Your permanent life insurance policy could be a ticking bomb. The Federal Reserve’s zero interest rate policy increases the likelihood the bomb will explode soon if it hasn’t already, costing you thousands of dollars. Owners of universal life insurance policies face this risk.
There are two main types of permanent life insurance. Traditional whole life insurance charges fixed annual premiums. Part of each premium pays for the life insurance, and part goes into a cash value account. The insurer pays a relatively low interest rate on the cash value. Universal life insurance can have several moving parts. The similarity with whole life is the owner pays premiums that partly are allocated to the life insurance and partly to the cash value account.
There are unique features to universal life. The interest earned on the cash value account is higher than the initial interest on whole life policies. The interest on a universal policy’s cash value account also varies from year to year with market interest rates, though there usually is a guaranteed minimum rate. Because of the higher interest, the cash value can build faster with universal life. Policyholders are told that after the cash value builds, the interest on the account can be used to pay future premiums. Then, the policyholder doesn’t have to pay additional premiums. This sometimes is called vanishing premium life.
Under some policies, the amount of insurance coverage fluctuates instead of the premiums fluctuating. When the cash value account increases, so does the insurance coverage.
The approaching problem for many universal life policy owners is that their cash value accounts aren’t earning the interest they were expected to. The earnings on the account fluctuate with market interest rates. When policies were sold before the financial crisis, the cash value was expected to earn the interest rates that prevailed then or historic rates. Since then, rates collapsed, and the Fed plans to keep them low. The premiums are being paid from the cash value account, but the account is quietly shrinking instead of growing.
Eventually, the cash value account will be exhausted. At that point, the policyholder will receive a letter stating that if he doesn’t begin paying premiums the policy will lapse. The coverage will expire, and the insured won’t have anything of value in the policy.
Even worse, the premiums required to keep the policy in force are likely to be substantially higher than the original premiums. In a universal life policy, the insurer charges essentially term life premiums for the coverage each year. That means as the policyholder ages, the charge for the insurance increases. Another problem is that various fees and expenses also are part of the premium each year. These amounts aren’t fixed and can rise.
You don’t want to be surprised by a letter saying you need to pay thousands of dollars into the policy in 60 or fewer days to avoid a lapse.
Here’s what you need to do and the choices you face.
You should receive an annual statement from the insurer updating the status of your cash value account and the policy. But the details might not be clear. To get a clearer picture, ask the insurer or the agent through whom you purchased the policy for an updated ?in force illustration.? When you bought the policy you were given illustrations projecting the policy’s performance under three sets of assumptions: one assuming existing conditions were sustained; a worst-case scenario, and a scenario between the two. You also can ask for an illustration that assumes interest rates drop to the minimum guaranteed by the insurer and mortality rates remain the same as today.
As part of these illustrations, you should ask how much you would need to increase premiums to maintain the policy’s current status or to improve the status if that’s what you want.
You should be asking for these illustrations every couple of years.
What do you do when the outlook for the policy is not good? Take these steps.
Check the surrender charges on your policy. They might have expired. The surrender charges might deter-mine which actions make sense for you. If they’re still in place and high, your best option might be to keep the policy in force until the charges expire, even if that means paying more premiums.
Evaluate your life insurance needs. Presumably you bought the policy because you had a permanent insurance need, such as estate taxes or liquidity or providing for loved ones. When the insurance need no longer exists, it makes sense to consider the optimum way to get out of the policy if the surrender charges aren’t too onerous. Keep in mind that if there is cash value in the policy and you are paid it as part of terminating the policy, the cash value will be taxed as ordinary income to you.
Check the minimum interest rate on the policy. More than likely, it’s a pretty good rate compared to what’s available elsewhere on safe investments. Though it might be far less than what was assumed when the policy is purchased, it might be the best you’re going to earn without more risk. Consider how else you would invest the cash value before deciding not to keep the policy.
Shop other insurers. If you still need the life insurance, consider the terms you can receive from other insurers for transferring the cash value and paying the same premiums your current insurer requires. You can make a tax-free exchange from one life insurance policy to another, but you will pay any surrender charges still in effect on the old policy.
Consider reducing the coverage. Perhaps you need permanent life insurance, but not as much as the current policy’s stated benefit. Ask the insurer what the premiums would be and what the illustrations look like for a lower benefit.
RW January 2013