Clients buy life insurance for a variety of reasons—to care for family members, to help transfer businesses, to cover estate taxes or other debts, to balance inheritances or even to enhance wealth transfer.
When clients need life insurance, advisors often focus on the amount of the death benefit received in relation to the premiums paid. As a way to compare different policies and features, advisors often use the internal rate of return (IRR) a policy owner might receive at various points in time, such as at a client’s life expectancy. Even when clients pay the same premium each year, the IRR might vary widely among life insurance carriers. However, there are often a variety of approaches advisors can take when designing a life insurance policy that might enhance a client’s death benefit IRR. When comparing policies, many advisors often overlook these designs, including policy features and premium-paying patterns, even though the designs can have a significant effect on policy performance. Let’s take a look at some of these design approaches and the trade-offs a client might need to consider, so that clients can survey their full range of options before buying a life insurance contract.
Comparing the Alternatives
Life insurance can satisfy two client needs: wealth transfer and insurance. Clients are often sensitive to the so-called “lost decade.” This is an allusion to the low returns clients have seen in equity for much of the 2000s. “Erratic Returns,” p. 58, displays the 5-year average S&P 500 return (without dividends) for the past decade.
Because of the low values represented in this chart, many clients are looking for alternatives that might help stabilize their overall wealth transfer and offer some certainty. Life insurance may be the answer. However, depending on a client’s circumstances, many factors may come into play.
These factors include a client’s overall life insurance need, cash flow, expected longevity, life insurance contract features and benefits and what return a client might reasonably receive with his dollars if he didn’t purchase life insurance. At the most basic level, an advisor working with a client on a wealth transfer strategy should examine what a client’s beneficiaries might receive if the client directed the funds to life insurance or to a non-life insurance alternative. This can be an intensive, assumptions-based discussion. It’s important for advisors to work with clients to determine a reasonable, non-insurance, after-tax investment return, based on a realistic look at the market and the client’s risk tolerance.
With most life insurance contracts, the IRR that a client’s beneficiaries might receive are extremely high in the policy’s early years compared to a non-life insurance alternative, such as equities or fixed income. That’s the case in the example described below. However, over time, the non-life insurance alternative might grow and compound, while the life insurance IRR decreases. The IRR for the life insurance alternative declines because of the passage of time before a benefit is received and, depending on the premium funding pattern, because of ongoing cash commitments (premiums) paid into the policy. At some point, the non-life insurance alternative will exceed that offered by the life insurance policy. The key is when the crossover point occurs (when the investment return exceeds the life insurance IRR) in relation to the client’s life expectancy. If the crossover point occurs beyond a client’s life expectancy, then life insurance may be a valuable planning tool for wealth transfer. Even when a crossover occurs prior to life expectancy, advisors need to weigh the fact that the family receives a death benefit and protection, regardless of the performance of a client’s own assets.
Enhancing the IRR
There are a variety of policy design approaches clients can take to enhance their death benefit IRR and take advantage of the flexibility offered by certain life insurance contracts, such as:
• Adjusting the premium-paying patterns, or
• Adding policy riders to a life insurance contract to enhance the death benefit or help meet other client objectives. This is generally at an additional cost, and the riders may contain restrictions and limitations.
In certain cases, policy design may allow an advisor to push the IRR crossover point well beyond a client’s life expectancy.
Life insurance is frequently illustrated for clients by showing level annual payments for their lifetime. This is often referred to as a “life-pay design.” In many cases, this approach makes sense for clients, as it minimizes their annual out-of-pocket cash flow and helps boost the death benefit IRR in the early years (in relation to the premiums paid). It may also help clients fund an irrevocable life insurance trust (ILIT) through relatively simple annual exclusion gifts, as opposed to other, possibly more involved, techniques.
However, with many life insurance contracts (typically universal life insurance), premiums can be spaced or timed to help enhance the death benefit IRR or to help meet client cash flow needs. For example, consider a client who might be cash rich in a given year, but less certain of a steady flow of funds in future years. The client might elect to frontload his premium payments, knowing that this strategy could allow him to skip or stagger future premiums. Depending on when the premium payments are made, the client or policy owner may see a significant shift in the death benefit IRR.
Let’s examine how three different designs might alter the death benefit IRR a client’s beneficiaries receive.1 In each example, we’ll consider Alan and Jane, a 55-year- old couple purchasing a second-to-die universal life policy. The three scenarios for their premium payments through their age 100 are:
1. Level payments each year to age 100,
2. A single lump sum payment in Year 1 and no future premium payments,2 and
3. A large up-front premium payment, followed by years of no premiums. This is often called a “skip-premium” design.
Each of these designs carries certain considerations:
1. The level-pay design requires an annual commitment. When an ILIT is involved, additional steps may need to be taken to qualify gifts for the annual exclusion.
2. The single lump sum payment may carry certain tax ramifications.3
3. The skip-premium design may, at some point, require the couple to restart premiums at a higher level. This can be both a benefit and a risk. Clients have the luxury of not paying premiums, possibly for decades. However, they must be certain that they or their advisors monitor the policy to keep it from failing, remember to restart premiums at some indefinite future date and be prepared to pay the higher future premiums or risk losing the life insurance benefit.
“Comparing the Options,” this page, compares the IRR that the couple’s beneficiaries might receive in key years, including age 91 (the couple’s joint life expectancy).
Clients might stagger premiums under any number of patterns that help address their cash flow needs; however, these scenarios show the broad impact of three widely different designs.
Depending on when a client dies, the IRR received by his beneficiaries can be very different. The single-premium design (modified endowment contract (MEC) or non-MEC) will typically result in a lower IRR, should a client die early. That’s because the larger up-front expenditure will take some years to offset. The skip-premium design offers the best IRR in the early years, as would be expected from the lower initial premium outlay and the years of going without any premium payments.4 This IRR advantage lasts through the client’s life expectancy and for some years beyond.5 However, that advantage is lost before age 100 because of all the years of higher premium payments that begin late in the client’s life.
When might one design work better than others? It will vary from client to client and product to product. In this example, the couple needs to live beyond life expectancy to see the single-premium design offset the high early cost. This would be the path of choice when a client has ready access to funds, but unpredictable future revenue. The level premium offered the steadiest result; however, the skip premium offered a significant IRR advantage beyond the couple’s joint life expectancy.
This example shows that advisors should consider a range of designs based on the client’s particular situation. Considerations might include:
Cash flow. Single-premium designs make sense when cash is available and the client wants to lock in his
insurability while he has funds. However, the level-pay design offers more predictability regarding a client’s cash flow than a skip-premium design. The level-pay design also offers a better IRR than the single-pay design through and for a period beyond life expectancy. By contrast, the level-pay design requires the greatest out-of-pocket commitment through age 100 ($2.763 million compared to $2.353 million). However, the skip-premium approach requires the greatest late-in-life cash commitment. That last item triggers the gifting and mental capacity issues noted below.
Future gifting capacity. Advisors should weigh a client’s near- and long-term gifting ability. The level-pay design may allow a client the capacity to make gifts well within his annual exclusions. By contrast, a skip-premium design might trigger large gifts that could require gift splitting. Because this may occur years into the future, clients must weigh the certainty that their situation will lend itself to split gifts decades from the initial plan design. They also need to weigh the longevity of each spouse and the risk of a divorce.
Future mental capacity. A significant skip period might trigger future premiums when a client is much older. The client may no longer recall the discussion requiring the need to pay these higher premiums years after the initial planning meetings. So, advisors should keep collateral documentation. Additionally, years from now, a client may not have the mental capacity to appreciate the need to increase payments or make late-in-life gifts. To address this concern, a strong power of attorney granting gifting rights to the attorney-in-fact should be considered as part of the overall estate plan.
Life insurance carrier product parameters. In today’s low interest rate environment, many life insurance carriers may impose limits on the amount of premium that can be “frontloaded” into their contracts. This is often done to avoid large influxes of dollars into their general account with the potential of lowering their overall crediting rate. These limits vary widely from carrier to carrier. Some carriers limit the amount of a single premium to a multiple of target compensation, while others might impose no limits, but offset the risk in other ways, such as product pricing.
The insured’s life expectancy. Certain clients may have a longer or shorter family history of life expectancy. When there’s a sense of client longevity, this may also weigh as a factor in determining the appropriate design.
Some life insurance carriers offer riders or other designs that allow the purchase of additional death benefit amounts to meet particular client planning solutions. Although the name varies from life insurance carrier to carrier, when these riders are designed to pay at the insured’s death, they’re often generically referred to as “Death Benefit Option C” (Option C). Others may call this option a “return of premium rider” or some variation. These options were originally designed to accommodate high-net-worth clients who used premium financing to purchase their insurance. The riders allow for the death benefit to increase each year, usually equal to the amount of the premiums, so that at death, the borrowed amounts could be repaid, and the net amount allowed the beneficiaries to receive the original planned for death benefit.
As one might expect from this name, these riders typically allow for a return of premium at some future point in time. With Option C, the refund is usually at death. However, when these options are offered as a rider, it may allow an earlier refund of premiums. Some riders allow clients or policy owners to dial a percentage of the premiums paid, up to 100 percent of the premiums. In some instances, this feature may even allow for a crediting rate to be paid on the returned premiums. In effect, a client can allow his beneficiaries to receive not only the desired death benefit, but also a return of the premium payments, plus a lost use of funds. For purposes of this discussion, the focus will be on a return of premium at the same time as the payment of the death benefit.
These features might also help enhance the IRR death benefit. For a client who wishes to enhance his wealth transfer, purchasing an Option C rider has the potential to offer an increase, particularly for those with longevity. Consider the following example from a recent client case.
Example: John, age 75, wants to leave a legacy to his family. His portfolio is primarily allocated to bonds and other fixed-income assets. He has substantial net worth and, as a result, substantial insurance capacity. He’s also frustrated with the current low interest rate environment, but he’s fearful of the equity market. As a result, he intends to purchase life insurance to assure a certain amount of wealth transfer to his family on his death.
John’s advisor shows him several policy design options and compares the death benefit against what John might receive if he didn’t purchase life insurance. “A Family Legacy,” this page, shows four possible scenarios with an amount that John expects to direct into life insurance; the next section addresses a fifth option, which focuses on Option B-type designs. Each of these alternatives has advantages and disadvantages.
• Not purchasing life insurance. Here, the hypothetical portfolio shows year over year growth. In the early years, the year-end values are far lower than a client might receive from life insurance. However, assuming the client does receive this average annual after-tax growth, by Year 20, the hypothetical portfolio might approach the results illustrated in some of the life insurance alternatives. The drawbacks are that clients may not receive the planned for average annual return, it might be preceded by years of loss (requiring greater gain in the later years) and the client may die before he reaches the crossover point.
• Purchasing a level annual death benefit. In this approach, the client uses the same dollar amount to purchase a death benefit that’s illustrated to be level year over year. As is typically the case with life insurance, this approach offers the highest IRR should death occur in the early years. The IRR the beneficiaries might receive is greatest in Year 1. Over time, it will decrease as funds are spent each year towards the same level death benefit. Even at life expectancy, the IRR can be a very respectable 8.78 percent, based on the assumptions used in the policy illustration. However, as the client ages beyond his life expectancy, the IRR decreases sharply in relation to non-life insurance alternatives. The crossover point here occurs in Year 18, four years past the client’s life expectancy. However, in all of the prior years, the level death benefit offers the client a potentially better alternative.
• Purchasing insurance with a return of premium rider. Typically, a return of premium rider comes at an additional cost. As a result, a comparison using the same outlay (premium in the case of life insurance) will purchase less death benefit than under a level-annual-death-benefit design. In this instance, the first year death benefit is lower than the level-pay design by over $1.2 million. As a result, the IRR in this design is lower in the early years. Over time, as the death benefit increases, the IRR will increase, and by the time the client reaches his life expectancy, the death benefit IRR exceeds that of the level death benefit. Essentially, by purchasing a lower death benefit in the early years, the same amount of premium allows for a higher death benefit in the later years. In all years shown, the IRR exceeds that of the non-life insurance alternative. However, the client needs to weigh which alternative best suits his objectives.
• Purchasing insurance with a return of premium rider with a crediting rate of 4 percent. Here, using the same premium dollar amount to purchase life insurance with both the rider and a crediting rate comes at cost. Because a client is purchasing this largest potential death benefit by using the same premium amount as the other two approaches, the early death benefit is the lowest of the three options. However, if the client lives past his 14-year life expectancy, the IRR and death benefit shift to the highest of the three approaches discussed in this section.
Which approach is best will vary from client to client and based on the product illustrated. Clients with longevity in their family may be willing to forgo the higher early IRR offered by the level death benefit design. They might take on some risk that they’ll live past their life expectancy and use one of the return of premium designs to boost their beneficiary’s death benefit IRR. On the other hand, clients who are risk adverse or who don’t believe that longevity runs in their family, may opt for the level death benefit approach.
All three of these designs, with and without the rider, use what’s called “Option A,” which is usually a level death benefit design. In the designs using the return of premium rider (Option C), a lower initial death benefit is purchased. The increasing death benefit comes from adding units of death benefits associated with that rider on top of the initial death benefit.
A common criticism of the return of premium rider is the expense. That said, the option offers beneficiaries a recoupment of funds. Another alternative is to use what’s commonly called “Option B” or a corridor- type design, also shown in “A Family Legacy.” This approach offers a policy owner the underlying death benefit, plus a death benefit that’s equal to the cash surrender value. Although it’s used primarily in cash value accumulation designs, it can help clients boost the death benefit IRR.
Option B also offers a higher potential death benefit, albeit one that’s less predictable because the cash value growth is less predictable. However, because of the higher potential death benefit, Option B comes at a higher cost than a pure level death benefit. As a result, the initial death benefit, using the same $100,000 annual premium, is lower ($2,340,600) than a level death design in the same chart. That level death benefit, $2,785,700, uses Option A. By contrast, Option B is lower in the early years, but offers the potential to increase and is less expensive than the other two options using return of premium riders. The trade-off is that it’s less predictable.
The Option B approach in “A Family Legacy” shows an increasing annual death benefit. The death benefit approaches that of the level death benefit in the early years, and it exceeds that amount by life expectancy. Only past life expectancy does the IRR drop behind those offered by the return of premium rider.
A strong advantage offered by Option B is cost. Although it comes at a charge, it’s likely to be more reasonable than that of a return of premium type rider. The trade-off is that its performance isn’t guaranteed, and it trails the return of premium type riders in the later years. It’s dependent on the underlying policy cash value performance.
When selecting an insurance policy, a number of other factors must be considered in addition to policy design. Here’s a brief review of those factors.
Always consider insurance capacity and the need for a death benefit. Even when a client has funds and wishes to use life insurance to help maximize his wealth transfer, the overall amount of life insurance he can purchase might be limited by his total net worth, family need, income and even other existing insurance policies.
Clients must always weigh a life insurance carrier’s financial stability and claims paying ability. Ratings and other factors will come into consideration when determining a carrier’s long-term ability to honor its death benefit commitment. Regardless of the flexibility in design, clients and advisors should also weigh each contract’s other policy features, riders and benefits. There may be significant additional advantages from one contract to another based on these benefits and features. Finally, clients should consider the cash value potential offered by their life insurance contracts. Cash values not only afford policy owners the flexibility to start and stop premiums in current assumption and certain other life insurance contracts,6 but also allow clients the flexibility to make contractual changes should their circumstances change years into the future.
One Size Doesn’t Fit All
Advisors working with clients can’t simply say that there’s a life insurance need and offer a basic illustration with a level pay and death benefit design. They need to weigh multiple factors, including client cash flow and risk tolerance. When a client’s ultimate desire is to pass the greatest death benefit to his beneficiaries, advisors may need to weigh multiple designs to determine which premium paying patterns, products and product features offer the best overall performance, death benefit IRR and flexibility for a client’s premium dollars and individual situation. Other designs will offer additional client options. The important take-away is that one size doesn’t fit all.
1. The rates used for the life insurance policies in this article are broadly representative of a universal life insurance policy using these features. They’re not representative of any one carrier. A client’s actual results will vary from carrier to carrier and with each individual based on his age and underwriting class.
2. The premium payment in this design is considered a modified endowment contract (MEC). MECs are reflected in Internal Revenue Code Section 7702. This section, effective June 21, 1988, was designed to limit the amount of funds that could be contributed to a life insurance contract and receive favorable lifetime tax treatment. When a life insurance contact is considered a MEC, withdrawals or loans from a policy’s cash surrender values will be taxed on a last-in, first-out basis, causing income taxation to be accelerated. However, assuming no other changes affect the contract, the death benefit from a MEC can still be received income tax-free under IRC Section 101. In this instance, the single premium funds required to carry the life insurance policy to age 100 violated the limits of Section 7702. In other instances, it might be possible to fund a policy with a single premium and not trigger MEC tax treatment.
3. Ibid. Additionally, the premium may be of such an amount that gift tax and lifetime exemptions factors must be weighed.
4. Although not clearly evidenced in “Comparing the Options,” p. 59, in this particular instance the client is able to skip premium payments until Year 22 (a 21-year skip). At that point, the client or policy owner must begin payments, at a higher rate, to maintain the life insurance policy.
5. Although not detailed in the chart, this advantage lasts through Year 42, age 97. In that year, the internal rates of return are, respectively, 3.02 percent—Skip Premium; 2.85 percent—Level Pay and 2.90 percent—Single Pay.
6. This may be different from what are often called “no-lapse guarantee contracts.” They may often offer little or no cash surrender values, but the policies might be intact based on underlying contractual guarantees or something often referred to as “shadow accounts.”