It happens all the time…clients walk in and, through a fact-finding exercise or just in conversation, you uncover that they own permanent life insurance policies. As the planner, your first reaction is, "What were you thinking?"

These policies historically have been riddled with high fees, large commissions, and unrealistic performance expectations. The insurance agent that sold the policy is long gone after making a whopping 90% of first year annual premium commissions. Now you are brought in to help clean up this mess.

What options are available to salvage life insurance assets in a more efficient retirement strategy?

Just like in the investment management world, clients' insurance needs change over time. Personal balance sheets, taxes, and legacy concerns have all changed since the client was sold the policy. If the client has been paying into a permanent life insurance policy for a reasonable period of time, they (hopefully!) have built up some cash value. Now the questions are:

    1. What kind of policy is it? Whole life? Universal Life? Variable Universal Life?
    2. Does the client still need life insurance coverage?
    3. Can they afford to continue paying the premiums as their costs of insurance increases with age?
    4. Can these assets be put to a more efficient use?

Options to consider

Whole life policies depend on consistent dividend payouts, whereas variable life insurance relies on market performance to build up cash over time. If the client is less concerned with or no longer needs the death benefit and needs cash, there are some possible options worth exploring.

  • Policy owners can borrow (loan/withdrawal) against the cash value. Loan interest typically ranges from 4-8% (but often is rebated to make the effective rate less than 1%). Loans in life insurance policies are essentially collateralize against the death benefit. Taking a loan against the policy is an easy solution to create income, however, this is generally a short-term fix because if the loan balance exceeds the cash value, the policy could lapse leaving behind nothing except a possible tax liability.
  • A life settlement where a third party purchases the policy in order to receive the death benefit proceeds. This is generally viewed as a last resort because the return is generally not very favorable to the owner.
  • Convert the cash value from the life insurance contract into an annuity via a tax free 1035 exchange. The downside of this strategy is that the death benefit would be forfeited, however, this option helps to preserve the tax status of the money, lowers (variable or fixed indexed annuities) or eliminates (SPIAs) the fees and provides flexibility to accumulate or generate additional retirement income.

When evaluating this option, it is imperative to understand the relationship between the cash value relative to the cost basis (the sum of all your insurance payments). If the cash value balance is higher than the amount paid in premiums, the excess represents taxable gains. But, with permanent life insurance policies, generally the cost basis exceeds the cash value.

Let's assume as an example your client has a cost basis of $200,00 and $60,000 in cash value. If the client were to surrender the policy, the $140,000 difference/loss is gone forever.

By executing a non-taxable 1035 exchange into an annuity, the owner could continue to grow the cash and optimize the otherwise wasted tax loss. Meaning, that $60,000 cash value can grow in annuity without gains until it surpasses $200,000! The annuity proceeds can then be used to relieve other assets and achieve retirement goals. If the client still had some life insurance coverage needs, they could even look at using the money from the annuity to purchase term insurance, which would be a more cost-efficient way to cover their liabilities than maintaining their permanent policies.

Next time a client comes in with an older life insurance policy, consider repurposing the assets into new and improved annuity solutions. You'll open a multitude of planning opportunities for you and your clients.

Meet the Author

Marcus Ellingwood specializes in low-cost, commission-free insurance solutions for fee-only advisors and their clients. He holds a Series 6 and 63, along with his Kentucky Life Insurance License.