Premium Advice — Using cash value plans instead of living benefits

(December 2007) The tax-sheltered growth of your client’s hard-earned dollars has long been one of the key benefits of permanent insurance products. The ability to offer similar investment vehicles to other open investments in a “self-directed” type plan (universal life) or a professionally managed balanced portfolio with low volatility (whole life) is an approach that many advisors have been promoting over the last number of years.

Our industry has positioned this additional cash asset as a flexible tool that can solve a number of needs for capital. Oftentimes, a client does not use the asset for the initially intended purpose — supplementing retirement income may turn into a capital creation vehicle that helps support the redemption of interest in a business or partnership. The client may even choose not to access this asset at all and simply opt for a larger estate value.

But one trend has recently emerged with increasing frequency. Over the past five years, many companies have added features that allow clients to access the cash value of their plans upon diagnosis of illness, inability to work or inability to perform daily tasks. Even if the definitions may not be as robust as a stand-alone living benefit product, it can offer another compelling reason for clients to shelter dollars in permanent insurance. And a client who doesn’t qualify for a claim but is suffering from health issues can always take taxable withdrawals from his or her plan or leverage the cash value through policy loans or bank loans.

This practice has prompted some advisors to sell cash value plans as an alternative to living benefits products by claiming that they offer the same benefits and are easier to underwrite, and if the client doesn’t make any claims, they retain their cash value.

While the cash value argument is hard to dispute and the underwriting perception may have some merit (though recent industry stats suggest that the perception is worse than the reality), there needs to be a closer examination as to what the definitions truly cover versus a stand-alone living benefit product. Regardless of the above-mentioned advisor perceptions, we must first ask ourselves, “What are the best financial uses for our clients’ money?”

Like any analysis of what might be best for a client, you need to conduct proper due diligence and examine the options. Let’s look at an example.

David Olson: Male, 40, non-smoker $1 million face amount UL (with no investment bonus and 6% growth rate) 15 pay maximum (approx. $37k/year) Cash value in 20 years = $1 million Cash value in 40 years = $3 million (note — numbers rounded within 5% to avoid any specific company representation)

Let’s assume that David has a critical illness event — a heart attack — at age 60. Because he’s able to return to work within 90 days, his disability insurance didn’t pay out. However, he decides to take some time off work with his employer’s blessing to focus on his recovery. His spouse joins him for three months, so their loss in after tax dollars, combined with their living expenses, is $100,000.

David has plenty of money in cash value in his policy. He could withdraw it or take a loan against it. But if he had bought critical illness protection at the same time as he bought his life plan, he could have purchased a level premium plan for $1,077. These same premiums would have had to be invested at a 13.11% guaranteed rate of return after-tax to have created the same $100,000 benefits he’d receive from critical illness insurance. Even though he could use his cash value, the critical illness plan offers much better value for the money in the event of a claim than taking full dollars out of his universal life policy.

As an alternative, let’s assume that David used his cash value to support his aging mother. We’ll say that his mom was 64 when David purchased his policy, and at 82 she began receiving care until she died eight years later. To keep things simple, we’ll say that she needs an additional $2,000 per month above her pensions and other income sources to cover the costs of assisted living. Over eight years, this bill amounts to $192,000. Upon the advice of his advisor, David decides to collateralize his UL plan to a bank and secure a line of credit. At 8% over eight years, this loan will grow to approximately $275,000. Upon her passing, he receives enough of an inheritance to pay off the loan, and his policy is intact with no debt. He’d then be able to access or withdraw from his capital or cash value.

However, his advisor could have recommended that David purchase long-term care insurance on his mother when she was 64 and healthy enough to qualify. They could have put up to $200,000 of benefits in place for his mother at $200 to $300 per month (depending on product structure) from a variety of carriers. If we take the higher end of that price spectrum and compare it to an alternative investment, $3,600 per year would have to be invested each year for 17 years at an after-tax rate of 12.1% to create $200,000 of capital for supporting his mother. Why does this number seem too good to be true? Rates for long-term care aren’t fully guaranteed, and they may not use the entire benefit amount. However, even at 5% growth, $3,600 grows to $97,676 by year 18.

With these examples in mind, it’s clear that your clients could withstand the financial pressures of certain illnesses or disabilities for themselves and their loved ones in either case. However, by incorporating living benefits solutions, they’d still have their cash value intact, and have received great value for their money.

Chris Paterson is vice-president of sales for Manulife Financial.

(12/03/07)