It seems safe to say, for now anyway, that most clients believe that the estate tax will not be repealed. Reformed maybe, but not repealed. So, the new year is a good time to reflect on what the current planning environment, broadly defined, is telling us about how we can help clients use life insurance more effectively and more expansively in their estate planning … or in lieu of it. It's also a good time to reflect on what we've learned during the past few years about approaches to paying premiums and how easy it is to make today's solution tomorrow's problem.

Life Insurance's Uses

I have said for years that life insurance can be sold or bought to play one or more of the following roles in an estate plan:

  • estate liquidity and/or preservation;
  • a default estate plan;
  • a hedge for the client who will plan; and
  • a capital transfer technique.

I still categorize the roles in the same way. But I find that these roles are playing out very differently today than they used to, sometimes for the better and sometimes not.

What's changed? A lot, obviously. But I would point to differences in:

  1. clients' concerns about the future;
  2. the development and marketing of insurance products targeted to those concerns; and
  3. fundamental changes in the business model of the life insurance professional.

These are the primary forces that are converging to reshape how life insurance is being presented to, and used by clients in their planning.

I have seen the most dynamic and interesting change in two of those roles: estate liquidity and/or preservation and the default estate plan. The reason I believe that the changes here are so interesting is because these uses of life insurance set the stage for better estate-planning results through a new and constructive conflict among those offering product versus non-product solutions to planning issues.

Estate Liquidity

A traditional approach to determining the need for insurance for estate liquidity has always been to determine:

  1. first, the amount and duration of the current need for liquidity for estate taxes and non-tax capital needs (such as survivor income or equalization);
  2. then, the projected amount and duration of those needs after the client has done his planning; and
  3. finally, if applicable, the optimum timing for providing the liquidity.

To be sure, many still take this traditional, comprehensive approach. But by and large, this tradition has fallen by the wayside. Or, to put it less benignly, it found itself in the middle of a busy five-way intersection, run over by a sharp decline in the public's interest in estate tax planning after 2001, a drop-off in training in traditional planning, easy replacements with no-lapse universal life, an abundance of tax-packaged insurance strategies and lucrative sales of stranger-owned life insurance.

Traditional planning's prognosis is not good — even if there is estate tax reform and not repeal. Too many planners believe that it's too labor-, people- and technically intensive a way to do business and sell insurance. More pointedly, compared with just targeting the current liquidity need for selling the “pre-programmed, tax-packaged sale du jour,” the traditional comprehensive planning can suffer from one or both of two fatal disadvantages: (1) it's far too drawn-out from a revenue standpoint; and (2) it's risky for the advisors. Comprehensive planning often can show a decreasing need for insurance as the planning takes hold, which, in turn, puts a “premium” on a truly flexible approach to policy selection, design and funding. Such an approach gives the client the utmost ability to reduce the true economic and tax cost of the insurance as well as to reshape the policy and the funding, if and when as circumstances require or allow. All this flexibility can be very uncomfortable for some planners, particularly those who would rather select, design and fund the policy for its guarantees and downside protection rather than for the financial and planning flexibility it could afford the client over the years.

Estate Preservation

Though arguably a spin-off of the estate tax liquidity need, a use of insurance that is underplayed is its use for equalizing inheritances among children who are involved in the family business and those who are not. We frequently see clients (parents) struggle to figure out how to preserve harmony among their children (and often between themselves) by giving the non-business children a piece of the business. Yet most of these parents know all too well how poorly that approach has worked for fellow business owners who took this route only to see it lead to anything but harmony among the children.

You might say that using life insurance — instead of for example, non-voting stock — is a “remorse avoidance” technique in these situations. Additional life insurance on the parents for the benefit of the non-business children can be a great alternative solution. For a relatively low cost per thousand of coverage, the parents can fix an intractable problem, with a solution that is simple, doesn't involve a fixed commitment and avoids a gift or bequest of that stock to a trust that rivals a Dickens novel in length and plot twists.

Default Estate Plan — Version 1

I use the term “default” estate plan to describe a situation in which, for any number of reasons, clients use life insurance in lieu of conventional wealth transfer planning to create or preserve estates for their children.

Previously, I've discussed how many clients are concerned (or are told that they should be concerned) about their “longevity risk,” meaning the risk that they might outlive their money because of increasing life spans, general inflation and particularly, rapidly increasing costs of health and perhaps long-term care. It stands to reason that such clients will be less than enthusiastic about wealth transfer planning that involves relinquishing total control of current or future income-producing assets to reduce potential estate taxes that the kids might pay many years from now. Note the emphasis on “potential” and “kids.”

Life insurance can be a very sensible answer for such parents who really would like to leave something to their children, whether after estate taxes, if things go well, or after substantial health or long-term care costs, if they don't. By putting a flexible premium policy into an irrevocable life insurance trust (ILIT) for the children, the parents are able to retain their asset base and give up only as much current income as they want by way of premiums on the policy. They avoid the fixed commitments and loss of control associated with the heavier duty wealth transfer planning, leaving them able to reverse course if either the outlay for premiums or the children's behavior becomes excessive. These clients also might see that dollars otherwise spent on long-term care premiums might be more profitably directed to the life insurance policy, which can preserve the estate for the children from depletion from either estate taxes or long-term care costs.

It's just a thought.

Default Estate Plan — Version 2

This version picks up on another theme I've written about previously: More and more spouses who would otherwise have acquiesced to having a substantial portion of their deceased spouse's estate directed to a typical bypass trust will no longer do so. These well-informed people conclude that even a liberally drawn bypass trust can impair their lifelong financial security and flexibility, all in the service of estate tax savings that may prove illusory. These clients are going to demand to be treated as individuals first, parents second and taxpayers third.

Such spouses have begun to suggest that if the kids are so concerned about saving taxes on mom and dad's estate, then they can buy some insurance on mom and dad to make up for the assets lost because mom and dad wouldn't use bypass trusts.

Default Estate Plan — Version 3

In this version of the default estate plan, the client is not averse to wealth transfer planning in principle, but is deterred by the complexity of the strategies and vehicles his advisors propose. If he had his druthers, this client would brush aside grantor retained annuity trusts (GRATs) and family limited partnerships (FLPs) to choose whatever lets him keep control, makes things simple, avoids taking on risk he doesn't personally profit from, and doesn't require commitments that can only be broken at great cost. The answer for such a client is life insurance.

Contrast this with wealth transfer planning, which usually involves a loss (or lessening) of control, complexity, risk and commitments that can't be broken without great cost. True, insurance isn't necessarily cheap and there is some element of administrative complexity and irrevocability. Also, the insurance will not lower his estate tax bill. But on balance, this type of client could find that, for a relatively low cost per thousand (or million), he can preserve both an estate for his children and flexibility for himself.

Paying Premiums

Okay, so once a client has decided to buy life insurance, the question becomes, “How should he pay the premiums?”

While the estate tax landscape has been anything but settled these past few years, there has been some settling in the thinking about the use of “multi-factor dependent” tax-driven strategies to pay large premiums.

True, gift tax-driven arrangements such as split-dollar and premium financing continue to evolve and get plenty of play in the industry press. For whatever else they do, these arrangements variously hold the promise of reducing the tax cost of paying large premiums or enabling the client to use someone else's money at what appears to be (and, can in fact be) a relatively reasonable economic and tax cost.

But unlike the descriptions of yesteryear, these strategies are now heavily footnoted and perhaps encumbered with caveats warning clients that the superb tax and economic results depicted in the presentations are exquisitely sensitive to, and dependent upon, a myriad of factors working out well for years to come. We are wiser now than we use to be. Experience has taught us that the clients don't create those exit strategies, if performance of a business or an investment falters, if a policy underperforms, if interest rates and borrowing costs exceed projections, if tax laws either stop cooperating or are found to have been uncooperative in the first place, then the strategy will fail — big time. It will simply collapse from its own weight.

Therefore, I sense a general recognition that (other than in very big cases where their use is virtually man-dated by the client's gift tax posture) there's little appeal in multi-factor dependent approaches. And this is a good thing. It'll spare a lot of clients (and planners) a lot of hassle and expense in the long run. But it's not enough.

The next step is to acknowledge that no matter how judiciously these multi-factor dependent arrangements are deployed, when they are used, their chances for success can be measurably improved by selection, design and funding of the insurance product to take some of the pressure off the premium-paying arrangement. In other words, a product used in a loan-based split-dollar arrangement should be selected, designed and funded in whatever ways give that arrangement the best chance for success by reducing the need for so many non-policy factors to work out right. This is perhaps the clearest lesson we've learned from trying to deal with pre-final-regulation split-dollar arrangements that defy solutions short of large gifts and policy replacements.

Into the Future

So that's the trend: towards the “decoupling” of wealth transfer planning from the sale and purchase of life insurance. Now firmly in place, this trend will accelerate as life insurance becomes an increasingly sensible way for certain clients to meet their objectives.

Conversely, there is no trend toward selecting, designing and funding of life insurance to serve overall estate plans, premium-paying strategies or a combination of both. And there won't be a change any time soon without regulation demanding suitability requirements. But this is a New Year's essay. And hope does spring eternal.

The views expressed in this article are those of the author and do not necessarily reflect the views of Ernst & Young LLP. This document should not be construed as legal, tax, accounting or any other professional advice or service. No one should act upon the information contained herein without appropriate professional advice after a thorough examination of the facts of a particular situation.

Charles L. Ratner is the national director of personal insurance counseling at Ernst & Young LLP in Cleveland. He's also vice chair of the Trusts & Estates editorial board and chair of the magazine's insurance committee