In my last blog post, we talked about Universal Life, how it works, and why yours might be failing. There are really two moving parts to a Universal Life policy, the interest rate, and the cost of insurance. I’ll talk about cost of insurance in the next post, but today we’ll talk about interest rates. Why does it matter what interest rate your UL policy is earning?
OK, first let’s review. Universal Life insurance is a flexible premium product. This means that, within certain ranges, you can pay what you want into the policy. If you pay in more than it costs, the extra premiums will be deposited into your cash value and will earn interest. As you get older, the internal cost of the policy rises, due to the cost of insurance, which I’ll explain next week. The idea behind UL is that you pay extra early, so that down the road, you have enough cash value accumulated that the interest it earns will help pay your higher cost of insurance. If you purchased a policy back in the 80s or 90s, your agent would have calculated an assumed premium that would keep your coverage in force based on how the policies were performing back then. One of the assumptions would have been interest rate.
How much impact can the interest rate really have on a policy? Frankly, a huge one. I know that one of the carriers I work with was paying as high as 12% back in the 80s, but they are only paying 5% today. That’s roughly half the interest rate. Intuitively, you might feel like earning half the interest results in half the cash value, but that’s not how compounded interest works. Let’s work through a quick example.
Say you bought a policy when the company was paying 10% interest, and let’s assume you paid a premium of $50 a month from the outset. Let’s ignore any other costs of the policy, and just look at the result of changes in interest rate. Paying $50 a month for 35 years (remember, we are talking about policies purchased in the 80s and 90s) at 10% interest would have given us a projected cash value of $193,427.52 today. That would mean your policy would be earning $19,343 of interest each year to help pay your insurance costs.
Now let’s drop that interest rate to 5% and see what happens. The same $50 a month premium at 5% for 35 years results in a cash value of only $57,169.80. That’s less than two thirds of the above example. What’s more, this policy is now only earning $2,858 of interest to help pay your costs. That's less than one sixth of the interest you would have been earning at 10%! This would leave you with almost $17,000 of policy costs to make up out of your pocket.
As you can see, the interest rate you’ve earned over the years has a major impact on the ultimate performance of the policy. It’s not even a proportionate impact; in other words, earning half the interest actually reduces your performance by almost 85%, not 50%. Any plan to “rescue” your coverage is going to need to take this impact into account.
Next time, I’ll cover the other major moving part of a Universal Life policy, the cost of insurance. I’ll explain what it is, why it goes up every year, and how it impacts your policy. Finally, the post after that will discuss some of the more common options for dealing with this situation, hopefully giving you the tools you need to come up with your own plan if you happen to be in the same boat. As always, contact us, or leave a comment below with any questions.