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Is It Time To Combine Immediate Annuities With Universal Life?

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By any standard of measurement, universal life insurance revolutionized the life insurance industry. Its inherent flexibility permitted everyone involved–insurers, agents and policy owners–to create insurance programs having the potential to fulfill consumer insurance needs well into the future.

Yet, UL’s very flexibility has detracted from a key historical element of scheduled premium life insurance–forced savings. Traditional scheduled premium cash value life policies created the psychological mindset in the owner that regular premiums had to be paid to avoid policy lapse.

A fundamental feature of UL, whether fixed or variable, is that it permits premium payments to be made on a flexible basis. Indeed, UL is usually characterized as “flexible premium whole life insurance.” It can be issued as a single premium policy or designed for a series of premium payments.

The only critical element of UL’s premium payment mode is to determine whether it will be treated as a “modified endowment contract” (MEC) for purposes of the Internal Revenue Code.

If a UL is an MEC, distributions other than at the insured’s death are treated for tax purposes the same as distributions from an annuity. If it’s not an MEC, loans or other distributions can be made from policy cash values on a more tax-effective basis than is the case with pre-death MEC distributions.

To not be treated as an MEC, UL must be designed to be at least a 7-premium payment contract.

In most cases, old-style scheduled premium cash value life policies (i.e. non-ULs) will be non-MECs. Combining the non-MEC status with the psychological power of forced savings to prevent policy lapses produces very tax-effective ways for policy owners to achieve liquidity needs–particularly since these policies remain in force for significant periods of time.

Unfortunately, ULs that are treated as MECs have little flexibility to provide liquidity without the potential for significant tax disadvantages. Moreover, once issued as a MEC, a UL is pretty well locked into that status for the remainder of its duration. Worse, ULs designed as non-MECs can become MECs if actual premium payment modes change their status.

Purchasers of UL often fail to fully fund their contracts on the basis that had been expected at time of purchase. Therefore, unless cash values fall below the level necessary to pay the costs of insurance, the UL may drift throughout its life without achieving its full potential. If cash values fall below minimum levels, the UL can lapse and all the advantages will be lost.

Agents are, above all, pragmatists. One reason why sales of annuities by traditional agents have grown so much in recent years is the agents’ recognition that sale of a single premium annuity guarantees the policy will remain in force until some event causes the policy owner to withdraw cash values or surrender the policy. It is sort of a “take the money and run” syndrome, even though a regularly scheduled series of premiums into a non-MEC UL would be far better for the policy owner.

A number of insurers have developed a solution to this “take the money and run” problem: Sell the policy owner a single premium immediate annuity, and use the annual distributions to pay the premiums on a non-MEC UL. Immediate annuities can be issued for a term certain with no real minimum period of time required. Thus, an immediate annuity with a 7-year term certain could ensure that the cash was available to pay the premiums on the UL and still have some tax benefits.

Although distributions from a term certain immediate annuity have tax consequences, over the relatively short period of time required to fully fund a non-MEC UL, the taxes involved are relatively minor. The bulk of the annuity payments are treated as tax-free return of principal.

Moreover, if the agent uses a variable immediate annuity or a fixed immediate annuity with excess interest credits, it is probable that there will be more than enough cash value left at the end of the immediate period to cover all taxes.

This is not to criticize agents for the “take the money and run” syndrome. This approach is certainly preferable to doing nothing. After all, using an annuity as a longevity planning vehicle is better than not planning at all. Still, using an immediate annuity to pay the premiums on a non-MEC UL for the minimum required funding period is really the best of both worlds.

This approach makes certain the commitment of the policy owner while at the same time providing that owner with the most tax efficient method for saving funds and either taking tax-effective distributions or passing them on to loved ones in event of the owner’s death. It combines forced savings with UL’s flexibility and enables the product to achieve its full potential.

Norse N. Blazzard, JD, CLU, and Judith A. Hasenauer, JD, CLU, are attorneys in the firm of Blazzard & Hasenauer, P.C., Pompano Beach, Fla. Their email address is: [email protected]


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