Q&A - Vanishing Premiums

 

Topic:  Personal Risk  Management

Q:  I have an insurance policy I purchased in 1983 that was supposed to be paid-up after 9 years of premium payments.  I've recently learned that my policy will not last as long as my expected lifetime unless I start paying (significant) premiums again.  What gives?

A:  It sounds like you purchased what is commonly known as "vanishing premium" life insurance.  Like a bad magician who can't get his act together, vanishing-premium life insurance has a way of reappearing just when you don't want it to.   That's why many policyholders have become frustrated and angry about the policies they bought - so angry in some cases that they've brought lawsuits against their insurance carriers.  So are vanishing premium policies ever worth buying?  Let's look at the pros and cons.

A vanishing-premium policy is a form of permanent insurance, whole life, universal life or variable life, designed so that the policyholder pays premiums for only a certain number of years instead of for life.  For example, you might want the policy paid up in ten years.  To do this, you must pay premiums substantially higher that what regular annual premiums would be for the same amount of death benefit.  By this over-funding method, you quickly build up the cash value.  Ideally, at the end of this projected "vanish" period, the policy's earnings generated by the cash value would be sufficient enough to pay all the future policy expenses and you would never pay another out-of-pocket premium.  Ideally, the cash value also continues to build tax deferred, and in time it grows large enough to increase the policy's death benefit.

The key word here is "ideally."  Where the trouble has come for many policyholders is that the projected dividends, or earnings have not materialized, policy expenses (risk charges) have increased, or both.  A lot of vanishing-premium policies were sold in the 1980s when interest rates were high and the company's fixed-income portfolios could generate sufficient interest or dividends to keep premium payments attractive.  However, as interest rates have declined, so did the earnings assumptions on these polices.  Thus, when it comes time for the premiums to vanish, the cash values are insufficient to fund the premiums and many policyholders find themselves having to continue to make premium payments to keep the policies from lapsing. 

It is important that you do not confuse a "vanishing premium" policy with a traditional "paid-up" policy, which does guarantee that you'll be done with payments after a fixed period of time for a given death benefit.

What's the moral of the story?  Always be cautious about "assumptions" or implied "guarantees," not only with vanishing-premium life insurance policies, but with any financial product.  This is especially the case if there are assumptions made about interest rates, inflation rates, investment returns, expenses, or other projections that clearly can't be guaranteed over the investment's time horizon.  It also illustrates the importance of periodically reviewing vanishing-premium policies, variable life policies, and similar financial products.  With better monitoring, many policyholders might have come to realize sooner that their policy's cash value wasn't building up as projected, and they could have either dropped the policy sooner or increased their premiums sooner.

This isn't to say vanishing-premium polices don't have their place.  Some experts say they can work well as long as the initial annual premiums are very high relative to a modest initial death benefit (which will grow as the cash value builds).   But before buying a vanishing-premium policy, or deciding whether your current vanishing-premium policy is worth keeping, see a Certified Financial PlannerTM for an evaluation.