A few weeks ago I wrote about 3-Legged Stools and the pitfalls of UL & VUL policies. This has been a rather hot topic, so I wanted to expand upon it this week.
UL & VUL policies can appear very attractive when illustrated. Whether they offer a guranteed rate of return or not, you must read the policy itself very carefully to check for hazardous provisions. Such provisions may limit access to cash values, eliminate your guarantees or lead to severe financial hardship.
First, let’s talk about guaranteed rates of return on UL & VUL policies. In today’s environment guaranteeing a rate of return with UL & VUL policies may become a trap. Anything with liquidity, use and control over the cash values will not create that rate of return without some offsets somewhere. Here are some to look for.
Surrender Charges and Limited Access to Cash Values: Some UL & VUL plans have long-term surrender charges, such as 20 years. In researching UL & VUL policies, we’ve found a rule of thumb: the lower the internal fees and higher the credited interest rate, the higher the surrender charge and the longer the surrender charge period. Surrender charges place a lien against the cash values and therefore those cash values are not available for policy loans nor can they be used to pay policy premiums. There are a variety of circumstances in life that may prevent someone from paying their premium. Divorce, job loss, reduction in pay, illness, or a death in the family are some of the most prevalent. If you’re unable to pay these premiums it could mean the loss of thousands of dollars of cash value. You want to be able to use your cash values not just have them look good on a policy design illustration. The limitations that steep surrender charges place on UL policies can cause severe damage.
Dividends in the Face of Inflation: UL & VUL policies do not offer dividends. Participating whole life insurance policies do provide a dividend. Dividends are non-taxable income because they are considered to be a return of premium paid. Dividends are calculated and declared at the end of the year based upon the total income and expenses of the insurance company. What happens in an environment of inflation or hyper-inflation which many economists predict we may see? Inflation is terrible for fixed income investments. It directly reduces the yield. A dollar earned today will be worth less tomorrow. That’s inflation. So, earnings from a fixed investment today with limitations on interest rate increases will be worth less when those earnings mature. Dividends are the hedge against inflation. In an inflationary environment, investment yields will increase across the board. The investment earnings that the insurance companygenerates will be greater in a period of inflation as those seeking investment dollars need to offer more in order to attract investment dollars. The increased earnings are passed down to participating whole life policyholders in the form of dividends. Holding a UL or VUL policy offers no such benefit and cash values will be worth less then anticipated.
The Term Insurance Chassis: The chassis of UL & VUL policies is renewable term insurance. The internal term rates automatically increase by contract. It is a slow, annual increase in cost early on until it begins to compound rapidly as the insured ages. The premise of UL & VUL policies is that the cash value and earned interest will offset the increasing cost of the insurance. When that does not happen, as in today’s low interest environment, the cash value will not grow enough to offset future cost increases which are, by contract, guaranteed to occur.
Beyond that, here is the fatal flaw. Internal UL & VUL term costs are based on current and guaranteed rates. Current is simply what the insurance company charges today. The guaranteed rates are printed in the policy and are commonly 2-4 times higher than current. Keep in mind that there are only 3 ways to access the cash values in these policies.
- Policy Loans – Funds can be borrowed from the policy without creating a taxable event. These are tax-free funds.
- Withdrawals – These become taxable after the cost basis (total premiums) have been withdrawn.
- Annuitization – The policy is annuitized guaranteeing a stream of income for life. This creates some taxation and the death benefit is taken away.
Let’s use this example: The insured takes a policy loan to avoid taxes, without the intention of repaying them. Conditions arise to cause the internal rates to move up to the guaranteed rate, which actually is the higher rate allowed by the contract. The combination of money removed for income and the higher mortality costs stresses the policy to the point that income (loans) and costs exceed earnings. From that “tipping point” the policy will lapse in a surprisingly short period of time. Once the policy lapses the previously unreported loan income becomes reportable, potentially causing a very large tax bill while the policy values vanish. The longer the policyowner lives the greater the risk and the greater the impact.
In effect, while the policy supposedly guarantees an attractive rate of interest it does not guarantee the income and death protection results that the insured wants and needs. Like all UL & VUL plans, it places the risk back onto the client.
When the death benefit is guaranteed, as it is with whole life, it becomes an asset which can be used to leverage guaranteed and tax free income without the risk of it coming back to bite the policy holder.
Scott Storace
Why do we insure our valuables? What makes a car, a wedding ring or your home worth protecting? Clearly, they have a financial value. You would suffer a financial loss if they were damaged or destroyed. Insurance will make you whole should a loss occur. I use the word should very specifically. The odds of losing your home are very small. Even car accidents are relatively rare.
Remember the parable of the tortoise and the hare? Slow and steady wins the race! Surely you’ve heard the expression that “It’s not a sprint but a marathon!”. Both effectively portray the discipline required to get ahead in a long endeavor. Financial security and independence is a long endeavor. But who wants to wait? Whatever happened to slow and steady?
