In this lesson, we will discuss life insurance endowment policies and the different types available. Endowment policies are like a term life insurance with a savings program.
Life Insurance Endowment Policies
A life insurance endowment policy is a life insurance policy that helps the policyholder save money over a specified period of time. This money is then paid out at the end of the policy term. So think of it this way: if you are 30 years old and are thinking about purchasing a 20-year term life insurance policy, but you also struggle when it comes to saving money, you could select an endowment policy. When the 20 years has passed and you are still living, you will be paid a lump sum on the maturity date. This policy would also pay the full sum to your beneficiary in the event of your death.
While an endowment policy doesn't earn any interest throughout the term, it's often used for college savings plans since it doesn't count against your child's financial aid eligibility. Another benefit is that you don't need a medical exam for these policies. So if you have ever been denied other life insurance options for medical reasons, you could select the endowment policy. These policies offer a risk-free savings plan to add to your portfolio and financial protection for your loved ones.
Types of Endowment Plans
There are many types of endowment policies. The most commonly used are nonprofit, traditional with profits, full, low-cost, and unit-linked. Any of these can be traded. There may also be a need for a modified endowment contract. Let's look at these different types in more detail one at a time.
The without-profit endowment policy pays the lump sum amount that was agreed upon at the time of death or maturity, whichever comes first. Say you buy a $10,000, 20-year plan. You will have paid $10,000 by the time the policy runs out in 20 years, at which point you'll get it all back.
The traditional with-profits endowment policy still pays the sum of money at maturity or death of the policyholder, but the amount of the policy can increase as the policyholder gets bonuses. These bonuses are guaranteed amounts that the policyholder receives. If you buy a $10,000 plan, you could receive annual bonuses on the plan and an additional bonus at the end in addition to your $10,000. However, if the provider elects not to give bonuses, you might get little or nothing. Not a lot of banks sell with-profits endowments anymore.
Full endowments are with-profit endowments that the sum assured is equal to the death benefit at the start of the policy. The final payout would be much higher than the sum assured if there is growth.
Low-cost endowment policies are designed so the estimated future growth rate will meet the target amount and pay a minimum death benefit. These are commonly used to help repay mortgage loans. It is made up of a decreasing term insurance and an investment element. It is referred to as low cost because the sum and the monthly premiums are lower than that of a without-profit or traditional with-profits endowment.
Unit-linked insurance plans (ULIPs) are technically types of endowment plans, even though 'endowment plan' more commonly refers to the plans we just looked at earlier. ULIP policy premiums are used to invest in units of the policyholder's choice, then these units are used to cover the cost of the policy at maturity. There isn't a fixed amount agreed upon for this type of policy. The value at maturity depends upon the performance of the units.
In the UK in the 1980s and '90s, it was common to opt for a mortgage-related unit-linked endowment plan designed to build up value and repay an outstanding mortgage at the same time, while also providing life cover to repay the mortgage in the event of the policyholder's death. However, the projections of growth delivered to consumers were somewhat optimistic, resulting in shortfalls. Banks and brokers eventually paid billions to consumers who felt cheated. They're rarely sold anymore.
A modified endowment contract is necessary when the premiums paid on the policy exceed the amount allowed to keep the full tax treatment of the cash value policy. The taxation then becomes similar to an annuity. To be considered a modified endowment contract by the Internal Revenue Service, three conditions must be met. First, the life insurance policy was entered into after June 20, 1988. Next, it has to meet the statutory definition of a life insurance policy. Last, the policy has failed to meet the 7-pay test.
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The 7-pay test is assessed by confirming if total premiums paid into the life insurance policy by the policyholder within the first seven years exceeds the amount of premiums required to have the policy paid completely in seven years. So if your premiums paid exceed the amount required, the life insurance policy is no longer considered a life insurance policy and is now a modified endowment policy. You may need to pay more taxes on the payouts from modified endowment contracts, but it depends on your individual plan and circumstances.
The Secondhand Market
Finally we have traded endowments, which are often referred to as secondhand endowment policies. The policy has been sold to a new owner partway through the term. When the policy is sold, the beneficiary rights are transferred to the new owner, and the new owner is responsible for all future premiums. This allows buyers to purchase an unwanted endowment policy for more than the surrender value. Why would someone want to do this, you ask? Well, that is because the new owner will still have a greater payout at maturity than if it were surrendered early. They may be paying a little more than the current surrender value, but by keeping it until maturity they will earn more.
All right, let's now take a moment to review the important information from this lesson. In this lesson, we learned about the different types of life insurance endowment policies, which are life insurance policies that help the policyholder save money over a specified period of time. We also learned that there are several types of endowment plans one can take, both basic and more complex. The ones we learned about included the following:
The without-profit endowment policy, which pays the lump sum amount that was agreed upon at the time of death or maturity, whichever comes first.
The traditional with-profits endowment policy, which still pays the sum of money at maturity or death of the policyholder, but the amount of the policy can increase as the policyholder gets bonuses.
Full endowments, which are with-profit endowments that the sum assured is equal to the death benefit at the start of the policy.
Low-cost endowment policies, which are designed so the estimated future growth rate will meet the target amount and pay a minimum death benefit.
Unit-linked insurance plans (ULIPs), which are used to invest in units of the policyholder's choice, then these units are used to cover the cost of the policy at maturity.
And, finally, a modified endowment contract, which is necessary when the premiums paid on the policy exceed the amount allowed to keep the full tax treatment of the cash value policy.
We also learned about traded endowments, also known as secondhand policies, which are policies that have been sold to new owners partway through their term. Most people purchase life insurance endowment policies to have a risk-free savings account as well as financial security for their family members. It's important to have a variety of investments in your portfolio and ensure you understand each type of endowment policy available so that you can make the appropriate decisions.
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