Financial Industry Rants & Sins, Vol 15

A number of months ago my friend Morris, a CPA, called me up on the phone. I knew I didn’t have any unpaid taxes, but the caller ID and the sound of his voice late in the year made me nervous for some inexplicable reason…and he’s not even my accountant! As it turns out there was no need to be nervous for myself, rather, only one of his clients.

“Howard I just got off the phone with my client, Steve & Tammy, and they said they had an unusual conversation with their life insurance agent. They’ve been doing some estate planning, and they asked the agent what his commission would be on the policy they bought for Tammy. He told them the laws regarding commissions changed and he would probably only make about $5000-$6000 on the policy. But Howard, their premium is $150,000 a year, and everyone knows that insurance agents aren’t making 2.5–3% commissions. No one would do it if that were the case. The second red flag for them was that the agent couldn’t explain to them why they needed to make a one time payment up front of an extra $50,000 in the first year. I thought you might be able to explain to me what’s going on.”

So a few days later I found myself at Steve and Tammy’s dining room table. They own several businesses in partnership with Steve’s two brothers, and their portion of the companies combined with their other assets was worth about $18 million. That means that in New York, their heirs will have to pay estate taxes when Steve and Tammy pass on. I was sitting there because they had just bought a Variable Universal Life Insurance policy (VUL) for Tammy, with the stated reason of “estate planning,” and a death benefit of $6 million. The insurance agent really rubbed them the wrong way, and they wanted to know (and so did their accountant Morris) if they bought the right policy for their needs.

In a word, no, and though it might exist, I can’t think of any situation that a VUL is the answer for estate planning. The reason is quite simple: a VUL policy has a cash value component, supported by the stock and/or bond markets. The policy is designed in such a way that the cost to maintain the policy rises every year, even if your premium never changes. What eventually happens is that the policy costs will strip away the cash value. Once that happens the owner of the policy will receive a pretty scary letter in the mail asking them to pony up more cash or risk losing the policy and everything they put into it. (If you’re an insurance agent reading this simple answer, yes, it’s much more complicated than what I’ve written.)

For Steve and Tammy, their agent designed their policy to fail around the 15th year, though I wouldn’t know if he did that on purpose. I used a very high 14% stock market CAGR as well as 8% bond CAGR to make my calculation. That’s a very generous, best case scenario calculation, and if I used lower returns the policy would lapse even sooner. The reason the agent asked for an extra $50,000 dump in is because he knew that without it the policy was guaranteed to lapse in its 11th year.

The best policy for Steve and Tammy, which was my recommendation, was a Whole Life policy. Before I tell you why that is best, I want to warn you. You might hear your agent tell you “This is a Whole Life policy because it can cover you for your whole life.” Always ask for and read the policy illustration, even if you don’t understand anything you’re reading. If they don’t give it to you when they recommend it, ask for it before you sign the delivery receipt, and read it right there and then. Read it, and usually on the cover or page 1 it will tell you if it is a term, universal, or whole life policy. You’ll also find it at the bottom of every page as a footer. Another hint would be how many pages is the illustration; around 5 pages or less is term, 10–12 pages is whole life (unless you have chronic care or long term care riders), and a college text book sized illustration is universal in any of its variations. The shortest I’ve seen for universal is about 40 pages, and the longest over 150 pages.

So here’s the reason why I recommended the real Whole Life policy to Steve and Tammy. The policy had a guaranteed level premium, guaranteed cash values, guaranteed death benefit, tax deferred growth, tax free access to cash value, tax free death benefit, possible dividends to juice the cash value and death benefit, and creditor protection. It also bypasses the probate process because it’s actually a contract between Tammy and the insurance company. Steve and Tammy decided to limit their premium payment period to 10 years. The prepaid all ten years and got a discount of close to 20%, and because it was prepaid the policy self-fulfills, even if something happens to their business interests.

Finally, there are only five companies that offer a true whole life policy, and they do everything they possibly can to pay a dividend year after year (it’s been paid for over 150 consecutive years for all of them). The dividend will grow the death benefit, helping to keep pace with both inflation as well as the growth of their estate. That’s super important because if G-d forbid the death benefit of $6 million is paid out today, that cash will go a lot farther than it will in 20 years. However, if the death benefit grows over those 20 years to $12 million, they’ll maintain their purchasing power as well as their ability to pay the tax man without destroying the estate they worked so hard to build.