“The grass isn’t always greener on the other side.”
—Ricky Gervais

There is a concerning movement now in our industry, in which some insurance agents and financial advisors are contacting policyholders (both their past clients and people they have not worked with before) and trying to talk them into “exchanging” their life insurance policy. This question of whether or not to exchange an older (usually Whole Life) policy for a newer (usually Indexed Universal Life) policy has come up with several clients lately, so I wanted to address it here for all our readers.

Let’s start by defining what we mean when we speak of “exchanging” a life insurance policy. We are referring to a 1035 Exchange (or a Section 1035 Exchange), which is a provision in the tax code which allows a policyholder to transfer funds from one life insurance policy, annuity or endowment to a new policy, annuity or endowment—without having to pay taxes.

The 1035 exchange is to a policyholder what a 1031 Tax Exchange is to a real estate investor, and the principle is the same: By exchanging an asset for a comparable, “like” asset, the exchanger is granted immunity from the otherwise taxable event that would be incurred upon the sale of the first asset.

With a life insurance policy, cash grows tax-deferred (tax-free if policy stays in force until death). If you liquidate your policy and do not roll the cash value into a new policy or annuity via a 1035 exchange, you’ll pay taxes on the gains, much like you would if you cashed out your 401(k) or IRA.

So if you could exchange one life insurance policy for a new one without taxation, would it make sense to do so? Several “sub-questions” lie underneath:

• Is there something wrong with my old whole life policy?
• Are there “new and improved” policies available now that I should take advantage of?
• Should I trade in a Whole Life policy for an Indexed Universal Life policy?
• Should I trade in a Universal Life policy for a Whole Life policy?
• Why do some advisors recommend 1035 exchanges?

Now, let’s shed some light.

Disadvantages of Exchanging a Whole Life Insurance Policy

First of all, there is rarely a good reason to replace an older Whole Life policy. Assuming it was purchased from a reputable dividend-paying mutual company—and you still have a desire for cash value savings and a death benefit—your existing policy is likely the best financial vehicle possible. (This is the same advice we give whether or not the policy was obtained through us, and yes, we have defended policies written by other advisors and agents, because it’s the right thing to do.)

You would never want to replace an older policy with a newer one unless you had a strong reason to do so, as in some ways, an older policy is better than a newer policy. I say this for few reasons:

Efficiency. The cash value in a policy becomes more efficient after the first couple of years, because the policy costs in a permanent life insurance policy are basically “front-loaded.” This is logical, since life insurance companies risk big losses in the early years of a policy. So it takes a life insurance policy takes a few years to gain momentum and be cash flow positive.

After the first few years of a policy, the annual increase in cash value exceeds the annual premiums paid. Now the “funding phase” of a policy is complete, and it’s full speed ahead! But if you exchange an older policy for a new policy, you’ll have to go through the funding phase again, paying policy costs and building momentum.

Premium cost. If you started your policy 5 or 10 or 20 years ago, you were younger, possibly healthier, and probably had a longer life expectancy than you do today. Thus, the premium was likely lower than a new (and otherwise comparable) life insurance policy would be now. You’ll essentially be starting from scratch on the death benefit, which was also being built (along with cash value) by your premium payments.

Contestability. If there are any contestability clauses in your old policy, you’ll be restarting the clock on those timelines.

The lump sum problem. Although a lump sum can be put into a Single Premium Whole Life (SPWL) policy—and if the dollars came from a non-MEC (Modified Endowment Contract) policy, the new SPWL policy would also not be a MEC—it is not always simple or advisable to try to put a lump sum into a life insurance product.

Yes, there MAY be some “new and improved” policy benefits available now that might not have been an option when you obtained your policy, such as long-term care riders, which are now available in nearly every state. However, we still wouldn’t recommend exchanging a good whole life policy for a new one to obtain an extra rider, due to the reasons listed above. If you want more coverage, a new rider or increased savings, it’s better to add policies rather than replace policies. (In my family, we purchased a new additional policy with a long-term care rider, and gave ourselves another “bucket” to save in!)

No, do NOT trade in your Whole Life policy for an Indexed Universal Life (IUL) policy!

IUL policies promise “downside protection with upside potential” and are linked to the performance of stock market indexes, with capped highs and a minimum interest rate floor. This is a big topic that may deserve a longer dedicated article or special report, but there are several points worth making here:

IUL policies lack essential guarantees. A whole life policy has a guaranteed level premium, a guaranteed death benefit, and a guaranteed minimum cash value amount. (It doesn’t matter what rate your cash value is earning if you have little to none of it!) Some IULs are now purchased with guaranteed death benefit riders—the result of many failed UL policies—yet the fine print and minimum (or missing) guarantees are not reassuring. Despite the rosy illustrations, UL and IUL policies transfer the risk of rising costs, underperforming markets and changing interest rates to the policyholder.

Unrealistic illustrated returns. New regulations have forced insurance companies selling IULs to adjust illustration practices, but many say this has not solved the problem of “unrealistic high gains.” Jason Konopik, an industry insider who actually helped companies create IULs, warned in a 2013 AMZ Financial Services article that agents who don’t adequately understand the product risk “making promises to clients that will never be realized.” And according to Evans Law, a firm that represents policy buyers who feel they’ve been scammed, it’s common for prospects to be shown shameless illustrations projecting 8-12% annual gains.

Changing terms. Even if the illustrated return is close to accurate, things can change. According to the PennMutual website, “Be aware of the ‘moving parts’ in your policy. Many companies reserve the right to change policy floors, caps, participation rates and persistency bonuses at any time.” As Konopik puts it, “IUL is a non-guaranteed product and as an actuary who has worked with the pricing actuaries at many carriers, I can guarantee you one thing – insurance companies won’t lose money on a non-guaranteed product.”

Possibility of loss. IUL policies have minimum (and maximum) interest rates for cash value earnings, with common policy “floors” of 0%, or perhaps 1 or 2%. This minimum interest rate is calculated before policy costs. If you have a zero percent floor and costs of 2% or more, your policy will lose value, in spite of the “downside protection” rhetoric. (Plus, you’re losing to inflation in weak market years.)

Rising costs. Since mortality costs (the cost of the life insurance portion of a policy) are not guaranteed as with Whole Life policies, policyholders can expect insurance costs—and premiums—to increase over time. Advises EvansLaw.com, “Potential buyers should be cautious about the Indexed Universal Life policies itself, not just the fact that projected potential gains may be higher than reality. Insurance expenses increase over the course of the holder’s lifetime… by the time the holder passes away, insurance expenses for Indexed Universal Life policies will likely have increased exponentially…”

Lawsuits. There are several existing and potential lawsuits involving Universal Life and Indexed Universal Life insurance, including two against TransAmerica. Currently, ClassAction.org is looking for plaintiffs for possible lawsuits against Axa Equitable and Pacific Life. The Evans Law website invites IUL policyholders of eight different insurance companies to contact them. (We work with none of these companies. We only do business with established Mutual Life Insurance companies who have paid annual dividends for over 150 years.)

While many Universal Life and Indexed UL policies do remain in force and pay death benefits, we don’t recommend them and don’t find their risks reasonable.

What about exchanging an old UL/IUL policy for whole life?

This can work. However, the problem with this idea is that there is rarely much if any cash value to exchange! Sometimes the best move is to simply shrink the policy death benefit to the minimum amount, keep it funded adequately for the death benefit, and monitor it carefully.

As you’ve probably figured out, we’re not big fans of 1035 Exchanges, although there can be situations in which one might make sense. Which may leave you wondering…

Why do so many agents and advisors recommend 1035 Exchanges?

Of course it’s a source of business, and perhaps easier to ask someone to buy a product with money they’ve already saved than to commit to paying for a new policy. Many are honestly swayed by their training that they are doing a good thing by convincing a client to scrap their boring old Whole Life policy for a newfangled IUL. But we have examined too many problematic policies to believe this in the best interest of our clients.

One product doesn’t meet all needs.

Ultimately, Indexed Universal Life is an attempt to get ONE financial product to meet four major needs of an investor:

• a place to save and store cash where it can outpace inflation
• a vehicle that can grow assets with minimum downside risk
• a vehicle for eventual cash flow or retirement income
• protection against loss.

However, an IUL is not the best product for all of those purposes! Investors will benefit from multiple financial products that can meet each need better. And while whole life insurance is our top pick for saving and storing cash while also protecting against loss (we also recommend convertible term policies), life insurance alone isn’t the most effective investment for growth or cash flow.

What DO we recommend then?

I spell it out in the complimentary ebook I wrote with Kate Phillips, Financial Planning Has Failed. Get your copy here now.