“Adopt the pace of nature: her secret is patience.”
– Ralph Waldo Emerson
Permanent life insurance is a descriptive term for policies designed to remain in force for the entire life of the insured. Most permanent life insurance policies (such as whole life, variable life or universal life) also feature a cash value account, and this unique combination of a lifetime insurance benefit and tax-deferred accumulation can be a very valuable asset in a comprehensive financial program.
However, maximizing the benefits from permanent life insurance requires some thoughtful planning and on-going management. It is a long-term financial product, one designed to deliver greater returns later in its lifetime. Therefore, permanent insurance must be maintained to ensure that it is, indeed, “permanent.”
The Challenge of Funding Permanent Life Insurance
A significant practical challenge with permanent life insurance policy is simply continuing to pay the premiums. In a June 9, 2012, Wall Street Journal article, Leslie Scism notes that “Many buyers underestimate how difficult it can be to pay the premiums year after year, and they end up canceling their policy before they break even.” To prove the point, she quotes a December 2011 study from the Society of Actuaries that “20% of whole life policies are terminated in the first three years, and 39% within the first 10.”
While the article provides no details on why policies are terminated, the point remains valid: In order to fully realize the benefits, a permanent life policy must remain in force.
Building “Equity” with Permanent Insurance
Although the comparison isn’t perfect, buying a permanent life insurance policy is analogous to taking out a mortgage, in that an amortized payment (the monthly mortgage or insurance premium) secures the ownership of a much larger asset (the real estate or the insurance death benefit). Eventually, the house is paid off, or the insurance benefit is paid to the beneficiary.
In both mortgages and permanent life insurance, early payments are proportionally weighted toward expenses, and only later tip toward accumulation (home equity and cash value). In the case of a permanent insurance policy, it may take 15-20 years for cash values to exceed total premiums paid, depending on dividends* paid or investment returns on the cash value.
And not unlike long term real estate values, which (until recent years) tend to appreciate over time, the value of the death benefit of a whole life policy also increases over the years. In this way, continued premium payments not only keep the policy in force, but a portion of the continued payments is eventually recaptured.
When deciding on the length of a mortgage, most consumers understand that longer mortgages mean lower payments, but also slower accumulation of equity. The prevailing standard is 30 years for a personal residence, though most mortgage lenders offer shorter and longer terms, allowing borrowers to tailor mortgages to personal preferences.
With permanent life insurance, the prevailing period of premium payments is the lifetime of the insured (hence, the term “whole life”). But consumers should be aware that, just like mortgages, other time periods are available for funding a permanent life insurance plan. Among the possibilities:
Single-premium life insurance. It is possible to obtain a permanent life insurance benefit and pay just one premium. Compared to a standard whole life policy with annual premiums, the single-payment amount will be significantly higher. But the cash value accumulation will also accrue more rapidly – in some policies, cash value may exceed the initial premium in the policy’s second or third year.
The cash values in single-premium policies are subject to slightly different tax treatment compared to most permanent life policies**, and depending on individual circumstances, this may be a disadvantage. However, individuals with substantial liquid assets may find it desirable to secure a permanent life insurance benefit through a simple one-time asset transfer.
10-pay and 20-pay life insurance. Instead of planning to pay premiums for a lifetime, most life insurance companies offer policies that can be paid-up in shorter periods, such as 10 or 20 years. As with a mortgage, a shorter payment term means a larger outlay, but “equity” (or, cash value accumulation) accelerates as well. An illustration of projected values for a 10-pay policy will typically show cash values not only exceeding premiums paid at the end of the 10-year period, but often providing a rate of return comparable to other conservative, guaranteed investment choices.
Unscheduled paid-up additions. This feature allows a policyholder to make irregular additional deposits to the policy, increasing both cash values and the total insurance benefit. Similar to extra principal payments that retire a mortgage early, unscheduled paid-up additions can be used to pay up a life insurance policy ahead of schedule.***
A Life-Long Strategy for Keeping Life Insurance
For some people, one of the best ways to meet present needs for life insurance and maximize the long-term value of life insurance may be to purchase a large term insurance policy with generous conversion privileges. This strategy works well for consumers who have high needs for insurance earlier in life accompanied by limited cash flow (for instance, when children are living at home).
The conversion provision allows the policyholder to convert some or all of the existing term insurance to a permanent policy (or policies) at a later date (or dates) without requiring new underwriting. Depending on the terms of conversion, this switch to permanent coverage could occur all at once, or in several transactions over time, using one or more of the options listed above.
For those with a long-range financial vision, this strategy of buying term then converting is a cost-effective way to obtain a life insurance benefit now, and retain the option to maximize its value at a later date.
*Dividends are not guaranteed, and are declared annually by the insurance company’s board of directors.
**A Modified Endowment Contract (MEC) is a type of life insurance contract that is subject to first-in-first-out (FIFO) ordinary income tax treatment, similar to distributions from an annuity. The distribution is also subject to a 10% tax penalty on the gain portion of the policy if the owner is under age 59 1/2. The death benefit is generally income tax free.
***(Note: The IRS has strict guidelines on the tax treatment of cash values. Paying up a policy too fast might mean forfeiture of the tax advantages of cash values. Expert assistance is essential when using paid-up additions to shorten the period of payments.)
IS YOUR LIFE INSURANCE PROGRAM BUILT TO LAST?
If you are looking for permanent solutions, now is the best time to connect with your financial professionals and weigh your options. Call Partners for Prosperity Inc. or your own Prosperity Economics advisor today to identify the ideal strategy for keeping your life insurance permanent.