Tax-Free Exchange of Life Insurance Policies Meant for Retirement? A Case Study.

Let me state up front that I'm not a big fan of cash value life insurance. In my mind, permanent (i.e., cash value) life insurance is best suited for permanent needs (such as liquidity needed to pay estate taxes). Most other life insurance needs, such as the need to replace lost income, can be dealt with through term insurance (and, today term policies can be found for very long periods, and with conversion privileges just in case the need becomes permanent.

But, cash value life insurance has another attribute - protection from claims of general creditors, at least in many states.

While some states (Florida, for example) offer a generous exemption from creditor claims for homestead, and some states offer protection from creditor claims for annuities, a much larger number of the states offer protection from creditor claims for the cash value of life insurance policies. In a state where other exemptions are limited, such as Kentucky, a person engaged in a high-risk profession (such as certain medical practices) might well decide to contribute to a cash value insurance policy over time.

(Arguably other asset protection strategies, such as the use of limited liability companies, certain types of asset protection trusts, should also be explored. But these were not that common 25 years ago, and even 15 years ago, when the physician took out these life insurance policies.)

Often life insurance is sold as a retirement funding vehicle. The general principle is that withdrawals can be made from life insurance policies up to the amount of the cost basis (generally, the sum of premiums paid for life protection, but not for certain riders). Thereafter loans can be taken from the policy.

Care has to be taken in such instances that the life insurance policy does not become a Modified Endowment Contract (MEC). If MEC status results, then any withdrawals become subject to income tax, to the extent of gains in the policy. Most life insurance policies are designed to avoid MEC status by meeting the "7-pay" test.

After the seven-year requirement is met, further testing to avoid MEC status is generally not required. But, if modifications are made to the policy to increase the death benefit, or (in certain instances) to decrease the death benefit, MEC status should be tested (before making the changes).

Recently I had the occasion to opine on four cash value life insurance policies for a physician. Two were whole life policies, and each policy had been in force for more than 20 years. Two were variable life policies, and both of these were 14 years old.

The physician was close to retirement. Premium payments had been made annually on all of the policies. The policies were issued by an extremely strong life insurance, in terms of financial strength. The insurer was a mutual insurance company. Strong dividends were paid, the result of both a conservative yet effective investment portfolio maintained by the insurer, as well as close attention to underwriting. The physician's long-time insurance agent stood by to assist with the changes needed to the policy, and was ready to assist with its defunding over time by obtaining new illustrations and, as necessary, obtaining testing of changes to the policy by the insurance company to ensure that Modified Endowment Contract status would not result.

Of course, some changes were needed in the way the existing policies were structured. These changes should have been considered several years before, in my view. Such as reduction in the death benefit, to reduce mortality charges. Eliminating paid-up additions (PUA), not needed. Possibly choosing to have future dividends distributed, rather than re-invested, upon entering retirement. The variable life insurance investment choices made for an all-equity portfolio in the policies, with a growth tilt; a more evidence-based investing strategy could have been deployed and should be deployed now.

With proper restructuring (in a manner that would not result in MEC status), cash-free withdrawals up to the cost basis of the policies could take place (along with further reductions, at such times, of the death benefit).

Thereafter, loans could be taken against the policy; however, at the present time the spread between the loan rate and dividend rate was 2.5%. Any large amount of loans could easily trigger a lapse of the policy. But, consideration could be given to a tax-free exchange to a form of annuity contract, as a means of avoiding concerns about lapse, while still accessing the policy's cash in full. (Annuities are not protected, except at minimal levels, from claims of general creditors in Kentucky; hence, any rollover to a low-cost, no-load annuity should not be done for many years - i.e., until the possibility of creditor claims was far less.)

While the strategy above is well-known, managing the policy during the retirement (decumulation) period can prove to be difficult. Far too many horror stories exist of policies that lapse and cause tremendous income tax burdens.

And, while this strategy does have its proponents, from a pure investment standpoint investing in low-cost, passively managed investments using a moderately conservative investment strategy, and purchasing term insurance, nearly always results in far superior returns over the long term. Why? Because the relatively high fees and costs of permanent cash value policies affect their returns.

In this case, such fees and costs might be considered the price of "asset protection."

At this point another insurance agent entered the picture. Things got more complicated.

In fact, this is why the physician contacted me.

Another insurance agent had provided the physicians illustrations for a "new" type of policy - an equity indexed universal life (EIUL) - that could provide better returns than the existing four policies, combined. The insurance agent proposed an EIUL policy funded by a tax-free exchange of the existing policies, plus tens of thousands of dollars a year in additional premiums for several years. The death benefit of the policy would be about four to five times the total premiums paid.

Why did the new insurance agent recommend this new policy? Because the investment returns in the EIUL policy "would be better." Equity indexed products are also touted for their downside protection - "you can't lose money in them" was what the physician recalled being told by the new insurance agent.

Ahem ... wait a moment, I beg to disagree.

Let me point out that the surrender fees on these policies approached 20% of the cash value of the insurance policies. And that these surrender fees would decline slowly - but would only terminate after 15 years. (Those surrender fees largely go to recoup the commissions paid to the insurance agent, paid mostly upon the sale of this product and when additional premiums are paid.)

Let me also point out that mortality expenses (the cost of insurance) and other policy charges result in a drain against the policy, if the investment returns are zero in any year. (As would occur, under the policy terms, if an index option was chosen and stock market returns were negative.)

Also ... (1) life insurance companies can decrease the participation rate; (2) companies can and do impose caps on the upside potential; and (3) index returns don't include dividends paid by companies in the index. Other restrictions exist which may limit the actual returns. In essence, the insurance company has shifted much of the investment risk to the policy owner. And the insurance company had a great deal of control over the policy's terms.

But, alas, insurance agents will no doubt point out that the EIUL product should be considered a "fixed income investment" and should be only compared to other fixed income products, like C.D.s. The comparison isn't a good one, since most CDs are FDIC-insured. There is a risk of loss if an insurance company defaults - which does happen.

Of course, if the insurance agents want to "compare" to another "fixed income" investment - how about the existing whole life policy, paying a nice 5.5% dividend, that the client had now?)

The physician requested that I evaluate the new insurance proposal. It was a no-brainer.

There was no need to pay a new agent many tens of thousands of dollars in commissions. There was no need to incur a new surrender charge period, and effectively hamstring the ability of the physician to undertake cash withdrawals from the new life insurance policy for many, many years. There was no need to abandon the outstanding financial strength of the current insurance company nor the excellent experience ratings found within the policy.

Fees and costs matter. Even in cash value life insurance policies.

While EIUL policies have performed well over the past 15 years, during these highly volatilie markets, there is no assurance that the underlying strategy behind EIUL policies (invest in fixed income investments, use part or all of the interest to purchase call options on indices) will work well in future years.

Don't get me wrong. I think the investment strategy of investing in fixed income investments, and using the interest earned (or part thereof) to purchase call options on an index, is a valid one. The costs of implementation of this investment strategy, in this instance, were just far too high.

But - was attention being paid to other financial planning needs? To other investments? To asset protection?

Kentucky is unusual in that, due to a Kentucky Supreme Court decision, there is no absolute time limit to filing a medical malpractice claim. There is a time limit from when the injury should have been discovered. But, unlike states that possess a 10-year or 12-year absolute time period for bringing claims, Kentucky has no such absolute limit.

Obviously, the client had other accounts. Qualified retirement plan accounts. The client's spouse had taxable accounts. With retirement approaching, a tax-efficient withdrawal strategy was needed, so as to take advantage of the potentially lower marginal income tax rates in future years.

And, of course, the timing and method of undertaking social security retirement benefits was a key decision for this couple.

The new insurance agent had not spoken of the need for comprehensive planning, nor of planning for a tax-efficient decumulation strategy with all resources looked at, rather than looking at each asset in isolation.

A fiduciary perspective ...

The new insurance agent was doing what he was trained to do - sell life insurance. And the marketing strategy (tout the wonders of EIUL policies) was one that, no doubt, generated substantial sales and a most comfortable living for the insurance agent.

This physician was astute. The physician didn't sign off on the new policy, when it was presented. But the physician may have done so in the future, had we not had a chance encounter at a reception, and had the physician not shared with me the physician's concerns about whether to go with the new policy or stick with the old ones.

Also, as I asked questions of the physician, I discerned that the physician was unaware that neither insurance agent, in this instance, was obligated to act in the physician's best interests (i.e., under a non-waivable fiduciary duty of loyalty). The physician "trusted" both agents, even though neither was a fiduciary, and the insurance agent-customer relationship was an arms-length one.

Without my fortuitous intervention, the physician may well have: (1) made a costly mistake upon entering retirement, losing tens of thousands of dollars to new commissions and other fees; and (2) not restructured the existing policies to reduce the fees and costs of these to lower levels, thereby enabling a better outcome (as to the policy growth and ability to withdraw funds from same).

The physician here was lucky. To receive advice from a fiduciary. To receive truly objective advice.

Most consumers are not so lucky.