Reaching age 100 is a milestone worthy of celebration. But for those who hold permanent life insurance policies, the birthday may bring an unwelcome gift from their insurer.
Centenarians are a small but growing segment of the population. U.S. Census reports show an increase of nearly 66 percent in this demographic between 1980 and 2010, and their current number is estimated to be about 77,000. Living to 100 is becoming more common in other countries too, including Japan, the United Kingdom and Canada. Innovations in medicine and public health initiatives continue to increase life expectancy, and some researchers believe the first person who will live to 150 has already been born.
All of this is, of course, good news. But it can complicate life insurance planning.
The End Of A Life Insurance Policy
People seek out different types of life insurance depending on the financial goals they want to achieve. (My colleague Anthony Criscuolo wrote an article a few years ago on how to tailor life insurance to personal financial goals.) But when discussing how life insurance policies end, the first major distinction is between term insurance and permanent insurance.
As the name implies, a term life insurance policy inherently includes a specific end point. When you purchase a term policy, you are buying temporary coverage for a certain period to protect against a loss of income should you die unexpectedly during that time. If the policyholder outlives the policy, it represents a good outcome. Much like fire insurance, term life insurance is a purchase most buyers hope they never need to actually use. For example, a working parent may not plan to retire for another 25 years and wants to provide for a surviving spouse and their young children if the policyholder dies unexpectedly in the meantime. If she outlives her term insurance policy, with her children grown and self-sufficient, the policyholder no longer needs the coverage.
Permanent life insurance is different. You might assume from the name that such coverage never expires, but the truth is more complex.
An individual who holds a permanent life insurance policy does expect his coverage to outlive him. When he is younger, the policy may serve the same income-replacement objective for his dependents as a term policy would; as the insured ages, a permanent policy often becomes a tax-effective method of transferring wealth to younger generations, because the policy’s death benefits are not subject to income tax.
Term insurance can run on a “pure” insurance model, in which the risk of an unlikely but catastrophic event (in this case, premature death) is spread among a population. Many people pay premiums, but only a few will need to make a claim. It is essentially the same model that underpins homeowners insurance, disability insurance and auto insurance. Since permanent life insurance will nearly always pay out sooner or later, however, it is structured differently. The three main ways that insurance companies structure permanent policies are traditional whole life coverage, universal life coverage and variable universal life coverage. All three include an investment component as well as an insurance component.
Because permanent life insurance can’t rely on a certain number of policyholders failing to collect benefits – obviously, no one lives forever – insurers structure these policies to endow at a certain point in the future, ideally far enough away that most policyholders will not live to reach it. Permanent insurance policies therefore have a maturity date, derived from mortality tables, after which the policy expires. This endpoint allows insurers to set premiums at a reasonable rate. The company also invests a portion of the insured’s premiums, so that as the policyholder ages, the insurance company’s risk of having to pay a large portion of death benefits out of pocket decreases.
For much of the 20th century, standard mortality tables assumed a maximum terminal life age of 100. But as life expectancies increase, the odds of outliving a permanent life insurance policy – while still low – have steadily ticked upward. Some older tables even pegged the maturity date lower, to age 96. So what happens if you outlive your policy?
A policy that fully matures pays out its cash value to the policy’s owner. This event has two significant implications. First, the intended beneficiaries will not receive the death benefit. Second, a portion of the lump sum payout will be subject to tax as ordinary income. (The payout’s cost basis, which is the aggregate amount of premiums paid, is exempt.)
More than one individual has received this unanticipated and unwelcome gift. After years of paying premiums for a policy they expect to remain in place until their death, these policyholders face the prospect of losing the benefit of passing wealth to their heirs tax-free and, adding insult to injury, must pay a hefty tax bill of their own.
For universal life and variable universal life policies, the surprise may be even more unpleasant. Traditional whole life policies gradually but steadily accumulate cash value over time; if the policy hits maturity, then the cash value will equal the death benefit plus accumulated interest, as long as the policy has been properly funded. Universal life policies, in contrast, unlink the investment and insurance components of a policy in order to offer lower premiums. Therefore it is common that a universal policy’s cash value at the maturity date is less than the promised death benefit. Not only is the payout taxable, but the pretax amount may be significantly less than beneficiaries would have received.
Years of low interest rates mean that policies’ cash values have grown sluggishly for quite some time. Insurance policy investments for whole life and universal life policies are usually relatively conservative. This means that a low interest rate environment has led to declining cash values, spiking premiums (if the premiums are not set in the contract) or both. If the cash value reaches zero, the policy may self-destruct even before it reaches the maturity date.
The increasing risk of permanent life insurance policyholders outliving their insurance has prompted most insurers to raise the maturity date to age 121 on policies issued within the past 15 years or so. But this change did not apply retroactively to older policies.
What To Do If You Might Outlive Your Coverage
If you own permanent life insurance, the first step is to carefully review your policy documents to determine your policy’s maturity date. It may seem morbid to seriously worry about the fact that you (or the insured, if you are helping a loved one through the process) might live past age 96 or 100. But as with all estate planning, considering various scenarios will let you make the best decisions for yourself and your heirs.
For policyholders who are concerned about outliving their insurance’s maturity date, the first step is to contact the insurance company. You can request a maturity extension rider to extend the policy’s expiration date to age 121. If the insurer grants you the rider, you may be able to avoid a taxable event and your beneficiaries will receive the policy’s benefits upon your death as originally planned. Generally the death benefit of a policy with an extension rider is the cash value of the policy at the original maturity date plus accumulated interest, without any additional premium payments.
You should be cognizant, however, that the extension rider may not completely resolve the problem. Under the tax principle of “constructive receipt,” once the policy matures the cash value should be taxable even if it is not disbursed, assuming the policy owner has unfettered access to the policy’s value. In other words, as far as the tax authorities are concerned, you may still owe tax at the policy’s original maturity date even if you choose to forgo the lump sum payout. The Internal Revenue Service raised this potential issue in Notice 2009-47. The life insurance industry has pushed back against the IRS’ stance, and for now the matter remains something of a gray area. While a maturity rider will definitely secure the policy’s death benefit for your beneficiaries – not insignificant with a universal life policy – it is not a guarantee of avoiding taxation.
Unfortunately, individuals with universal life policies may find it more difficult to secure a maturity extension rider than those with traditional whole life coverage. Since most whole life policies endow, the company is not on the hook for any insurance costs past the original maturity date. In these circumstances, most insurance companies are happy to keep customers’ business. On the other hand, insurers may be obligated to pay out less to customers whose universal life policies mature than they would if the same policy paid out death benefits; as such, the company may be less enthusiastic about providing an extension rider.
These concerns are not purely hypothetical. In 2017 The Wall Street Journal covered the story of Gary Lebbin, who sued Transamerica on the grounds that the insurer allegedly used a too-low mortality age deliberately when selling universal life policies and that it misleadingly marketed the policies as “coverage for life.” Lebbin, who turned 100 in September, was the insured for two universal life policies collectively worth $3.2 million. These were held in a trust, with his children acting as trustees. According to the complaint, Lebbin requested an extended maturity rider in advance, but the company declined to grant him one. Lebbin and the trust, which served as a co-plaintiff in the suit, are currently involved with a tug-of-war with Transamerica regarding jurisdiction. Unfortunately, the best they can hope for at this point is likely a private settlement.
If your insurer will not offer a rider, and you don’t wish to or cannot practically take the company to court, you may decide to purchase a replacement policy with the now-standard higher maturity date. This is not a decision to make lightly, however. I strongly recommend working with an independent financial adviser to weigh a variety of factors that could contribute to your ultimate choice. These may include the performance of your current policy, your age and your health. For a relatively healthy individual in his or her 60s, this plan may be practical; it may be much more difficult, or even impossible, for those who are older or sicker.
Should you decide to pursue a new policy, make sure you obtain the replacement first, before surrendering your existing policy. This protects you against a worst-case scenario in which something goes wrong and you completely lose coverage. Note, however, that this means you will not be able to use the value of your old policy to cover the upfront costs of your replacement. You should also take care to structure the transaction to avoid recognizing taxable income. This can be accomplished with a Section 1035 exchange, in which the IRS allows life insurance policyholders to swap an old policy for a new one without realizing a taxable gain, as long as the owner, insured and annuitant are the same on the old and new contracts. A 1035 exchange occurs directly between insurance companies, and is best conducted with the involvement of a tax professional.
If none of the above options are possible, your final choice is whether to surrender the policy early or to play the odds that you will expire before your policy does. Most of the time, the potential for a tax-free death benefit will make holding out a better choice. But if the maturity date is imminent, you may consider timing the recognition of the income with the help of your financial adviser. For example, you may elect to transfer the disbursement of the cash value into an immediate annuity payout option, in which a portion of each annuity payment is taxable, or a deferred annuity option that postpones the recognition of income until some future date.
As more people live to celebrate their 100th birthdays, a firmer answer on how the IRS and insurers will handle policies with too-short maturation dates should eventually arrive. In the meantime, policyholders need to take proactive steps if they wish to capture the full value of their “permanent” insurance policies.