| 03 January 2012
Life insurance is a set-it-and-forget-it type of thing. Most view life insurance as a topic that only needs to be revisited if something major in life changes; like marriage, the birth of a child, to pay estate taxes, or for a buy/sell agreement with your company. In general, this might be okay if all you purchase is term insurance (and even then, a more formal review might save you money). But if you have a policy with a cash value component (permanent insurance like whole life, universal life, or variable universal life), an annual review is more likely needed. This is especially true in a low interest rate environment.
Few understand the inner workings of a permanent life insurance policy, but it is really pretty simple. There is an insurance component (kind of like term insurance), and then there is a savings component (cash value). The insurance component charges for the insurance, and that cost is taken out of the cash value. On top of that, other policy fees will be taken from the cash value. The interest paid on the cash value (or if it is a variable policy – i.e. stock market investments – the gains) is credited to the account in regular intervals. In an annual review, part of the emphasis should be on the insurance component – do you have enough for your goals? But just as large a part of the review should be spent on the cash value, since underperformance in cash values will ultimately lead to bigger problems.
Three moving parts need to be understood about cash values:
- Crediting Rates – Insurance policies typically will have two different methods to credit the cash value with interest. The first is a guaranteed rate – a floor rate that the insurance company must do as a minimum. In many policies that might be three or four percent. The second is a current rate – this is a rate based on current interest rates, which historically has been higher than the guaranteed rate. In today’s low interest rate environment, however, insurance companies are not making as much on their bond portfolios so they might be paying only the guaranteed rate (they get to decide this annually so you cannot assume to know the answer unless you check annually).
- Insurance Costs – While you might not see it inside a permanent policy, the cost of insurance will go up with age. There are ways to reduce that cost, but if you have the same amount of insurance at risk, you will have increasingly higher costs. Thus, as you age, more and more money is pulled out of the cash value side.
- Premiums – Insurance policy illustrations are typically run showing a level premium for the life of the policy. This means we all assume the premium never increases. Yet if you think about it, early on when the insurance costs are low, you are basically overpaying by putting more in the cash value than is really needed so that down the road, as insurance expenses rise with age, there will be enough cash to cover the shortfall of a premium that did not rise.
Knowing these three moving parts, now think about the effects of a low interest rate environment; the crediting rate drops to the guaranteed minimum, yet the cost of insurance might be increasing, and your premium has stayed the same. Eventually what happens in this scenario is that the policy could run out of money, possibly when you need it most, and you could lose the insurance. The way to avoid this would be to add more money to the policy or to reduce the amount at risk (i.e. the amount of insurance). And that is the key to an annual life insurance review – if you catch problems early, you can work with the different options to have the most impact with the lowest amount of disruption to your cash flow or ultimate goal for the insurance.
Life insurance is not fun to talk about and most people have never heard from their agent once the policy was sold to them. Yet life insurance is a tool that can be used very effectively, and provides a lot of leverage, if it is maintained properly. Do not just set-it-and-forget-it, be proactive in 2012 and get it reviewed so that you there are no surprises down the road.
Jon T. Meyer, CFP® is the President of Boeckermann, Grafstrom & Mayer Wealth Management, LLC, a Minneapolis-based Registered Investment Advisory firm. Jon specializes in working with retirees and individuals nearing retirement to help them create the income they need in retirement by utilizing advanced social security planning, tax planning and investment strategies. For more information visit www.bgmwealth.com.
