Accumulating cash value in life insurance policies

By Jeffrey Reeves MA

EUREKONOMICS[tm]


There is a great deal of misinformation about the different kinds of permanent life insurance. Here's the straight skinny. There are two basic types of permanent cash value life insurance: universal life (UL) and whole life. Each might have a role to play in the insurance and financial planning portfolio of an insurance agent and financial advisor. This article presents a simple overview of these types of cash value life insurance.

Universal life insurance

UL is a modern invention. EF Hutton -- an investment company -- manufactured and marketed the first UL policies (c. 1980). EF Hutton wanted to convince its clients to move their money from the security of whole life insurance policies and savings accounts into their less secure and fully experimental UL contracts.

These early UL contracts removed the investment risk associated with life insurance from the insurer and placed it on the policyholder. These policies guaranteed a rate of return on cash values, but they did not guarantee that there would be cash value accumulations in the policy owner's account. If the insured put enough money into a policy account -- usually substantially more than the target premium -- there was a chance funds would accumulate, but there was no inherent guarantee that they would.

In addition to not guaranteeing cash values, these early UL contracts did not guarantee that the initial premium would not increase or that the initial death benefit would not decrease. They generally relied on very high year upon year returns, often illustrating as much as 12 percent, and thereby projecting large accumulations against increasing costs so the increases were effectively invisible.

Most UL contracts today still rest on this original chassis.

Universal life insurance: How not to...

UL is the most commonly recognized and most frequently sold form of cash value life insurance. UL claims to be flexible, because it allows the insured person some control over the premium payments and the amount of the death benefit.

UL takes three basic forms:
  • Interest sensitive UL, which relies on returns from conservative savings vehicles chosen by and managed by the insurer

  • Indexed UL, which relies on the performance of one of the major indexes, such as the S&P 500, the DJIA, the Nasdaq, etc., which are also chosen by and managed by the insurer

  • Variable UL, which allows the insured to choose from among various mutual fund like investments chosen by the insurer and managed by a fund manager
In every case, the insured is on the hook for the performance of the policy's cash value accumulations, but has no control of either the process or the expenses related to the process.

Therefore, many of the benefits that UL policies promote end up being liabilities in practice. In addition to the inherent limitations of UL contracts as accumulation vehicles, the ideal financial plans, which are usually presented to prospects as a part of the selling proposition, seldom, if ever, turn out the way they are idealized. The flexibility of the product ends up being relatively useless because the plan upon which it relies is unrealistic or unachievable.

In addition, advisors often present UL as less expensive than other forms of cash value life insurance by using initially low premiums to fund larger face amounts. UL is seldom (never in my experience) less expensive than whole life insurance. It's easy to show a lower initial premium for a flexible UL policy. The problem shows up years later when the cost of the death benefit -- which typically increases annually -- and other internal charges by the insurance company exceed the lower premium that was originally illustrated, erode the cash values that have accumulated, and the insured person faces paying much higher premiums or losing their life insurance coverage altogether.

Universal life insurance: The right way

In order for UL legitimately to serve as an accumulation vehicle, the premiums need to create cash value accumulations adequate to assure that the policy will:
  • Stay in force for the lifetime of the insured and guarantee at least the original death benefit without consuming all of the accumulated cash values

  • Create enough cash value -- uninterrupted and guaranteed year after year -- to allow the insured to repeatedly borrow and repay those cash values throughout his or her life
Many UL policies serve some purpose other than cash value accumulation and are not, therefore, suited to the accumulation strategies discussed here.

Currently, the most common form of UL proposed by advisors is indexed UL. This form of contract promotes that it generates better cash value accumulations than traditional UL and is more secure than variable contracts.

The most significant risk with this type of policy is not with the policy itself. The risk is that the values illustrated during the sales process rely on unrealistic assumptions -- sometimes as high as 8 percent compounded over many years. Although the market might perform at that level, it is not necessarily a realistic assumption. The market:
  • Doesn't pay fees or commissions

  • Isn't faced with the life challenges that might force a policy owner to withdraw money when there's a slump and she or he can least afford it

  • Is a snapshot of every investment represented in an index at one given moment not a true moving picture of what's really happening to the funds of the individual

  • Doesn't get penalized for buying high and selling low

  • Isn't dealing with the policy holder's money and life
Any ongoing assumption of returns over 5 percent is aggressive and should be viewed cautiously.

I am not implying that a higher percentage of return is not possible over the longer term, however, its good planning practice to operate on conservative assumptions of long term returns. One can adjust plans upward if the results are better than planned, but it's more difficult to adjust the other way and keep a happy client.

Straight whole life insurance

Straight whole life insurance guarantees that the premium and death benefit remain the same throughout the life of the insured person. It also guarantees that your cash value accumulations will increase every year and will endow at a specific age of the insured. The cash values of straight whole life policies are generally available as loans at a fixed interest rate.

Participating whole life insurance

In addition to the characteristics of straight whole life noted above, an insurance company that issues a participating whole life insurance policy offers at least 12 additional benefits:
    1. A policyholder has access to the money in a whole life insurance policy whenever he or she wants or needs it -- and with no surrender charges, no penalties, no waiting, no taxes.

    2. The government, an employer, or any other outsiders have nothing to say about how a policyholder manages the money that accumulates in a whole life insurance policy.1

    3. A whole life insurance policy is protected from creditors and lawsuits in many states.

    4. A policyholder can borrow against a whole life insurance policy for any reason, doesn't have to qualify in any way, and can choose to repay a loan on his own schedule.

    5. When a policy owner borrows from a whole life insurance policy, the cash values of the policy keeps growing as if the owner hadn't borrowed a cent.

    6. A whole life insurance policy allows the policy owner to recover and recycle the borrowed money used to purchase cars, household furnishings, vacations and other big ticket items, or to fund education, business start-ups, or any other costly expense, and deposit both principal and interest right back into the whole life insurance policy.

    7. A whole life insurance policy allows the owner to recycle all of the interest she would normally pay to credit card companies, banks, and other credit grantors through her whole life insurance policy, where it compounds for her benefit.

    8. A whole life insurance policy allows the owner to pre-pay the cost of future health and long term care so the money the owner needs as he ages is safe and accessible on a tax-free basis when it's most needed.

    9. A whole life insurance policy funds inflation-protected income that the owner doesn't have to work for and can't outlive.

    10. A whole life insurance policy owner can use the cash values in a policy when any unforeseen life event throws her off track. (And that happens to everyone at some time or another).

    11. A whole life insurance policy lets the owner grow wealth tax free every year --no sliding backward, no worries about stock market crashes or real estate market bubbles, just peace of mind about his money.

    12. A whole life insurance policy serves its owner without compromise while she is alive, and allows her to pay forward -- tax free and to anyone she chooses -- a legacy of wealth and wisdom.
Summary

This is just a thumbnail sketch of a few major highlights of the two forms of permanent life insurance that dominate the discussions of the cash accumulation capabilities of modern life insurance policies. We know there may be omissions and some general statements that can be taken out of context. If you have a question or comment, we will gladly address it.

1 This document does not provide legal advice. Protections are not the same in every state and may not be available in some states. Consult an attorney about the laws in your state. *For further information, or to contact this author, please leave a comment and your e-mail address in the forum below.