Your life insurance is probably broken - and you don’t even know it
Posted on 04.27.16
It is our goal as tax and accounting advisors to go beyond traditional tax preparation and identify tax savings and planning opportunities for each of our clients. With that in mind, we are sharing an article by Eric Hieber, principal at BCG Companies on life insurance planning. We hope you find this article informative and if you would like to learn more about life insurance planning, please contact your Keiter representative or firstname.lastname@example.org | 804.747.0000.
Tax season always generates a lot of conversation and questions about financial plans, strategies and vehicles. Often overlooked during these planning discussions are existing life insurance portfolios. For various reasons, many clients take their life insurance for granted assuming that the policies are owned by the appropriate entity, premiums are being applied properly and the death benefit is funded sufficiently to meet their planning objectives.
Life Insurance Reviews
There are many reasons life insurance policies may be “broken” without the policyowner knowing there is an issue:
- The primary purpose for the insurance may have changed because of the individual’s revised planning objectives or a new legislative environment
- Financial markets may have a detrimental impact on the long-term performance of the policy that is not reflected on annual statements routinely provided by the carrier
- Product restrictions that were commonplace 15-20 years ago may result in diminished returns or unexpected adverse tax consequences
Without proper planning, any one of these dynamics could result in a disastrous outcome for the client. Many life insurance portfolios are broken and clients are not aware because they have not taken a close look at their needs and how their life insurance fits into their current planning objectives.
There are a handful of specific trends we have seen in recent years that demonstrate broken portfolios where the client thought the existing insurance was meeting their objectives:
- Transitioning from term to permanent insurance
- Paying for perceived guarantees in a decreasing interest rate environment
- Fixing policies with limited maturities
Term to Permanent Insurance
Term insurance has its place and we use it when it is appropriate for a client’s planning needs. Specifically, it works great to cover a short-term liability. However, it is not a good solution to meet long-term insurance needs because it becomes expensive at older ages and is not available after age 85-90. Clients often use term insurance to meet their long-term planning objectives and are unaware of the costs of maintaining the term insurance until it is too late.
In most cases, permanent insurance is less expensive if an individual lives to life expectancy and it has the added benefit of providing lifetime coverage. As an example, the total cost for a 35 year old healthy male to fund $25,000,000 of term death benefit until age 85 is approximately $9,750,000 – there is no term coverage after age 85. Alternatively, that same individual could fund a permanent $25,000,000 death benefit for a total premium of $4,000,000.
As planning needs change from funding education costs or income replacement to estate liquidity or business succession needs, the life insurance products used to meet these needs often need to change as well. Educating clients about their product alternatives and the long-term costs associated with the decisions they make today can have a significant impact on the outcome of their planning.
Life insurance policies are often sold with a strong focus on guarantees. In some cases, guarantees are an important aspect of a client’s planning. In other cases, the product they purchased does not offer the guarantees they thought they were buying. A good example of this can be found in whole life policies with premiums that have been funded with dividends in the past. As interest rates continue to decline, carriers have decreased their dividend rates resulting in less funds available to meet the premium requirements in many policies. The result is a reemergence of premiums or an extension of premiums beyond what the client expected to pay.
In one case, we worked with a client with a whole life product he believed had a 10-year premium to provide a guaranteed lifetime death benefit. The annual statements he received provided no information about changes in the dividend or revised illustrations of the future performance of the policy. As a result of decreases in the dividend, the original 10-pay premium had to be extended to 32 years to fund the required death benefit – an increase of 320%!
A little education about the product he purchased and periodic reviews would have helped the client better understand the risk he was taking. Fortunately, we were able to help him update his coverage to a structure better suited for his risk profile and planning objectives.
Limited Policy Maturity
Policies issued 10-20 years ago have a defined maturity of age 94, age 95 or age 100. Clients need to understand that this often means that if they live to that age, the carrier will pay them the accrued cash value, the policy will be terminated and any gain will be taxable as ordinary income. Few clients are aware of this dynamic and this is certainly not the outcome most client’s expect from their life insurance.
Current life insurance products are based on mortality tables that stretch mortality out to age 120 so there are opportunities for policy owners to update older policies and take advantage of this extended maturity and avoid the potential tax burden of limited maturities. An interesting dynamic in these situations is the age of the insureds. We have seen several situations with insureds over age 75 where the client was able to qualify for new insurance and resolve their concerns within the constraints of their planning objectives.
The issues highlighted here are only a few specific examples of broken life insurance policies that have been identified through comprehensive reviews. Talking with clients regularly about what they want to accomplish, their appetite for risk, cash flow available to fund the strategy and other issues related to their planning are critical to ensuring the plan’s success.
We all manage various aspects of our financial plans by monitoring performance, evaluating costs and changing strategies over time. Life insurance portfolios should not be treated any differently. A life insurance death benefit will become an after-tax cash asset at some point in the future and it should be managed appropriately including annual reviews to evaluate the performance and the appropriateness of the product type in the client’s planning goals.
About BCG Companies
In 1988, BCG was founded on a simple premise: Serve the specialized insurance needs of affluent families and corporations.
Eric oversees the case design team and is responsible for managing client relationships in both the wealth transfer/estate planning and nonqualified executive benefit planning markets. In addition, he works directly with our clients and their advisors to design, implement and administer customized plans to meet their specific needs.