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Federal Employees Owning Universal Life Insurance Policies May Lose Their Policies as a Result of Current Low Interest Rates

Edward A. Zurndorfer, Certified Financial Planner

Those federal employees who may have purchased universal life (UL) insurance policies years ago when interest rates were much higher compared to today's interest rates could lose their policies unless they make modifications to their UL policies. With the current low interest rates, UL policies today are not generating sufficient interest to pay the expenses associated with most UL policies. To help understand the problem associated with many UL policies, it is important to review UL insurance and how it works.

There are two types of life insurance, namely:

  1. Term life insurance which offers a set death benefit for a certain number of years -- for example, 10, 15, 20, 25 or 30 years; and
  2. Permanent life insurance which includes whole life insurance and universal life insurance policies. Permanent life insurance policies can remain in force throughout policyholder's life and build up cash value which grows at least tax-deferred. Whole life insurance policyholders most often pay set premiums that cover the fees of the policy including a set death benefit while also building up cash value that can be tapped into during one's retirement years. In contrast, many universal life insurance policyholders pay flexible premiums and sometimes use the investment returns on the cash value account to pay the policy's future expenses.

Why do individuals buy UL insurance? A possible reason is because they want permanent life insurance whereas term life insurance offers only after a set number of years of life insurance coverage. They also like the idea of building cash account that grows at least tax deferred. Unfortunately, many UL policies carry high fees and pay large commissions to the insurance agents who sell UL policies. These high fees and large commissions typically are not apparent to the UL buyer. The UL buyer in return gets a savings vehicle that produces a sufficient investment return to generate a cash account which is sufficient to pay the UL death benefit and to save additional money on a tax-deferred basis.

The problem today for many individuals currently holding UL policies -- and this includes some federal employees - is that many insurance agents said in their "sales pitches" that interest paid on the cash account would be sufficient enough to pay for the increasing cost of the death benefit as the policyholder gets older. Many UL policyholders were told that they could pay a smaller premium compared to what whole life policy owners paid for the same amount of death benefit.

Many UL policies were sold in the 1980's when market interest rates were double digit. Even during the late 1990's many UL policies generated interest yields of 7 to 8 percent per year. But in recent years and currently, market interest rates are low, with the result that the cash accounts of many UL policies are increasing much more slowly than the UL insurance agents who sold the policies first suggested.

Insurance companies who sold UL policies in the past when interest rates were higher will defend their sales practices by noting that written materials given to UL buyers stated that "only a minimum interest rate is guaranteed" and any higher interest rates used in a sales pitch are hypothetical, not promises of a UL policy's "future performance".

For those UL policyholders who are severely affected by the current low rates, one possible solution is to contribute more money to the UL policy in order to pay the increasing policy expenses and fees.

What should employees who bought UL insurance policies at a time market when interest rates were much higher and have since decreased do with their policies, especially if additional money has to be paid into the policy in order to pay for the ongoing policy expenses?

For starters, UL insurance policyholders should ask their agent, broker or insurance company for an updated "in force" illustration showing how the policy's cash value will change based on current interest rates, premiums, and policy expenses. In addition, policyholders should ask the insurance company to run a projection that shows how the cash value would survive were the interest rate to drop to the minimum. A new illustration is recommended every two years, especially if interest rates stay low, which is expected.

Does it make sense to drop a UL insurance policy if the policyholder has to put more money into the policy in order to keep it? Not necessarily. Even though the UL policy's interest rate has severely decreased, the interest rate amount is probably still higher than the low interest rates offered on savings account and certificates of deposits at most banks and credit unions. According to publisher, as of Nov. 17, 2012 rates on certificates of deposits are currently averaging 0.79 percent per year in interest. That is well below the minimum guarantees offered by the UL policies sold in the 1980's, 1990's and early 2000's.

UL Insurance policies also carry some tax benefits. Capital gains and interest income are not taxed provided they are not withdrawn from the cash account.

To decide whether these benefits outweigh the costs associated with keeping a UL policy, UL policyholders should also assess whether they still need life insurance. Those federal employees who are getting close to their retirement date may no longer need life insurance. For example, an employee with no dependents   and whose mortgage is paid off may no longer need any life insurance. On the other hand, keeping a UL policy makes sense if the policyholder wants to use the policy's "accelerated death benefit" rider in case the policyholder is diagnosed with a terminal disease and expected to die within two years.

There is another choice for UL policyholders who do not want to cancel their policies. If the interest rate paid by the UL policy is still relatively high and the UL policyholder wants to keep the policy, they can ask the insurance company to lower the death benefit. That will reduce the share of the cash account being used to pay the insurance death benefit.

Another important consideration for a UL policy cancellation are the "surrender" charges. Surrender charges are fees imposed when a policy is cancelled within a certain years following the policy issue date.  Surrender charges typically last from 10 to 20 years from the policy issue date and can eat up a large amount of the cash savings if the policyholder tries to cancel the policy or lower the death benefit. That would mean for UL policyholders to hold onto their policies until the surrender charge period expires.

Posted:  12/5/2012

About the Author

Edward A. Zurndorfer is a Certified Financial Planner, Chartered Financial Consultant, Chartered Life Underwriter, Registered Health Underwriter, Registered Employee Benefits Consultant and Enrolled Agent in Silver Spring, MD -- and the owner of EZ Accounting and Financial Services, an accounting, tax preparation and financial planning firm also located in Silver Spring, MD.  Zurndorfer is also is an instructor at federal employee retirement seminars throughout the country and writes numerous columns and books on federal employee benefits.