Life Insurance as an Investment
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Life Insurance as an Investment
In May 1994, North Carolina Insurance Commissioner Jim Long announced an out-of-court
settlement with the Metropolitan Life Insurance Co. over deceptive sales tactics used by
some of the company's agents. The agreement called for Met to pay more than $12 million
in fines and make full restitution to affected consumers.
The dispute centered on the misrepresentation of whole life insurance policies as
retirement products. Rather than setting up retirement plans, many Met clients were in
fact buying life insurance policies.
"Our investigation concluded that some Met Life agents were deliberately obscuring the
fact that they were selling life insurance by calling the policies retirement plans. We
believe that insurance consumers have the right to know what they're buying and we hope
this settlement sends the message that slippery sales tactics have no place in North
Carolina," said Long.
The agreement also detailed an extensive accountability and compliance plan to assure
that'the deceptive practices did not recur in the future. Similar agreements with Met
Life were reached with regulators in more than 40 other states through the National
Association of Insurance Coinmissioners.
Life Insurance and Retirement Planning
Life insurance and related annuity products are frequently used to provide the funding
for retirement plans and other types of plans. Some of these plans may also be funded
with other produCts such as mutual funds, certificates of deposit, stocks and bonds, cash
held in bank accounts, etc.
A cash value policy accumulates a sum of money for retirement while providing a death
benefit. Upon retirement, the policy pays an income such as $10 per $1,000 of life
insurance for the insured's lifetime~or for a specified period.
- Once the cash value of the policy becomes gfeater than the face amount, that cash
amount becom~s the death benefit.
You can tailor these 'policies to a~cumulate "rapidly high premium or slowly lower
premium.The fact that a nonqualified plan is not approved by the IRS does not imply that
it is illegal or unethical. A nonqualified plan is a legal method of accumulating money
for retirement funds and other purposes.
Example: A person buys an individual annuity for the purpose of accumulating his or her
own retirement benefits.
When this person pays the annuity premium or payment, there is no tax deduction for the
payment of the premium.
The annuity is not Itled with the IRS.
Pension plans and other qualified' plans may include incidental life insurance benefits,
but these must be incidental to the purpose of the plan. The primary purpose of the plan
must be to provide retirement benefits.
In order to stay within the requirements established by the IRS, qualified plans must
satisfy the incidental limitation rule, which requires that the cost for life insurance
benefits provided by a pension plan (or profit-sharing plan) must be less than 25 percent
of the cost of providing all benefits under the plan.
Generally, the cost for insurance protection unde!" a pension or profit-sharing
plan is taxable as income to the employee to the extent that any death benefit is payable
to the employee's beneficiary or estate. The cost for any protection for which the
proceeds are payable to and may be retained by the plan, trustee or employer is not
taxable as income to the employee.
Example: An executive insured under a key person life policy does not have to pay tax on
the cost of that coverage.
Retirement Options With Cash Value
Wh€n you retire, you can use a cash value life insurance policy in several ways. You can
borrow cash values or annuitize payment plans. Both will allow you to use your money for
retirement, but each has distinct pros and cons which have to be assessed individually.
Borrowing allows you to avoid income'taxes on the income borrowed. This is the good news.
However, if you borrow all of yo~r cash value and the policy terminates, you will be hit
with capital gains tax on the growth in excess of premiums-for money you spent years ago.
That's the bad news. This kind of capital gains tax can be a nasty surprise at age 80 or
85, when most people are busy worrying about health coverage or estate taxes,
Depending on the individual policy's characteristics (the crediting rate, the dividend,
etc.) and the actual amount you decide to withdraw; you may be able to avoid paying back
a policy loan. If you carefully keep enough cash in the policy to keep it in force, upon
your death the life insurance proceeds will payoff the loan.
Many people lost a lot of money on these investments in the 1980s, when interest rates
fell and policies weren't performing the way they expected. Perhaps the highestproftle
failure of any life insurance company in recent years was the 1991 insolvency of
California-based Executive Life Insurance Co.
Executive Life had invested heavily in junk bonds and other high risk securities to
rmance the high interest rates it had promised policyholders. When the junk bond market
crashed, Executive Life became technically insolvent-even though it was still paying
claims.
When California insurance regulators seized Executive Life, its policyholders didn't know
how much of their money they would ever get back. Indeed, regulators remained unable to
sort out the company's liabilities, making it difficult for them to calculate how far
Executive Life's remaining assetsplus money promised by several competing rescue
planswould go.
Most policyholders ended up getting close to the full value of their policies, but some
holders of large p~licies (and tricky investment vehicles like guaranteed investment
contracts and single-premium deferred annuities), which weren't completely covered by
state insurance guaranty funds, got less than 70 percent of the face amount of their
policies.
Annuities
Annuities are not-strictly speaking-life insurance, but they are often sold by life
insurance agents, so a basic understanding of how they work may be useful.
The basic function of an annuity is to liquidate a sum of money systematically over a
specified period of time. An annuity contract provides for a scheduled series of payments
that begins on a specific date-such as when the recipient reaches a stated age-or a
contingent date-such as the death of another person. The payments continue for the
duration of the recipient's life or for a fixed period.
The annuitant is the po insured, the person on whose life the annuity policy has been
issued. As is the case with life insurance, the owner of the contract mayor may not be
the annuitant. Unlike insurance, though, the annuitant is in most cases also the intended
recipient of the annuity payments.
Depending on the type of annuity and the method of benefit payment selected, a
beneficiary may alsocbe named in an annuity contract. In these cases, annuity payments
may continue after the death of the annuitant for the lifetime of the beneficiary or for
a specified number of years.
There are two principal types of annuities: fixed and variable.
Afixed annuity is a fully guaranteed investment contract.
Principal, interest and the amount of the benefit payments are guaranteed. Fixed annuity
payments are considered part of the insurer's general account assets (the conservative
investment portfolio, not the stock market one).
There are two levels of guaranteed interest: current and minimum. The current guarantee
reflects current interest rates and is guaranteed at the beginning of each calendar year.
The policy will also have a minimum guaranteed interest
rate-such as 3 percent or 4 percent-which will be paid even if the current rate falls
below the policy's guaranteed rate. The minimum guarantee is simply a predetermined
lowest rate.
A variable annuity, like variable life insurance, is designed to provide a hedge against
inflation through investments in a separate account of the insurer consisting primarily
of common stock. A variable annuity is not a fully guaranteed contract. However, either a
fixed or a variable annuity can guarantee expenses and mortality.
Any expense deductions made to annuity benefits are guaranteed not to exceed a specific
amount or percentage of the payments made. And, as long as they're reasonable, these
expenses can be worth absorbing. The guarantee of mortality provides for the payment of
annuity benefits for life.
Variable annuities may be purchased in the same way as fixed annuities-single premiUm
immediate or deferred and periodic payment deferred contracts.
Also, variable annuities include a variable premium feature, known as a flexible premium
deferred annuity (FPDA) contract. Variable annuities offer the same annuity options for
settlement of the contract as fixed annuities. Both types of annuities are primarily used
as retirement vehicles.
A variable annuity poses several other unique issues:
- If the portfolio of securities performs well, the separate account performs well and
tlIe variable annuity-backed by the separate account-will also do well. Due to this
dependence, there is investment risk to the annuitant. There is no guarantee of
principal, interest or investment income associated with the separate account.
- As evidence of the annuitant's participation in the separate account, units of the
trust are issued. This is very similar to shares of a mutual fund which are issued to
mutual fund investors. During the accumulation. period, these units are identified as
accumulation units. Both the number of the units and the value of these units will vary
in accordance with the amount of premium payments made and the subsequent performance of
the separate account.
Example: Jan invests $100 per month in her variable annuity. On the day the insurer
received her $100 payment, the value of an accumulation unit was $10. Thus, Jan is
credited with 10 additional accumulation units.
- When the annuitant reaches the annuity period, these
- accumulation units are
converted to annuity units.
The number of annuity units remains constant. No further money is being contributed to
the annuity.
Thus, there is no further increase in the number of annuity units.
However, the value of the annuity units will vary in accordance with the daily
performance of the separate account. Accordingly, during the annuity period, benefit
checks issued to the annuitant will vary depending on the value of the annuity units at
the time the monthly check is issued.
Occasionally, an annuitant may decide that it is in his or her best interests to purchase
an annuity which offers some guarantees but also offers protection against inflation.
This type of annuity is usually identified as a combination or balanced annuity.
Example: You cash in a 20-year-old cash value life insurance policy soon after you
retire. This generates a sizable lump sum of cash-say, a little over $100,000. You can
use the cash to buy a single premium annuity that creates income for you an4 your spouse,
if you should die first.
When an Annuity Pays
If you buy an annuity with a single payment, the benefits may begin immediately or they
may be deferred. If you buy an annuity with a series of periodic payments, then the
benefits will be deferred until all payments have been made. (This second kind of annuity
is commonly called a periodic payment deferred annuity.)
The accumulation period is the time during which the annuitant is making contributions or
payments to the annuity.
The interest paid on money contributed during this time is tax deferred. The interest
earned will be taxed eventually, but not until the annuitant begins to receive the
benefits.
Annuity settlement options are the provisions of the annuity. Generally, when the
annuitant decides to take money from the annuity, an annuity option will be selected as a
method of disposing of the annuity's proceeds. It is not unusual for an annuity option to
be elected at the time of application.
If you bought a single payment deferred straight life annuity, you would own an annuity,
purchased with a single payment, which will provide a payout for life. Even if an annuity
option is elected at the time of purchase, it may (and probably will) be changed at the
annuity period- to reflect your changing needs. These changes usually have something to
do with retirement or the death of 5l spouse.
There are two periods of time associated with an annuity: the accumulation period and the
annuity or benefit period.
The amount of money available durmg IDe .ann~ity periog is determined by the annuity
option selected, the amount of money accumulated by the annuitant and the life exp~ctancy
of the annuitant.
A life only or straight life option provides for the payment of annuity benefits for the
life of the annuitant with no other payment following the death of the annuitant. There
is a risk to the annuitant due to the fact that he or she must live long enough once the
annuity period begins to collect the full value. If an annuitant dies shortly after
benefits begin, the insurance company keeps the balance of the unpaid benefits.
This option will pay the highest amount of monthly income to the annuitant because it is
based only. on life expectancy with no further payments after the death of the annuitant.
A refund option will pay the annuitant for life-but, if he or she dies too soon after the
annuity period begins, there may be a refund of any undistributed principal or cost of
the annuity. The refund may take the form of continued montl)ly installments (an
installment refund annuity) or it may be in one lump sum (a cash refund annuity),
whichever has been elected by the annuitant. This option assures the annuitant that the
full purchase price of the annuity will be paid out to someone other than the company
issuing the annuity.
Life with period certain is basically a straight life annuity with an extra guarantee for
a certain period of time. This option provides for the payment of annuity benefits for
the life of the annuitant but, if death occurs within the period certain, annuity
payments will be continued to a survivor for the balance of that period.
The period certain can be for just about any length of time-5, 10, 15 or 20 years. Most
often, the period selected is 10 years because 10 years is approximately the average life
expectancy of a male who retires at age 65. Thus, an annuitant retires at age 65, selects
life with 10 years certain and dies at age 70, his survivor will continue to receive the
monthly annuity payments for the balance of the period certain (five more years).
The joint-survivor optionprovid~ benefits for tJ:1e life of the ant)uitantand the
life of the survivor. A stated monthly amount is paid to the annuitant and, upon the
annuitant's death, the same or a lesser amount is paid for the lifetime of the survivor.
The joint-survivor option is usually classified «s Joint and 100 percent survivor,
joint/and two-thirds survivor or joint and 50 percent survivor. .
The joint-survivor annuity option should be distinguished fro~ a joint life annuity,
which covers two or more annuitants and provides monthly income to each annuitant until
one of them dies. Following the first annuitant's death, all income benefits cease.
Calculating Guaranteed Interest Rates
Premiums or payments made during the accumulation period earn a guaranteed return on a
tax-deferred basis. There are two ways to calculate guaranteed interest paid on these
contributions:
- The guaranteed purchase rate is the minimum interest rate that is guaranteed for the
life of the contract. This will be a fairly modest amount-such as 4 or 5 percent. This is
the minimum return which will be paid even if the current annual rate falls below the
guaranteed rate. Thus, deferred annuities guarantee a minimum interest rate which
contributions will earn. Since the guaranteed rate is less than prevailing interest
rates, the insurer will often credit excess interest on the contract.
- Excess interest is calculated based on how much the insurer has earned through its
investments. If the insurer considers all of its invested reserves and net investment
earnings over a relatively long period oftime, the interest rate calculation is said to
be made based on the portfolio method. If the insurer instead con'siders portions of its
invested reserves over a shorter period of time the interest rate calculation is based on
the tier method.
Annuities and Retirement Planning
Most often, the primary purpose of an annuity is to provide retirement income. Like life
insurance policies, annuity contracts may include nonforfeiture provisions to protect
_the, contract holder from total forfeiture or loss of benefits if he or she stops making
the required periodic . payments, and surrender charges, or penalties for cashing in the
annuity before the payout period begins.
Group annuities are often used to fund an employersponsored retirement plan, with the
employer as the contract owner. If the annuitant dies during the accumulation period, the
money accumulated will be paid.to a survivor. A common illustration is the annual premium
retirement annuity contract, in which the total accumulation is calculated based on an
annual premium, an assumed interest rate and retirement age (usually 65),
During the accumulation period, the annuity contract is very flexible in that the
annuitant may make payments or not make payments. In addition, the annuitant has
withdrawal options whereby the money accumulated can be withdrawn totally, or in part,
during the accumulation period.
Annuities may be used to fund individual retirement accounts (IRAs), in which case
premium payments maybe tax deductible. But, in this application, there are more
restrictions on withdrawals (including tax penalties for withdrawals before age
59).
Conclusion
There are few guarantees associated with a variable annuity or other insurance-related
investment vehicles. These contracts will usually guarantee that expenses chargeable will
not exceed a specific amount or percentage. In addition, they may also guarantee
mortality-which means a benefit check will be guaranteed for the life of the beneficiary
or annuitant. However, these investment tools do not guarantee the amount of the benefits
at retirement nor do they guarantee principal or interest.
Considerable controversy has raged over the regulatory issue of whether variable
annuities are really insurance products or equity investment tools. This is generally
true of all investment-type insurance products.
Buying life insurance or ahtlUities as investtnel1ts..may make sense to some people as
tht!yplan for their retirement. If you're going to use these toolS, though, you.;,should
think of them as an addition JO your basic income-replacemel1t life insurance covt!rage..
In most cases, theinyestmel1t1type policies entail a degree of risk -either in what you
pay in or what you can take out-that wakes them a shaI(yfoUtldation for your essential
needs.
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