If youâre in that situation, you do have choices, but they involve trade-offs. But before we discuss potential solutions, letâs look at what caused the problem.
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 is more flexible and less expensive than whole life because policyholders have more control over the policyâs 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 policyâs death benefit to cut costs. You can usually borrow against the savings account. However, these actions can slow the growth of the policyâs cash value.
Universal life worked great at first. But then it didnât.
Insurers assumed that interest rates would stay at the 1980sâ 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.
But 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 policyâs cash value has grown far more slowly, often with disastrous effects.
Some insurers have told policyholders theyâll have to pay much higher premiums to keep their policies in force. But many retirees wonât be able to pay them easily.
If your policy is failing, what are your options?
Review your annual statements closely. Determine whether your policyâs cash value has increased or decreased. If it has decreased, how quickly has its value declined year over year?
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. Youâll find this information either in the statement itself or in correspondence from your insurer.
Even if your policy isnât in danger of lapsing, donât wait passively for bad news. Request an updated policy illustration built on the following assumptions:
This serves as a âstress testâ 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 policyâs death benefit or both.
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 policyâs 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 youâre retired and have finished paying for your childrenâs 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, donât let the âsunk costsâ 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 thereâs still a lot of money in the policy, surrendering it could cause a substantial tax hit. But thereâs a way around it. You can exchange a 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.
Another possibility is to let the policy lapse once the cash value has been exhaustedâespecially 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.
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.
Shomari Hearn is managing vice president of Palisades Hudson Financial Group in Fort Lauderdale, Florida.Â He holds the Certified Financial Planner (CFPÂź) and IRS Enrolled Agent (EA) designations.Â
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.Â