By Michael Lynch, CFP
Life insurance, notes industry expert Barry Flagg, is America’s worst managed asset. This is not good. One in two Americans own at least one life insurance contract. One in five Americans own a contract with cash value. There is nearly $20 trillion in face amount in force.
Confusion Leads to Failure
Having spent nearly two decades attached to life insurance companies, I believe structural reasons prevent people from properly managing this important asset.
Starting with the consumer, people think of a life insurance transaction as one-and-done event, rather than the start of an important relationship that involves a complicated contract that must be understood, monitored, and managed. In fact, I find few people understand even the basic features of their contract.
Term means term
Level Term is perhaps the simplest contract, offering a fixed premium for a fixed number of years, after which it’s gone unless extremely high premiums are paid. I’ve seen people shocked that, as year 20 approaches, their premiums are increasing to unaffordability. This is a feature, as the tech-industry saying goes, not a bug.
Permanent may not mean forever
The consumer’s understanding approaches zero as we move from term to the land of permanent insurance. Here the products range from traditional whole life to investment-based VUL (variable universal life) with a few stops in between for Universal Life and Indexed Universal Life. These contracts are complicated with varying features of guarantees and flexibility. People think if they pay the premium on the statement, the insurance will last forever. This may be true for whole life—provided it does not have a loan—but it’s not the case for many other contracts. Most people think they own whole life if the policy is permanent. Yet only a fraction of contracts are whole life.
Built for Failure
Finally, the industry is set up to sell policies, not service them. Insurance agents collect the bulk of their income in up-front or “heaped” commissions. Even the most successful professionals cannot afford to spend time reviewing the policies they’ve sold. The average agent has failed out of the typically 100% commission business in fewer than five years. The home offices pay people to be reactive not proactive. These policies are known as orphans and we all know from reading Dickens that an orphanage is not an ideal place to be.
The sad result is often frustration and lost value for the consumer. Interestingly, best estimates of this closely held secret figure a mere 20 percent of whole life insurance policies eventually pay a death benefit. Since we all must die, what went wrong? Here are a few examples from my recent travels.
Studies of Distress
Work is a great place to start with stories of distress. Employers are providing more and more benefits these days, and one popular benefit is group life insurance. Four in ten life insurance policies are group or employer provided. This makes sense as it’s easy for companies to distribute and consumers to acquire this insurance. Premiums tend to start absurdly low and then bump every five years, jumping considerably in the ages of 50s and 60s.
High prices in one’s fifties is not the only thing that can go wrong with group coverage. Try getting terminal cancer, being forced to go on disability, and a year later, being terminated from active employment. Your disability carrier will keep sending checks, but you’ll say goodbye group health and life insurance. Not all companies work this way, but some do. I’ve seen it happen twice.
The simple lesson: confirm with your human resources that you will remain an active employee if long-term disabled. If not, secure a contract in the individual market. You will own and control it, not your employer.
The insurance industry innovated in the late 1970s. Faced with high interest rates and lagging whole life returns, it developed a product known as universal life. These policies are designed to be permanent—that is, last until the insured no longer does.
This goal is frequently undermined, however, by the flexibility the policy offers its owners. The premium required to keep a policy in force is dependent on interest rates, and if those drop the premium must increase or the policy has a good chance of expiring. The interest rates for the policies set up in the 1980s and 1990s were high, and therefore the suggested premiums were low. As interest rates dropped, few people understood that the premiums they needed to pay moved in the opposite direction.
I’ve seen this happen to scores of clients. It’s an industry problem, not company specific. Joe and Jane provide an illustrative case. They purchased a universal life policy on Jane in 1985 when she was 21 years old. The 10 year Treasury was 10.65 percent. The suggested premium was $250. By the time I stumbled on their policies in 2020, interest rates hovered at .89 percent, a 92 percent collapse!
They told me they had whole life when we first talked. The policy’s statement told me otherwise. I had them call the company for projections of what they will get if they keep paying what they are paying. These are called in-force projections.
The sad truth, the policy would expire worthless at age 73 unless substantially higher premiums were paid. In this case, the solution was worse than the problem. They could expect to put in more premiums than the death benefit of the policy or walk away with $2,000. This was after paying $9,000 in premiums.
The simple solution here is to read your annual statement or get it to an unbiased professional to do so. Ask for annual in-force projections and adjust premiums slowly to ensure that your permanent life insurance in fact lasts longer than you.
Tax Free Sometimes Creates Big Taxes
One of the most tragic cases I’ve stumbled upon centers on an old whole life policy known as endowment contract. These policies were designed with good intentions: Pay a certain amount and have a guaranteed insurance amount and cash buildup during working years. At retirement, when insurance was projected to be less in need, the cash could produce income for life.
What could go wrong?
In this case, the culprit was a feature of the policy that allowed for the cash value to be loaned. Times can get tough and when they do, a benefit of whole life contracts is that they allow contract owners to borrow their funds, albeit at substantial interest rates, and not have to pay the money back on any particular schedule. If the loan exists when one dies, the life insurance pays it back. Until then, the company considers the loan an “asset” and makes money on the interest.
In this case the contract matured at age 65, at which time the loan either needed to be paid back or the amount withdrawn, plus interest never repaid, in excess of the premiums paid, would be considered taxable income in the year the contract matured. This unexpected maturity added $180,000 of taxable income in one year.
The simple solution is to understand the terms of any life insurance loans take. When will they need to be paid back and what are consequences if you fail to do so.
Yes, You Must Pay the Premium!
The life insurance industry is innovative, and this in generally a very good thing. In 1986, with the stock market booming, creative people built on the universal life concept. They reasoned if money market funds could be installed as the engine for life insurance cash values, why not stocks and bonds directly? These products registered with the Security and Exchange Commission (SEC) —sub accounts—soon created the basis for Variable Universal Life Insurance or VUL.
I confess that I am an equity zealot. I love to own stock in the world’s great companies. As a result, I have a natural bias to this “innovation.” I’ve used it successfully in my life. But there’s plenty of ways to run this train off its promising track.
I ran into one such derailment early in my career when I met a couple who insisted that their VUL policy was going to last a lifetime as they paid the premium that was established with the agent who sold it to them years prior.
The agent was of course long since on to other pursuits, which is why I, as a new representative, was attending to this orphan couple. I had the pleasure to inform them that despite their premium payments, the policy had the trajectory of a Japanese Kamikaze pilot due to the loan they extracted from it a few years prior and never paid back.
They protested and insisted that this couldn’t be the case, as they always paid the premium. I explained that a dollar can only be one place at a time, and if they extracted and spent these dollars, they could not possibly support the insurance contract. I’m not sure they ever understood.
Fortunately, in this case there was a fix. By the late 1990s, the industry had developed a new product, a universal life with a secondary guarantee. This meant that if a preset premium was paid and no loans taken, the policy would last until a person was 121 or dead, whichever came first. In other words, it was in fact permanent, just like the original whole life contracts. The catch—which exists with them as well—there is no flexibility.
The simple solution here lines up with the others. If you have a VUL, get an annual projection of the expected future values. Since the returns vary, ask for low future rates such as 6 percent and higher ones such as 8 percent. The company will also provide a zero percent return.
Push Momma from the Train
No, this is not a section on Danny DeVito’s’ greatest roles. It’s an exploration of the side effects of a good problem—people are living longer. It seems that few days pass without news stories of famous members of the greatest generation making it into their 11th decade before moving on. In 1990 only fewer than 100,000 people worldwide were older than 100. By 2020, nearly 600,000 will blow out more than 100 candles on their special day.
This is good news, right? Sure, unless you are the owner of a life insurance policy bought prior to the 2000s that matures at age 95 or 100.
With many people living past age 95, the question begs: What happens to the life insurance policies? Interestingly, the answer is an adult diaper: It Depends.
I have one couple who owns two substantial second-to-die policies for whom I started to ponder this question. Second-to-die or survivorship life insurance policies insure two people, typically a husband and a wife, and pay out only on the second death. These contracts mesh nicely with the formerly rapacious U.S. estate tax rules that delivered a bill when the second person in a marriage died.
In this case, I have a notion that the woman may in fact make it past 95, the age of maturity for each of their two contracts. I instructed an employee to call the insurance carriers and get in writing what in fact will happen if she doesn’t get unlucky and die prior to age 95. The answers did not make me happy.
For one contract, the policy will remain in force, with no further premiums required. This is good. For the other, the policy is done, and the cash value, a sum deliberately far less than the face amount of the life insurance death benefit, will be delivered to the client. And it gets better. The amount over and above the premiums paid, will of course be taxable.
Not much to do here other than the sit tight and hope for the best, or worse, depending on one’s point of view. The simple lesson is to know that life changes, good things can have bad effects, and contracts that establish security for the future can blow up. That’s just how it is.
I could go on and on, rambling with cautionary tales from nearly twenty years in the life insurance industry trenches. But what good would that do? Life insurance is an incredibly important product, and many of you have it. If this is the case the simple lesson is to take the time to understand what you own, the job it needs to do, and whether it is likely to actually do it. Don’t assume it’s designed to last forever. Then monitor it each year on its contract anniversary. If you don’t want to do this, hire someone who will. This will replace big frustrations with big payoffs.
About the author: Michael Lynch, CFP®
Michael Lynch, CFP®, is a financial planner with the Barnum Financial Group in Shelton, CT, and the author of Keep It Simple, Make It Big: Money Management for a Meaningful Life, October 2020. He can be reached at firstname.lastname@example.org or 203-513-6032.
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