I wrote a post last Spring about how to dump your whole life policy, which also discusses WHETHER you should dump it, since the decision to get out of a policy is not the same as the decision to buy it in the first place. I often get feedback on what I write, especially if it is about whole life insurance, and this article led to an email exchange with an agent last fall who felt that I had left out a significant option for those wishing to get out of their policy.
Swap Your Permanent Life Insurance Policy For Another One?
His plan was to swap that whole life policy you hate so much for a different policy. Naturally, my reaction to this suggestion, from an agent no less, was that it sounded like a great way for him to make two commissions off my ignorance instead of just one. But I like to think I'm open-minded, so I heard him out. Here was what he was really suggesting.
1035 Exchange Your Cash Value Into a Universal Life Modified Endowment Contract (MEC)
His point was to look at the reason why people want out of their whole life policies. Often, it is because they don't want that reminder sitting there that they used to be financially stupid. But his point is correct, that what people really don't like about them is that they are forced to pour good money after bad. There is an ongoing payment required each year. It might be for 20 years, to age 65 or even until death. It isn't that they don't like or value the permanent death benefit, it's that they have a better use for their money now.
They might want to use that money to pay off student loans, purchase an investment property, max out a retirement account, pay for college, buy a boat or pay off a mortgage. But they can't, because every year they've got to come up with $1,000, or $10,000, or $25,000, or $100,000 to pay that premium, year in and year out for decades. So what's the solution? A single premium insurance policy paid for using the cash value via a tax-free 1035 exchange. Voila- no more payments due ever, no taxes due, and you still get that permanent death benefit and probably some asset protection benefits, depending on your state. What's more, he argued, is you can get MORE of a death benefit by doing this. That part, of course, sounded a little squirrelly to me, so I made him prove it with some illustrations.
The main problem with investing in insurance is you have to quit doing stuff that keeps you from getting insurance at a decent rate, like this.
Comparing Life Insurance Illustrations
You're really comparing three things. First, a whole life policy on which you continue to make the premium payments. Second, a whole life policy on which you simply allow the policy dividends and cash value to make the payments (keep in mind this option is only really available for policies you've had for a long time, like 20 years or more.) Third, a single premium universal life policy. The idea is that you have a healthy, 50 year old non-smoking male who has had a whole life policy for 20 years and has $27,255 of cash value in it available to exchange. Where does that $27,255 of cash value come from? It came from the 20 year projected cash value for a Mass Mutual Whole Life Legacy 100 policy bought on a healthy 30 year old non-smoking male. The premiums on that policy were $1,028 and the face value was $100K. After 20 years, you've paid in $20,560 and have a cash value of $27,255, representing an internal rate of return of 2.61%. (Again, this is projected, not guaranteed.) Meanwhile, your death benefit has increased to $119,718.
Option 1 Keep the Original Policy, Keep Making Payments
At age 90, it is projected that you'll have paid in $61,680 in premiums and have a cash value of $369,709 and a death benefit of $428,467. The IRR on the cash value would be 4.92% per year. But you'll have had to make another 40 years of payments, which you don't like.
Option 2 Keep the Original Policy, Stop Making Payments
Now, instead of your dividends going toward paid up additions, they are used to pay the premiums. At this point, the dividends precisely equal the premium (now you know why the numbers above aren't so round.) So what do you get? You never make another payment and you get a permanent death benefit of $119,718. Granted, if the dividend rate goes down the policy will start shrinking, and if they go up you can either spend the difference or you'll have a larger death benefit.
Option 3 1035 Exchange to a Single Premium Universal Life Policy
So you not only get to quit paying premiums, but you also get a larger death benefit. Plus your agent gets to make a new commission. Everybody is happy- you, your heirs, and your agent.
[Update prior to publication: I asked the agent to look into what kind of a guaranteed (to death) death benefit could be had, and this was his response:
He did eventually find one that guaranteed $114K until death, but that's less than the WL policy's $119K, so it's pretty hard to get excited about.]
The Downsides of Exchanging Your Whole Life Insurance Policy
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The downsides of doing this exchange are several fold. First, single premium insurance policies are by definition a MEC. That means you can't borrow from them tax-free. The death benefit is still income tax-free to your heirs, but you can no longer borrow from the policy to bank on yourself or to pay for expenses in retirement. You've essentially committed to leaving this money as part of your estate.
Second, there is an opportunity cost. If you took that money out, paid any taxes due on it (or claimed any tax loss), and invested it in stocks or real estate, you have a decent chance of leaving more to your heirs in the end, plus you have the flexibility to spend some of it yourself if you need to.
Third, if you go for a guaranteed universal life policy, you may be better off just getting the whole life policy to the point where the dividends can cover the payments. That's pretty easy to do if you've had it for a couple of decades already, but not such a great option if you've only been paying for 5 years.
What do you think? Would you consider this a viable option for dumping your whole life policy? Do you see any significant advantage over keeping the whole life policy and just paying the premiums with dividends in this scenario? Comment below!
There are at least two good reasons why you never hear about doing this exchange.
The first is that it is an option for very few people. Almost everyone surrenders whole life much earlier than 20 years. They never needed a permanent death benefit and were suckered into a “great investment” (sarcasm). So it’s a very small % of whole life purchases. Most who get to this point actually don’t have a problem with the continued payment. Hopefully they are paying yearly and have dividends set to PUAs. Keeping the WL has better options going forward.
The 2nd is that its not a new or even really a good idea. Agents are always trying to pretend switching to their permanent product is good for you. You are much less likely to get a good health rating at your now older age and you are sacrificing the CSV for POSSIBLY more death benefit. There is substantial risk with this move which the agent seems to have down played. As noted, it isn’t guaranteed until death and we are talking about in a time period when insurance companies are CURRENTLY increasing cost of insurance on older in force polices due to low rate environment. So its not like we are talking about something that has never happened or only happened one time in the distant past. Additionally this agent is recommending a company that has in my opinion engage in other similar behaviors in my opinion. Isnt JH one of the companies that felt it was being too generous with its guarantees on income riders so they unilaterally forced customers into higher cost/worse options of investments or forfeit their income guarantees? Im pretty sure they were.
Its actually very telling about agents that this person thinks that you missed the boat and thinks someone can pay another high commission and do better in the long term most of the time. Really the only good reason to do this sort of exchange is IF you have good reason to believe your WL will be poor performing in the future compared to other permanent insurance (maybe your WL policy was sold to some other company and dividends aren’t happening), you are in great health (ie lucky), you want a permanent death benefit and willing to sacrifice your CSV (most people don’t need a permanent death benefit), and you can find a policy with better guarantees than what was shown in this post (becoming less common partly due to low interest rate environment).
What do you think about the asset protection that a whole life policy provides in certain states. In Florida, a very litigious state, I believe whole life policies are protected from creditors. This is the only reason I would be willing to consider a whole life policy. Basically accepting lower returns in exchange for asset protection. Thoughts?
Yes, it will do that (check your state laws.) Personally, I console myself with the incredibly low likelihood of being sued above my limits and the fact that the vast majority of my portfolio is already protected because it is in retirement accounts. But if you’re lying awake at night worried about someone getting your taxable account, then I guess it’s worth the lower returns and other issues with investing in life insurance.
Florida may be litigious, but it also has nice asset protection laws, such as their homestead law. I think if I lived in Florida and was really worried about asset protection I’d pay off my house before I bought whole life.
Also your regular non limited pay whole life can be a burden. It REQUIRES yearly premiums. If your money is tied up in something then you can’t pay and it collapses. Thus the policy would need to be old before that angle would help.
My father bought one of these for each of my kids to “help” pay for their college tuition. (something the agent denies, claiming he never suggested that knowing I would call him on it… Oh how I wish he’d put it in a 529, but It’s the thought that counts). My older son is graduating college this year and is going to be a non-dependent with half a year or less of his own income – hence in a low tax bracket. And yet the policy is 20+ years old with enough PUA to help cover the premium along with the dividends for the foreseeable future. Or my son could cash out and do something else with the $28,000+. So what do folks on here suggest?
I’d start with this post.
https://www.whitecoatinvestor.com/how-to-dump-your-whole-life-policy/
The first thing the individual needs to do is figure out if they would like a permanent death benefit and request an in force illustration.
If you dont want a permanent death benefit then its pretty hard to come up with a great reason to keep this thing indefinitely. If you do or think well maybe then more needs to be considered.
What you do is look at the in force illustration and look at the returns going forward (looking at mostly the illustrated column but realize things could drop to the pitiful guaranteed returns). Best to get an illustration with dividends set to pay premium and one where you continue to pay premiums but have dividends buy PUAs.
See after 20 years most of the horrible costs are gone. If you forget about the past and look forward then the returns might at least currently illustrate bond like performance (they are practically zero when you consider inflation up till this point). If you would otherwise invest this money conservatively like in bonds then its very reasonable to keep going. IF you would invest this money more aggressively like all in stocks for multiple decades then its going to likely beat the WL going forward given their age and non premature death. If you surrender and have gains then remember those are taxed as income and not long term capital gains. Im always amazed at how many agents tell people the opposite. You re-evaluate this every couple of years looking at new illustrations (the company must provide them yearly upon request). If you are happy with the results going forward then best to pay yearly (paying monthly or quarterly has a huge finance charge which doesnt go to your CSV or death benefit) and having dividends set to PUAs since that is the “better” deal of the situation bc it has a lower load on costs.
If one does surrender or 1035 then best to wait until after dividend paid if thats coming up soon.
The agent should have been able to tell you exactly why the policy was purchased if he/she is more than a sales person.
The agent claims it was so my son would always have life insurance. I know thatbis not how mynfather understood it, and I suspect the salesman/agent misled him.
Fun2befree,
I’m curious if you could provide more specific info on the policy.
When was the policy started, How many payments have been made on the policy, and how much was each payment. Given that the policy is 20+ years old, you might be surprised to find out that the IRR is over 5% on the policy, and wouldn’t have been much better had you put the money in an SP500 index fund.
If you would be so kind to provide the details, I’ll post a comparison of IRRs.
Not sure what “much better” means to you, but the CAGR of the S&P 500 with dividends reinvested over the last 20 years (Jan 1 1996 to Dec 30 2015) is 8.18%. $50K per year invested at 5% over 20 years grows to be $1.65M. At 8.18%, that’s $2.33M, or 41% more.
http://www.moneychimp.com/features/market_cagr.htm
Hey WCI,
The CAGR of 8.18% you are referring to only works if you put the entire investment in at the beginning.
I ran the numbers in Excel and if we assume equal installments each year for 20yrs starting 1/1/1996, the XIRR is 7.23%.
Obviously this is still much better than 5%, but not nearly as good as 8.18%.
My bigger concern is that the actual returns are high because we are at or near the top of a market cycle. Over the long run, the Shiller PE ratio has averaged 16.6; the market is current trading at about 26x Shiller PE. Simply reaching average would require a 36% decline in the index.
Were this to occur this year, the 21 year CAGR would drop to about 3.25%.
We’ve traded about the average Shiller PE ratio for almost all of the last 25 years. As you well know, at some point in the future we will have to spend time under the average, given that it is an average.
Note: I’m a big fan of stocks. I also happen to think that well designed permanent insurance is a great way to build the savings component of one’s wealth. That said, I haven’t started a policy myself because I have my money invested in specific stocks that I believe are trading at 50% of their true value.
However, people not interested in reading 10-K’s and simply indexing would do well to be patient and not throw large sums of money into the market at this time. They will almost certainly be able to buy the indexes at much better prices at some point over the next 3-5 years.
I’ve asked Fun2BFree for actual datapoints so that I can run the comparison. I haven’t seen a lot of actual results for long term policy’s, so its always interesting to get real numbers.
I have no idea if your predictions of the future are correct or not. My crystal ball seems to be much cloudier than yours.
WCI,
Would you disagree with anything I’ve laid out regarding the need for stocks to spend time under the Shiller avg PE at some point? If not, then doesn’t that imply that returns have to be lower than average over some period of years?
I have no idea. If I could predict the future based on valuations I would invest very differently than my “know-nothing” portfolio. I’ve read many very good arguments for future returns being lousy. But I was also reading those in 2009 and 2010 and was very glad I stayed the course in that time period.
WL will trail bonds (like it always does) so those returns are even worse.
In addition to what Rex suggested, you can call the insurance company and ask if the policy can be changed to a paid up policy. The insurance company will reduce the death benefit and the entire policy becomes like a single premium policy. The death benefit will be guaranteed and the policy will still get dividends if it is a participating policy. However, like Rex mentioned, it is important that you compare IRR of different options.
Dr Dahl: Many insurance companies allow whole life policies to become paid up after 7 years of premium. I definitely think that is a good solution for people who do not need a permanent policy and want to use it as an investment. Agents will not tell you this, because they don’t get commission from this solution. That is why the agent you talked to recommended a new single premium policy that might lapse rather than asking the insurance company for an option of a paid up policy. Also the agent provided the wrong information: you can 1035 an existing policy into a single premium policy that is non-MEC.
Disclosure: I am in financial services but I do not sell insurance. I have an optimal blended whole life policy from the Big 4 mutuals.
Interesting option- 1035ing into a non-MEC single premium policy. That’s news to me.
I agree that if you’re buying a whole life policy as an investment, that a 7 pay policy helps decrease a serious risk- the need to make premium payments for years come hell or high water.
One of your advertisers: insuringincome.com, has a version of term4sale software that can illustrate single premium GUL.
I got an illustration for 50 yrs old healthy male that $26422 can buy $150000 in DB with Midland National or North American GUL. This would be 100% guaranteed. Depending on which state that the policy is bought, the GUL can include both the chronic illness rider and critical illness rider, which your MassMutual Legacy 100 does not have. However, I do not see this as a better option than Option 2, where the DB and CV might continue growing if interest rates stay the same or goes higher. Also, CV is worth a lot more than DB, so I will take access to CV over slightly higher DB any day.
One thing to consider if you have a Universal Life policy that you have had for a long time and that the annual interest is paying the yearly premium. That consideration is that this insurance could be a backup to expenses paid later in life for care not anticipated today. So if one needed end of life care and the money expensed during the last years could be reinstated so to speak with the life insurance proceeds. Thus you would not leave your spouse with a smaller estate due to those medical expenses. So keep the life insurance and consider it long term care estate reimbursement funds.
If it’s a universal policy then the cost of insurance increases over time so I need to be careful about that assumption.
How is that different from having a taxable investment account as a “back-up?” I see no reason to preferentially use life insurance for that sort of thing.
I’m thinking it is probably a good idea to exchange a bad life insurance policy for a good one if possible. I have life insurance for a reason, and I don’t want to get rid of it, however, you are right that I am more financially savvy now than I was when first getting life insurance. So, it makes sense for me to switch to something better.
This was a great site for me to read. My mom is in a horrible Whole – Life policy that she needs to get out of. I had no idea which way to turn. Thank you