Guidance for life insurance in or near retirement
“Will you still need me? Will you still feed me when I’m 64?”
These Beatles’ lyrics are good questions when illustrating life insurance or when implementing policy changes in or near retirement. What will the need be for cash value to support the death benefit? What will your client have to feed the policy in premium payments? Will the client choose to reduce the benefit if needed to make the policy permanent without paying extra premiums?
In or near retirement, a change in your client’s needs typically occurs where your client is more concerned with providing a death benefit in case of a long life rather than in protecting against the loss of income in case of early death. Accordingly, we may illustrate life insurance such as Indexed Universal Life (IUL) as providing a death benefit to help ensure your client’s beneficiaries will have funds available to cover medical, funeral, or any other expenses your client leaves behind while at the same time providing the opportunity to build cash value that the owner can choose to access via withdrawals and loans during their lifetime to help supplement income during their retirement. To help increase your client’s ability to use the cash value of the policy to supplement income, you need to help increase the policy’s cash value. Even if your client does not take withdrawals and loans from the policy, you may also help increase or extend the death benefit when you help them increase the cash value.
In our reviews of our clients’ existing life insurance policies as part of our CAR program (Comprehensive Analysis and Review), the typical need I see is to change the policy mix in or near retirement particularly for Universal Life (UL). The need may also apply to how IUL and other policies may be best illustrated and administered at any age depending on the needs and financial goals of the client. The concept may also apply to term life in or near retirement when you may decide to advise a client to drop a term policy or term rider because premiums are increasing due to age. Or with whole life, you may decide to advise your client to convert to a reduced paid-up policy rather than continue making premium payments or perhaps to exercise options that may be available in their policy to put in extra premium payments to build paid-up values.
An exception to needing cash value in this age range can be when life expectancy has decreased and there is sufficient cash value to keep the policy in force until death. Guaranteed UL also seems to be an exception to needing cash value, but it uses a shadow account or implied account value to keep the coverage going. You need to be sure your client continues making premium payments to keep up the value as essentially lifetime term insurance.
As a rule of thumb for IUL, I like to see the cash value of the policy equal to about half or more of the death benefit around age 64. How do you get there? Premium Opportunity and Insurance Tailoring are concepts I advocate.
You should advise your client about the Premium Opportunity that allows them to pay up to limits in order to increase policy values to the maximum allowed under the Tax Code. Often, the billed premium in a cash value policy is presented and viewed as the cost for the policy, but the reality is that paying higher premiums may reduce the actual or relative cost of insurance. Policyholders may see an advantage to paying premiums beyond the insurance costs up to the tax limits. An IUL policy may start with a target premium, but I recommend to my clients that they make premium payments sufficient for the cash value of the policy to be at or near the tax limits by the time they reach retirement.
I also recommend to my clients that they manage the amount of insurance in or near retirement. An example is where you illustrate changing to a level death benefit when your client is at or near retirement in order to help reduce insurance costs and still provide sufficient death benefit to their beneficiaries to help them cover medical expenses and burial costs. This may also help you to increase your client’s ability to supplement their income by taking withdrawal and loans from the cash value of the policy. As always, the client should be made aware that taking withdrawals and loans from the policy will reduce the policy’s cash value and ultimate death benefit. Even with a change to a level death benefit, the policy may need a reduction of the face amount in order to bring it close to the tax limits. This tailoring may also help to increase your client’s ability to take withdrawals and loans against the cash value of the policy to supplement their income. If your client does not withdraw or take loans against the policy’s cash value, keep in mind that a level benefit becomes an increasing benefit when the cash value reaches the tax corridor. Ideally you want the policy in the corridor to help increase value.
Age 64 Scenarios for IUL
Suppose a policy issued many years ago is now at attained age 64. This age is 36 years to age 100 which fits conveniently with the rule of 72 for growth rate compounding. The chart below summarizes different cash value scenarios and what growth would be needed along with covering costs. This example is for a $1,000,000 level death benefit at age 64 with $8 per 1000 in insurance costs. Insurance costs are based on the net insurance amount which is the death benefit less the cash value.
|less Cash Value age 64||125,000||250,000||500,000||800,000|
|Equals net insurance amount||875,000||750,000||500,000||200,000|
|Assumed Annual Cost
|Cost as % of CV||5.60%||2.40%||0.80%||0.20%|
|CV Growth to Endow age 100||6.00%||4.00%||2.00%||0.62%|
|Cash Value Use after age 64||Eventual Lapse unless premiums added||Insufficient Cash Value Available to Supplement Income||Sufficient Cash Value Available to Supplement Income||More Than Sufficient Cash Value Available to Supplement Income
This is a hypothetical illustration intended only to demonstrate the impact different levels of cash value at age 64 may have on an IUL policy and is not intended to represent any individual’s specific situation. This illustration assumes that sufficient premium payments are made prior to age 64 to achieve the assumed cash value at age 64. There are other risks, fees and charges associated with an IUL that are not taken into consideration in this illustration. Depending on the specific policy, these may include, but are not limited to, administration fees, premium loads, participation rates and index caps. You should always instruct your client to read their policy carefully. Financial Independence Group and its employees do not give tax or legal advice. Your clients should consult with and rely on their own tax and legal advisors prior to withdrawing or taking loans against the cash value of a life insurance policy.
If you have 50% cash value, then the net insurance amount is $500,000 with a $4,000 cost. This cost represents 0.80% of the cash value. Over the next 36 years it would need about 2% growth to double and endow to equal the benefit. This leaves room for providing your client with the ability to access the cash value via withdrawals and loans to supplement income.
This growth rate to endow is net of insurance costs and the spread needed to cover insurance costs increases dramatically with the lower percentage of cash value. Keep in mind that the cost of insurance rate would increase with age so the net insurance amount needs to continue decreasing due to cash value growth and/or distributions decreasing the death benefit.
If the policy cash value were 25% of the benefit, then the value would need to double twice to endow, a 4% growth rate. The insurance amount is $750,000 with a $6,000 cost. That represents 2.40% of the cash value. So in terms of a spread off the cash value credit rate, the insurance costs have tripled. You need 4% + 2.40% = 6.40% to keep up the cash value growth and cover insurance costs. An IUL may have a good chance of achieving this growth, but it has little room for providing your client with the ability to access the cash value via withdrawals and loans to supplement income while keeping up the death benefit.
If the policy cash value were 12.5% of a level death benefit, then the value would need to double 3 times, a 6% growth rate, to endow. As shown in the chart above, the insurance cost at age 64 would be 5.60% of cash value. When you combine these you need roughly 11.60% to keep up the cash value. The policy is likely to eventually lapse unless premiums are added or the insurance amount reduced.
The irony of under funding IUL is that the tax law corridor typically allows you to have a much higher percentage of cash value to death benefit than in Whole Life. For example, see IRC 7702 (d) where for at age 64 the death benefit can be as low as 1.22 times the cash value. For whole life, this ratio at age 64 is around 1.8. 1
If the policy were near the cash value corridor, then the cash value could be about 80% of the value at age 64 and have ample room for providing your client with the ability to access the cash value via withdrawals and loans to supplement income. The net insurance amount of $200,000 would cost $1,600, only 0.20% of cash value.
How to Rescue Underfunded Policies
You may show your clients the Premium Opportunity to bring the policy up to tax limits. However, if the policyholder is not willing or able to put in enough premiums to properly fund the policy for this strategy then you may want to recommend a benefit reduction should be made. A future article will give examples of how these benefit reductions can be made under various scenarios.
Credit % to Cover Net Insurance Amount Cost = (q*(DB – CV)/1000)/CV
where q is the cost per $1,000
DB is the Death Benefit and CV is the Cash Value
1Legal Information Institute, Cornell Law School, Ithaca New York; 26 U.S. Code § 7702 – Life Insurance Contract Defined. Web page accessed November, 2015: https://www.law.cornell.edu/uscode/text/26/7702
Guarantees are backed by the financial strength and claims paying ability of the issuing insurance company.
FIG does not give tax or legal advice. Your client should consult with and rely on their own tax and legal advisors regarding their particular situation.
This is not a comprehensive overview of all the relevant features and benefits of any particular product. Be sure to review all of the material details about any products referenced in this article before making specific recommendations to clients.