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Peter Katt
Peter Katt
Level Death Benefit Policies

Pros and cons divulged.

July 21, 2011
by Peter Katt, CFP, LIC

A recent case has an interesting life insurance premium-paying perspective:

Ben, 61, is in great health. He owns a very successful business with substantial additional assets. His wife, Jenni, is 52, in good health and a joint insured. I was retained to review their existing life insurance. Like some clients I work for, Ben was using a quick-pay premium payment strategy for his policies. There are two motivations for preferring a quick-pay approach:

  1. Just a psychological desire to get the premiums over with and
  2. Due to cash-flow considerations, such as a client’s drop in income level during retirement.

There is another premium paying factor — level vs. increasing death benefit policy designs. (Level death benefits refer to the same death benefit from when the policy is purchased until it matures – either at death or specified age). Level death benefit designs are a real deal breaker for the quick-pay method.

An increasing death-benefit design features minimal initial-death benefits with maximum premiums. Such policies are intentionally overfunded to produce the best long-term value and are conventional participating whole life with dividends used to buy paid-up-additions. Premiums can continue until the death of insureds or they can cease once the policy has become self-sustaining with dividends used to pay future premiums. Of course if more premiums are paid the cash values and death benefits will be larger, so the return on premium dollars will essentially be the same. This policy design can be thought of as a defined contribution. Contributions/premiums are paid in and the cash values and death benefits go up. If contributions/premiums are stopped, the values go up but not as much as when they continue. This is a choice your client can make though it is not necessarily the better option in terms of continuing premiums or stopping paying them.

As part of Ben and Jenni’s life insurance portfolio, their advisers asked me to compare much larger premiums for five years or lower premiums paid every year for the participating whole life policies. Either way works. The premium pattern depends on Ben and Jenni’s preference.

Level Death Benefit Policies

However, level death benefit policies create very different premium pattern efficiencies. A level death benefit policy has the same death benefit when purchased until it matures. The efficient management of the policy is to have minimal cash values to support the level death benefit until maturity. To have more than minimal cash values is to overpay for the coverage. For example, a $1-million policy pays the same death benefit whether the cash value is $100,000 or $300,000. The instinct to quick-pay a level death benefit policy leaves it vulnerable to creating too much cash value at an insured’s death. This is economically inefficient for two reasons:

  1. Overfunding for an extended period of time if a quick-pay policy is started during a low interest-rate environment followed by much higher interest-rate environment. Low interest rates usually translate into low UL crediting rates and higher interest rates translate into higher crediting rates.

    Ben and Jenni’s $3 million survivorship UL purchased several years ago was set up on a quick-pay premium design of $60,000 through the 10th policy year, then zero premiums. The $60,000 quick-pay premium is based on the current 4.5 percent crediting rate. With respect to the interest rate factor this works fine as long as the 4.5 percent rate stays the same, but if it gradually goes up and stays up (say 8%), the policy is overfunded for an extended period of time vs. paying minimum continuous premiums that are adjusted as the crediting rate changes. In this example, Ben and Jenni’s initial continuous annual premiums would be around $18,000, reduced to the $7,000 range (assuming the interest rate does increase to 8% over time and remains there). Using this latter premium design the policy will not become overfunded and this will maximize the policy’s value. In this interest-rate scenario the quick-pay policy’s death benefits will go up as the cash values go up to remain consistent with the prescribed death benefit to cash value ratio (under IRC Section 7702). However, the return on premiums will be slightly less than continuous-pay premiums over the very long run. Bottom line? In an increasing interest-rate era, quick-pay policies may be less valuable than continuous-pay policies that are managed properly. Ben and Jenni decided to change to a continuous-pay premium pattern on their policy.
  2. Inflexibility in managing a known shorter mortality situation by avoiding quick-pay premiums with level death benefit policies. This takes some explanation. A level-death benefit UL is set-up to fund it to maturity, which is the earlier of death and a specified time in a policy. Older UL policies had an age 95 maturity, then they became 100 and for the past five years or so they have gone to 115 or 120. As long as insureds remain in good health, funding needs to be to policy maturity.

    Ben and Jenni’s policy needs to have $3 million in cash value at age 100 to continue for life, in the event one of them lives beyond 100. In managing a policy (usually every few years) the first thing I want to know is what the health of the insured is. As long as Ben and Jenni remain in good health, the funding goal will be to 100. But let’s say that Ben died and at age 83, Jenni has terminal cancer. Suppose it is concluded that she won’t live more than another five years. The UL’s cash values are large enough to continue the policy for another five years without additional premiums. I would have Jenni stop paying premiums and save the beneficiaries the amount of the premiums that would otherwise be paid. However, when a policy is quick-paid there is no flexibility to stop premiums in this manner because the policy was essentially pre-funded.

Conclusion

By paying close attention to various life-insurance policy factors, personal financial specialists can recommend the most effective premium design. Participating in whole life with dividends and buying paid-up-additions may have increasing death benefits. Premiums can be quick-paid or continuously-paid, without losing policy efficiency. However, level-death benefit UL policies lose efficiency using quick-pay premium designs. They should only use minimal continuous-pay premiums for the above-stated reasons.

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Peter Katt, CFP, LIC, is a fee-only life insurance advisor since 1983, he has written insurance columns for AAII Journal and Journal of Financial Planning since 1991.

* DISCLOSURE: Readers should assume that all investment advice mentioned in this column are the author’s and/or his firm’s unless otherwise noted and does not necessarily reflect the views of the AICPA or the AICPA Wealth Management Insider.

* The AICPA’s PFP Section provides information, tools, advocacy and guidance to CPAs who specialize in providing tax, retirement, estate, risk management and investment advice to individuals and their closely held entities. All members of the AICPA are eligible to join the PFP section. For CPAs who want to demonstrate their expertise in this subject matter apply to become a PFS Credential holder.