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Kiersten Essenpreis for Money

It’s been harder in recent years to find whole life and other permanent life insurance policies, which provide both a death benefit and an investment vehicle. Now a new tax provision promises to make them more widely available and more flexible, say experts.

“Permanent life insurance is an important safety net for families and small businesses,” says Paul Graham, senior vice president of policy development for the American Council of Life Insurers. Yet this financial lifeline was at risk of becoming a casualty of the economic distortions brought about by the pandemic -- notably persistently low interest rates -- and of regulations that hadn’t kept up with that rate reality.

Enter the Consolidated Appropriations Act, the COVID-19 relief and spending bill Congress passed at the end of 2020. In addition to its many stimulus measures, it contained an easily overlooked provision that affects whole life and universal life policies, collectively known as permanent life insurance.

Here’s an explanation of the rule change, why it’s a shot in the arm for permanent life insurance, and what this all means if you’re a prospective policy buyer.

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How whole-life and universal-life insurance went wrong

Unlike cheaper but less versatile term life insurance, permanent life insurance appeals to customers who want the flexibility of an insurance policy with a cash-value component that can be tapped in retirement as well as a guaranteed death benefit. A policy’s cash value varies according to what the insurance company is earning on investing the premiums, along with whatever the policyholder chooses to add to the policy to increase its value.

The cash value in such a policy is supposed to be secondary to its death benefit, and usually grows on a tax-deferred or tax-free basis. But the tax feature eventually led to policies that were lopsided -- intended to serve first as investment vehicles, rather than insurance policies, and exploiting the tax advantage afforded to life insurance.

“If you put money into a life insurance policy, it builds up, tax-deferred. The government is okay with that -- within limits,” says Steve Parrish, co-director of the Center for Retirement Income at the American College of Financial Services.

In 1984, federal regulators narrowed the tax loophole by limiting the amount of money that could be socked away in the cash-value portions of these policies as a percentage of the death benefit. To add those curbs to the tax code -- in Section 7702, in case you’re curious -- regulators had to define the range of returns on the conservative investments insurance companies are required to make with the premiums they collect. The federal government assumed that invested premiums would earn at least 4%.

That was a reasonable threshold back in 1984 when the average return on long-term Treasury bonds was 12%, but not today: The yield on 10-year Treasuries ended 2020 just below 1%. The rate has been rising, but is still far short of the 4% level -- which continues to be a problem for these policies.

From bad to worse in the pandemic

Historically low interest rates have been throwing a wrench into permanent life insurance since the global financial crisis more than a decade ago. But the problems deepened in 2020.

To stabilize market gyrations and support a financial system reeling from the pandemic, the Federal Reserve pledged last spring to keep its benchmark interest rate near zero for the foreseeable future.

The Fed’s announcement prompted insurance companies to reevaluate their sales of permanent life insurance, with some coming to the conclusion that it no longer made financial sense to write these policies. The pledge made it increasingly difficult for insurers to find acceptable investments that earn enough to meet that 4% benchmark.

“COVID’s impact on interest rates pushed this problem to the breaking point,” the ACLI’s Graham wrote in a recent article on the trade group’s website. (The organization was instrumental in lobbying for the Section 7702 change.)

“They weren’t comfortable selling a lot of these cash value products, especially during the pandemic. We began to see companies start to pull some of their products,” Parrish says. Those that remained available became more expensive, with companies hiking premiums — sometimes by double-digit percentages, and often with little notice.

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The 2021 regulatory fix

The change to the tax code implemented on January 1 of this year lowered that 4% threshold to a variable rate that is currently 2% — a more reasonable target for insurers to hit. “Now, the industry is comfortable issuing some of these policies again, which is a positive for consumers,” Parrish says.

This doesn’t mean policies reflecting the change will be available immediately, though. Insurance companies are facing a lot of other changes in 2021 due to the pandemic, from the mortality assumptions they use for their actuarial calculations to advances in technology that make it easier for them to write policies without the customer having to first undergo an in-person physical exam. Experts say consumers should start seeing policies that reflect the revision to Section 7702 by approximately mid-year.

Lowering the threshold from 4% to 2% lets policyholders put more money into the cash value portion of their policy, says Tim Hoying, a managing director at consulting firm Accenture. “The advantage comes from the cash value amount you’re able to contribute into the policy,” he says. “It gives consumers greater flexibility in terms of being able to use a permanent life insurance product as a tax-advantaged investment vehicle.”

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