The many advantages and disadvantages of a prolonged low-interest-rate environment affect almost all areas of clients' personal financial plans. For example, low interest rates may be attractive to a young couple applying for a mortgage to buy their first home, but those same low interest rates on bonds and CDs hinder the lifestyles of many retirees on a fixed income. The interest-rate environment can also have a dramatic effect on universal life insurance policies.
Universal Life: How It Works
Flexible premium adjustable life insurance is the technical name for universal life insurance. Unfortunately, it is commonly confused with whole life insurance, since, unlike term insurance, it can remain in force for an insured's "whole" lifetime. Universal life operates differently from whole life, however, primarily due to its flexibility in making premium payments and transparency in policy illustrations.
A universal policy combines term insurance with an interest-bearing savings account. Just like whole life, the account value builds inside the policy tax free if used to support the cost of the risk at older ages. Unlike a whole life policy, a universal life policy can be funded in ways that best match a client with unpredictable cash flow. This premium flexibility therefore makes regular monitoring especially important to avoid unpleasant surprises.
Issue: Lack of Regular Monitoring
Universal life policies are highly sensitive to both the interest crediting rate and the choice by the policy owner to adhere to the premium funding schedule. The good news is that there is no requirement to make a premium payment, or even take a policy loan to make the premium payment, as long as the cash value can otherwise support the policy. That is the bad news, too. Not unlike saving for a child's education, the flexibility to choose not to make a payment may cause a shortage when the policy is needed most. Coupled with an assumption that interest would be credited at a higher rate than actually achieved in the policy, this could translate into a double disaster.
When any "permanent" insurance policy is purchased, certain assumptions have to be made by both the buyer and the company selling the policy. With universal life, the main assumption is the future crediting rate of the policy, which in turn determines the annual premium. This means that the higher the interest crediting rate, the lower the premium, based on current insurance charges.
The buyer also has the option to make an assumption about life expectancy. In many cases, the buyer can either purchase the policy to "full duration," which can be up to age 121, or select a shorter life expectancy. A universal policy with an assumed death by age 90 could have much lower premiums than one that will pay a death benefit even if the insured dies well past age 100. Depending on the carrier, the most dramatic pricing difference can be found in a wider age spread. Whatever the buyer selects for the "assumed policy duration" along with the assumed future crediting rate is then captured in the "as sold" illustration at the time of purchase. This illustration should be retained along with the original contract in the policy owner's files for future reference.
Unfortunately, in most cases, the "as sold" illustration is only as good as the paper it is printed on, since the policy owner can alter the premium funding, and the insurance carrier can, and likely will, change the interest crediting rate throughout the life of the policy. The illustration can provide historical perspective, but, as with most investments, both funding and earnings can invalidate the expected results.
Oddly enough, the policy owner is not informed of any negative effects until the policy may be close to lapsing. This is not only disastrous for beneficiaries expecting a death benefit, but also for an unsuspecting trustee if the policy is owned by a trust. A trustee has the fiduciary responsibility to maintain the policy in good standing under the same standards as any other investment. This applies even to the unsuspecting friend or family member who is named as trustee. To fulfill this duty, the trustee should meet with the agent, broker, or consultant at least annually to review the policy's performance.
Potential Solution: Revisiting Life Expectancy Assumptions
Although the common approach to "fixing" an underperforming policy is to exchange the policy for a new one if the client is still in good health, this may not be the best route. It may be more prudent to revisit the assumptions made when the policy was purchased, along with the current goals of the policy. In the past 10 years, carriers have decreased their crediting rate by 50% or more in some cases. When compared with the "as sold" illustration, this dramatic decrease can translate into a significantly lower cash value inside the policy. Do not stop there, however, since the original assumption of policy duration must also be revisited.
The solution to fix an under-performing policy due to a lower interest crediting rate may come from the assumption that the policy was scheduled to last to age 100+. Depending on the client's current health, this now may be unnecessary. A younger age assumption for the policy duration may be adequate. A significantly younger age may also be appropriate if the insured has had serious health issues. The first step is to determine the health of the policy, and the second step is to determine the health of the insured.
Step 1. The health of the policy: An "in-force ledger" can be provided by the servicing broker to solve for the years the policy will stay in force based on the current cash value and a future assumed crediting rate. It is also prudent to run the in-force ledger at the guaranteed minimum crediting rate. Note that on older policies this rate could also be the current crediting rate.
Step 2. The health of the insured: In addition to a general discussion of the insured's medical and family history, a new tool can be used, called a life expectancy quote. This can be requested from companies that specialize in reviewing an individual's health records to determine how long the client may live. Other than an unhealthy young client, this generally only makes sense with a client who is age 70 or older to have any chance of relying on the results. Life expectancy quotes may not be worth much, either, but many consider them better than guessing how long the insured may live. The insured's life expectancy can then be matched to the duration of the policy, as explained in the previous paragraph. If the life expectancy quote results in an age that is longer than the current cash in the policy can support, the policy owner may choose to put additional funds into the policy or perhaps reduce the death benefit to match the insured's life expectancy. Since this is not an exact science, the broker or consultant should present several alternate plans if the insured lives beyond the premium funding solution chosen. These can be easily laid out and discussed with the policy owner and are essential if the policy is owned by a trust for legal/fiduciary protection. It should then be monitored each year.
The sample exhibit outlines a case recently provided to a fellow CPA to help a 77-year-old client save thousands of dollars of unnecessary premiums. The CPA, who was also the trustee, felt that since the policy experienced a 200 basis-point drop in the interest crediting rate for several years, it must have meant that it was time to increase the annual premium to make sure the policy would stay in force. The original premium was scheduled at $85,000 per year, but the "revised" premium provided by the agent to make up for the loss of interest credited was thought to be $131,000. However, this was based on a guess that the insured would live to age 95. After the analysis was done and the insured's life expectancy was estimated at 7–10 years, the more appropriate premium was estimated at between $62,000 and $93,000. Ironically, after reviewing all options as detailed on the downloadable spreadsheet, the trustee resumed the original premium schedule, but now with the knowledge that the damage done by the drop in the interest crediting rate was mitigated by the insured's life expectancy. The sample analysis can be provided to any agent or consultant to guide the CPA through the best decision for his or her clients.
Conclusion: Comprehensive Analysis Is Essential
The flexible structure of a universal life policy is attractive at the time of purchase, but it must be managed properly. If a policyholder skips a premium and/or the carrier credits the policy at a lower-than-expected interest rate, the policy could lapse well before it is expected to. The immediate solution is almost always assumed to be either to purchase a new policy or pay higher future premiums in the current policy, but that is not necessarily the case. If the owner is willing to do some homework with the servicing broker or pay a consultant to perform a comprehensive review of options, it is quite possible to save thousands of dollars. The results may show that higher premiums are not necessary, and in some cases there may even be a lower premium than was originally planned at the time of purchase, despite low interest rates.
From the policy owner's perspective, the goal for any universal life policy purchased with a level death benefit is to die with $1 of cash value. Without a crystal ball, this is nearly impossible, but it is much more likely if the owner understands and manages the variables of universal life policies. Quantifying how much to fund a universal life policy is critical to maintaining and preserving this valuable asset.
|Theodore Sarenski is president and CEO of Blue Ocean Strategic Capital LLC in Syracuse, N.Y. Susan Bruno is managing partner with Beacon Wealth Consulting LLC in Stamford, Conn. Mr. Sarenski is chairman of the AICPA Personal Financial Planning Executive Committee's Elder Planning Task Force and is a member of the AICPA Advanced Personal Financial Planning Conference Committee and Financial Literacy Commission. For more information about this column, contact Ms. Bruno at firstname.lastname@example.org.|