Lately I have been involved in a few situations where there was clearly a lack of understanding about the concept of Policy Maturity and what it means. This post will not attempt to be terribly technical nor an exhaustive history of the evolution of life insurance but rather a summary of what most advisors and policy owners need to know regarding Policy Maturity. Not understanding the basics can be the cause of significant distress and regret.
First of all, an idea which kind of goes along with Policy Maturity is “Endowment”. I put the word in quotes because it is used loosely today and not always as it is technically defined. Generally speaking, an Endowment Policy is a contract which will pay out a certain amount at a stated date. The term “to endow at maturity” is also often used to mean the cash value will equal the death benefit at policy maturity (a date defined in the contract) whether or not the cash value is to be paid out. In true endowment policies or any policy where cash value is to be distributed at policy maturity, the amount paid out over basis will likely be taxed as ordinary income.
The age at which Policy Maturity is reached is specified by the particular contract in question. It’s common to see them them range from age ninety to one hundred twenty something. There is also something very important called a Policy Maturity Extension Rider. This is a contractual provision which allows the death benefit, however it is defined, to stay in force as a death benefit after the stated point of maturity. Clearly the benefit is that for those fortunate enough to live past the Policy Maturity date, they do not experience the adverse tax effects of the policy paying out. I’ve always thought it was odd to say, in effect, “Congratulations, you made it to 100, we’re going to change your tax free death benefit into a taxable distribution at the highest tax rates possible.”
Whole life policies and universal life policies have a meaningful difference
in the fact that most traditional whole life policies definitionally have to “endow” at maturity, whether or not they pay out at that point. Theoretically, the cash value will grow to the original death benefit, or if the policy has an increasing death benefit, the cash value grows at a faster rate than the death benefit and the spread between the death benefit and the cash value narrows over time and eventually comes together at the maturity date. Unfortunately, in a declining interest rate market, dividends haven’t been able to sustain all whole life policies and the death benefit is going down to meet the lower than expected cash value. One way or another, the cash value and the death benefit will eventually come together.
With universal life, there isn’t this definitional cash value and death benefit connection. The original sales ledger may have assumed a cash value equaling the death benefit at a certain date but it will actually do so only by sheer coincidence. A universal or variable universal life insurance policy panning out like the sales ledgers signed off on when the policy was put in force is like your 401(k) having exactly the balance in it at 65 that was projected when you were 30 after not making a single adjustment in 35 years. It is impossible.
Following is roughly the evolution of universal life style of policies over the years as it pertains to policy maturity.
A few generations ago, a universal life policy, when it reached the policy maturity date, would simply pay out the cash value. This means that if your $1,000,000 policy reached the maturity date and the cash value was $50,000, you received a check for $50,000.
The next generation of policies didn’t pay out the cash value, but had a maturity extension rider which kept the cash value in force as death benefit. Keeping the $50,000 in force as a death benefit isn’t meaningful, but if you had a $1,000,000 cash value, it would be important for it to stay in force as a tax free death benefit rather than a taxable distribution.
The next generation of policies were even more consumer friendly. The new feature stated that if your policy lasted to maturity with at least a dollar of cash value, the entire death benefit stayed in force beyond policy maturity. This reduced the risk somewhat but also tempted policy owners to underfund policies which, because there was no meaningful understanding of how life insurance works, probably hastened the demise of innumerable contracts.
Most recently, the guaranteed no-lapse policies offered a death benefit even if the policy had no cash value whatsoever. Until then, there was a simple rule; when your cash value went to zero, your death benefit went to zero. These new policies are a double edged sword. On one hand they actually work, on a fundamental basis, how the consuming public has always thought life insurance works. Namely, you pay a premium and you get a death benefit. On the other hand, there is a set of rules which need to be followed and history has taught us, very clearly, that consumers have almost no ability to follow rules associated with life insurance. Furthermore, too few agents tend to make sure the rules are followed and insurance carriers have little incentive to make sure the policy is well managed as doing so increases the chances of a death benefit being paid.
As with so many products, the new shiny one is oversold. The guaranteed UL policies are a fabulous evolution of contracts which are perfect for some people in the appropriate situations but are clearly not for everyone.
Lately I have had a higher than normal number of cases come across my desk involving older insureds with older universal life policies which will simply pay out their low cash value at maturity (if the policy lasts that long) leaving the family with none of the expected coverage. These are on individuals who have a reasonable chance of living to policy maturity. The conundrum is that this is, for example, a $5,000,000 policy on an 88 year old with $2,000,000 of cash value in a contract with an age 95 maturity date. The cash value is projected to be minimal at age 95. (Don’t think for a second that the policy won’t burn through $2,000,000 of cash value in seven years!) If the insured passes away at 94, the full $5,000,000 is payable. If the insured lives a day “too long”, it’s all gone. So… do you risk it or do you cut and run with the $2,000,000 today and minimize your potential losses? The required cash infusion to get the policy to “endow” is generally prohibitive and often prohibited by insurance and tax law. That can be a tough question, especially when there are multiple people involved in the decision making process. An unsettling number of times the question comes down to “at what age are we willing to bet that grandma will die?”
This is also where everyone looks to the consultant for advice. But guess what? I can’t tell you. I can slice and dice the numbers innumerable ways and tell you with some degree of certainty what will happen under a variety of scenarios. You can hire me to perform a personalized life expectancy study which will likely be beneficial but we’ll only know for sure if the right decision was made when we’re sitting around drinking punch and eating ham buns in the church basement after grandma’s gone on to her reward.
Make sure your clients understand policy maturity features or they may be in for some nasty surprises. Our consulting service will bring you and your clients the objective information needed to make informed decisions.
