Let’s face it, not a lot of us are excited about life insurance. “A necessary evil” is how it is often described. However, if one took the time to study the economic dynamics and risk mitigation aspects of an appropriately procured, well designed and regularly managed policy, there would be a discovery that, independent of the emotional aspect of life insurance, the benefits can be attractive.
Whether it is due to emotional or economic factors (or good salesmanship), many of us have decided to layer life insurance into our family, business and estate planning. Cash value life insurance may be one of the most complicated and least transparent financial transactions with which many of us are ever involved. That being said, most people wrongly believe it to be a rather simple transaction: I pay my premium and someone gets a benefit when I die.
Life insurance is a financial product built on static assumptions in a dynamic market. What does that mean? That the various types of cash value life insurance policies have more variables and fewer guarantees than you might think. They need to be actively managed, which is seldom, if ever, done for most policies. Yes, even term insurance needs management.
Let me share a series of quotes from a Wall Street Journal piece that are essentially identical to quotes in numerous finance, business and estate planning periodicals: “Policies are imploding.” “… leaves the owner on the hook for unexpected costs.” “If a policy collapses, it’s demise can even result in a big tax bill.” “Policies are starting to fail at an alarming rate.” “… have to pay premium out of pocket longer than expected.”
Most life insurance policies are underperforming the assumptions and expectations in place at the point of purchase. This doesn’t mean that most life insurance policies will fail, but it does mean that a majority of policies will pan out differently than expected.
Many policies will collapse with no benefit if meaningful action is not taken. That is the almost unbelievable part of what is happening, so I will repeat it: Many policies that you believe to be sound, if not guaranteed, will never pay a death benefit without a substantive infusion of cash or an alternate re-engineering of the policy.
I regularly see “permanent” policies, which after many years of dutifully paid premiums and without so much as a single late payment, are literally thrown in a trash can with no value and no death benefit. Other policies that don’t collapse will have death benefits and cash values significantly lower than once expected. The worst case scenarios will result in collapsing policies that may generate potentially massive phantom gain tax consequences.
Why are many of our life insurance policies failing us? There are a number of reasons but primarily it is due to a multi-decade drop in dividend and interest rates and a lack of industry education and client understanding of how a drop in crediting rates affects policies.
Without regularly performing a thorough policy audit and performance analysis, it may be impossible to determine if a policy will perform suitably. Even a policy with an annually increasing cash value may never pay a death benefit. Here are a few things to keep in mind:
Life insurance transactions are exceedingly complicated and not very transparent.
Don’t take anything, especially conventional wisdom, for granted.
Life insurance needs ongoing financial management and modeling.
No one is more concerned with your best interest than you, and information is power.
Third-party, fee-based, objective information is rarely a bad thing.
Think about it: If you did your retirement planning based on an assumption you would earn 10 percent in the market over time, but in reality you are earning 6 percent, you know that you will not be able to live the retirement of your dreams. You must either increase contributions or decrease expectations. Undoubtedly you would not make decisions on your 401(k) once and throw it in the drawer and blindly trust that when you needed it decades later, it would have taken care of itself.
If you understand this, you are most of the way to understanding a little known truism of life insurance. Life insurance works the same way as other financial assets. One difference is that over the past two to three decades, while the investments in your 401(k) have gone up and down, the crediting rates for traditional life insurance policies have generally only gone down — 500 to 1,000 basis point drops from the mid-80s and meaningful drops in only the past few years. Too few understand that this has a negative effect on policy performance.
But my life insurance death benefit is guaranteed, right? Don’t count on it. While there are some underlying guarantees, a majority of life insurance policies, as they were sold, are not guaranteed to pay a death benefit if funded at the originally illustrated premiums. It’s a “dollars in, dollars out” financial transaction, and if the policy doesn’t get the projected dividend or interest rate, it cannot perform to expectations. There continues to be an unfortunate disconnect in the market regarding cause and effect in life insurance policies.
Generally speaking, your policy might be fine or it might be a disaster. You may want to maintain it but adjust your expectations, or you may look to market alternatives that better accomplish your goals.
Please pay attention to your life insurance policies. The business owner community and their advisors are my core constituency and the people I work with on a day-to-day basis. Trust me, even the wealthiest and most sophisticated business owners surrounded by the best counsel may be facing these issues and not know it. If you are lucky enough to be in the minority with the best of policies, tended to by the most conscientious of insurance professionals, an independent audit based on empirical data will bear that out and you can dismiss this “alarmist” message.
The bottom line is that appropriate policy procurement, thorough and effective management, and regular review and benchmarking of life insurance policies can save money, increase returns and avoid catastrophic, sometimes irreplaceable, loss of coverage and/or devastating tax consequences.
While life insurance may be complicated and something lower on your list of pleasantries than undergoing a root canal, if your family’s security, the continuity of your business or the completion of your estate plan is built around life insurance, it’s simply too big a price to pay to not understand and to find out the hard way.
Bill Boersma is the owner and president of Opportunity Concepts LLC and Lawson Insurance Services Inc. He can be reached at firstname.lastname@example.org or (616) 456-1000.