Universal life insurance policies are almost universally failing. It’s a slow-motion disaster that many industry professionals have seen coming, but that does not make it any less painful for policyholders trapped in the wreckage.
Unlike term life insurance, which can work on a pure insurance model of spreading risk among a pool of insured with only a few who will ever need to collect benefits by restricting coverage to a certain period of time, permanent insurance is designed to last until it pays out. After all, not everyone dies unexpectedly young, but everyone dies eventually. Therefore, in order to work, permanent insurance policies must accumulate cash value to help defray the expense of insurance in later years, when coverage is more costly. In effect, such policies are a combination of a term policy and a tax-sheltered savings account.
Since every permanent policy pays out as long as the insured keeps paying premiums, they are more expensive than term life insurance policies. Universal life insurance is a form of permanent life insurance initially designed as a more affordable option than traditional whole life insurance. Insurance companies in the 1980s thought that, by unbundling the insurance and savings components of a permanent policy, they could offer cheaper products and expand the pool of potential policyholders.
Universal life works this way: A customer effectively buys a one-year term policy and renews it annually. In the beginning, the customer pays much more than the equivalent term policy alone would cost, and the insurer puts the excess into a tax-deferred savings account. In theory, the interest earned in that account would eventually offset part of the cost of renewing the term policy in future years, making such costs reasonable for policyholders in their late 70s and beyond, when they would otherwise be prohibitively high.
Universal life policies offer added flexibility, as well as generally lower costs than traditional whole life insurance, because policyholders maintain some control over the policy’s cash value. They can use the accumulated cash value to cover premiums if they need to temporarily stop or reduce their out-of-pocket premium payments. For most policies, they can also adjust their death benefit to try to control costs. And policies generally allow borrowing against the savings account. All of these actions can slow the growth of the policy’s cash value, though the policyholder can make additional payments to make up any shortfalls (at least in theory).
In the 1980s, and for some time after, all of this sounded wonderful to many insurance consumers. It put permanent life insurance in reach of customers who found traditional whole life insurance too pricey, or who worried about its lack of flexibility. Today, however, the shortcomings of these products are painfully clear. Author John Resnick told The Wall Street Journal that of the older universal life policies he has reviewed in the past decade, “easily 90% or more actually were in trouble or soon to be in trouble.”
The culprit? Insurers’ optimistic but incorrect assumption that interest rates would not drop significantly. When insurers sold many of the earliest universal life policies, they illustrated them to potential customers with projections that the cash values would earn interest rates of 10 to 13 percent annually, the Journal reported. While most policies have a much lower minimum guaranteed return, such scenarios seldom received much emphasis. Unfortunately for policyholders, nearly a decade of historically low rates has demonstrated the consequences of that mistake.
The savings account component of a life insurance policy is, by design, typically low-risk. Insurance policyholders generally do not tolerate much volatility or chase high returns; they just want the assurance that their policy will pay out when the time comes. But because insurance companies invest permanent insurance policy premiums conservatively, universal life policies have been especially vulnerable to the war on savers. Since the cash value of such policies has grown much slower than expected, insurers can either chase riskier investments – something almost no insurer is willing to do – or dramatically raise premiums.
This reality creates an uncomfortable choice for policyholders. Some retirees feel they have no choice but to drop policies that they have paid into for decades. Others contribute an increasingly burdensome portion of their monthly budget or reduce their policies’ death benefits to try to retain at least some value.
While insurers continue to sell universal life insurance policies, the painful choices facing people who bought policies 30 or 40 years ago should give today’s prospective customer serious pause. It almost certainly makes more sense to take one of two alternative approaches, depending on your situation and goals. First, if you can afford traditional whole life insurance instead, you can secure the assurance that as long as you keep up with your fixed premiums, your policy will remain in place, and if you outlive the policy’s maturity date, the policy will endow (that is, its cash value will eventually reach or surpass the guaranteed death benefit).
If you cannot or do not wish to take out a whole life insurance policy, you could instead follow the old adage: “Buy term and invest the difference.” Rather than letting the insurer make the investment for you, however, take out a term policy and invest the extra you would have paid for a universal policy in a well-diversified portfolio. You will give up some tax savings and take on some risk, but you will be able to respond to changes in market conditions and the interest rate environment as they arise.
People who already have universal life policies occupy a more complicated position, but they do have options. First, policyholders should review their annual statements closely. Determine whether your policy’s cash value has increased or decreased; if it has decreased, consider how quickly its value has declined year over year. If your policy is in danger of lapsing, your insurer should indicate how much premiums must increase to keep the policy in force, as well as how soon the policy will lapse without further payments. You will find this information either in the statement itself or in additional correspondence from your insurer.
Even if your insurer hasn’t told you that your policy is in danger of lapsing, you should not passively wait for bad news. Request an updated policy illustration built on the following assumptions: that you continue to pay your current monthly or annual premium; that your policy only earns the minimum guaranteed interest rate (typically between 4 and 5 percent); and that the maximum expense charges are deducted annually going forward. Effectively, this is a “stress test” for your policy, showing the worst-case scenario. It should indicate the earliest point at which your policy is likely to implode if you do not increase premium payments, reduce your policy’s death benefit or both.
You may feel uncomfortable performing this analysis yourself. If so, I recommend hiring a fee-only financial adviser, preferably one who holds the Certified Financial Planner™ designation. He or she can help you to evaluate your policy’s performance and advise you on the best course of action for your particular circumstances.
Depending on your situation, you have a few options if your policy is in jeopardy. First, consider whether or not you still need the insurance at all. While it is frustrating to surrender a policy or let it lapse after paying years of premiums, you should not let the sunk costs affect your evaluation of the best choice going forward. The primary – though not the only – purpose for life insurance is to provide protection for loved ones who depend upon your income in the event of your premature death. If you are now retired and have finished paying for your children’s educations, the life insurance has likely served its purpose. You may decide it is better to either surrender the policy and receive the remaining cash value or let it lapse once the cash value has been exhausted, especially if paying higher premiums is not within your budget.
If you are in poor enough health that it seems likely the policy will pay out soon, it may be worth maintaining your universal life policy, even at the cost of higher premiums or with a lower benefit. If your budget allows you to pay higher premiums without impeding your ability to pay other living expenses, you may find it worthwhile to hold on to your policy. Similarly, if you just hope to cover finite expenses, such as funeral or burial costs, you may be able to substantially reduce your death benefit, and thus your costs, while still getting some benefit from the policy.
No interest rate environment lasts forever, just as no human lifespan does. As the universal life insurance market continues to self-destruct, prospective buyers should steer clear, and current policyholders should do what they can to minimize the collateral damage.