washingtonpost.com
Certain Insurance Policies Benefit Some
More Than Others
By Albert B. Crenshaw
With tax season upon us again, many people are no doubt pondering ways to
reduce their burden in the future. This is good news for sellers of life
insurance, which has long gotten very special treatment from the writers of our
tax laws.
But while the tax benefits of insurance are very real, the costs of buying
coverage can sometimes be even greater. A reminder of that came last week in
the form of a consumer group's analysis of one of the many insurance products
living inside the tax code: a magnificently complex device called
variable-universal life.
Sold mainly to well-to-do individuals, variable-universal life is basically a
bit of life insurance wrapped around an investment resembling a mutual fund or
family of mutual funds. It is variable because its value is tied to the
performance of the investment, and it is called universal because that's what
the life insurance industry likes to call it when they allow the policyholder
to pay varying premiums on the same policy.
These policies have been quite successful, at least for insurers, with sales
increasing 24.4 percent a year on average from 1990 to 2000, according to the
American Council of Life Insurers. In 2000, more than $1.3 trillion of
variable-universal life was in force, the council's figures show, out of about
$9.4 trillion in individual policies. Other studies suggest that sales have
fallen off more recently, however, as the stock market has declined.
The policies take advantage of the fact that, as life insurance, the
investment earnings -- called the "inside buildup" in a life policy
-- are not subject to income tax. This exemption was originally built into
insurance so insurers could invest premiums and pay death benefits without the
inconvenience and expense of paying taxes while a policy was in force.
But the tax benefits of life insurance have been greatly exploited by the
industry and by taxpayers. Policy death benefits remain exempt from income tax
even when they are paid out to survivors, and while life policies are subject
to estate taxes if owned by the decedent, clever taxpayers have engineered ways
to put them into irrevocable trusts that escape taxation altogether.
The industry has also devised a number of variable products, both insurance
and annuities, that are widely marketed as
tax-sheltered investment devices. They have to have an insurance feature to
qualify for the special tax treatment, but much of their appeal is as
investments.
But these products can be hard to understand, and many carry substantial
fees. And, according to a new study, this is particularly true of
variable-universal life.
The complexity allows many insurers to sell policies that are quite costly,
knowing that few buyers are willing or able to learn the product and analyze
the pros and cons of an individual policy, concludes the study, which was done
by former
The study concludes that the product can be a good value for certain people,
but only "if one takes the time to understand how the policy works and is
confident of his or her ability to hold the policy until death."
The policies include charges for their insurance component, surrender
charges that make it very expensive to drop the policy for at least a period of
years, and money-management and administrative charges. These eat into
investment returns, even tax-free ones, which is why these policies must
usually be held for decades to be effective investments.
Insurers argue that Hunt focused too much on the investment aspect of the
policies and not enough on the insurance component, which is a major benefit.
"Whether the consumer purchases variable universal life insurance, or
any other version of life insurance . . ., the fundamental component of the
product is the promise of funds to the insured's beneficiary," the
American Council of Life Insurers said in a statement about the report.
The questions for a potential purchaser are, first, is this kind of policy
the best option for covering both insurance and investment needs, and then, if
so, which is the best policy for me?
Hunt suggests that consumers analyze first whether they need permanent life
insurance. This is insurance that remains in force as long as premiums are paid
and is widely used for estate planning. They should also make sure they have maxed out other tax-deferred investment alternatives, such
as 401(k) plans. Don't overlook Roth IRAs, and for shorter-term goals such as
college saving, devices such as Section 529 plans.
Comparing the lowest-cost variable-universal policy (and using the
lowest-cost investment option inside it) to the combination of a low-cost term
insurance and a low-cost index mutual fund, the study concludes that the
variable-universal policy is better if the owner expects to take substantial
withdrawals or policy loans in retirement. Otherwise, if the mutual fund is
held until death, the combination of an index fund and term life insurance
seems to work better.
Variable-universal policies are often quite large, in the millions of
dollars, with annual premiums in the tens of thousands, so anyone contemplating
buying one should either do a lot of homework or seek out an adviser who is
both disinterested and expert. Some fee-only financial planners will do these
kinds of analyses. The study suggests looking at the offerings of low-cost
direct marketers -- who sell directly to the public and not through agents --
such as Ameritas, USAA Life and TIAA-CREF.
Hunt doesn't recommend specific policies but CFA offers a Rate of Return
Service run by Hunt that will analyze a policy for $55 to $75. Information is
available online at either www.evaluatelifeinsurance.org
or www.consumerfed.org.
Although it doesn't address this question directly, the report also suggests
a potential benefit to the tax-free savings vehicles proposed by President
Bush. As one expert asked some years ago, if the government thinks tax-free or
tax-preferred saving is a good idea, why do I have to buy my tax shelter from
an insurance company?
Nearly 70 percent of plan balances in 2001 were invested in stocks, either
directly or indirectly, the study found. The mix of stocks and other
investments varied, though, depending on the age of the account holder. The mix
was also affected by the investment options offered by the 401(k) plan sponsor.
Regular contributions to 401(k) plans and diversified investments helped
reduce the full impact of the
The decline in average account balance for workers in their sixties was
about 9 percent in 2001. Part of that decline came because people in this group
were withdrawing funds from these accounts. Balances for accounts held by
workers in their twenties rose by 16 percent, since contributions typically are
large relative to account balances and more than offset investment declines.
The report was based on data from the two groups' collaborative databases.
They track data from about a third of the nation's active 401(k) participants
who have held accounts since 1999, about 14.6 million accounts holding more
than $632 billion in assets.
© 2003 The Washington
Post Company