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Practical Application

An estate planner should be able to field these inquiries on at least a structural basis.

Let’s apply what we’ve covered so far to some real life scenarios, meaning the kind of situations in which a client (or a colleague) might ask for your advice on everyday life insurance questions. Our premise is that an estate planner should be able to field these inquiries on at least a structural basis, meaning with some general rules, before getting to “It depends.”

Life insurance for survivor incomea capital question. The classic role of life insurance is to provide financial security for survivors. And, the classic way to assess the need is to compare the needs that the survivors will have for capital with the sources of capital. The analysis compares the immediate needs for capital plus the sums that should be set aside and invested for future needs, less capital sources available at the individual’s death. The result will be a capital need (or a surplus). As we take a closer look, it will become clear that the analysis is far more sophisticated and nuanced than it first appears.

Immediate needs include expenses, debts, mortgages, income taxes and estate taxes that would have to be paid shortly after the individual dies. Some of these immediate needs are straightforward, others aren’t. For example, should the individual plan on having enough life insurance so the survivor can pay off the mortgage(s) or just build that cost into the income needs? Anyone who thinks that’s just a matter of the numbers probably hasn’t had that discussion with clients (or with a spouse). Set asides include the present value of the funds to be invested for children’s education and can include funds for resumption of education by the surviving spouse. Income needs are the present value of the amount of money that the surviving spouse and children will need (or want) on an annual basis. This need is a good example of how the analysis should be more sophisticated than it first appears, because their needs will change as the spouse and children get older. In addition, there’s the issue of whether the survivor wants to live off of income only or consume principal as well.

Capital sources can include Social Security and other survivor benefits, including pension and other benefits from the individual’s employer. The planner has to determine how much those benefits will be, when they’ll start, whether they’re adjusted for inflation and so forth. There’s usually some existing life insurance, but the planner has to determine how much of it is payable in all events as opposed to only if death occurs at work or in an accident. The individual’s (or couple’s) investments are certainly a source of capital, but the planner has to help the individual determine an appropriate assumption for the after-tax return for the survivor’s portfolio. If continuing tax deferral of such qualified accounts as an IRC Section 401(k) is desirable, will the survivor be able to afford to keep the money in the plan? Finally, if the individual’s spouse currently works outside the home, to what extent will he be able to continue to do so? Of course, this topic then raises the issue of the cost of day care. And on and on…

We know the right amount, but now what? A rule of thumb is that term insurance is appropriate for needs that will last no more than 20 years (with gusts up to 30). If that thumb is on the hand of a conservative planner, the client who’s inclined to buy a 15-year term policy should be advised to buy a 20-year policy. The cost difference isn’t that much, but the 5-years’ worth of protection could be worth its weight in gold if the client’s plans don’t gel as anticipated. Needs of greater duration should be funded with a cash value policy, which really just means some form of permanent product.

Clients will usually resist permanent insurance, but the planner should urge the client to look down the field, as it were, and think about what his financial picture looks like 15 to 20 years hence. The planner can be especially helpful by identifying the needs that many 55 to 60 year olds (still) have for life insurance and the difficulties that these individuals can encounter when they try to buy the coverage at that age. Then, the client’s cash flow permitting of course, the planner can work with the agent to show how some cash value insurance can provide enduring coverage without enduring out-of-pocket cost.

The clinical case notwithstanding, most clients won’t and shouldn’t fill the entire prescription with permanent insurance. Perhaps they should consider a bifurcated approach, that is, a 15 to 20-year term policy for needs that will be met within that time frame and a cash value policy that will meet the longer term needs. The chief virtue of that approach is that it will remove the risks associated with term conversion, meaning that when the client might be ready to convert, the product(s) available for conversion may be expensive (because the carrier knows who’ll want to convert) or may offer less design flexibility than the client wants. Meanwhile, if the client’s health has deteriorated over the years, he might have little or no choice in the marketplace. So, if this bifurcated approach is of interest to the client, then the planner can ask the agent to show an illustration for a CAUL product that has a relatively low premium that the client can increase (without evidence of insurability) when and as the budget allows.

We took the liberty of identifying CAUL as the policy of choice here because the hallmark of the approach is going to be premium flexibility. Premium guarantees may be attractive at first blush, but could be counter-productive over time for a (particularly younger) client who might need that flexibility budget-wise now and, in later life, want to use the policy as an investment vehicle. Cash value accumulation won’t be relevant at the outset because the client will be looking to keep the premium so low relative to the death benefit. But, as funding possibilities pick up steam, then that use/application of the policy could be of interest. Investment flexibility is probably contraindicated early on because of the risks associated with minimum funding of a policy that could be volatile if returns are subject to the markets, directly or otherwise. But, the client may be interested in a policy that offers both a general account and the opportunity to allocate cash value to the capital markets once funding can be more robust.

Pension maximization. Assume that a client calls to sound out your views on a proposal that she received from an agent. She tells you that her husband, a long-time executive of a major company, is going to retire in a couple of years and is just starting to consider his options for payout of his pension plan. Apparently, his pension is projected to be $250,000 a year. If he predeceases her, she’ll get 50 percent of that for the rest of her life. But, if he takes a single life pension, meaning that she would get nothing if she predeceases him, then he gets something closer to $280,000 (projected). Some of the people he works with do this thing they call “pension max,” in which they take the single life payout but buy life insurance to leave their surviving spouse enough cash to invest or buy a single premium immediate annuity (SPIA) to replicate the 50 percent survivor benefit. That’s the deal. Your client would like to know what you think about that strategy.

First though, a little more background. The agent was very clear that the strategy will only make sense if the premium for the needed coverage is less than the after-tax difference between the single and joint pensions. The agent was also very clear that the strategy can harbor some risks for the spouse, primarily that the right amount of life insurance on (in this case) the husband is inherently unknowable. After all, the whole calculation is based on assumptions about key variables, such as how long each spouse will live, what the capital markets will return on the insurance proceeds and what a SPIA will cost at the time she needs to buy it. The point is that the strategy involves a lot of “ifs.” The pension doesn’t, though some might argue that the pension does indeed involve risk. For example, the husband’s company could one day have difficulty maintaining the plan.

But, let’s assume that the client and her husband would like to explore the strategy. Let’s further assume that the agent has conservatively determined the amount of insurance that the husband would need to replicate the survivor pension with, shall we say, reasonable downside protection. How easy it would be to implement this strategy if the husband had (followed the agent’s advice and) purchased a cash value policy years ago. But, he didn’t. So now, the task is quite a bit more daunting. That’s because, depending on his health, the premium for a cash value policy that provides the considerable amount of insurance the husband will need could well be greater than the after-tax difference between the two payouts.

In this scenario, which isn’t altogether uncommon because many executives first consider their pension options shortly before retirement, a reasonable approach might be to bifurcate the coverage, that is, mix some term with some permanent. For example, the husband could buy a 15-year convertible term policy for perhaps half of the need and a flexible premium CAUL or GUL for the balance. This approach would enable the couple to design the insurance portfolio in a cost-efficient manner, with plenty of opportunity to reshape the portfolio in later years. “By the way,” you advise the spouse, “Be sure that you own the policy!”

Incidentally, even when couples, such as the one in our example, decide against using pension maximization, the exercise itself can illuminate the need for some additional life insurance on the husband (or maybe even the wife). While the husband might not buy as much as he would have if he did the pension maximization, he might still buy some insurance to hedge against the risk of the company’s faltering on the pension. And, even if that risk is negligible, the couple might decide that, pension notwithstanding, the wife would feel a lot more secure if the husband had more coverage going into retirement.

Life insurance as an investment. We wrote on this topic in 2013,1 and much of that article is incorporated here by reference. Perhaps the only thing that’s changed since then is that, under current proposals, high bracket taxpayers may end 2017 as somewhat lower bracket taxpayers, which is a headwind for cash value life insurance as an investment vehicle. Beyond that, it remains to be seen whether this concept/application has more going for it than against it, primarily because:

  • Clients may be reluctant to take a physical, though this will be much less of a concern if the policy will be needed anyway for family security.
  • The client realizes that, at the end of the day, the tax rules that offer the deferral and the tax-free access to the cash value become seriously constraining when he really wants to use the policy, reshape it or get out of it altogether.
  • Given the need for efficiency of both cash value accumulation and distribution, the interests of an informed buyer may not align well with the interests of an informed seller. In fact, they could be irreconcilable.

But, if the client is going to explore this use of insurance, he’ll be well advised to demand that the discussion about the tax aspects of this application not monopolize the conversation. The planner should work with the agent to illuminate for the client the nuances of policy selection (based on the above-described characteristics), components of and risks to pricing and the practical guidelines for premium funding, death benefit design and the timeline and guidelines for tapping the policy for cash. The mission should be for the client to understand how the policy works and what and how things can go right and can go wrong, whether it’s with the carrier, the policy or the agent.

Meanwhile, no type of policy has a monopoly on functioning as an investment-oriented vehicle. Any cash value policy other than a pure GUL can serve in this capacity, though premium flexibility can begin to suggest one type over another in a clinch.

Life insurance for estate liquidity (or maybe not). In light of the potential for repeal of the estate tax, many individuals who were considering the purchase of life insurance for estate liquidity (and only for that purpose) are now reconsidering that notion. While these individuals could easily postpone the purchase until there’s some clarity to the estate tax picture, postponement courts the risk of loss of insurability in the meantime. So, rather than applying for a heavily funded permanent policy that would potentially involve a lot of unrecoverable sunk cost, they could consider setting up an ILIT and having the trustee apply for a convertible term insurance policy. The term policy would protect their insurability, and the conversion feature (if well designed) would enable them to go long on the coverage when and if the time is right. Meanwhile, if the estate tax is repealed, they can just stop funding the premiums (or maintain the coverage through an election or two). One caveat to this approach is that it involves conversion risk, which can be avoided by having the ILIT instead buy a flexible premium product and fund it at the minimum premium to support the death benefit for a while, somewhat mimicking the term policy approach. Then, if there’s a need to go long, the insured can just increase the funding without evidence of insurability (and without the risks of conversion). In larger cases, you’ll want to consider diversifying the coverage, regardless of which approach you take.

Life insurance in collateral assignment (loan regime) split-dollar arrangements. We published an article on this technique for financing premiums,2 and it too is incorporated herein by reference.

So, assuming the client understands the potential risks and pitfalls of split dollar or any leveraged approach that one would categorize as “multi-factor dependent,” it will then be important for the client to address these questions to begin to inform policy selection and design:

  • Should the ILIT’s death benefit remain level net of the loan, perhaps by using a return of premium rider?
  • Will loan interest be paid currently or accrued?
  • If there’s an exit strategy that doesn’t involve the client’s death, will the policy’s cash value be used to repay some or all of the loans?

Depending on the answers to the above questions (and other aspects of case design), premium flexibility may again be the most helpful characteristic of the policy, for example, to minimize the loans in the early years while the ILIT is being funded with discounted gifts, grantor retained annuity trusts and other techniques. Efficient distribution of cash value in subsequent years (perhaps to pay loan interest or assist in the rollout) could also be an important consideration.

While having less to do with policy design than politics, use of split dollar with a permanent policy in the near term doubles down on the risks of incurring unrecoverable sunk costs and then having to deal with loans that still (likely) have gift tax implications because that tax isn’t repealed.

Life insurance as a trust investment. Life insurance is often touted as a worthy investment for ILITs, notably dynastic ILITs. The concept is that an individual would establish a dynastic ILIT and fund it with remaining gift and generation-skipping transfer tax exemption so that the ILIT could purchase a policy for pure wealth transfer. Depending on the insured’s life expectancy, the internal rate of return on the policy’s death benefit can be attractive on a risk-adjusted basis.

We often see GUL proposed in this space, largely because of its guaranteed return. We also often see second-to-die policies proposed because they appear to be cheaper than coverage on one of the spouses individually. As we’ve noted before, the GUL product may not be the most attractive one, largely because its absence of robust cash value could deprive the ILIT of a valuable (and tax-efficient) asset for decades. Also, when the policy will insure two relatively younger spouses, whose deaths could be separated by decades, it may make more sense to insure one of them (even for a lower face amount) than to risk a scenario in which the first insured dies proximately, the survivor has to continue to fund the policy and the ILIT has nothing but carrier risk for decades.

—Portions of this article were presented at a workshop given by the authors and Mary Ann Mancini of Loeb & Loeb LLP at the 51st Heckerling Institute on Estate Planning in Orlando, Fla.


1. Charles L. Ratner and Lawrence Brody, “Life Insurance After ATRA,” Trusts & Estates (April 2013), at p. 40.

2. Lawrence Brody and Charles L. Ratner, “Today’s Split Dollar,” Trusts & Estates (May 2007), at p. 38.


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