Financial Advisors: How to Talk to Clients About a Life Settlement Option

Someday, history books will dedicate far too many pages describing the year of 2020. A pandemic-fueled economic crisis has caused many problems for U.S. households — but one outcome that will linger on for years is the damage done to Americans’ retirement plans. A study from The Commonwealth Fund estimates that, in 2020, 11% of workers aged 65 and older have lost their jobs. That’s 1.1 million people who likely have to overhaul their retirement outlook. Those who can’t replace their income may have no choice but to retire earlier than they’d planned, with a much lower savings balance than they’d like.

That presents an interesting challenge for financial advisors and planners. When your client faces an income shortfall just months or years away from reaching his or her retirement goals, what are the best options to course-correct? Downsizing is one, but it’s probably not the prospective retiree’s first choice. Another strategy is to get creative about liquidating non-investment assets to raise cash and shore up the savings balance. That’s where a life settlement can help.

What are life settlements?

A life settlement is the sale of a life insurance policy to a third-party investor for cash. At the close of the transaction, the investor owns the policy along with all rights to the death benefit. The investor is also responsible for any future premium payments. In return, the policyholder receives a lumpsum payment that can be used for any purpose, though a portion of the proceeds are normally taxable.

 

Are life settlements legal?

Life settlements are legal transactions nationwide. They’re also regulated in most U.S. states. The exceptions are Alabama, Michigan, Missouri, New Mexico, South Carolina, South Dakota, and Wyoming. Most regulated states enforce a waiting period before the policyholder can sell, though there may be exemptions available under certain circumstances such as illness, divorce, retirement, or disability. These states also typically require state approval of contracts, escrow agreements, and disclosures used throughout the life settlement process. That approval is intended to ensure transparency and protect policyholders from fraud — both of which are central themes in life settlement regulations.

 

What asset class are life insurance policies in?

Life insurance is its own asset class that falls under the umbrella of alternative assets. Characteristics that differentiate permanent and convertible life policies from other asset types include the tax treatment, low volatility, liquidity, streamlined wealth transfer, and versatility.

Tax treatment

The tax treatment of life insurance is very favorable to policyholders. For cash-value policies, investment savings grow without tax consequences. And, if the insured chooses to hold the policy until end-of-life, no taxes are incurred on the gain that naturally arises between cumulative premium payments and the amount of the death benefit. Life insurance gains only become taxable when the policyholder benefits from them during his or her lifetime. That happens when the policyholder pulls out more cash than was paid in total premiums, such as in a surrender or a life settlement.

Low volatility

Life insurance is not as volatile as equity assets and can have a low correlation to the financial markets. The rate of return on whole life insurance, for example, is guaranteed. Other forms of life insurance, such as variable life, do allow the policyholder to invest in sub-accounts that are tied to the financial markets. These policies can be structured so that only the cash value growth, but not the death benefit is affected by market fluctuations.

Liquidity

New life insurance policies are not liquid, though they do gain liquidity as the cash value grows over time. Once the policy has accumulated cash value, policyholders can access that cash very quickly, either through a direct withdrawal or a low-rate loan. Those policyholders who no longer want or need the insurance can also liquidate their asset by surrendering the policy or selling it in a life settlement.

Simple wealth transfer

Life insurance shines as a straightforward strategy for leaving money to heirs. Named beneficiaries receive the death benefit in cash without probate and without tax consequences.

Versatility

Life insurance can be extremely versatile. Its cash value grows without tax consequences and can later be used to supplement one’s retirement income. Or, if cash is not needed from the policy, it can be left alone until the named beneficiaries receive their tax-free death benefit. No other asset type offers that combination of liquidity, tax-free earnings growth, and simple wealth transfer.

 

Why are life settlements beneficial for your clients?

A life settlement is often the most fruitful method to liquidate life insurance, since life settlement investors normally pay more than the policy’s surrender value. In some cases, policyholders can get as much as 60% of the policy’s face value. The extra cash could solve a retirement savings shortfall, without requiring a lifestyle downgrade or a reverse mortgage.

 

What types of life insurance policies qualify for a life settlement?

Individual and group universal life, variable life, and convertible term life policies normally qualify for life settlements. Non-convertible term life is sometimes sellable, depending on the status of the level-term period and the health of the insured.

 

What is your role as a financial advisor?

Fiduciary duty is the legal responsibility to act in the best interests of your client. In practice, that usually involves being transparent about how you get paid, avoiding conflicts of interest, and making personalized, objective recommendations to clients based on their situation, goals, and risk tolerance. Those principles apply whether you’re a CPA, tax advisor, estate attorney, financial planner, or retirement advisor. In any one of those roles, you might be the one fielding the client’s question about how to improve liquidity. If the client has life insurance, a life settlement may be an option to explore. If your client is interested in selling their life insurance, you’ll want to make sure you’re getting the highest value for their policy. Harbor Life helps get you the highest possible offer through its partnership with Suncrest Benefits, which utilizes an online life settlement auction platform that puts your client’s policy in front of the nation’s top providers. By putting the policy in front of more providers, you’ll get more offers which will drive up the value.

 

How to talk with clients about life settlements?

You can start the life settlement conversation with clients by taking inventory of their existing life insurance policies. Review the beneficiaries, death benefits, and premiums. Revisit your client’s goals with respect to end-of-life wealth transfer and your client’s willingness and ability to continue making premium payments. If your analysis uncovers redundancies or unnecessary coverages, it could be time to discuss options for liquidating or eliminating some of those policies.

The options including lapsing, surrendering, or selling the unwanted life insurance. Letting a policy lapse wouldn’t normally provide any cash proceeds, though it would keep the policy in force for a longer period of time. The policyholder would simply stop making premium payments. The insurance company would use any accumulated cash value to fund those payments going forward, until the cash runs out. There is a grace period, but the insurer will eventually cancel the insurance if no payment is made.

Surrendering the policy cancels the coverage immediately. The insurer pays the policyholder any accumulated cash value, less surrender fees. Surrender fees can be very high if the policy is only a few years old. Any gains recognized as a result of the surrender payment would normally be taxable.

Selling the policy in a life settlement usually results in higher cash proceeds for the policyholder, but the process can take two to four months to complete. As with a surrender, gains on the policy are usually taxable.

 

How do life settlements benefit financial advisors?

As a financial advisor, you build trust by objectively educating your clients about all of their options. For the client who has excess life insurance and a savings shortfall, the life settlement may be one of the least intrusive solutions. Prospective retirees who’re worried about losing a home, running out of money, or being forced into a lifestyle downgrade should appreciate the guidance. Whether or not they ultimately decide to pursue a life settlement, they should understand that it’s an option — especially if they’ve already considered surrendering or lapsing the insurance policy.

Also know that the life settlement industry continues to grow and mature. With that growth comes greater regulatory protections, not only for sellers and buyers, but also for advisors. That is a welcome change, as it helps legitimize these transactions which can be so beneficial to seniors who are facing cash shortfalls.


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