In a January 2010 Trusts & Estates article entitled “The Estate Planner's Guide to Product Suitability,”1 I suggested that it's imperative to have a process for determining the characteristics of a life insurance policy that's well suited for what a client is trying to accomplish and how that client wishes to accomplish it. I then offered some practical guidelines for determining policies' suitability.

The process and skill sets associated with determining what a client is trying to accomplish with the insurance he's buying are as critical to a successful, enduring estate plan as those associated with product suitability. However, in the same way that most clients aren't getting the benefit of a rigorous process for determining suitability, most clients aren't getting the benefit of a rigorous exploration of their needs for life insurance. So, let's consider some practical guidelines for determining what a client is trying to accomplish with the insurance — that is, the roles the client believes, or may come to appreciate that, life insurance can play in his plan.

A Hypothetical

The scene is a meeting. The client is a successful business owner in his early 60s. He's married, has one child in the business and one who's not. Present are the client's CFO, his attorneys and accountants and an insurance agent who's been introduced by one of those advisors. The meeting is about the client's estate planning. He's heard lengthy presentations on gifting, grantor retained annuity trusts (GRATs) and sales. He's also heard the agent's proposal for a $50 million second-to-die policy that would be paid for through a loan regime collateral assignment split-dollar arrangement between the client's company and an irrevocable life insurance trust (ILIT).

The presentations are concluded. The attorneys and accountants would like to get started on modeling the wealth transfer vehicles, and the agent would like to start the underwriting process. But the client sits back, sighing deeply. He looks at the forest-worth of slide decks, flowcharts, diagrams, exhibits and illustrations on the table and says:

I don't like this. I'm just not comfortable. Don't get me wrong, you guys have done a great job, very professional. But, you know, I've worked for years to build a business and make money. I've done well, but I haven't achieved all that I wanted to. The recession set me back financially, both business-wise and personally. Things are definitely turning around, though I think we have some rough patches ahead, particularly after the election. Anyway, I'm just starting to feel like I'm on my way back. And what are you guys telling me? That, because of an acute estate tax problem, I should give away as much as I can, as fast as I can. In fact, because of an almost heavenly confluence of high exemptions, low interest rates and presumably ‘temporarily’ suppressed values, I apparently have an ‘historic opportunity’ to make gifts and other transfers? Though it can't be all that historic, because I don't hear any of you talking about giving away your money. And meanwhile, because I can't give my money away fast enough, I have to spend hundreds of thousands of dollars a year on life insurance. So, I'm not happy.

Then he turns to the topic of life insurance:

You know, I kind of understand the gifts, GRATs and sales. I generally understand how they work and why I'd do them. But, I have some issues with the life insurance, not with the presentation, which was very sophisticated. I mean, those exhibits have more columns than the Parthenon! But here's what bothers me about it. First, the life insurance and the split-dollar plan are totally wired for one purpose, which is to help pay an estate tax bill that won't be due for years … decades actually. I understand that the $50 million figure is based on a guesstimate of what the taxes will be on my estate at current values, plus some growth. That's fine. But won't all those gifts, GRATs and sales eventually make a big chunk of that insurance unnecessary? Shouldn't you guys have coordinated all that, so I don't buy more insurance than I have to? Meanwhile, trust me, if I die tomorrow, the first question my wife will ask won't be about what the estate taxes are going to be when she dies! It seems to me that her needs should have been figured into the planning. Yet, the only time I heard her mentioned was when she'd die and the trust would get the money. Frankly, that's my fault. I shouldn't have allowed you to assume as much about my situation as I did. I guess we just need to talk some more.

Then the CFO weighs in:

You know, from a strictly dollars and cents point of view, we heard over and over again about how the split dollar reduces the tax cost of the premium. But we never heard a word, from anyone, about reducing the actual premium, meaning the amount of the check we have to write every year. I guess what I'm saying is that we're so focused on the estate taxes, which are very distant problems, that we're forgetting about our actual out-of-pocket cash flow, which is a real issue today. We need to take a sharper look at the cost and see if there are other ways to structure the coverage. Especially if, as my boss says, all that estate planning should reduce the liquidity need over time.

Finally, both the client and the CFO express a little good-natured cynicism:

It's interesting that you guys, the attorneys and accountants, never challenged the agent about anything other than some technical stuff about the split dollar. Nothing about why he was showing that kind of policy with that kind of premium or how, as my CFO said, we might be able to get things done less expensively. I know it's not your business, but maybe you could have helped us ask some good questions based on what you've seen other clients do … or ask. On the flip side, it's interesting that you, the agent, never challenged the attorneys or accountants about how insurance might just be a more efficient way of meeting some needs and let us keep a lot more control than some of the techniques they're proposing. Obviously, you're all trying to be professional and collegial, but all that collegiality could be costing us a lot of money. We constantly debate business issues around here. We argue. We challenge each other's points of view. It helps us see the pros and cons and get to a good decision. The same should be true for you guys, so how about a little ‘collegial’ conflict?

Then, the client breaks the tension with a smile, picks up his pen and says:

Let's start over. I know I need to do some planning and that I need insurance. And I know that I owe you some ground rules, so you can help my CFO and me identify my needs, put some numbers on them, estimate how long I'll have those needs and prioritize them. That way, you can coordinate the planning with the insurance. I want to start with the things that I'm really concerned about. The things that if I were to die tomorrow, would present my wife, kids and business with real problems. I have a feeling that we can fold the estate tax planning and liquidity needs together as we go along, meaning that I think you guys are clever enough to show me how every planning and premium dollar can serve more than one objective. I want to hear some dialogue … collegial, of course.

Now we'll rewind the tape and pretend that we're at the early moments of the meeting. While the topic of life insurance, per se, won't come up for a while, we'll structure our discussion and our probing questions to get the client (and the CFO) to talk early on about the things we need to know to: (1) coordinate the estate planning with the insurance; and (2) identify the characteristics of the policy or policies that will best address the client's needs. We'll make no attempt to presume what the client would do, so as not to impose an arbitrary “design” on the case. We'll just talk in specific generalities.

Here are our avenues of inquiry:

  • Why is the client buying the insurance?
  • Who will be the policy owner and beneficiary?
  • Who will pay the premiums and under what type of arrangement?
  • How much is the client willing to spend?

Why Buy Insurance?

If the conversation is sufficiently comprehensive and the questions sufficiently probing, a client like this one is likely to identify a number of needs for life insurance, even if, at this juncture, that identification is in general terms. These needs might include financial security for his surviving spouse and other dependents, his own personal financial planning (perhaps for investment or retirement), equalization among business and non-business children and liquidity for estate taxes, something I call the default estate plan and “pure” capital transfer. As the hypothetical client suggested, the conversation starts at whatever need the client identifies as most proximate and proceeds from there.

Financial security for the surviving spouse

In our hypothetical case, we saw a kind of autopilot program that's all too predictable whenever the client has a large taxable estate and a marital deduction that will defer taxes to the death of his surviving spouse. Indeed, the almost kneejerk prescription is for a survivorship life policy, especially if it looks cheaper than individual coverage on the client. I find that this occurs most often when everyone has focused on the estate tax need and ignored or underestimated the need for or the potentially effective uses of cash at the client's death.

Nowhere can this prescription be more problematic than if the client is a business owner. Often, clients like this build strong businesses, but not strong personal balance sheets. Their money either goes back into the business or into things that consume cash, but don't generate it. The older the client gets without acquiring a solid base of income-producing assets outside of the business, the more his surviving spouse will be dependent on the business for income, a situation that becomes “problematic-squared” when we consider the constraints on the surviving spouse's ability to take money out of the business after the client/employee spouse passes away. In these situations, the primary role of the estate plan is to create a retirement plan for the surviving spouse.

It's probably safe to assume that the client and his spouse have talked about this issue many times. Indeed, the need to provide for his wife's financial security independent of the business may well be the most pressing of all of the client's insurance needs. It's certainly more pressing than estate taxes, because the marital deduction and Internal Revenue Code Section 6166 deferral are available. Therefore, we can run a survivor cash flow projection and create a simple flowchart that shows his wife the estimated amounts and sources of her income after her husband passes away. To the extent that there will be a shortfall in her income, we'll ask the agent to look at coverage on the client.

Now, because our conversation is comprehensive, we might find that a policy on the client that's intended to provide financial security for his wife can be arranged to serve more than one purpose. For example, a child who's in the business can own the policy and be bound by agreement to use the proceeds to buy the stock from the client's estate. This approach gives the surviving spouse liquidity and cash flow independent of the business, removes growth (above the growth on the cash proceeds) from her estate, accelerates the business child's ownership of the company and possibly avoids a contentious issue between mother and child for the rest of the mother's life. We'll return with some observations on survivorship insurance when we look at capital transfer.

Personal financial planning

A case like our hypothetical can initially appear to be about estate and succession planning but, upon further probing, it turns out to be a retirement planning case first and then an estate-planning case. The same absence of income-producing assets on the personal balance sheet that creates the need for insurance coverage on the client, also impedes his ability to stage a seamless, successful financial exit from his business. This, in turn, can have important implications for business succession planning. For example, it can preclude transfers of dividend-paying stock or mandate use of wealth transfer techniques that allow the client to retain cash flow and, thus, have a higher hurdle rate for success.

When the underwriting makes it feasible, this type of client could do far worse than to “overfund” an efficiently constructed flexible premium cash value policy that can serve as a retirement planning vehicle. This type of product is already attractive under current tax law. The cash value grows tax-deferred and can be accessed on a tax-free basis through withdrawals and loans (assuming it's not a modified endowment contract). Also, any residual death benefit will pass to the client's spouse income tax-free, which helps with his financial security objective. In light of potentially increased tax rates on investment income after 2012, including the 3.8 percent Medicare tax, the traditional tax advantages of cash value life insurance might be very appealing to a client trying to reduce the tax on investments earmarked for retirement. But, the keys to making life insurance play that important role to stellar reviews are policy selection and design.

Equalization among business and non-business children

This is about as vexing and multi-faceted an issue as there is in estate and business succession planning. Beyond such substantive (and often emotional) issues as defining and quantifying “equal” or “fair” and figuring out when to equalize, business owners are often hamstrung by the difficulty of carving out assets when the: (1) business comprises the bulk of the value of the estate; and (2) owner doesn't want the non-business child to be involved in the business or to own any piece of it. Insurance can be a very effective way to create a non-business pool of cash for equalization. Aside from its inherent leverage and favorable tax economics, life insurance offers the owner/parent some piece of mind that no gift of stock in the company, even non-voting stock in trust, can offer. After all, the policy doesn't represent a fixed commitment, and the owner/parent can stop the premiums forthwith if he (or his spouse) stops getting along with that child (or his spouse). In other words, use of life insurance for equalization is what we might call a “remorse avoidance” technique.

Estate tax liquidity

We touched on this role for the insurance earlier. What's more, I've written about it in previous articles for Trusts & Estates. Therefore, I'll just echo the hypothetical client's observation that the life insurance proposal fell short on at least three counts. First, it didn't adequately consider the current shortfall in non-tax capital needs. Second, the amount of insurance was based on a static or increasing liquidity need that could well be reduced over time by all those gifts, GRATs and sales (let alone by another serious recession). Third, the size of the premium fairly dictated the use of loan regime split dollar, which can create many of its own problems. So, this client, and others similarly situated, would like to see the insurance programmed or layered to track what could be a declining liquidity need. By doing so, he may not only need less insurance for less time, but also may have less need to resort to such a multi-factor dependent approach for paying premiums as split dollar.2

I know this will sound perverse, but I think one could make an argument that, relative to cash value insurance, term insurance is oversold/overbought in the so-called personal market and undersold/under-bought in the estate-planning market. It's oversold in the personal market because the declining fortunes (and retirement benefits) of many clients will create needs of far greater amount and duration than they ever thought they'd have. On the flip side, in the estate-planning venue, a 15-to-20 year level premium term policy may provide a given client all the cover the client needs or wants to enable him to meet his objectives for wealth transfer, without busting his own budget. And, if he miscalculates, the conversion feature of the term policy might give him the wiggle room he needs to make a successful mid-course correction. Now, life insurance professionals would be absolutely right to point out some huge caveats associated with this approach, namely the risks of conversion, which involve not only the terms of any conversion option, but also the nature/pricing of the product to which the term policy is convertible in the future. These professionals might well be able to show that a minimally funded universal life (UL) policy can offer the same cover, fit the budget and avoid the conversion risk. The convertible term or a thinly funded UL can be used to get the coverage in place in the trust and minimize the client's gifts of premium while he funds the trust with GRATs of income-producing property. The trust can eventually convert the policy or “go long” on the UL, with the higher premiums now supplemented by the trust's own cash flow. After all, every dollar of premium the trust can pay on its own is a dollar of gift (or loan) that the client doesn't have to make!

Default estate plan

While the particular role of life insurance that I describe here may have limited application in the business owner market, I believe that we'll see more and more of it in the personal estate-planning market. Given many clients' perception of their economic prospects for the foreseeable future, I believe that they (even relatively wealthy clients) will bypass estate-planning-oriented wealth transfer because they're far more concerned about long life at lower yields than they are about estate taxes their children might pay. Said another way, when asked whether their greater regret in 10 years would be to find that they gave away more assets and the associated income than they should have or knowing that they will die with a taxable estate, clients will identify the former. Therefore, they won't rearrange their affairs or part with assets to reduce their taxable estates. However, they may well part with some income for life insurance if they want to assure an inheritance for their children.

Capital transfer

Many rich people use life insurance as a trust investment for pure wealth transfer. They believe that the internal rate of return on the death benefit may be as good or better on a risk and attitude-adjusted basis as anything else they would use for this purpose. We're hearing a lot about this concept these days; far more than we'd hear if the picture for traditional liquidity sales were brighter.

Survivorship insurance often is shown as the product of choice in this setting. That product absolutely has its place and, in certain cases, can be the only show in town. But, when it's shown to two relatively younger people, it's helpful to ask them to consider that if one were to die tomorrow, the other would likely survive for several decades, with no investable payout from the policy for all those years. It might well be that single life coverage, which by definition could pay a death benefit tomorrow, is the better choice. What's more, it might be helpful and enlightening to ask the person more actuarially likely to be the surviving spouse, whether he/she is truly committed to supporting those premiums with his/her own money after the first spouse dies. My anecdotal evidence suggests that the answer will be “No.” There will be an unabridged answer available for the asking as well.

Who Will be the Owner/Beneficiary?

In an estate-planning context, the default owner/beneficiary is an ILIT or other entity to keep the proceeds out of the estate. But, an ILIT may be contra-indicated if the client, even a wealthy one, wants absolute control over the policy, something I'm seeing more and more these days, regardless of whether the estate will be taxable. In any event, once we know the ownership/beneficiary designation, we can start understanding whether we're going to be dealing with the tax implications of funding the premiums and, if gift tax is going to be a factor, we know we should start looking at tax-effective ways to get premium money into the trust which, in turn, has implications for policy selection and design.

Who Will Pay Premiums?

Closely related to the owner/beneficiary question is who will pay the premiums and under what type of arrangement. Do we have a corporate payer or is it all personal money? What are the economic and tax implications associated with the premium paying arrangement? If the client will pay the premium with straight-ahead gifts, that's one thing, although we can talk about trust funding, etc. But, if the client will entertain split dollar or some kind of leveraged approach, then past is prologue, and the client had better understand all that has to go right for the arrangement to work and the limited and usually expensive options he'll have to choose from to fix the plan if things go wrong. Meanwhile, the choice of premium paying arrangement can and should have a tremendous impact on product selection and design, especially vis-a-vis the role of the product in contributing to the success and mitigating the downside of the premium paying arrangement.

How Much?

I've found that most clients will put a ceiling on what they're willing to spend on the insurance. Sometimes, that figure is governed by pure economics and cash flow. Other times, it's governed by tax considerations. And sometimes, it's both! The problem can be that the client may know what his premium tolerance is or what his assumptions are, but doesn't tell anybody (or maybe just won't admit it to himself). So, the agent and advisors can spend months getting illustrations, going through underwriting and designing structure, but it's all for naught because the client really and truly didn't want to spend the money! A common variation on that theme is when the advisors and the agent are beating the estate tax liquidity drum and focusing on the relationship between the death benefit and estate tax liability. But, the client and his CFO are much more focused on the premiums and out-of-pocket income and gift tax cost of paying those premiums over many years. Once again, there's a disconnect.

The sooner the agent, and everybody else, can get an indication of what the client has in mind, the better. So, the agent should commence informal underwriting as soon as possible, and then, based upon the preliminary findings, show the client the ballpark cost, perhaps per $1 million of coverage or $10 million of coverage, under various product types and funding approaches, meaning variations on the theme of how much premium he'll pay and how quickly he'll pay it into the policy. This up-front work can hopefully determine if the client is really ready to proceed, strategically and emotionally.

One of the key elements of this discussion is the “funding approach.” I typically see agents and advisors recommending that the client plan on paying a premium that will support the death benefit to well beyond age 100. On its face, this makes sense because nobody wants the client to outlive the coverage. But in many of those cases, especially when the underwriting is well south of preferred and has increased the cost of the insurance, but the client can't or won't increase the amount of available premium dollars, that kind of recommendation may not make a lot of sense. It means that the client will buy far less face amount than he needs today! In many of those cases, the client needs all of the insurance that the market will offer him, but if he pays a premium that's either guaranteed or projected to “eternally” support the death benefit, he'll be able to afford far less than he really needs and will leave needs uncovered.

I like the client to see that he has a choice; that he can choose between more coverage funded for a shorter duration or less coverage funded for a longer duration. My experience is that clients will most often choose to strike a reasonable balance between the two, meaning they'll go for the most insurance they can get at a premium calibrated to support the death benefit to something beyond life expectancy, but not to age 100-plus. This way, they'll avoid the big mistake, which is to die early without the needed liquidity. They can revisit the funding in later years, especially with today's flexible premium products, and make adjustments if they're needed.

More Dialogue Needed

I wrote this article as a small step towards reversing what I perceive to be a trend towards less real dialogue among professional advisors and life insurance professionals. Absence of dialogue is attributable, in my view, primarily to two factors. First, more advisors (and trustees) want no part of life insurance policy selection, design and funding. It's outside their wheelhouse, and so much of what they read admonishes them that their involvement potentially exposes them to all manner of risk, without potential for reward. Second, agents are business people who, for a host of perfectly valid business reasons, must necessarily limit their bandwidth for acceptable product selection, design and funding. The client in our hypothetical case will be well served. But, in the absence of advisor-agent dialogue, many an insurance-funded estate plan will be less than the sum of its parts. Maybe that dialogue will come back. If so, it will pay dividends for all of us.

The views expressed herein 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.

Endnotes

  1. Charles L. Ratner, “The Estate Planner's Guide to Product Suitability,” Trusts & Estates (January 2010) at p. 27.
  2. Charles L. Ratner, “Lessons Learned,” Trusts & Estates (January 2008) at p. 30.

Charles L. Ratner is the national director of personal insurance counseling at Ernst & Young LLP in Cleveland

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