Q: Several years ago, my mother purchased a variable universal life insurance policy to help defer estate taxes when she dies. Fortunately, she has lived much longer than she would ever have expected (she is now 92 years old.) Unfortunately, the cash value of her policy has evaporated and we face the prospect of having to pay the annual premium out of pocket. The death benefit is worth several hundred thousand dollars, but the upcoming premium will cost more than $75,000 and next year it will be even more. Should we keep paying the premium, or should we let the policy lapse?
A: The answer depends on several factors, including the size of your mother’s estate. The new tax law raises the estate tax exclusion for individuals to $11.18 million in 2018. It may be that the original reason for the insurance policy no longer exists.
Your question raises a very important point about variable universal life (VUL) policies. Many policy holders faithfully pay their premiums for years only to wake up one morning and discover that their cash value has suddenly “evaporated” and their policy is about to lapse. Of course, there was nothing sudden about it except their new-found awareness. In most cases, they had been stuck for years in what I call the VUL death spiral. They just didn’t know it. Here’s how it works.
Universal life insurance combines permanent life insurance with a savings element. Part of the premium you pay covers the cost of insurance, including mortality and administrative costs—everything the insurance company needs to insure you for your death benefit. The amount of your premium beyond the cost of insurance goes into the savings element of your policy known as cash value. The cash value earns a return based on market interest rates.
Variable universal life is a variation on the universal life theme. With VUL, instead of earning a return based on market interest rates, your cash value is invested in one or more sub-accounts. Sub-accounts are very similar to mutual funds and, like mutual funds, their value fluctuates with the movement of the underlying markets.
VUL policies were popular in the wake of the strong stock market of the 1990s. Many people bought VUL policies with the expectation that cash values would grow large enough to eventually cover the high cost of life insurance in their old age. But things changed. Between January 2000 and January, 2010, the S&P 500 stock market index suffered a rare ten-year loss. The drop in the stock market meant the growth in the cash value of VUL policies didn’t keep up with the rising cost of insurance. Many policy holders used more cash value than expected to subsidize premium payments. This left less cash value to invest to offset future increases in the cost of insurance requiring even larger draws on cash value to offset the rising cost of insurance. This is what I mean by a death spiral.
A VUL policy caught in a death spiral will self-liquidate much earlier than originally anticipated unless the policy holder is willing to pay out-of-pocket for the rising cost of insurance. Holders of VUL policies should do an annual checkup with their insurance broker or financial advisor to see how rapidly their cash value is dropping. If you act early enough, you may be able to roll your cash value into a more stable insurance vehicle using what is called a 1035 exchange.
Steven C. Merrell MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey. He welcomes questions that you may have concerning investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to: firstname.lastname@example.org