guaranteed values. Understanding the differences in the context of a split-dollar arrangement is essential to making a well-informed, strategic decision.
Key features to consider when choosing between whole life and index universal life
Consider two key features from a cost and risk mitigation standpoint: policy credits, and required premiums and death benefits.
| Policy credits | Required premiums and death benefits | |
| Whole life | Policy credits are based on a guaranteed interest factor at policy issue and a non-guaranteed dividend scale. Most WL carriers have consistently paid yearly dividends, some for well over 100 years. Although dividend rates can be attractive, the net impact to the policy values is somewhat offset by relatively higher insurance expenses, especially in the early years, to provide the underlying guaranteed cash value and death benefit found in WL policies. | The policy guarantees require that the scheduled premiums are paid. Although many over-funded WL policies use paid-up additions — which can be partially surrendered and provide more flexibility — the overall structure is less flexible than its universal life counterpart and typically requires 30%-40% higher premiums to provide the same level of income stream to an executive and death benefit to credit unions. |
| Index universal life | The main earnings driver is the performance of index accounts based on the performance of well-known market values (e.g., S&P 500), typically over a one-year period. Each index account can have a floor, a cap, a participation rate, a charge and an enhancement. | This product design separates the insurance component from the earnings component, which allows for more flexibility post-issue. With the option to modify premiums and death benefits, the policy's lower guarantees help minimize long-term costs. |
Assumptions and (no) guarantees
Split dollar plans are most commonly designed to both provide executives with a future income stream and have sufficient remaining death benefit to repay the split-dollar loan plus the accrued interest to the plan sponsor. Assumptions must be made regarding future policy earnings rate (either dividend or Index Credit), policy loan rate and mortality.
There are no guarantees that a policy will earn an assumed rate — dividend or index credit — annually or over the life of the plan. For policies issued between 2012-2023, we saw WL carriers decrease their dividend rates, although we've started to see the dividend rates start to increase. Therefore, a plan design that used a dividend rate assumption for the early part of that time experienced a steady decrease in rates and only a mild increase from the low point.
Most importantly, while death benefit guarantees are inherent in a WL policy, there's no guarantee that the policy will have enough cash value to provide the original projected income stream, or in some cases, any stream at all. So, while the plan sponsor is protected, the executive remains at risk.
In order for split-dollar plans implemented seven to 12 years ago to provide the original projected income to an executive, the dividend rates must rise above the original assumed rate so that the average dividend rate equals or exceeds the original assumed rate. While many of the major carriers have begun to increase their dividend rates, some have also increased expenses, often offsetting the higher dividend rates with these increases.
Similarly, many IUL carriers have reduced the index credit cap on their existing block of business in recent years. While this reduction isn't ideal, the underlying floor of the index account — typically 0% or 1% — has a powerful impact on future earnings. When a market return is negative, the next segment will start at that lower value, allowing the policy to earn a credit even if the market index doesn't return to its original level.
It's important to note that IUL policies implemented eight to 12 years ago have experienced returns based on the historical higher caps. While future projections might be limited today, these plans have typically outperformed the original crediting rate assumptions to date. Additionally, IUL cap rates can still rise — or fall — in the future. As interest rates rise, IUL carriers will have bigger budgets to purchase options that provide downside protection (floor), which in turn can allow caps to increase. To assume that market returns and cap rates will remain the same for the next 10 to 30 years is unreasonable. It's almost impossible to predict what future market returns will look like.
When choosing a financing vehicle, it's important to understand the long-term effect of interest credits. Using a WL product can reduce volatility but can also reduce the chances of achieving long-term assumptions during a decreasing dividend rate environment. An IUL product can result in wider swings in crediting rates; however, the floor can help smooth returns and increase the probability of achieving original projected crediting rates.
