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

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

I see many misguided initiatives to drop cash value policies, coming from a guru’s generalization that “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, when 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 a vintage 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 the life policies were poor quality, so termination 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. 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 elements present, but with this happening with two clients in the same week, it may have broader application than I’d thought.

If I’m with a Good Company, Isn’t that Enough?

Some people are so convinced of how great their insurer is, that they cannot see any benefit from outside advice. Nothing could be further from the truth.

Perhaps the best way to illustrate this is by example. I just finished a life insurance review that illustrates the dramatic potential for improvement within the same company. This client was a little extreme for most of us: his income was higher and what he was asked to spend on life insurance may seem absurd (though it happens all the time). But it graphically shows what frequently happens, albeit often on a lower scale.

A Northwestern Mutual agent approached this newly practicing doctor earning a very strong income and recommended a life insurance policy as an investment. The doctor contacted me for a second opinion. The agent emphasized what an outstanding company he represented (true) and proposed a 3 million dollar policy costing 25k/yr with a surrender value of 3k at the end of first year. I suggested a variation with the same company: a lower death benefit, costing 12k/yr with a surrender value of 10k at end of first year. Over 12k less premium for 7k more value!

The gist of this recommendation was to shelter money in an investment that would be exempt from a medical malpractice lawsuit. Whole life cash values fall in this category. The thing to keep in mind is that it was an investment.

One should not tuck an investment inside a 3 million dollar life insurance policy, with its ever-increasing internal mortality costs, unless you need the death benefit. This was a newly married couple, with no mortgage debt, no school debt, and no children. She was a Peace Corp worker who had never dreamed of marrying a high income professional anyway.

Part of this misdirection lies in the fact that the company has some policies that are (much) better values than others. The consumer doesn’t know that and the agent has no incentive to tell it. The commission on the proposed policy was over 12k; the commission on the variation was less than 2k. The influence of this commission on advice can be profound. It’s much better to get your financial advice from someone not under that influence. How is my compensation influenced by his choice? Zip. I’m paid to help clients find good values.

The conclusion is that connecting with a fine company is just the beginning. Northwestern is such a company that I deal with frequently, and I cannot recall a single time when arrangements with them were not improvable, either with proposed or in-force policies. * There will always be a conflict between your interest and the company’s, no matter how good they are. Paying a guide is money well spent and if you think because you are with a good company you don’t need a guide, think again. This doctor made a 2000% return on his guide fee. Extreme? Yes. But excellent returns on fees for impartial insurance advice (even when you are with a good company) are common- the rule, not the exception.

If you don’t mind living with the advice of an agent who is “under the influence”, you can save that fee. Most people will never know how much better it could have been. However more and more people are discovering the advantage of using an impartial guide, while they save their fee back many times.

*These all had Northwestern policies (see Testimonials):

  • Mark and Liesl Marmon
  • Paul Caldwell
  • Roger Smith
  • Charlton Veazy
  • Bob and Peggy Arrington