An RIA-Friendly Life Insurance Strategy for Retirement Security (Part One)

This strategy is so compelling, wealth assets that typically never find their way into life or insurance will migrate to this solution. Look for my detailed explanation of this innovation in part two of this article, which will appear next week. Unti then, some historical context will set the stage for your understanding of this important development.

Some historical context

When the first universal life policy was introduced in the late 1970s, every policy, no matter the size, paid the same flat-fee compensation to agents. The policy also paid a commission that was solely based on the internal term insurance element within the policy. This was a radically different compensation structure that perfectly aligned with the differences in the policy itself. For the first time, permanent life insurance became unbundled and transparent.

Universal life gave insureds visibility into the policy’s internal costs including the cost of insurance (COI). Prior to the introduction of universal life, whole-life insurance dominated the marketplace. But by the late 1970s, whole life had come under intense criticism from consumer advocates and federal regulators, culminating in the July 1979 Federal Trade Commission (FTC) report that was harshly critical of whole-life insurance. According to the FTC’s research, whole-life policies on average earned a rate of return of 1.3%, far below market rates.

The prime rate in 1979 was 11.2%. CDs paid an average of 13.43%. In that interest rate environment, it appeared to many policy owners that money locked up in low-yielding whole-life insurance policies was a losing proposition.

A massive volume of replacements

Many life insurance agents seized upon the opportunity to replace whole-life insurance policies with new universal life policies offering double-digit interest rates. As more and more insurance companies introduced their own universal life policies, an unfortunate competition developed. Life insurance illustrations became weapons in a battle to win sales. Invariably, the agent with the illustration projecting the highest accumulation values two, three or four decades hence won the sale. To this day, the sales dynamics remain largely unchanged.

“Spreadsheet wars” describes today’s competition for sales.

Where it began and changed

The first company to offer universal life insurance was Hutton life, the wholly owned subsidiary of the big Wall Street firm EF Hutton. Hutton life’s tagline was, “Life insurance from the investor’s point of view.” That tagline captured the imagination of many life insurance professionals, including myself. I became a wholesaler of Hutton life products. It was easy to recruit agents who throughout their careers had sold whole-life insurance. Many were galvanized by the opportunity to replace old policies with the modern, high-yielding, flexible, and lower cost universal life.

In virtually every instance of a replaced policy, it was the value proposition of high cash value projections combined with an increase in life insurance coverage that consumers found so compelling.

Oftentimes these policy exchanges were extremely beneficial to the consumer. A $25,000 whole-life insurance could be exchanged for a $100,000 universal-life insurance policy. In instances where the insured was a head of household with dependents, the increase in life insurance coverage that came with no additional out of pocket cost was an unambiguously valuable benefit.

As more universal-life policies entered the market, agents acquired the ability to control the commission they would earn on any given sale. By maximizing the amount of life insurance for a given premium outlay, agents could increase the “target” or fully commissionable portion of the premium. There was a huge difference in the amount of commission generated depending upon whether the amount of life insurance is minimized or maximized.

Nonetheless, the exchange of a whole-life policy into universal life was oftentimes a genuine benefit for a family’s financial security. But these exchanges also created what I call “stressed” premium dollars. The expanded level of life insurance increased the policy’s internal costs and made it far more sensitive to the impact of lower-than-projected interest crediting.

A decades-long, economy-wide reduction in interest rates resulted in significantly lower interest crediting to universal-life policies compared to what was projected at the time of purchase. The underperformance of cash-value growth became a feature of almost all universal life policies. This reality held dire implications for many policy owners who were, are, or will be faced with three unpleasant choices:

1. Dramatically reduce the amount of life insurance coverage.
2. Significantly increase the amount of money paid into the policy.
3. Allow the policy to lapse.

In recent years, many universal-life insurance policies have lapsed. The loss of life insurance coverage is often a tragic consequence for families.

How financial planners can be heroes to clients who own underperforming life insurance policies

Apart from losing one’s life insurance protection, when policies lapse, owners figuratively light a match to what is often a large and valuable financial asset: the life policy’s cost basis. Most policy owners have no idea what they are giving up when they let an underperforming life insurance policy lapse.

It is not advisable to throw away an asset that can easily be worth tens of thousands, or sometimes hundreds of thousands of dollars. If you have clients with underperforming life insurance policies, you need to be the hero who explains how they easily transform a soon-to-be worthless asset into a valuable tax-savings strategy.

Avoid lighting a match to cash

Consider a modest universal-life insurance policy sold 30 years ago with an annual premium of $2,600. Based upon the double-digit interest rate projection at the time of sale, the policy was expected to have a cash value today of $110,000. Instead, its cash value is $1,800 and declining quickly. The policy is headed for a lapse, and the owner is unwilling to provide the additional funds required to keep the policy viable.

If the policy lapses, the owner receives nothing. The $78,000 invested in the policy over 30 years is not deductible against current income.

But – and this is significant – if the $1,800 is exchanged under IRA Sec. 1035(a) into an annuity, the annuity inherits the life insurance policy’s $78,000 cost basis.

Repositioning some of the client savings into that same annuity creates an opportunity for the client to save tens of thousands of dollars in ordinary income taxes.

If the client needs immediate income, repositioning some savings into a single premium immediate annuity (SPIA) will likely create a 100% exclusion ratio.

Alternatively, repositioning some of the client’s savings into any type of deferred-annuity () such as a multi-year guaranteed annuity (MYGA) or a fixed-index annuity (FIA), also creates huge tax savings. For example, assume that the client repositions $150,000 of non-qualified funds into a FIA. If over 10 years the value of the DIA doubled to $300,000, and if the client were to withdraw the money at that time, income taxes would be owed on the gain. What is the gain? We first must calculate the cost basis:

The cost basis

$150,000 + $78,000 (from the life policy) = $228,000

The taxable gain

$300,000 - $228,000 = $72,000

The tax bill (35%)

$72,000 X 25% = $25,200

The carryover cost basis of $78,000 creates a tax exclusion of more than 50% of the gain in the annuity contract. Without the carryover basis, the tax bill would have been $52,500. If income tax rates in the future increase, the income tax savings resulting from an exchange like this only increases.

You may be thinking, “I don’t sell annuities.” Or “I don’t like annuities.” If this is your mindset, I urge you to move past it. There are many annuities, including multi-year guaranteed annuities, that pay high interest rates, are free of commissions and that dovetail perfectly with the RIA AUM model. Failing to exchange the unperforming life insurance policy into annuity costs the client a lot. You serve clients in a much better fashion if you preserve their valuable cost basis.

An uncomfortable position for life agents

The insurance agents who sold universal-life policies when interest rates were high have been thrust into an unfortunate and uncomfortable position. They must engage in a difficult conversation with their clients about the necessity to increase the premium outlays or ignore such situations out of fear. I always urge agents to confront this head on because it is not their fault that the United States experienced the most significant decline in interest rates in 200 years. Consider that between 2000 and 2021, retirees who were reliant upon interest income from CDs saw their incomes systematically eroded by 99%. Still, some agents continue to ignore the problem (and the opportunity).

The real failure and how it could have been avoided

Compound interest is a wondrous thing. When it works against you, however, it is devilish. In essence, this is what happens when a universal-life policy becomes unstable and the costs coming out of its cash value overwhelm the policy’s ability to add back funds via premiums plus interest credited.

If the premium for a universal-life policy had been adjusted minimally upward as soon as lower than projected interest rates became a reality, much or all the problems we see today could have been avoided. It was the waiting, the failure to address the issue for five or 10 years or more, that was fatal.

About indexed-universal life

The advent of indexed-universal life made profound sense. Linking the policy’s interest crediting to the performance of one or more stock indices was a logical outgrowth of the years-long surge in equities. But once again, the basis of competition became the projection of high cash-value accumulations decades into the future. In some cases, this set the stage for a repeat of the same problem that plagued the earlier generations of universal-life policies.

The most attractive retirement security solution you’ve never heard of

In part two, I will present a detailed explanation of a life-insurance strategy you should be excited to present to your clients.

Wealth2k® founder, David Macchia, is an entrepreneur, author, and public speaker whose work involves improving the processes used in retirement-income planning. He is presently focused on creating solutions to mitigate the threat to human financial advisors that is posed by emerging AI competitors.

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