By Richard A. McGrath, CIC, LIA
Record low interest rates are great for home buyers, the federal government and anyone else who has had to borrow money. They’re not so good, though, for owners of universal life insurance.
Over the next few years, if interest rates remain low, owners of universal life insurance that was purchased years ago when rates were high will face an unpleasant choice:
- Paying more money for their insurance
- Accepting a lower death benefit
- Walking away from the policy, and getting nothing in return for the many years of premiums that were paid
Such insurance policies were created based on the premise that interest rates would remain somewhere close to their historic average. They haven’t. As a result, insurance companies are not generating enough income to cover their costs.
Universal life insurance has been a popular alternative for many, because under normal circumstances it can be self-sustaining. As “cash value” insurance, it builds value over time and that value can be used to pay premiums. But interest rates have been so low, universal life policies have not had the opportunity to build the value they need to build to be self-sustaining.
Premium payments above the current cost of insurance are credited to the cash value of the policy. Cash values from universal-life policies are invested in fixed-rate accounts and each month the policy is credited with interest earned and debited for the cost of insurance and any other fees of policy charges.
Interest rates credited to the cash values are regularly subject to change. The policy holder generally receives interest at close to market rates, so universal life is most attractive when interest rates are rising.
In addition, gains in cash value are not taxed until they are withdrawn, so the insurance can provide an attract vehicle for saving for retirement, while also providing protection for the wage earner’s family by providing a death benefit.
When insurance agents sell universal life, they provide three illustrations, showing what the policy will be worth in a “best case” scenario, a “worst case” scenario and a scenario in between the two extremes. Before 2008, no one could have predicted that interest rates would be near zero percent for several years and with no plans to increase them, so reality has been even worse than the “worst case” scenario.
The net result is that owners of universal life insurance should meet with their insurance agents, ask for updated illustrations based on today’s rates and consider whether a change in coverage is in order.
Many people will be affected, as universal life insurance is a popular insurance alternative. In 2008, about 40% of life insurance premiums came from universal life, according to The Wall Street Journal.
Those who own universal life insurance and who will be affected by continuing low interest rates have several options, but it’s best to make an informed decision.
Ask your agent for an updated “in force” illustration showing how the policy’s cash value will change based on current interest rates, premiums and charges. You may also ask for a projection that shows how the cash value would be affected if the interest rate dropped to the minimum and mortality rates stayed the same.
This will tell you how much extra you will have to pay in premiums to keep the insurance in force. Be sure to consider the cost not just for the immediate future, but for years ahead, keeping the rising cost of insurance in mind.
Remember, too, that interest rates will not remain low forever. While The Federal Reserve Board’s quantitative easing policies have brought rates to historic lows, some on the board have been talking about ending the program, which would cause interest rates to rise.
Once you have reviewed the illustrations, you have several options:
- Pay the higher premiums. If your policy has high interest rates and a low cost, it is worth continuing, even if you need to put more money into it. Keep in mind that cash value is building on a tax-deferred basis. If you elect to continue the policy as is, make certain you have money put aside for increased premiums, since you typically will have only 20 to 60 days to pay after the savings balance runs out.
- Overfund the policy. If the rate after accounting for fees is higher than you can get elsewhere, you may even want to overfund the policy. Universal life offers the flexibility to adjust premiums from one year to another, as long as there is sufficient cash value to cover insurance charges, fees and expenses.
- Reduce the benefit. If you want the insurance, but can’t afford the higher premiums, downsize your death benefit.
- Cancel the policy. If you no longer need the insurance, cancel it. While you will lose the death benefit, keep in mind that the policy provided protection for you and your family for as long as you owned it. Fortunately, the death benefit was not needed.
- Shop around. Look at other options. You may be better off, for example, investing in whole life insurance, which provides a set premium for as long as you own the policy and pay the premiums.
Before making a decision, ask for your insurance agent’s advice. Your agent should be able to recommend the best alternative, based on your current financial condition, your insurance needs and the status of your universal life policy.
Richard A. McGrath, CIC, LIA is President and CEO of McGrath Insurance Group, Inc. of Sturbridge, Mass. He can be reached at firstname.lastname@example.org.
This article is written for informational purposes only and should not be construed as providing legal advice.