Volatility Can Kill Your Variable Life Policy
You or your spouse or parents may have purchased a life insurance policy several years ago. You always thought life insurance was a bad investment with returns of only 3-4%. However, this policy was supposed to be different – the premiums could be flexible and you could invest the cash value in the stock market where returns had historically averaged 10%. The promise of "stock market returns" would reduce the premiums you were required to pay for the insurance death benefit. Life insurance finally seemed attractive, based on what your financial advisor was saying, so you made the investment in something called "variable universal life insurance."
The stock market performed well for several years and the cash value of the policy increased. There were some market "corrections," but the stock market recovered and continued to prosper, and so did the variable life insurance policy.
Then a significant prolonged stock market decline occurred; one that caused your 401-K to shrink dramatically. However, you did not notice the impact on your variable life insurance. You thought you just needed to keep paying the premium your financial advisor had provided and the insurance would be fine. The stock market recovered over time and so did your 401-K and the cash value of the life insurance policy seemed to bounce back. You didn’t really pay attention to the statements that came from the insurance company to notice that the insurance policy cash value did not recover as much as your 401-K.
Years passed and the stock market went into another prolonged decline, with substantial negative returns, followed by a period of significant volatility. Your retirement funds and your retirement seem extremely vulnerable. One day the life insurance company sends a letter that captures your attention – your policy may lapse unless you pay a substantial additional premium.
You contact your financial advisor who confirms the grim facts – you have to pay substantially greater premiums for the rest of your life, or you may have no life insurance. You cannot afford the huge premium increase, as you are trying to save enough in your last working years to retire; or maybe you have already retired, and the required premiums are impossible. Your financial advisor tells you that you can decrease the face value of the life insurance policy and continue to pay the same premium or just let the policy "lapse" if you cannot afford additional premium payments.
How could this happen to your life insurance? When you purchased the policy years ago, your financial advisor showed you how it would work if the stock market continued the historic trend of a 10% return over time. Of course, there was no guarantee, but after all it had been true for 70 years. Your financial advisor gave you a very thick disclosure document required by federal securities law that explained it all. Another massive legal document not read or understood.
The devastating, insidious truth is that your variable life insurance was never guaranteed to last and to provide the death benefits you counted on for your family. You bought in part because of lower "premiums" and stock market returns. No one, not even the federal securities law prospectus, disclosed the hidden and toxic effects of negative stock market returns and volatility on your variable life insurance. Many policy owners have faced this dilemma in recent years. Some have surrendered or reduced the face value of their policies or exchanged into safer types of policies. Some have died and their families have not received the death benefits they expected and needed. Why?
The hidden truth about variable life insurance is that mortality and expense charges ("M&E Charges") have been deducted from the cash value of the policy by the insurance company every month. This was true when the stock market flourished and when it sank. However, when the stock market "rebounded" after a significant decline, your life insurance cash value rebounded less, since it had been reduced by M&E Charges. The same was true when the stock market suffered prolonged volatility. Negative returns, volatility and M&E Charges created a death spiral for your variable life policy. Computer analytical tools could have predicted the probability of this result, even when the policy was originally acquired.
If this has not yet happened to your variable life policy, review its status and your choices now. If this has been your experience, consult with your financial and legal advisors. If you are considering life insurance products, to paraphrase Aristotle, "avoid the attractive impossibility, as compared to the less attractive probability."
Gordon Schaller is a partner in JMBM’s Taxation, Trusts & Estates Department, and a senior member of JMBM’s Global Hospitality Group®. Gordon helps businesses set up captive insurance companies and advises them in a full range of strategies to achieve tax efficiencies. For more information, please contact Gordon Schaller at 949.623.7222 or GSchaller@jmbm.com.