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Distributions Out of a Cash Value Life Insurance Policy

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It’s no secret the life insurance industry rides the waves of the latest hot product. In today’s market, that hot product is indexed universal life insurance. And with that comes a plethora of sales ideas from the life insurance companies offering IUL to help position their product in a crowded IUL market.

So, we’re all familiar with the pitch—cash-value life insurance, in general, offers tax deferral, tax-free distributions (diversifying tax rate exposure), no contribution limits based on income, no pre-591/2 distribution penalty, Roth IRA alternative, no RMD requirement, tax-free death benefit, and add LTC, chronic illness, or other riders.

(Related: Life Insurance Premium Increased 3% in 2016)

This product is often positioned as a supplemental retirement tool, adding a tax-free bucket to a retirement savings account to go along side the more traditional retirement savings resources — tax-deferred buckets, such as 401(k) plans and IRAs, and taxable buckets, such as brokerage accounts, stocks, etc. It’s also a potential source for funds to cover LTC costs in retirement. And with IUL, there’s the added pitch of no market risk.

There is no question as to the legitimacy of IUL (or any cash value product) as an accumulation vehicle and many of the sales ideas focusing on accumulation. The objective here is to address a rarely mentioned issue: the distribution phase.

Typically, when advisors have a suitable client for using IUL as an accumulation vehicle for supplemental retirement savings, they will contact their product provider/broker for illustrations. The generic illustration scenario is a maximum funding approach initially using an increasing death benefit (option 2) then switching to a level death benefit (option 1) at the optimum time. This design helps maximize cash accumulation and distributions, which is the goal.

In addition, the illustrations are run showing projected distributions which are structured as a withdrawal of funds up to the client’s basis in the policy, then switching to loans to maintain a tax-free distribution stream of income. There can be, of course, other design approaches depending on each individual client; however, this is traditionally how these scenarios are illustrated.

A majority of insurance companies focusing on the IUL and accumulation market also offer an overloan protection rider, which essentially freezes policies when loan balances exceed a certain threshold as a percentage of cash value in the policy. This inhibits the policyholder from continuing to take additional loans from the policy,  preventing the policy from lapsing and creating a potentially disastrous tax situation.

Many financial and investment advisors will agree that sequence of returns is a critical element of retirement planning. There are a variety of techniques available for developing allocation strategies to help ride out the highs and lows of the market in the accumulation phase. However, the challenge of managing market volatility in the distribution phase can be quite different.

Dollar breaking up (Image: Thinkstock)

(Image: Thinkstock)

If retirement distributions begin in a stable or rising market, the client has the potential to preserve or even grow their retirement assets. If a client begins retirement distributions in a declining market, they are both drawing down on assets and selling into losses. Their retirement assets may begin to erode faster than initially planned. The bottom line is that the distribution of retirement funds must be managed carefully so a client doesn’t spend down the retirement nest egg much quicker than anticipated and potentially run out of money in retirement.

I mention this because, similar to the challenge of managing sequence of return in an investment/retirement account during the distribution phase of retirement, the same careful management in the distribution phase out of a IUL cash value life insurance policy is a necessity. So, if it’s not properly managed and the policy lapses due to overloan, the client will receive a 1099 representing the taxable gain the policy.

(Related: 18 Reasons for Making Indexed UL Part of Your Portfolio)

There are other concerns when designing these plans using IUL, such as overly aggressive illustrated rates of return and variable loans, that can cause major issues and derail the policy. However, the reason for raising this issue is to address the one component rarely, if ever, mentioned when IUL is recommended as an accumulation vehicle, and that is effectively managing distributions out of the policy.

As a life insurance professional for more than 20 years, I can debate why cash value life insurance works as an effective accumulation vehicle but, for the purpose here, I can also debate why it doesn’t work.

Most advisors and product providers/brokers have their favorite IUL company and product. I know I have my “go to” IUL providers. The question I always ask is this: What is that company doing to help administer the assumptions in an illustration and, more importantly, what can they offer the client to help manage that policy, specifically in the distribution phase.

Most advisors are unaware of the numerous moving parts that exist and the required paperwork involved on the client’s part to manage those moving parts in the effective management of the policy when turning on distributions.

Machinery (Image: Thinkstock)

(Image: Thinkstock)

It requires, primarily, that the client/policyholder to be proactive and heavily involved. How many clients do you know who like to complete paperwork on a regular basis?

What are the moving parts?

  • The option 2 death benefit needs to be changed to option 1. Failure to make this change will reduce the amount of income received or cause policy to underperform and, potentially, lapse in distribution years if client takes out consistent and significant withdrawals and loans.

  • Switching from withdrawals to loans must be requested. If withdrawals are more than the basis in the contract, it is a taxable event.

  • Completing paperwork when a distribution is desired.

  • An overloan protection rider must be activated by the policyowner. If it isn’t, then the policy lacks the necessary safeguard to keep from lapsing and preventing a taxable event.

  • Annual recalculation of income based on performance. Annual inforce illustrations must be requested to monitor the plan.

So, when working with your product provider/broker and comparing IUL illustrations, take time to learn more about how the assumptions in an IUL illustration are actually administered. Put the companies through the following checklist to see which one has the edge in making the assumptions in the illustration into a reality. One company has completely automated the distribution process and a few have an efficient policy management platform that can help, but still requires proactive policyowner involvement.

Chances are, based on my experience, if the company and product sold doesn’t provide any of the following and is simply the one that illustrates the best, it, without question, falls into the category of why IUL won’t work as an accumulation vehicle:

  1. What is required to request income both initially and moving forward?

  2. What is required to switch from option 2 to option 1 and who is responsible for initiating a reminder to make the change?

  3. What is required to switch from withdrawals to loans and who is responsible for initiating a reminder to make the change?

  4. What is required to activate the overloan protection rider and who is responsible for initiating a reminder to activate it?

  5. What is your process in recalculating income and inforce projections and who is responsible for initiating requests?

Utilizing indexed universal life insurance or any permanent, cash value life insurance product as an accumulation vehicle for suitable clients, can be a powerful tool as a part of their overall portfolio and financial plan. I strongly encourage advisors considering life insurance in this capacity to look well beyond the illustrations and dig deeper into the products being considered by putting them through the above checklist and fully understand how the assumptions in the illustrations are administered. By doing proper due diligence and being proactive in the monitoring and management of these plans, advisors can help meet their fiduciary responsibility and provide significant value to their clients.

— Read Opportunity Creation: 5 Ways to Grow Your Business on ThinkAdvisor.