As I've been engrossed in a many month-long process, I thought it would be hellpful to explain the decisions and process in broader terms - in part to summarize my experience and go forward strategy.
WHY DID I BUY WHOLE LIFE AND VARIABLE INSURANCE POLICIES?
I had been a partner in several businesses in which we owned key man insurance. Our insurance broker recommended buying key man insurance. In essence the company (or partners) owns the policy and buys back a partners shares from his surviving spouse. This provides liquidity in case of an emergency and money for the berieved. Nice idea. In fact I did have a young partner pass away in one business and it worked like a charm.
Later on, the agent recommended investing in whole and variable life policies for the same purpose - except that they would be cross-owned. The benefit being we could take some money out of the company without providing similar bonuses to all employees (who may/may not have deserved it). Although we did it - it was patently wrong - any life insurance policy for premiums exceeding $50,000 are taxable benefits. We did it anyway. Stupid.
We were taking quite a bit of money out into the policies. Once we started maxing out our retirement contributions to SEP-IRAs (they didn't have individual 401ks then), we increased our contributions to the insurance investments. The fact that taxes on capital gains and dividends were deferred was attractive.
Another benefit of the approach was fairly novel, but real - the assets in the policies were shielded from liability claims. This was beneficial if things were to go very wrong.
Years later, after I had sold my interests in the businesses, I still had these policies. I decided to analyze them to determine the best approach.
VERY EXPENSIVE INSURANCE
I realized that the premiums were graded - not level - every year they went up. In my case they were increasing $10/month every year. I compared the death benefit charges and found I could buy twice the coverage for less money with a 30 year term.
VERY EXPENSIVE INVESTMENTS
I also looked at the investment performance - it was disappointing. Not only due to administratitive and overlay fees, but also the limited selection of mutual funds performed poorly and had high expense ratios - even the index options. I would have done better to have kept the tax liability and let the money grow in low cost index funds.
Even the whole life policy averaged less than 3% interest growth.
THE CONUNDRUM - SURRENDER CHARGES
Unfortunately all of the policies except the whole life policy had very expensive surrender charges - usually $7500 - $8000 in fees gradually reduced over 15 years. Fee components were administrateive charges that fell off after 8 years and surrender charges that fell off after 10-15 years.
In light of the surrender charges I really had no idea what to do. I talked with quite a few insurance agents and all advised me to keep paying in. Somehow I felt this was very wrong and they were ALL corrupt.
In the interim I reduced the payments to cover ONLY the death benefits and some administrative charges. Any small excess could come from the cash value / investments.
During an annual check-up with my new accountant, I asked him to review my investments. He told me to liquidate all variable and whole life policiees ASAP and invest the proceeds in low-tax ETFs.
BACK IN ACTION
Over time I called the various insurance companies and asked for the surrender charges and anniversary dates when charges were lowered. Prepared for almost $10k in surrender charges, I decided to move forward. I would still net about $70k and over time it would grow more effectively.
The next step was to obtain replacement insurance. My conversation with my accountant also indicated that I might consider more coverage (double what I had).
It turned out that my estate planning firm also provided financial planning and insurance sales. Normally, I would not be too comfortable with this model, but what they offered compared very favourably. In addition, we created ILITs - Irrevocable Life Insurance Trusts - which receive cash gifts from me and my wife which then use the money to pay the insurance policies. This removes the policy proceeds from our estates. The proceed distribution is a mirror or our living trusts. We were able to double my coverage with 30 year term policies for a bit less than I had been paying for the combined whole and variable insurance death benefit premiums.
THE AGONY OF WAITING
Setting the ILITs up and finalizing the policies took much longer than planned. What should have taken 2-8 weeks took almost 9 months. I'm sure it didn't help that we switched insurance companies in the middle of the process - but it took forever. As fairly high wage earners, we sought larger amounts of insurance that require more aggressive physical examinations and underwriting. One insurance company even flew an underwriter out to meet me.
Also, as a business owner, it was difficult to recharacterize my income in a manner that was consistent with most underwriting models. Eventually we worked things out.
The policies were finally issued about a month ago.
During this entire time I was wringing my hands eager to strike back at the sneaky evil insurance companiees bleeding my hard earned savings with their over expensed investments.
I STILL HAD TO WAIT
I couldn't cancel any of the policies until I had the signed new policy in force. Furthermore, in a conversation with my investment advisor regarding investments (part of the asset inventory process), he recommended I go to the a third party to see if liquidating the policies was the wisest thing to do. In some circumstances enough money may have been already invested (and overpriced fees paid) that keeping the policies might make sense.
THE DECISION TO ANALYZE THE POLICIES
The gentleman from the Federation was very nice and told me what information to obtain from the insurance companies - essentially investment growth illustrations without premium payments. He would then analyze the projections and compare the alternative to liquidation. A very interesting point was his mentioning that if the policies had substantial capital losses, they may be better placed in a low cost annuity through a 1035 exchange to retain the capital loss - I guess the capital loss would be lost if I liquidated the policies.
As it turned out some policies had very small gains and some had some losses. I'm waiting to receive the analysis.
My concern is that setting up variable annuities may be more work than benefit - but I'll find that out. I believe Vanguard and Fidelity sell them. One benefit would be deferal of additional capital gains taxes.
None of the policies have substantial if any capital gains which would otherwise cause me to seek a 1035 exchange. Even if I do an exchange I will have to pay the surrender charges.
IMAGINING NEXT STEPS
Although my preference would be a clean liquidation, I have a feeling there may be enough capital losses in a few of the policies to justify a 1035 exchange. I'm hoping if we go in that direction I funds available will have symbols with listed prices, low expenses and a large variety of low cost index funds. I expect both Vanguard and Fidelity will be able to provide these.
The short term result with be a $10,000 drop in networth. The long term result will be a dramatic reduction in investment expenses for $70,000 worth of my investments. By substantial, I'm thinking from 1-2% drop in expense ration (and administrative expenses). Over 30 years, that would mean quite a lot!
Have a wonderful weekend,