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Know the Inner Workings of your Life Insurance Policy

Inner Workings is the Disney animated short that preceded Moana in the theaters. The film depicts an office worker who needs to use both his brain and his heart to understand his options and to get the most out of life before his life eventually runs out. To understand the inner workings of your life insurance and get the most out of it, you need to look at it from all angles.

Life insurance is a popular way to fund a special needs trust. As an investment, life insurance is one of the closest things to “guaranteed” (a word we never, ever actually use in the financial planning world), as long as you buy from a company with solid financial credentials. You can find this out by checking any company’s ratings at Standard and Poors or Moody's, where it is free to create an account. You should also work with a reputable general agent or a broker who can sell policies from many issuers. This is because each insurance company underwrites health conditions slightly differently. One company may be more lenient towards someone, who had a heart condition. Another may be less strict towards someone with pre-diabetic indicators. The list goes on. You want a broker who can find the company that not only has strong ratings, but also has a sweet spot for your particular health quirks.

Beyond that, though, you need to be very clear on the nature of the insurance policy and how it works. At a very basic level, the relationship between the premiums that a policy holder pays and the death benefit that his or her heirs will receive is influenced by the policy holder’s age and health at the time the policy was purchased. Term insurance—where the policy holder pays premiums for a specific term of years and the insurance company commits to paying a death benefit only if the holder dies within the term—stops there. But term insurance is a lousy choice for funding a special needs trust because it is virtually impossible, and certainly very expensive, to continue term coverage into old age.

Permanent life insurance policies, as the name suggests, are expected to sustain coverage on the policy holder until s/he dies, even if the person lives to be a supercentenarian. I say “expected to” because permanent policies have a lot more moving parts than term policies and thus a lot more variables that can influence the policy’s long-term viability. Within the category of permanent policies, whole-life policies are the most straightforward. You pay a fixed premium for either a fixed number of years or for the life of the policy. Some of the premium goes to meet the actual cost of the actual insurance. The rest accumulates. Many whole-life policies are “participating”, which means that the insurance company pays dividends to the policy holder. As a result, whole-life policies may pay dividends. The policy holder can choose to receive the dividends in cash, use them to offset future premiums, use them to purchase additional coverage, or leave them in the policy to accumulate and earn more return. Dividends may be guaranteed by the insurance company or not. If you have chosen to use the dividends to pay future premiums but the dividends are not guaranteed, you need to watch it, so that you’ll be certain that the dividends credited to your policy are, in fact, sufficient to cover the premiums.

Universal life, which also provides lifetime coverage, is more complicated. Universal life premiums are flexible. This is often used as a selling point by less scrupulous brokers who present it as: “You can pay as little as $xx/year for this coverage”. The adjective “flexible”, however, only refers to the timing of the premium payments and not the aggregate that will need to be paid over the life of the policy to keep it in force. For example, let’s suppose you purchase a universal life policy with a $250,000 death benefit. You begin to pay premiums. As with a whole life policy, a portion of your premium goes to cover the cost of insurance. The rest accumulates and generates returns, according to the current market interest rate or the policy’s minimum guaranteed rate, whichever is greater. In order to keep the policy in force for your expected lifetime, you would need to pay $1,800/year or $150/month. Because it’s a UL, you can pay a lower premium, perhaps as low as $80/month. At the beginning, that would be enough to get the policy going, because the cost of insurance is lower when one is younger. BUT you cannot pay this low rate for too long, because the cost of the insurance will continue to rise every year that the policy is in force, as you get older.

Eventually, you must make up the difference between the low premium you had been paying and the premium you should have been paying, which means that eventually you will end up paying more than $150/month to keep that policy going. I have met a number of clients with UL policies that they “got started” with a low premium. Because they did not understand the mechanism, they never increased that payment. By the time the clients got to me, the policies were seriously underfunded. Instead of building cash value, they were running it down just to make up for the insurance costs that the premiums were no longer covering. In most cases, the policies were poised to lapse long before the insured’s expected mortality. It was then up to me to break to the clients the unfortunate news that they would have to pay a hefty catch-up of additional premium to make sure the policy lasts as long as they likely will. In some cases, the clients had put themselves in an even worse position by borrowing from the policy’s cash value. As long as the policy remained in force, they would not need to repay the loan, although it would reduce the death benefit. However, if they’d choose not to pay the catch-up premium, or if they’d find out that it was too big to be affordable and the policy would lapse, that loan might become a taxable distribution.

Indexed Universal Life policies add slightly more complication. With an IUL, the rate of return is not based on a standard interest rate but is rather tied to the performance of a certain financial index; for example, the S&P 500. And the rate is generally capped. For example, if the S&P goes up 10% over the period, your return may be capped at 6%. A slight compensation is that when the index goes down, the policy assets have a flat return rather than a negative return. As with a regular UL, IULs have flexible premiums. But because the rates of return can vary a lot, policy holders need to be extra careful that the premiums that they are paying are sufficient to keep the policy going, even when there is a string of periods where the policy returns are flat or very low.

Finally, we have Variable Universal Life policies, which are the most complicated. With a VUL, the amount of your premium, that exceeds the actual cost of insurance, accumulates AND is invested in “sub accounts”, which are basically mutual funds, used exclusively by insurance companies. Like mutual funds, they have additional expenses and like mutual funds, they rise and fall on a daily basis. When you purchase a VUL, you need to be very cognizant of the expect market rate of return that the insurance company uses to create the illustration. For example, the policy illustration shows that you can pay $200/month and that will keep the policy in force until your age 110. But if that outcome is based on the sub accounts earning an average of 10% per year, then that might be unrealistic. Make sure that the rate of return implied in the premium calculations is one with which you are comfortable. Otherwise, if the sub accounts perform more poorly than expected, you will, again, need to make catch up payments to keep the policy going.

Life insurance is a very appropriate mechanism to fund a special needs trust because the funding is predictable and will happen at the exact moment when the trust is most needed, which is when the parents or other primary caregivers die. For life insurance to work as a funding mechanism, though, the policy has to remain in force until the covered person actually does die. A UL, IUL or VUL may offer the opportunity to leverage your premium dollars, but it is imperative that you keep up-to-date with your premium schedule and make sure that you are paying enough to keep the policy going. By using his heart as well as his brain, the office worker protagonist of Inner Workings was able to start finding ways to enjoy life, while keeping up his performance at work. By listening to your heart and your brain, you’ll be able to find the best life insurance policy for you too.

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