Life-insurance policies, along with wills, are bedrock components of many estate plans. But variable life insurance, the best-selling form of life insurance since 1999 when measured by dollars paid, may be anything but a solid foundation.
The reason? Variable life policies link a death benefit to an investment account. That means many policies sold in the late 1990s have been so decimated by the falling stock market that the cash value of the policy is either too low to maintain the value of the death benefit or will become too low in a few years if the policyholder doesn't pay higher premiums. Thousands of policyholders now face the choice of paying higher premiums, reducing their death benefit, or letting their policies lapse. "Variable life has the potential to be a time bomb," says Robert Cohen, an independent insurance agent in Framingham, Mass.
While not all variable life policies are in trouble, the substantial risks associated with the product have only recently moved front and center. These policies became popular during the bull market because they were sold as a way to receive a guaranteed death benefit while building a nest egg that could grow tax-free. If the investment produced large-enough returns, policyholders could increase their death benefit or take out excess cash to pay for retirement or other expenses.
A bear market can derail all of this. Consider the case of a Wisconsin couple in their 30s with young children who bought a variable life policy in 1997 with a death benefit of $620,000. Their scheduled premium payments have risen this year from $676 a month to $905. They've put a total of $57,000 into the policy, but the combination of high fees and the poor performance of their investments, which were split between large-cap and mid-cap equity funds, have left the policy's cash value at $28,000, says Thomas Batterman at Vigil Trust & Financial Advocacy in Wausau, Wis., a financial adviser the couple hired to evaluate the policy.
Batterman is advising the couple to let the policy lapse. He says they should stop paying the premiums and consider another type of insurance. By letting it lapse, the remaining cash value should fund the death benefit for three or four more years. If they surrendered the policy immediately, they would get the existing cash value minus a surrender penalty of $6,300 and they would have to pay taxes on the remaining $21,700. "The risks of these policies are very hard to understand," Batterman says.
Indeed, variable life is full of twists and turns. There are two kinds of policies: variable whole-life and the more popular variable universal life. Both let you invest part of your premium in mutual fund-like investment pools called subaccounts, which often include a broad selection of funds from major fund companies. The key difference is that variable whole-life policies require fixed premiums, while variable universal life policies let you vary your payments.
Consumers can't always detect the dangers of variable life when brokers show them illustrations of how the policy works. Most brokers use marketing materials illustrating how the policy would perform if the investment returns ranged anywhere from 0% to 12%, says Keith Maurer, an insurance specialist with Low Load Insurance Services in Tampa. Low Load helps financial planners buy low-cost insurance for their clients. To make it look attractive, many brokers show a 10% to 12% annual rate of return. While this is within the ballpark of the long-term average annual return of 10.7% for the Standard & Poor's 500-stock index, the market doesn't move in neat 10% steps. A bear market can make those projections worthless.
A policy can end up in a squeeze if its investments have a negative return over a period of years. Mortality charges rise as policyholders grow older, taking a larger bite out of the investment account. If the cash value of the policy falls too low and premium payments are also too low, you might not add enough each year to cover your insurance costs in future years. Your insurer will start to draw down your cash balance to cover its costs. When this happens, your policy will eventually "blow up," meaning there won't be sufficient funds in your investment account to cover your annual insurance costs, and you will lose your death benefit (table). That's why Cohen recommends to clients who can afford it to pay higher-than-required premiums to build a cushion into their policies.
Insurance companies try to avoid these blowups. Some time before it happens, they will mail you a warning of trouble ahead. If you receive one of these letters, you have three options: Do nothing and hope the investment returns rise sharply--realizing that if they don't rise, the policy will lapse; pay a higher premium; or reduce the death benefit. The last option can be costly because you may have to pay steep surrender penalties, especially if you've only had the policy a few years.
Another problem with these policies: They demand multiple fees. Besides mortality charges, they typically include a broker's sales charge, which can be 4% or more at the time of purchase; an administrative fee; state and federal premium taxes; and fund management fees. These charges often eat up the entire first year's premium and much of the second year's as well. "It's such a confusing type of contract, I don't think even some lawyers understand how it works," says George Cushing, a Boston estate lawyer.
Variable life policyholders can take their policy to their insurance agent and ask for an updated analysis of its performance, along with its chances of blowing up. For a second opinion, it's a good idea to hire an independent financial planner to review your policy with an eye toward damage control. The National Association of Personal Financial Advisors (1 800 366-2732 or www.napfa.org) can give referrals. Another option is the Consumer Federation of America, which has an insurance-evaluation service run by James Hunt, former Vermont state insurance commissioner. It costs $50 for the first policy. Details are available at www.consumerfed.org.
Some insurance professionals say variable life has advantages for the right person. It's often recommended to wealthy individuals who have made the maximum contributions to other tax-deferred retirement programs and are looking for further tax savings. The insurance industry take is that the tax savings from the policies more than makes up for the higher fees. That may be true. But first, you have to make sure your policy isn't undermined by bad investments.
Corrections and Clarifications
In ``Variable life insurance variables'' (BusinessWeek Investor, Apr. 8), financial planner Thomas Batterman acknowledges he erred when he said that liquidating his client's variable-life policy would require paying tax on the proceeds. He says he is recommending his clients keep the policy in place while he explores other insurance options, such as term life.
By Geoffrey Smith