David Pohndorf, a 60-year-old Far Hills (N.J.) resident who raises money for venture-capital funds, recently received a letter from his insurer telling him his whole-life policy was about to lapse. The reason: The $6,200 balance on a loan he had taken out 33 years ago against the policy now almost exceeded the policy's cash value. "I was shocked," says Pohndorf. In the past, the cash value -- the initial premium he had paid plus the investment return generated by the insurer -- had grown fast enough to cover the loan's interest and then some. Pohndorf hadn't paid a premium in 20 years.
Falling interest rates and years of deteriorating stock prices have taken their toll on the dividends that insurers pay to policyholders. Yet the rates on policy loans today can be fixed at about 6% or 7%. Even if they're variable, they may not have fallen as much as policy dividends. If those payouts are no longer high enough to service the loan, the unpaid interest gets tacked onto the balance. If a loan exceeds the cash value, the insurer will terminate the policy.
It gets worse. When an insurer terminates your policy, chances are you'll have "phantom income," and the Internal Revenue Service will want its cut. Say you put $50,000 into a policy as an initial premium, and its value rises to $100,000 over 20 years. During that period, you borrow $70,000. If the loan's unpaid balance grows to $100,000, the policy lapses with no value, but the IRS treats it as if you received $50,000 in income. The best way to avoid this scenario is to pay off enough of the loan to keep the policy in force.
But what if you don't have the money? You could ask for a "1035 exchange," which, in effect, allows you to swap your policy for another one. You could move into a universal life policy, which unlike whole-life policies, have flexible premiums and death benefits. Opting for a lower premium would leave you with extra money to pay the loan.
Suppose you trade in the whole-life policy with a $100,000 cash value and a $70,000 loan balance for a universal life policy. With such a policy, you can withdraw as much as the amount you paid in at the outset, in this case $50,000, without tax consequences. You can use that money to pay down the $70,000 loan. That would leave you with a much smaller debt -- as well as a lower death benefit.
Such exchanges can cost you, though, through exit fees or premium hikes. "If you bought a policy at age 35 and you're now 60, the new premium will be higher if you're in bad health," says Joseph Godfrey, an insurance broker at American Business & Professional Program in New York.
Also, you may pay commissions on the new policy that nix the benefit of the swap. Keith Maurer, an insurance consultant for financial planners in Tampa, knows of three insurers -- ING Southland, Ameritas, and Security Life of Denver -- that offer exchanges from other insurers' policies with no commissions or commissions of less than 2%. "In 90% of these exchanges, I've saved people money," he says.
Before you make the exchange, ask if your insurer offers any solutions. Some will provide debt counseling to people who are strapped. Your agent can also help you understand the details of your contract, so you don't make costly mistakes.
Since insurance contracts vary greatly from policy to policy, there is no one-size-fits-all solution to this loan problem. In Pohndorf's case, he simply wrote a check to pay off the balance. Not every borrower can afford to do that. By Lewis Braham