Shift in Permanent Life Insurance: Impact of Reduction in 7702 Rate

In December 2020, a significant change in permanent life insurance came about when lawmakers reduced the 7702 Rate to 2 percent in 2021 and a floating rate thereafter. What does this shift in the 7702 Rate mean for clients considering the purchase of permanent life insurance?

A HISTORY OF THE 7702 RATE

In 1984, lawmakers established a 4 percent guaranteed growth rate assumption on the cash value of permanent life insurance. This was to correct a popular trend at that time which was to overfund premiums primarily to achieve enhanced cash values. By paying substantially more premium than was necessary to support the life insurance death benefit, cash values quickly grew income tax deferred to the extent that the corridor between the death benefit and the cash value was insignificant even in the early years of the policy. Policy holders could then access this enhanced cash value throughtax favored withdrawals and /or policy loans. From the lawmakers’ perspective, the tax advantages afforded life insurance were being abused for investment purposes. To correct this abuse, lawmakers introduced the Modified Endowment Contract (MEC) rules which, if triggered, taxed the cash value of life insurance under less favorable annuity rules. One of the MEC formulas defines an acceptable corridor between the death benefit and the cash value of a permanent life insurance policy. At a guaranteed 4 percent growth rate, only a limited amount of premiums can be paid into a policy over a given period and still maintain this acceptable Non-MEC Corridor.

WHY THE 2020 CHANGES

Why in 2020 were lawmakers willing to reduce the 7702 Rate? The primary impetus for the change came from insurance companies whose core permanent insurance product is some form of a whole life policy. These companies convincingly argued that without a significant reduction in the guaranteed 4 percent 7702 Rate, they would no longer be able to financially support whole life as a permanent insurance option in the future. This is due to the unprecedented and sustained low interest rate environment and its adverse effects on bonds that are the core component of these insurance companies’ investment portfolios. For example, the average yield on long-term government bonds from 1960 through 2000 was 7.33 percent. That average yield dropped to 3.18 percent from 2001 to the present; to 2.35 percent from March 2009 to the present; and is now below 2 percent. Although not all insurance companies may choose to reduce their guaranteed interest rates from 4 percent to 2 percent, their expressed and granted need to consider that large of a reduction is a Big Shift affecting permanent life insurance products going forward.

CONSEQUENCES FOR CLIENTS CONSIDERING THE PURCHASE OF CASH VALUE LIFE INSURANCE

First, the premium required to produce a given guaranteed cash value and guaranteed death benefit will increase significantly. Second, the overall financial performance of the policy will be much more dependent on the non-guaranteed investment return accounted for in the contract’s cash or reserve value. Third, substantially more premium can be paid into a contract without the policy violating the MEC Rules. Although it may be the latter part of 2021 before most permanent life insurance contracts incorporate the 7702 Rate Change, the following case study will help illustrate each of these consequences of the rate change.

Increasing Premiums Required to Secure Guaranteed Policy Values: In 2019, a male age 48 (who qualified for best rates) could purchase a $500,000 whole life policy (contractually paid up in 10 years) for an annual premium of $23,375. At a 4 percent 7702 Rate (after policy expenses), the guarantee cash value equaled $242,220 at the end of policy year 16, exceeding aggregate premiums paid of $237,150. By the insured’s age 100, the guarantee cash value (after policy expenses) increased to $500,000, equaling the $500,000 guaranteed death benefit. To achieve similar guaranteed results at a 2 percent 7702 Rate, the annual premium will have to increase significantly.

Policy Financial Performance More Dependent on Non-Guaranteed Investment Returns: At a 6.40 percent dividend interest rate, the referenced 10 year pay whole life policy illustrated a non-guaranteed cash value (after policy expenses) of $331,959 at the end of policy year 16 and a $1,245,118 non-guaranteed death benefit (after policy expenses) at the end of policy year 40. Prior to the 7702 Rate change, 4 percent of the 6.40 percent dividend interest rate was guaranteed by the insurance company and 2.40 percent was non-guaranteed. After the 7702 Rate change, up to 4.40 percent of the dividend interest rate may be non-guaranteed. This increase in the non-guaranteed aspect of the policy coupled with a lower guaranteed floor of policy performance may result in insurance company portfoliomanagers shifting a segment of their assets into more speculative investments in hopes of achieving higher returns. Policy holders who are willing to accept all the investment risk in the life insurance contracts may find variable life insurance attractive; or policy holders who found the four percent guarantees attractive will have to act fast to purchase those contracts before the lower guaranteed rates take effect later this year.

The Ability to Increase Premium Contributions Without Violating the MEC Rules: In 2019, $23,375 was the maximum premium this 10-pay whole life policy would accept without being deemed an MEC. Pursuant to the reduction in the 7702 Rate, this same contract will be able to accept substantially more premium before running afoul of the MEC Rules, therefore potentially building substantially more cash value dependent on non-guaranteed investment results.

Considering the changes taking place in the life insurance market, there are important factors that have not changed. Life insurance remains a compelling financial solution at the death of the insured that affords families the ability to replace lost income, pay debts and fund college educations. For businesses, life insurance death benefits continue to fund buy-sell agreements, compensate for the loss of a key person and can reduce debt. In the estate planning market, life insurance death benefits continue to provide a cost-effective solution to pay estate taxes. The living benefits of life insurance also have not changed, offering a source of family and business liquidity via access to cash values, as well asthe potential to fund supplemental tax favored retirement income, help fund the buy-out of a retiring business owner and fund non-qualified deferred compensation to help retain key employees.The increasing cost of insurance guarantees, the added importance of non-guaranteed policy performance, and the ability to pay additional premiums into a life policy and not violate MEC Rules are all consequential changes. DHG Agency is well-equipped to help clients understand and successfully navigate these changes. We work in tandem with the client’s accountant, attorney and other trusted advisors to provide a thorough insurance needs and products analysis that complements the client’s financial, estate, or business planning goals. For more information, reach out to us at info@dhgagency.com.

The information set forth in this article contains the analysis and conclusions of the author(s) based upon his/her/their research and analysis of industry information and legal authorities. Such analysis and conclusions should not be deemed opinions or conclusions by DHG or the author(s) as to any individual situation as situations are fact specific. The reader should perform its own analysis and form its own conclusions regarding any specific situation. Further, the author(s) conclusions may be revised without notice with or without changes in industry information and legal authorities.© 2021 Dixon Hughes Goodman LLP. All rights reserved. DHG is registered in the U.S. Patent and Trademark Office to Dixon Hughes Goodman LLP. DHG Agency LLC is an affiliated company of Dixon Hughes Goodman LLP.

ABOUT THE AUTHORS

Wm. Talbot Carter, CLU, ChFC
DHG Agency Vice President/Financial Consultant

GET IN
TOUCH
© Dixon Hughes Goodman LLP. All rights reserved.
DHG is registered in the U.S. Patent and Trademark Office to Dixon Hughes Goodman LLP.
praxity