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Certain Insurance Policies Benefit Some More Than Others

By Albert B. Crenshaw

Sunday, March 2, 2003; Page H04

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 Vermont insurance commissioner James H. Hunt for the Consumer Federation of America.

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?

The average balance in 401(k) accounts dropped with the overall stock market in 2001 to $58,785, a decline of nearly 4 percent, according to a report from the Employee Benefit Research Institute and the Investment Company Institute.

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 U.S. stock market's 12 percent drop in 2001, the study found.

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.

The Maryland Higher Education Investment Board said last week that it is extending the enrollment period for the Prepaid College Trust to March 31. The extension is the result of the cancellation of more than 30 presentations statewide as a result of the recent heavy snowfall. The presentations are part of an education campaign that was launched earlier this year. The pre-paid plan offers families contracts promising to pay tuition and mandatory fees at the state's colleges when their child reaches enrollment age. Information is available at www.collegesavingsmd.org.

2003 The Washington Post Company