To begin, you need to understand the difference between a paid-up additions rider and a dividend option to buy paid-up additions. A dividend option to buy paid-up additions is one of the options given to you as to how to take your dividends. There are many options, but here are the most common: 1) you can pay your premiums with it, 2) you can take your dividends as income, or 3) you can buy paid-up additions with them.
What we will be discussing today is the paid-up additions rider. If you are going to optimize the cash value in a whole life policy, you can’t do it without a paid-up additions rider. A substantially large portion of your premium outlay should be going to the paid-up additions rider and it is this rider that allows you to optimize the cash value of your policy. The other thing that should be known is that paid-up additions riders are not universally the same across insurers. Just because a life insurance company has a paid-up additions rider, it does not mean that it functions the same way that it would on a different life insurance company. At the core, they all accumulate more cash value quicker and they also eventually create more death benefits. There are a number of differences, most of which are related to flexibility and what you can and cannot do with the rider. These flexibilities, dos, and don’ts greatly differ from insurer to insurer. As a point of interest, all those books that talk about “supercharged riders” that are special and generate a lot of cash for you, this is what they are talking about: a paid-up additions rider. The fact that you have a paid-up additions rider on your policy doesn’t necessarily mean that you have a good paid-up additions rider, or that your policy is using it correctly. Many people that have or want a paid-up additions rider on their whole life policies often ask what is the right amount and that differs a lot from one insurer to the other.
What exactly is a paid-up additions rider? It is a rider that is attached to a whole life insurance policy and it allows you to buy more paid-up life insurance. That is because paid-up additions have a death benefit associated with them and for every dollar you put in, you get a multiple of your dollar in death benefit and it’s like you’re buying tiny little whole life policies that are attached to your base whole life policy. Paid-up additions have an immediate cash value that is worth roughly what you paid, less the paid-up additions load fee. This load fee is a percentage that ranges typically between five and nine percent, depending on the life insurance company. The load fee is deducted immediately and that is the only expense you will ever pay for paid-up additions. There are no ongoing fees for paid-up additions. As mentioned before, it is like a little paid-up policy that is very efficient for cash accumulation but is not the most effective way to get the death benefits. By virtue of having more paid-up additions, you end up having more dividends and more cash value. This is effectively how you compound growth inside a whole life policy. Paid-up additions can be surrendered to withdraw cash from your policy, or used as collateral to borrow from your policy. There are rules involved with paid-up additions riders and how they can be funded, and those rules vary a lot by the insurer. It is an elective rider and you are giving the insurance company more money than you have to and they in turn are rewarding you with the returns that they get on the money. Your ability to contribute to this rider and change the amount that is going in differs greatly from one insurance company to the next. It also differs in that if you don’t contribute to the paid-up additions rider for a while, you may forfeit the rider and lose your ability to put more money into it. These rules vary by the insurance company. The reason for these rules has to do with the death benefit associated with these paid-up additions. Most companies, when you are adding a paid-up additions rider, will underwrite you for all of the additional death benefits associated with the paid-up additions that are being added to your policy. As a rule of thumb, paid-up additions should be at least 50% of your premium outlay.
Only a few companies have the flexibility to use paid-up additions in the most efficient way possible.
There are four key elements that you need to understand to make an informed decision before purchasing a whole life insurance policy using a paid-up additions rider:
- Maximum annual paid-up additions payments.
- Lifetime maximum paid-up additions payments.
- Payment flexibility; can the policyholder adjust the paid-up additions rider up and down and can the policyholder make paid-up additions payments as lump sums throughout the year instead of systematically with the premium mode such as monthly, quarterly, etc.
- Paid-up additions rider load fees.
Remember, you can’t just assume that because a policy uses a paid-up additions rider, it meets the criteria that we would demand of a properly-designed whole life policy.
What is it about paid-up additions that makes it so magical anyway? The answer is that the cash value generated by the base portion of your policy is much more expensive than the cash value generated by paid-up additions.
Example: Say we have a $20,000 premium and the base whole life and term-like insurance premium is $5,000 and therefore, $15,000 is going to paid-up additions. We understand the base portion of the policy: it is just a whole life policy. There is also term-like insurance involved, and the paid-up additions are going to cash minus the load fee, so whatever the paid-up additions are, minus the load fee, is the cash value you have in the policy immediately. The amount of term-like insurance in most policies decreases because the paid-up additions premium is offsetting the death benefit on the term-like insurance. What this means is that every time a paid-up addition is paid and a death benefit is generated from it, this new death benefit causes the insurance company to automatically reduce the term-like insurance portion by that new death benefit.
As you can see in our example, the vast majority of the premium is going to paid-up additions, so you’re going to see a very large jump in cash value very quickly. This is in stark contrast to a $20,000 whole life policy with no paid-up additions. You pay the first year’s premium and get to the end of the year and you have little or no cash value to show for your premium.