What to Do If Your Universal Life Insurance Policy is About to Crash

If you’re stuck with a failing universal life insurance policy, what should you do?

People who bought these policies in the 1980s and ‘90s are now often stuck paying much higher premiums to keep the policy in force. Since many of them are retired, they find it hard to shell out more.

The Issue

If you’re in that situation, you do have choices, but they involve trade-offs. But before we discuss potential solutions let’s look at what caused the problem, in order to understand what options you have now.Universal life is a form of permanent life insurance designed to be more affordable 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, better products.

Universal life insurance is more flexible and less expensive than whole life because policyholders have more control over the policy’s cash value. For instance, they can use the cash value to cover premiums if they need to suspend or reduce their premium payments.

Most policies also let you reduce the policy’s death benefit to cut costs. You can usually borrow against the savings account. However, these actions can slow the growth of the policy’s cash value.

Universal life worked great at first. But then it didn’t.

Insurers assumed that interest rates would stay at the 1980s’ abnormally high rates. They projected that the earliest universal life policies would earn interest rates of 10 percent to 13 percent annually. They also illustrated the much lower minimum guaranteed return, but agents assured customers that rates would never go that low.

Yet rates did go that low, and for the last decade or so, policyholders have probably been getting the guaranteed minimum rate, perhaps 4 percent. And the policy’s cash value has grown far more slowly, often with disastrous effects.

Some insurers have told policyholders they’ll have to pay much higher premiums to keep their policies in force. But many retirees won’t be able to pay them easily.

First, understand your situation.

So, if your policy is failing, what are your options?Review your annual statements closely. Determine whether your policy’s cash value has increased or decreased. If it has decreased, how quickly has its value declined year over year?

Be proactive.

If your policy is in danger of lapsing, your insurer should indicate how much additional premium payment is needed to keep the policy in force. It should also tell you how soon the policy will lapse without further payments. You’ll find this information either in the statement itself or in correspondence from your insurer.Even if your policy isn’t in danger of lapsing, don’t wait for bad news. Request an updated policy illustration built on the following assumptions:

• You continue to pay your current monthly or annual premium.
• Your policy only earns the minimum guaranteed interest rate (typically between 4 and 5 percent).
• The maximum expense charges will be deducted annually from now on.

This serves as 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.

Consider dropping or exchanging the policy if you no longer need insurance.

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 evaluate your policy’s performance and advise you on the best course of action for your particular circumstances.The main purpose of life insurance is to provide protection for your loved ones in case you die early and deprive them of your income. If you’re retired and have finished paying for your children’s educations, the policy has likely served its purpose and you may not need it.

While it is frustrating to surrender a policy or let it lapse after paying years of premiums, don’t let the “sunk costs” affect your course of action.

One possibility is to surrender the policy and receive the cash value in it. Depending on how much remains, you may owe tax on the distribution.

If there’s still a lot of money in the policy, surrendering it could cause a substantial tax hit. But there’s a way around it. You can exchange a universal life insurance policy for a different life insurance policy, such as a whole life policy, or an annuity tax-free. This is called a Section 1035 exchange.

Keep your policy; consider reducing the death benefit to reduce premiums.

Another possibility is to let the policy lapse once the cash value has been exhausted—especially if paying higher premiums would break your budget.If you are in poor health and it seems likely the policy will pay out soon, it may be worth maintaining your universal life policy. If your budget allows you to pay the higher premiums needed to maintain the full death benefit, this may not be a hard decision.

Takeaway

Many insurers will let you substantially reduce your death benefit, and thus your premiums. This can be a good way to maintain your policy and still get some benefit from it. While you may no longer need the original death benefit, a smaller benefit can be valuable to cover specific expenses, such as funeral costs.Don’t let your potentially failing Universal life insurance policy become an issue. You brought it in the first place to provide peace of mind for you and your family, and if you tackle the issue right life insurance can still do just that. Make sure you understand your situation, and are proactive about it, and you’ll be able to determine whether or not you have to adjust your policy or exchange it for a new one altogether. Make your life insurance work for you, not against you.

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Shomari Hearn is managing vice president of Palisades Hudson Financial Group in Fort Lauderdale, Florida. He holds the Certified Financial Planner (CFP®) and IRS Enrolled Agent (EA) designations.

Palisades Hudson Financial Group is a fee-only financial planning firm and investment manager based in Fort Lauderdale with $1.4 billion under management. It offers financial planning, wealth management, and tax services. Its Entertainment and Sports Team serves entertainers and professional athletes. Branch offices are in Stamford, Connecticut; Atlanta, Georgia; Portland, Oregon; and Austin, Texas. The firm’s daily blog and monthly newsletter covering financial planning, taxes and investing are online at www.palisadeshudson.com.