When financial advisors start offering life insurance to their clients, they soon learn how wide the divergence is between term and permanent policies. Term life insurance policies can provide a big death benefit for a relatively low premium. But, the advisor won't make much money on it and the client will be left with nothing if they outlive the term.
Permanent policies are much more lucrative for you and provide some cash for clients during their lifetime. Yet, clients might leave themselves underinsured because they balk at paying the sky-high premiums permanent policies come with, or, worse yet, scurry out of your office without buying any coverage at all.
With that dilemma in mind, a growing number of insurance companies have been offering a compromise that is worth considering as a third option. It's called return of premium (ROP) term life insurance, and it offers surviving clients a payoff in the future that could put more money in your pocket today.
How It Works
On the surface, the proposition is pretty straightforward: Let's say a 40-year-old male buys a $1 million 20-year term life insurance policy with the return of premium feature. If it costs $200 per month, he'll pay a total of $48,000 over the next 240 months. Assuming he survives the term, he will then receive his $48,000 back from the life insurance company. If he doesn't, his heirs get $1 million.
With something to be gained either way from ROP term policies, clients may be inspired to buy (and maintain) insurance that they otherwise wouldn't have had, meaning survivors will have a million-dollar safety net in place should the insured die before the term is up.
If the insured does survive the term, that check from the insurance company will not only make a nice supplement to his retirement funds, but, according to many of the companies and agents promoting the product, the reimbursed premiums will be tax-free.
What's Not to Like?
First, the return of premium feature doesn't come cheap. The cost to clients could be at least 50 percent more than if he were to buy a traditional term policy — in the case of the 40-year-old client, over $16,000 extra. (Of course, the bigger premiums mean more commission for you.) And if the client cancels the ROP policy before the term expires, he may get little or none of his premium dollars returned.
There also may be a cloud in the tax-free picture. Peter Katt, principal of Katt & Company and a longtime consultant to life insurance companies, agents and policyholders, thinks that the money sent to the client under the ROP arrangement is technically taxable — but may escape the attention of the IRS.
“Do I think it qualifies as taxable income?” he says. “Yes. Will the IRS have a way of tracking the return of premiums? Probably not, unless the insurance companies issue a 1099.” Still, Katt recommends that agents and companies promoting return of premium life insurance warn clients that part of the payback may have to go to the government.
All things being equal, Katt favors standard term life insurance instead of the ROP policies. He thinks clients are better served by paying a lower premium, and then investing the difference.
Give Them the Choice
What's best may just come down to who the client is. To put this theory to the test, suppose two 40-year-old males of similar health each buy 20-year $500,000 term life insurance policies. Tom buys straight term for a premium of $70 per month, and Jerry buys a return of premium policy for $175 per month (approximate figures taken from Insure.com). Tom will take his extra $105 per month savings and invest it.
Assume Tom and Jerry survive the next two decades. Jerry will receive his premiums back — $42,000. To equal what Jerry has just pocketed, Tom will have to earn about 4.75 percent annually on his monthly savings over the 20-year period — almost exactly what Bloomberg was quoting for a 20-year AAA-rated insured tax-free bond when this column was submitted.
While Jerry is locked into his investment, Tom is not. The freedom Tom has could be good for him down the road. With interest rates historically low, he stands a decent chance of some day finding a higher rate at which to invest his $105 a month. Jerry, on the other hand, may be forced to abandon his original contract to take advantage of any better investment opportunities.
Their tax position is also different. Tom can move his money around depending on changes in the tax code. Jerry meanwhile, can only “wait and see” if the IRS will want part of his ROP at the end of the term.
These reservations aside, the best solution for advisors is to simply present a client with all three options — straight term, ROP term and permanent life insurance — give your recommendation and reasoning, then let the client decide.
Writer's BIO: Kevin McKinley is a CFP and vice president of investments at a regional brokerage and author of Make Your Kid a Millionaire — 11 Easy Ways Anyone Can Secure a Child's Financial Future. kevinmckinley.com
If return of premium term life insurance whets a client's appetite, it may be a better deal to go with a 30-year policy instead of one lasting 20 years. The difference in premiums between straight term and an ROP policy is much narrower for the 30-year version when compared to corresponding 20-year policies.
Although the numbers used here seem to support the critics of return of premium term life insurance, comparing actual quotes for a client may be closer and, therefore, give the advantage to the ROP version. Here are some attributes of clients who may be best suited for return of premium policies:
Unable to save for retirement in traditional vehicles (especially Roth IRAs) and willing to bet the return of premium will be tax-free.
Life expectancy of at least three more decades so that the more cost-effective 30-year policy can be used.
Enough predictable income to afford the higher premiums of ROP term but still can't stomach the cost of permanent life insurance.