Should I Drop My Whole Life Policy? Case Study #11

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This is a common question from clients unsure about what they have and a common recommendation from agents seeking to earn a new commission. Yesterday I talked to a Virginia client considering dropping a Lafayette whole life policy which he had purchased eight years ago when an agent recommended he replace a 20 year old Northwestern policy. Earlier this month a local client’s Edward Jones advisor recommended he replace a 30 year old Northwestern whole life policy with a new John Hancock policy. All of these were bad ideas.

At least three things drive these costly mistakes:

  1. it’s difficult for the consumer to understand the value of a cash value policy, since it’s a mixture of insurance and investment.
  2. the entire industry moves on agents pursuing commissions which only happens when new policies are sold.
  3. some respected financial advisors, e.g. Dave Ramsey, make generalizations disparaging whole life insurance.

I am not a fan of whole life insurance and rarely recommend a new purchase. (Though some companies and specific policies are much better than others and there’s a small niche for these.) However there’s a dramatic difference in purchasing a new policy and continuing an old policy that’s beyond the high early year transaction costs. Just because I don’t recommend new purchases doesn’t mean that I endorse casually dropping old policies. This decision is influenced by your age, health, investing alternatives, and largely the caliber of your policy.

Yesterday’s client should keep the Lafayette policy. An in force ledger revealed cash value earning 4%, and he already had a lot of cash earning next to zero. His immediate priority is putting his low earning cash to better use. He should have never bought the Lafayette policy to replace a Northwestern Mutual whole life policy, but that’s water over the dam now, and at least this time he’s getting advice before acting.

My local client averted a mistake by asking for an unbiased opinion first. Replacing a 30-year-old Northwestern policy with a new John Hancock policy would have only profited the agent.

Consumers don’t recognize commissions on a whole life policy are one to two year’s premiums (!), a flagrant violation of John Bogle’s eternal triangle principle of minimizing cost. It’s usually impossible for improved nuances of a new whole life policy to overcome such a blow. Adding insult to injury, switching from Northwestern Mutual to Lafayette or John Hancock were steps down in quality, only underscoring the lack of discernment and/or self-interest of the agent.

There’s another valid perspective on whether to keep a whole life policy. Whereas the Lafayette cash value was earning a net 4%, and that’s very favorable compared to a savings account, it’s unfavorable compared to long-term stock market returns averaging around 10%. And make no mistake, a life policy is a long-term investment if kept until death.

However for both these clients the cash values were a minor portion of their assets much of which were already invested in equities. Also each had a lot of low-earning cash which became the most-likely-to-improve candidate. Had this not been the case, replacement was more of a possibility, but for the sake of putting proceeds in equity returns and certainly not to buy another whole life policy. Client context can swing the decision either way.

If you’re tempted to cash in an old whole life policy:

  1. Understand what rate of return is being earned on its cash value. (Not the published rate, but the real rate.) It’s usually higher than alternatives of similar risk.
  2. Agents recommending replacing old cash value policies with new ones are often the fox guarding the hen house. Rarely can improvements overcome new commissions.
  3. If a financial guru categorically suggests replacing any whole life insurance he is often throwing out the baby with the bathwater.

What’s the take-away from these cases? ASK before you ACT. The Virginia client’s mistake eight years ago was an uninformed response to an uninformed agent. This time he’s ASKING. The local client averted a similar mistake by ASKING upfront. It grieves me to see such waste so easily avoidable. Calculating the true rate of return on your current policy is child’s play for me and my charge is small potatoes compared to what’s at stake. Proverbs 20:18.

Corollary: ASK an IMPARTIAL source. Ironically the supposed authority, the licensed insurance agent, precipitated these mistakes.

Qualification: We’ve been talking about old policies. If a whole life policy is less than three or four years old (before transaction costs have been paid) it may be best to discontinue ASAP, after replacing with cheaper coverage first, dependent on several considerations.

Surrendering a Cash Value Policy? Don’t Waste the Loss

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I see many misguided initiatives to drop cash value policies, coming from a guru’s generalization that “all whole life insurance is bad”, or an agent’s effort to make a new sale.  Dropping a cash value life insurance policy warrants careful consideration: calculating the real (not nominal) rate of return, comparing alternative investing strategies, assessing the current health of the insured, one’s current need for death benefit, and the taxation upon surrender.

If the policy is a poor value, no longer needed, and without a taxable gain, the common advice is to surrender.  Not so fast.  If there is no gain there must be a loss.  How much is it?  Could it be used to offset the gain on other life policies or annuities?  Often it can by merging the losses on some contracts with the gains of others, via a 1035 tax-free exchange.

I recently had two clients who were dropping cash value policies at a loss: the surrender value was less than the cumulative lifetime premiums. Normally upon surrender no tax deduction is allowed.  However, both these clients also had annuities with gains. Annuity gains are tax-deferred until withdrawn, and then they are taxed as ordinary income.  I’m not a fan of annuities, but these were unusual. One client’s annuity was issued October, 2007 (market peak before Subprime mortgage crisis) with the guarantee it would double after 10 years. The insurer bemoaned the day it made that guarantee, but it’s an elite annuity that shouldn’t be dropped (until after it doubles), when it will have a large taxable gain. The other client had a Fidelity no-load annuity, also with a gain.

Both clients were “self-insured” through other assets, healthy, and their whole life policy cash values earned a low rate of return, so terminating them was appropriate. Standard procedure is surrender since there’s “no gain”. However, the loss can be rolled into the annuities to offset its gain which must ultimately be recognized.

If there’s a loan on the life policy it must be paid off first and this can be a problem since you don’t want to stuff more cash into the annuity, particularly if it’s a commissionable annuity.   However, one could open up a commission-free annuity (Fidelity or Vanguard), pay off the loan, and then roll over the life policy (with its loss) into the annuity.  Once the rollover is complete, the cash could be withdrawn from the annuity, at least if the annuitant is over age 59 1/2, or if the loss totally or at least mostly negates the gain.

Again, I don’t like annuities, where the tax wrapper becomes the major selling point while the investments within languish in less than optimum strategies and subject to high transaction costs for most.  I’m only suggesting using them as a temporary tax strategy, and then get back to better investing strategies.

Withdrawals from annuities, before age 59 1/2 are subject to the 10% early withdrawal penalty, to the extent of the taxable gain, and it’s gain out first.  However, the loss of the life policy would reduce and sometimes eliminate that gain, so this penalty may become moot.

It’s important to only use commission-free annuities such as with Fidelity or Vanguard.

In summary, here are the four ingredients to make this work:

A poor cash value policy you want to drop, with a tax loss.

  • An annuity or life policy with a gain or prospect of a gain.
  • Preferably over age 59.5.
  • A no-load annuity.

It’s a rare scenario that has all these elements, but with this happening with two clients in the same week, it may have broader application than I’d thought.

[I just did another case where “not wasting the loss” came in play, by retaining a whole life policy as a paid-up policy, since its cash value grew at 3.5%.  This client had no annuity with gains to offset, but an elite cash value policy.  This policy will be retained as an emergency fund substitute and until it’s loss becomes a gain (four of five years) the 3.5% return is essentially income tax free.  See, “Is Whole Life Viable for Anybody?” for the full story.]

“I am an Insurance Salesman”: The Necessity of a Second Opinion Case Study # 9

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I just finished a case that started as a call to the radio show, Money Wise. This listener’s agent encouraged him to replace a whole life cash with a new term policy and put the $45k cash value in an annuity. “Term is cheaper and the cash value will earn more”, sounded plausible. Mark Biller of Sound Mind Investing was the guest and recommended he call me.

First I evaluated the whole life policy to see if it needed replacing and then assessed his overall need for life insurance. The cash value was earning 3.87%, much higher than money in the bank, but lower than long-term equity investments. This wasn’t bad, but it was an inordinate amount of his net worth tied up in a relatively low long-term return.

He was no longer married, and had a 22 year old independent working son and 19 year old student daughter. He already had two good life policies: the 150k whole life and a 200k term policy costing only 342/yr with level premiums for another nine years, more than long enough to see his daughter to independence. The agent recommended a new $400k 20 year term policy costing 1492/year. He didn’t need insurance for 20 more years and he didn’t need that payment.

…there comes a time when emphasis needs to shift from the what-if-I-die scenario to the what-if-I-live scenario…

He had a Roth IRA which he hadn’t been able to fund in recent years. He also had 200k of debt. He’s in his young fifties and dedicated to his children, however there comes a time when emphasis needs to shift from the what-if-I-die scenario to the what-if-I-live scenario. Also, one should never fund an annuity (tax-deferred) when eligible but not funding a Roth (tax-free).

We returned the annuity and rejected the new term policy. The dividends on the whole life policy had bought paid up additional insurance which we surrendered for 13k of the 45k cash value. He will use that to fund his Roth for 2013 and 2014. We’ll keep the whole life at least until Roth funding is due for 2015, then maybe whittle it down further or discontinue it altogether if his daughter becomes independent. He’ll apply that extra $1492 to his mortgage.

I explained the rationale behind these decisions to the agent. He acknowledged it made sense, but then added, “I am an insurance salesman”. That code language meant, “My responsibility is to sell policies; besides I’ll forgo a $1k commission if I don’t place the life policy, aside from the $1500 commission I lost not placing the annuity.” I respected his candor and expected him to try to place this term policy. Indeed he did, but my client had a balanced understanding of the risks of both rejecting the policy (premature death) and accepting the policy (opportunity costs) and stood firm.

It’s not a matter of understanding, but of motivation. What saved this client was reaching outside the traditional box of advice exclusively from a salesman, and getting input from someone who understood insurance nuances and the marketplace, investment alternatives, and had the proper motivation. His retirement should be larger, his debt and taxes smaller, while he saves his fee back three times per year for two decades. It started with a phone call.

The Most Common Lie in Life Insurance Sales Case Study #8

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One purpose of IIA is to shine light on deceptive sales practices in the industry in order to help insurance consumers spend their premium dollars more efficiently. After my last two cases I can say what is the most frequently spoken mistruth in the sales context. Its plausibility disarms consumers yearning for help and it’s glibly uttered or implied in most interviews: “I will recommend what’s best for you.”

This tendency was observed by Solomon millennia ago. In Proverbs 20:6 he writes, “Many a man proclaims his own loyalty, but who can find a trustworthy man?” Two adjectives contrast the frequency of loyalty to another’s best interest. Many claim it, while few provide it.

In the first case an agent was trying to sell an oral surgeon a large cash value policy for asset protection. (Cash values are exempt from malpractice suits.) I had reviewed the proposed policy and discouraged it (wrong priority; better policies), but my client wanted me to hear the sales pitch firsthand. “When I talk to the agent it sounds so good, I want you to hear it to be sure I’m not missing out.” So the client, agent, and myself had a conference call for well over an hour.

The agent was pleasant and persuasive. I can see how my client, who did not understand the alternatives and was fuzzy on appropriate priorities, could be drawn in. The agent said multiple times, “We need to do what’s best for (client) “. His recommendations were not.

The stakes for the agent were high (a 10K commission) so I expected resistance. When I finally showed an alternative (a last ditch effort for illustration only, not as a recommendation) with a second year cash value of 34K compared to his policy’s cash value of $700, the agent was undaunted, persisting his policy was better. This surprised me, but such denial of the obvious highlighted the disparity between the claim (to “do what is best”) and the recommendation.

The second client shipped me brochures and charts from a financial planner recommending a poor value annuity and cash-value life policy. The “planner” never even evaluated the client’s current policies, one of which was a good value (right type, strong company, lower rates) that met his need much better than the proposed policy. Scattered through the literature was a plethora of claims such as “client’s interests are to be placed first and foremost” and “employees agreed to act in an ethical manner, and with integrity.”

Andrew Carnegie said, “As I grow older, I pay less attention to what men say. I just watch what they do.” These advisors proclaimed their own loyalty with words, but their real loyalty, as per behavior, was marketing policies. Neither client needed more life insurance.

What’s the lesson for insurance consumers? A successful agent routinely claims to put your interest first. Expect it. However this in no way means he keeps your best interest first. It only means he is a good salesman. He survives by persuasion and no line is more effective than claiming to keep your interests first.

The wise consumer will heed Solomon and Carnegie:

  1. expect many noble sounding (but empty) claims. Solomon- Pr.20:6
  2. pay little attention to them. Carnegie
  3. test them with a second (impartial and experienced) opinion. Solomon- Pr. 18:17

Like Solomon and Carnegie, these two clients paid little attention to what men said and reached outside the box to test them with a second and impartial opinion. Like Solomon and Carnegie they both kept more of their wealth. Pr. 14:15 & 24

Comparing Northwestern Mutual’s Term Insurance Case Study # 7

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I just finished an insurance review for a Michigan business owner. The results were straightforward and with a company I deal with regularly- Northwestern Mutual. NML is an excellent company, as their agents will tell you, but like all companies they have their strengths and weaknesses. An eclectic strategy can use them for some needs but not all. Even in their strong areas (cash value life insurance) there’s a vast disparity among cash value policies within their portfolio. We addressed that with the Dr. Ryan Wetzel who is featured on our Testimonials page with an accompanying blog.

Here I’d like to compare NML’s term life insurance rates to alternatives. The first step is to ascertain the appropriate amount of insurance. This client had $1.2 million of term life insurance with NML. He is well-managed with a strong income, emergency fund, debt-free, and retirement assets. Because of his large young family, should he die, Social Security Survivorship benefits would be over $4,000/month until the children were age 18. This is something he did not fully comprehend. In light of his assets, and after careful review with his wife, they felt comfortable reducing his life insurance to $1 million.

From there it was simply a matter of shopping for a term policy with more favorable rates.
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NML’s term insurance was convertible to a more favorable whole life policy, but the client and I discussed this and he was not inclined is to use whole life anyway. The new company’s financial strength was slightly less than NML’s, however this is not as important for term insurance as for cash-value insurance.

He paid me a fee of $675, higher than most reviews. However it took over seven hours of time, carefully and objectively considering his assets, goals, and sentiments. (I also reviewed his Northwestern disability policy which was left intact, and his wife’s life insurance which they changed for additional savings not reflected above.) He adjusted down to a more appropriate amount after having it brought to his attention the survivorship benefits that commissioned agents rarely explain. There were over 50 emails over several months. I walked him through the underwriting process, though I did not sell the replacing term policy.

We got the best of the best; found a strong company with very favorable rates and he got the superlative risk category. It was worth the effort, he will recover his fee the first 14 months and earn (by saving) a substantial tax-free return on his investment, far better than any other way he could “invest” $675.

Most who think they are with a “great” company have little idea of how much they can save. That’s what objective experienced guidance provides and why Scripture so frequently commends it- Proverbs 1:5, 11:14, 15:22, 20:18, 24:6.