As might be expected, I’m getting more calls lately from advisors, on behalf of their clients, asking what should be done about life insurance no longer needed for estate liquidity purposes.
I generally answer the same way every time: “Let’s evaluate the policy and then talk about options.” Depending on the client situation, the first issues I discuss with the advisor is what happens when the current estate tax law sunsets, and does your client really want to bank on what the tax laws will be, 17, 28 or 42 years from today? With life insurance, it seems many people will jump on a reason to walk away.
Your clients are big kids so if they decide to bail on a policy and that turns out to be a mistake, they can live with it. However, it’s important that they’re making these decisions with all the data they need to make an informed decision and not an emotional one.
An Objective Financial Analysis
With an in-force ledger in hand, I perform an internal rate of return calculation to show them what they have. Sometimes, this is surprising, positively or negatively. What I propose to provide is black and white information. I’m going to stay agnostic relative to product style, carrier and IRR. After all, let’s say the tax-free rate of return at actuarial life expectancy is 5 percent. Who am I to say if that’s good or bad? Someone who has most of his money in CDs and conservative investments might feel that’s a good use of money, while a business owner making 25 percent on her money might question why she’d ever distribute capital to fund such a vehicle.
I take the current cash surrender value and enter it as present value, the death benefit at life expectancy is future value, the number of years to life expectancy (or whatever duration is desired) and the premium payment. I calculate interest. If the life insurance contract is one that’s designed to accumulate reasonable cash value, I also calculate the IRR on the premium to future cash value so we can evaluate it as an accumulation vehicle.
Let’s take two recent files on my desk. One was a relative new whole life contract. My calculations show the IRR on premium to death benefit at life expectancy to be about 4 percent, while the IRR on cash value is two point something percent most of the time and tops out at 3 percent at age 90. This client decided it wasn’t worth it and is going to exit the policy.
The next policy was a survivor Guaranteed Universal Life on a 77-year-old couple. It was put in force as a single pay and is guaranteed for life with no additional premiums. Running the IRR numbers at 10, 15, 20 and 25 years, the IRR on current cash surrender value to guaranteed death benefit is 16.59 percent,10.78 percent, 7.98 percent and 6.33 percent, respectively. Mind you, that’s 87, 92, 97 and 102 years old. At age 97, they’re looking at an 8 percent guaranteed, net, tax-free return that’s a double digit tax equivalent return. This is an unduplicable financial transaction.
Knowing the return of the transaction, the clients can now decide if there’s any useful reason to keep the contract in the absence of estate taxes. If cash flow into a contract isn’t an issue, and it looks to be a good use of money, then the policy can be maintained as a part of a diversified estate portfolio or legacy planning or used for charitable purposes.
Tweaking Existing Contracts
Often I find many people failing to evaluate tweaking an existing contract. If the policy needs premiums, what does the death benefit need to be reduced to for it to stay in force indefinitely with no more cash flow? Is there a way to better use dividends or manage loans? I’ve seen GUL contracts with little or no cash surrender value stay in force for a couple of decades with no premium paid, even when they were designed to assume premiums paid annually.
Assuming a decision is made to bail on the contract, please advise your client to not simply cash it in without further analysis. For some, a life settlement may be a windfall. There’s still a robust settlement market, and this potential increase in value should be evaluated if it’s in the cards. Beyond that, virtually every contract is in a gain or a loss position. If in a gain position, let’s evaluate ways to eliminate or mitigate the gain. If it’s in a loss position, let’s evaluate ways to salvage the loss in the contract. One would never take a loss on real estate or investments and not bother to share this with the accountant. Why should life insurance be any different?
Once everything is evaluated, policy owners can take advantage of the most favorable opportunities or cut and run and put the funds into investments or dissolve the trust and distribute to the kids. The freed-up cash flow can be used for taking the grandkids to Disney or buying that boat your client has his eye on.
Life insurance should be evaluated like anything else before making decisions. I’ll always be at a loss to understand why such a significant portion of the market chooses to treat it so differently than anything else.