Draining Away!
In the next few years, millions of savers are in for a surprise that could
cost them tens of thousands of dollars now—or hundreds of thousands later.
The reason: Universal-life insurance policies bought years ago when interest
rates were high will face cancellation if policyholders don't pay more.
Many people are "sitting on a ticking time bomb," says Kenneth Himmler,
president of Integrated Asset Management, an advisory firm in Los Angeles. About
70% of the new clients whose insurance coverage he reviews are facing higher
out-of-pocket costs because policies aren't generating enough interest income to
pay costs, he says.
The picture isn't all bad. For some savers, their existing universal-life
insurance policies, which rise without incurring taxes, are working out just
fine. They offer an unusually high interest rate compared with other low-risk
investments, say financial advisers and insurance experts. And there are steps
policyholders can take to salvage at least some of their coverage.
But this confusing set of circumstances can cause people to make the wrong
decision.
"There are two mistakes you can make: to drop a policy you should keep and to
keep a policy you should drop," says Glenn Daily, a fee-only life-insurance
adviser in New York. "You don't want to do either."
The Problem
There are two main kinds of life insurance. Term life offers a death benefit
for a certain number of years, often 20. Permanent life, which includes "whole
life" and "universal life" policies, is designed so it can remain in force for
the policyholder's entire life. Whole-life buyers most often pay set premiums
that cover fees, such as the cost of insurance, while building up cash value
that can be used for retirement income.
In contrast, many universal-life buyers pay flexible premiums and sometimes
use returns on the cash-value account to pay for the policy's future costs.
People who buy universal life often do so because they want insurance that
will last longer than term coverage. Many policies carry high fees and
commissions that typically aren't transparent to the buyer. In return, buyers
get a savings vehicle that is aimed at helping them pay insurance costs and salt
away money on a tax-deferred basis.
The problem for people holding such policies now is that many agents said in
their sales pitches that interest on the cash account could subsidize rising
insurance costs as policyholders aged. That let policyholders pay a smaller
premium than they would have paid on a whole-life policy.
Since then, though, interest rates have plunged. In the late 1990s, many
universal-life accounts paid interest rates of 7% to 8% a year, says Jeremy
Kisner, a certified financial planner at SureVest Capital Management in Phoenix.
Now that rates are at multidecade lows, the savings portions of old policies are
rising much more slowly than the agents suggested—and Fed Chairman Ben Bernanke
has announced his intention to keep then that way for years.
Insurers note that written materials given to consumers state that only a
minimum interest rate is guaranteed, and any higher ones used in a sales pitch
are hypothetical, not promises about the policy's performance. "The
unprecedented decline in interest rates has been an enormous burden for
Americans," a New York Life Insurance spokesman said, adding the company "works
with our policyholders to explore the options available to them." and other insurers say annual
policyholder statements contain details on the impact so consumers can set a
course correction.
If rates don't rise soon, policyholders will have to cough up more money to
cover fees—typically 20 to 60 days after the savings balance runs dry.
Who Is at Risk?
People who bought policies before interest rates fell sharply in 2008 are
particularly vulnerable—and their ranks could be immense. In the mid to late
1980s, universal-life insurance policies generated at least one-fourth of all
life-insurance premiums, according to Limra, an industry-funded insurance
research firm. In 2008, about 40% of overall premiums came from universal-life
coverage.
Such policies tend to be in the hands of wealthy Americans. According to
Federal Reserve survey data, about 31% of the highest-earning U.S. families
owned whole-life or universal-life insurance as of 2010, the latest year for
which figures are available. That is much higher than the 20% rate for families
overall.
Vincent Romeo, a 66-year-old retired podiatrist in Monroe, N.J., realized
about a year or so ago that his universal-life insurance policy and another for
his wife could run out of money within a few years unless they kicked in more
money.
"Things were not the rosy picture that was painted" at the point of sale, he
says. "It was a little bit of my fault. Buyer beware."
Mr. Romeo ended up moving the policies' remaining cash to new policies that
carry a guaranteed death benefit as long the couple pays specified premiums.
Assessing Where You Are
It's easy to see why universal-life policyholders are frustrated.
Agents selling the policies, who must follow state insurance-department
rules, typically give illustrations of how the cash value would perform under
three different scenarios. One scenario shows how the cash value of the policy
would change if interest rates and charges stay the same.
The second shows a worst-case scenario: how it would change if costs reached
the maximum permitted by the contract and rates hit the "guaranteed"
minimum—typically around 4% for policies sold in the 1980s and 1990s. The third
gives a midpoint scenario.
When interest rates drop, the difference in outcomes can be striking. For
example, a 37-year-old man buying a $1 million policy earning 5% interest would
have a cash value of about $304,000 when he turns 68, if he paid about $5,000 in
premiums a year, according to one company's recent projections. There would be
ample cash value to pay premiums until he is past 100 years old.
But in the worst-case scenario of the policy, if the interest rate drops to
the minimum 3% and the policy's insurance charges rise to their max, the savings
component would fall to zero when he is 68. That year, the owner would have to
kick in at least $275 or lose the policy. The required payment needed to keep
the policy alive would increase from there as insurance costs rise to reflect
the aging of the policyholder, as with term life, to at least $5,000, when the
owner is 76.
To check a policy's health, customers should ask their agent or insurer for
an updated "in force" illustration, showing how the policy's cash-value will
change based on current interest rates, premiums and charges.
For another view, policyholders can ask their insurer to run a projection
that shows how the cash value would fare were the interest rate to drop to the
minimum and mortality rates stay the same, says James Hunt, a retired
life-insurance actuary who works with the Consumer Federation of America, a
consumer advocacy group.
And since reality is unlikely to mirror the estimates, it's important for
policyholders to get a new illustration at least once every two years, says
Peter Katt, a fee-only life-insurance adviser at Katt & Co. in Mattawan,
Mich.
If you are healthy and the updated spreadsheets show your cash value dropping
to $0 before age 100, you might need to kick in substantially more money to
ensure the policy lasts until your death. Financial advisers say policyholders
also should ask for an estimate of how much extra they will have to pay in
premiums to prop it up.
Deciding Whether to Keep a Policy
Just because a policyholder has to put more money into the policy doesn't
mean he or she should automatically cancel it, Mr. Daily warns.
That's because, even though an old policy's interest rate has dropped, it
still is likely higher than low-risk rates found elsewhere—potentially making it
a good investment option.
According to publisher Bankrate.com, for example, rates on one-year
certificates of deposit are currently averaging about 0.79% a year in interest.
A five-year CD pays 1.41% a year on average. That is well below the minimum
guarantees offered by many old policies, Mr. Daily notes. An investor hoping to
match that would have to venture into higher-risk investment grade U.S.
corporate bonds, which currently pay 3.3%.
The policies also carry some tax benefits. Gains most often aren't taxed as
long as they stay in the cash account. Owners can withdraw money, subject to tax
regulations, but on most accounts any gains withdrawn are taxed at ordinary
income-tax rates, and the withdrawal could lower the death benefit.
To decide whether these benefits outweigh the costs, savers first must assess
whether they still need life insurance, says Allan Roth, a fee-only financial
adviser in Colorado Springs, Colo. Many times, as policyholders age, their
savings increase and kids graduate from college, their need for a death payout
diminishes, he says.
Meanwhile, the cost of the insurance charged to the policyholder continues to
rise, Mr. Roth says. One of Mr. Roth's clients 13 years ago bought a
universal-life insurance policy that charged about 4.1 cents per $1,000 of
coverage, he says. Now, the same policy is charging $1.29 per $1,000, or 30
times the original amount.
If a policyholder doesn't need or want a death benefit, it probably makes
sense to get out of the policy and invest the money elsewhere, Mr. Roth
says.
There is a third choice as well. If the interest rate paid by the policy is
still relatively high, and savers want to keep it, they can ask the insurance
company to lower the death benefit, says Bob Phillips, managing partner of
Spectrum Management Group, a financial-advisory firm in Indianapolis. That will
reduce the share of the cash account taken by insurance costs.
If a saver wants to keep his policy's death benefit, he should ask a few
other insurance companies for an illustration if he were to move to one of their
policies.
One of Mr. Kisner's clients, for example, recently cut his death benefit in
half to $100,000, but no longer has to pay any future premium. The 71-year-old
man was able to exchange his remaining $42,000 in cash value from a policy he
took out in 2001 for a new policy from another insurer.
An important caveat: "surrender charges," which are fees levied when you
cancel a policy, typically last from 10 to 20 years from the start of the
policy, and sometimes are more than the first year's premium. They can eat up a
big chunk of savings if you try to try to cancel a policy or even lower the
death benefit. That could make it worthwhile to hold onto the policy until the
surrender charge period expires, Mr. Hunt says.
Write to Leslie Scism at leslie.scism@wsj.com and Joe Light at joe.light@wsj.com
A version of this article appeared November 17, 2012, on
page B7 in the U.S. edition of The Wall Street Journal, with the headline:
Draining!.
Posts
