Universal Life: How Much Cash Value by Retirement?
If you own universal life insurance, it’s probably because you didn't want a policy that just provided for dependents in case you died during your earning years. You were looking for a policy that could act as an investment as well, a source of savings that you could draw on, especially after you retired.
But if you’re going to view an insurance policy as an income vehicle during retirement, you have to consider the value of that policy when it comes time for it to begin paying you. If you bought your universal life in the early days of these policies, say the 1980s, check with your broker to see how your policy has fared. Some policyholders have run into unpleasant surprises in recent years.
Before we get into the details, a brief look at the basics.
Term Life vs. Permanent Life
There are two major categories of life insurance – term life and permanent life. A term life policy is in place to protect a wage-earner's family, usually while he or she is working. If the wage-earner passes away, the policy pays a lump sum (a death benefit) to those the policyholder has designated, the beneficiaries. Term life policies run for a designated period of time, though they can be renewed.
Permanent life insurance, also known as cash-value life insurance, isn’t designed to expire (hence the name) – within a normal lifespan, at least (some do routinely terminate when the insured person hits 100 years old). Just like the term life, it pays a death benefit. But it also comes with a cash-value component: a savings account, in effect, funded by the premiums the policyholder pays. Permanent life policies are more expensive than term life ones because of the cash value portion.
Two Types of Permanent Life
That's not all you have to understand. As Permanent Life Policies: Whole Vs. Universal makes clear, there are two types of permanent life.
- Whole life insurance gives you a consistent premiums and a guaranteed cash value accumulation. In return for this, the premiums are likely to be much higher than for term insurance, but the payout, if the company stays solvent, is assured. The only risk you have with whole life is that you paid more in fees than your return is worth – or that the company goes bankrupt (see Are You Protected If Your Insurance Company Goes Belly-Up?).
- Universal life offers more flexibility in premium payments, death benefits and the savings element of the policy because the policies allow policyholders to earn more when the stock market is strong.
Because whole life offers no flexibility and doesn't allow policyholders to benefit from strong markets, some pundits started asking Is Whole Life an Obsolete Product? What few noticed in those rosy early days was the fine print of what happens to universal life policyholders if the market does not do well.
Universal Life: Investment Earnings Roulette
Early generations of policyholders ran into nightmare scenarios because their policies were written assuming 11% to 15% rates of return. Those policies didn't take into account that, as the 20th century ended and we lived through the first 15 years of the 21st, interest rates would drop into the single digits – playing havoc with cash value's growth and undermining the earnings needed to maintain the insurance. Policyholders found themselves forced to pay premiums entirely out of pocket; if they couldn't, their policies became worthless. Once that happened, they faced a big tax bill on any sums they'd withdrawn over the years – undermining a key selling point for these policies when they were invented.
It helps to remember what made universal life look so appealing when it was invented as an alternative to traditional whole life. For starters, it's a particularly flexible option, allowing the policyowner to shift funds between its insurance and savings components. Some policies also allow you to choose how the funds in the savings component will be allocated (similar to how you might choose among different mutual funds for your 401(k) plan). See Pros & Cons of Indexed Universal Life Insurance.
As cash value accumulates, policyholders can borrow against it. In fact, borrowing is the most tax-advantaged way to use these funds. “Life insurance cash values can be accessed during the policy owner’s lifetime through two ways, loans and withdrawals," says Jason Silverberg, vice-president of financial planning at Financial Advantage Associates (Rockville, Maryland). "You can access your basis (what you contributed to the policy), without any tax implications." That is, the funds you withdraw from the account usually aren't subject to income tax – unlike Traditional IRA and 401(k) plan distributions. See 5 Tax Advantages of Indexed Universal Life.
"The gains, however, are taxed at ordinary income rates, unless you take them out as a loan," Silverberg cautions. In other words, you technically don't withdraw funds from the insurance policy; you borrow against it – not unlike taking out a home-equity loan against the accrued value of your house. These loans are not subject to income tax. You do pay interest on them (though you can use the cash value account funds to cover the interest payments too).
What Happens When You Retire
Another key benefit, in addition to the life insurance component, is that you can tap into your universal life policy for income after you've retired. There are some compelling reasons to do so: The cash value account within an insurance policy accumulates tax-free, for one thing. “Some people use the cash value in their life insurance policy to bridge the gap from [the year of their] retirement to age 70, when they can receive the highest Social Security benefit," David Wilken, president of Individual Life for Voya Financial’s Insurance Solutions division says. "Others allow their policy to mature and cash out later to receive the maximum benefit [of the policy].
"In general, the more time you allow your cash value life insurance policy to grow, the better. A good rule of thumb is to plan to wait at least 15 years [after you purchase a policy] before you begin taking distributions.”
The Risk of Lapsing
In order to take distributions, of course, your insurance policy has to have cash value. That's never a problem with whole life, but universal life policies are differently designed. Earnings on the cash value are an important component in maintaining the policy – it's not just the premiums you pay. Often, with universal life policies, the size of the premium varies based on how the investment portion of the policy is performing. In other words, the cash value of the policy isn't just your cash cow; it's there to help pay for the insurance, supplementing or even covering your premiums.
Earnings on cash value are designed to help keep a policy from lapsing – especially during periods when the policyholder takes out a loan against the policy's cash value. “If you take out too much money and the cost of the policy exceeds the cash value," Wilken says, it's "similar to being underwater on your home." Your insurance policy could lapse. Not only would you lose your death benefit; all the funds you borrowed or withdrew from the policy would now be considered taxable income.
Deciding What’s Safe to Withdraw
How do you know how much you can safely withdraw – before retirement or after it? When you buy one of these policies, the terms will be laid out in what the insurance industry calls an illustration. This is a document that lays out the assumptions made to compute your expected cash value, monthly interest rate and other key components of your policy (see Understand Permanent Life Insurance Illustrations).
It is key to making sure that once you reach a point where you might draw on the policy's cash value, you have enough in money in place to meet your financial needs – and to keep the policy in force. Unrealistically optimistic illustrations were what left so many early holders of universal life policies underwater, often just when they were counting on their holdings to help them into retirement.
If your policy was written years ago and you haven’t had a comprehensive review of it lately, it might be time to pay a visit to your insurance agent.
The Bottom Line
If you're thinking of buying a universal life policy, you (and your financial advisor, if you have one) should cast a critical eye on the illustration, making sure it errs on the side of conservative. One help: The National Association of Insurance Commissioners recently adopted a new actuarial guideline to regulate and standardize illustrations. Going into effect in March 2016, "the new law AG 49 makes sure the illustrated rate of return and its growth is realistic,” according to Brad Cummins, founder of Local Life Agents, a Columbus, Ohio-based firm of independent insurance agents.
Breaking it down, you have to properly watch and manage your universal life policy to keep pace with the rising cost of insurance, the rate of return on the cash value, and how much of a death benefit you need, in order consider this a viable income source. It's complicated, and some financial professionals argue that there are better, easier ways to save for retirement that don’t involve life insurance policies – mutual funds, ETFs, annuities, to name just a few.
Still, the cash value policy – old-style whole life included – might be a good fit for some individuals. "If properly planned for, life insurance policies can produce a pretty hefty income stream in retirement," as Silverberg puts it. "Just make sure that the policy doesn’t lapse.”
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