Evaluating Creative Planned Giving Scenarios Involving Life Insurance. Part 1: An Introduction to Life Insurance Products. Eric L.

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1 Evaluating Creative Planned Giving Scenarios Involving Life Insurance Part 1: An Introduction to Life Insurance Products Eric L. Abramson Editor s Note: The following queries were posted to NCPG s discussion list, GIFT-PL, in February We have been approached by a group suggesting we ask major donors to allow us to purchase large ($2,000,000 minimum) single pay life insurance policies on their lives, with the upfront premium funded by loans taken out by the foundation. Assuming the donors are insurable and we can arrange for reasonable financing, the earnings on the policy should usually cover the interest payments on the loans. The loans would be secured by assignment of the policies and possibly by pledges in the early years, and at the donor's death, the loan would be repaid and the remaining funds would go to the foundation. The company says they have reduced sales commissions paid to make the economics more favorable to the foundation. Also because it is a single payment policy, the policy value should generally exceed the amount of the loan, so the foundation could either drop the policy or cash it in should it decide not to continue the program. There are obvious questions such as quality of the insurance company and whether the projected numbers seem reasonable. Are there other things we need to look out for? Is there a UBIT problem because of the debt financing? An organization recently made a presentation to our organization. It is a plan that loans part of a donor's Self-Directed IRA, say $100,000 of a $200,000 IRA, to a newly formed LLC which in turn loans the $100,000 to charity. The charity uses a portion of the loaned amount, say $60,000 (amount varies based on age), to buy a single premium life insurance policy with a $100,000 death benefit and the charity keeps the $40,000 loan balance. The charity pays interest on the loan, say at 5% annually until the donor's death. The donor makes a gift pledge, coincidentally, of $5,000 annually for life to the charity. The donor gets to deduct the annual gift on his/her income tax within contribution limits, but since the interest is not paid to him/her personally, but rather to the LLC, he/she does not have to report the interest income on his/her personal income tax return. When the donor dies, the insurance policy repays the full amount of the charity's loan to the IRA through the LLC and charity gets to keep the loan proceeds that it did not spend on life insurance premiums, in this case, $40,000. Of course, the charity's annual interest payments are washed out by the donor's annual gift, thus no gain or loss to charity. However, charity's cost to gain a $40,000 gift in this case is the annual paperwork for the length of the donor's life. Is this a real gift to charity or just another split-dollar insurance scheme? Most planned giving officers are not insurance experts, and many feel ill-equipped to judge proposals like these. Are they gifts or nightmares? And who can be trusted to evaluate them fairly, balancing the interests of the donor, the charity and the firm presenting the proposal? In a series of articles, The Journal of Gift Planning will examine the components of gift proposals involving life insurance, beginning with this primer on the technicalities of the underlying insurance products. Future articles will address specific innovative insurance programs and provide suggestions for evaluating the viability of insurance proposals and determining whether or not the plan will produce real value for the charity. Journal of Gift Planning 13

2 Life insurance is perhaps the most misunderstood tool in financial planning. Sadly, many planned giving officers first reaction is to shun all charitable life insurance. Evaluating a complex and creative life insurance proposal is much like fully evaluating the tax code. Fortunately, gift planners don t need to be insurance experts, although they should be well educated and informed. The gift planner s role, as an employee of a charity and the friend of its donors, is to instigate a very thorough and comprehensive process of due diligence. The Model Standards of Practice for the Charitable Gift Planner remind us that the involvement of true experts in this process is crucial. The purpose of this article is to provide a foundational education in the basic types of life insurance: term, universal, variable, and whole life (or permanent life insurance). These are the components of proposals that range from the simplest assignment of a charitable beneficiary for a paid-up policy through the full spectrum of creative and unique proposals involving life insurance. From Charitable Reverse Split Dollar to the new found Premium Financing techniques, there are an unlimited number of opportunities presented everyday. Some of these opportunities may be viable and very beneficial, while others are nothing more than the proverbial smoke and mirrors. While this overview will NOT make you an expert on the types of life insurance, it should prepare you to communicate with the experts you will enlist to evaluate the next proposal that crosses your desk. Term Life Insurance As its name implies, term life insurance provides coverage for a definitive and limited term of years that s all, nothing more and nothing less. In addition, for the most part, term insurance is merely a death benefit. If the insured dies during the time the policy is in force, the beneficiaries will collect the stipulated death benefit. In general, term insurance builds no equity or cash value. And in a long-term economic sense, due to the time limits of the coverage, structure, and the ultimate costs, there is no permanency of the death benefit. There are numerous types of term insurance products, differentiated by their cost or premium and coverage time frames. Many products have premiums that increase every year, often called annual or yearly renewable term insurance. Other products offer a level term, in which the premium remains constant for a certain number of years. This type of coverage usually extends between five years to as many as thirty years (and in some cases, forty years) as the specified term. The products are often referred to as five year level term or 20 year level term. Of course the premium cost for a 20 year level term product, while it is level, would be higher than an annual renewable insurance product issued at the same age. Actuaries would calculate how much more they would have to charge on a level basis, as opposed to increasing the premium every year. A 20 year level term product would have a level premium for 20 years and a specified death benefit for the same 20 years. At the end of the 20-year term, the insured might have the option of continuing the coverage, but at a drastically increased premium cost. Generally, if an option to continue the coverage exists, the premiums for level term products rise incredibly after the specified term. The premiums for pure term insurance are determined by insurance company actuaries, who base their pricing guidelines using mortality tables, mortality experience and the operating expenses of the issuing insurance company. Other factors may be used as well. Statistically, a very small percentage of term policies ever pay a death benefit. This is the reality because, most often, the premium becomes very expensive as the insured gets older, and ultimately the coverage is cost prohibitive. Thus, most people drop the coverage, and as such, no death benefit is paid. As people get older and their children s educations are paid for, mortgages are paid off, etc. they no longer feel they need life insurance protection. Term life insurance policies offer limited opportunities for charitable giving. The insured might name a charity as the secondary beneficiary or ultimate contingent beneficiary of a term policy. However, as relatively few people actually die during the time their term policies are in force, these designations will usually not result in a charitable gift. However, in estate planning, wealth replacement and numerous other arenas, people do find that having life insurance 14 Journal of Gift Planning

3 throughout their lifetime and, of course, at death is very important. As such, the life insurance and the death benefit must be made permanent. Very often, purchasers of life insurance and their advisors feel that if a life insurance policy provides cash value, it is permanent life insurance coverage. The misconception that life insurance is permanent results in a sense that there are also guarantees perhaps meaning the cash value, the premium, and the death benefit are guaranteed. This thinking is not only very often untrue, but can also be very damaging. To understand why, we must examine the basic types of life insurance policies that build equity, or what is often generically referred to as cash value. Universal Life Insurance Universal life insurance is one type of insurance that has an equity or cash value component. In reality, however, the equity portion of the product is not truly cash value as we may understand it. We will examine this in detail shortly. From its inception, universal life insurance has taken on a variety of different forms, and it is known by many names, depending on the specific structure. Universal life insurance is often referred to as flexible premium life insurance, adjustable life insurance, interest sensitive life, and others. Universal life insurance has a lower premium or cost than truly permanent, or whole life insurance, although this is usually only the case on the surface and does not reflect the true cost of the policy. A lower premium cost may be attractive, and may offer some perceived advantages, but there is also a long-term economic cost. In most cases, universal life insurance lacks the guarantees that one would want in a truly permanent life insurance vehicle. For the most part, universal life insurance does not have a stated table of guaranteed cash values. Therefore, many of the wealth creation or enhancement strategies that could use a truly guaranteed life insurance product may not be available with a universal life insurance product. Generally, universal life insurance policies have two components. First, is the death benefit or mortality component. In the simplest sense, this is nothing more than a term insurance element. As with any term insurance product, the mortality costs increase every year since, as people get older, a larger percentage of them will die. Thus, the costs associated with this death benefit component of a universal life insurance policy get more expensive every year. The second component of universal life insurance is often known as the side fund. In simplest terms, the side fund is like a savings account, held at the insurance company, with an interest rate attached to it. In summary, universal life insurance is simply term insurance coverage with a side fund. The side fund dollars are intended to support the death benefit protection, absent of premium payments or if scheduled or projected premium payments are not sufficient. To truly understand the product, however, we need to dig deeper and see how the two components behave. What actually happens when a universal life premium is paid? As an example, we will assume that a level premium is paid every year. When the premium is paid, first, a certain portion of the money is allocated to the side fund. When the premium dollars go into the side fund, (depending on the specific insurance company, specific product, etc.) sales charges and certain expenses are subtracted from the premium amount paid. Then, during the year, often on a monthly basis, the mortality expenses or term charges, and sometimes other expenses are also subtracted. Again, there is an interest rate, which is credited to the side fund and the dollars in it. While there is often a guaranteed minimum interest rate, for the most part, the interest rate is variable. Journal of Gift Planning 15

4 As premium payments are allocated to the side fund and the term insurance coverage, the insurance company is concerned with the net amount at risk. This is the real amount that the insurance company has at risk in order to pay the death benefit of any policy. At a given point in time, if one looks at the amount of the death benefit, and subtracts the value of the side fund, this gives us the net amount at risk. And so we see that there is a third variable with a direct impact on the policy: the premium. If a fixed premium is being paid, and the term portion of this coverage gets more expensive every year, then less money every year is going to the side fund, and more money is going to cover the increasing term costs. Conceptually, what can happen is that in later years, if the mortality charges become more expensive than the premium being paid, the policyholder only has two choices. First, he can pay higher premium amounts. Or, second and what most often happens the higher payments required, in order to maintain the coverage, are taken from the side fund, and the side fund is depleted over time. In a perfect world, and in some cases, the side fund may earn enough interest to support the higher mortality costs, and still may continue to grow. This is usually how universal life insurance illustrations are portrayed. However, that result is completely contingent on then current interest rates and the amount of money in the side fund at the time. If the side fund does not earn enough interest, and the policyholder does not pay more money, then the amount needed is taken from the principal of the side fund. This is why, if you examine illustrations for universal life insurance, you will most often find under the guarantee section that in early years, the side fund is growing. But in later years, the same side fund account is decreasing, and often very rapidly. This is the hidden cost of universal life coverage. A properly funded universal life insurance policy, designed so that the side fund will grow and the coverage does not become jeopardized, often does not have a lower premium cost than certain types of whole life insurance. If you have increasing mortality costs, and decreasing interest rates your costs are going up, and your equity is going down you are moving in the wrong direction. There are innumerable variables than can affect a policy, and one could never project every possible outcome. However, if the side fund is exhausted, the policyholder is left with term insurance very expensive term insurance. In other words, in examining the net amount at risk, the death benefit minus the side fund, if the side fund is exhausted, there is nothing left but term insurance requiring very expensive premiums to maintain. If the premium is not paid, the policy will lapse and the policyholder is left with no value and no protection. The mortality charges that a universal life insurance policy contains also have a variable element. When these products are approved by the respective State Departments of Insurance, there is an approved table of mortality charges, often specifying a minimum, a current and a guaranteed maximum mortality charge for any given year. The issuing insurance company sets and changes their mortality charges, on an annual basis, based upon their actual mortality experience and operating expenses. The insurance company is allowed to move the mortality up and down, as long as it remains within the previously approved range. Thus, the current mortality charges one sees in an illustration represent a snapshot in time, accurate for that moment. In the next year, mortality charges can increase within the approved range, and the illustration you looked at last year is no longer accurate. Often, in ensuing years, mortality charges increase beyond the previously projected and current level, but are under the guaranteed maximum level. However, if the trend continues, mortality charges would be getting closer and closer to the guaranteed maximum charge. The most recent version of universal life insurance, known as secondary guarantee universal life, is structured with insurance companies guaranteeing the death benefit to age 100 or even beyond. This has the potential to be very dangerous, and in many states these products are not approved and not allowed to be sold. The risk to the specific policy-holder, and to all of the company s insureds, is that if the insurance company is at risk for the entire death benefit (due to the side fund being exhausted), and hasn t set aside additional funds (known as a deficiency reserve), the insurance company would have to invade its surplus to pay death claims. This could have a 16 Journal of Gift Planning

5 significant impact on the issuing insurance company. These products are relatively new and there is understandable uncertainty about them. However, if they became common, the potential liability could be very damaging for the insurance companies issuing the policies and for the entire insurance industry, as well as for buyers of life insurance throughout the United States. To understand the ramifications of this type of arrangement, let s examine the concept of risk management, one of the traditional reasons people have purchased life insurance throughout the years. Risks that an individual can manage can be self-insured, something like the deductible on your auto insurance. You self-insure the deductible amount. On the other hand, risk management also insulates and alleviates the subject from larger, more catastrophic risks. This is done by transferring larger risks to insurance companies. In the basic scenario, this would be the amount(s) above your deductible, those that an insurance company would cover in the event of a loss. However, with a universal life insurance policy, the insured is participating in a mutual or shared risk with the insurance company. The side fund dollars are not guaranteed, and must support the death benefit protection, absent of premium payments or if scheduled or projected premium payments are not sufficient. In many cases, policyholders are completely unaware of the risks they may be assuming with universal life insurance. This may sound all bad, but universal life insurance does not always have to be a bad deal. It is just a misunderstood deal, that if not fully understood can be very bad. At this point, gift planners can see that many variables have a very direct bearing on a universal life continued on page 46 Journal of Gift Planning 17

6 Abramson continued from page 17 policy. As such, a policyholder s expectations, based upon her understanding or ignorance of these variables, may not be an accurate portrayal of reality. Variable Life Insurance A natural next step from universal life insurance is variable life insurance. This type of insurance became very popular throughout the 1990s, primarily due to the performance of the stock market. Most commonly and very simply, variable life insurance is a universal life insurance product with the side fund being a series of different investment options. Thus, the side fund dollars can be invested in the stock market instead of staying in the simple bank account with the insurer. These investment options are known as sub-accounts. The subaccounts offered are usually a wide array of investment classes: stocks, bonds, international, and other types as well. In addition to the inherent risks associated with universal life insurance, if the side fund dollars are in market-type investments, the policyholder has now taken on another very significant risk investment risk. Thus, contrary to the goal of risk management, more risk is transferred back to the insured. While this may appear only be the case in the short term, in the long term the insured may be assuming a great deal more risk. We ll examine just one of the vulnerabilities that exists with respect to the side fund dollars. First, variable life insurance illustrations are supposed to show how the product behaves how the side fund dollars (may) grow, and how the death benefit stays in force, etc. In these illustrations, certain variables are taken very much for granted. The illustrations also contain, although they are often not clearly illustrated, assumptions and projections of the mortality charges and costs. In addition, the illustrations assume a certain rate of return attached to the sub-accounts or investment choices. This is where the actual problem lies, or at least one of the problems. The illustrations themselves are rather misleading from an economic perspective. This is NOT because of any malice or bad intentions from any insurance company or agent, but simply because what the illustrations show could never truly happen. To fully understand this, we need to understand some basic economic principles: the average rate of return or yield and actual yield. Chart 1 shows a basic portrayal a pool of money, with a fixed rate of return. This could be a stereotypical mutual fund or side fund that achieves an eight percent average rate of return. If we look at the result, $317,217, and use this as our baseline, we now have a benchmark to measure against. In fact, however, mutual funds, equity markets, or most any investment do not actually behave this way. Rates of return are actually variable. And because of the variable rates of return, our average rate of return has a new sibling the actual (economic) yield. Chart 2 illustrates the real world of variable rates of return. It is critically important to note that while the rates of return fluctuate, the average rate of return is still eight percent. However, the actual yield is less: 6.96 percent. While this may not seem like a great difference, one must examine the account value: $274,512! What this means is that a difference of slightly more than one percent in actual yield (104 basis points, or 1.04 percent) causes the dollar value to shrink by approximately 14 percent. And the problem compounds. Chart 3 shows, once again, the unnatural eight percent rate of return every year for the 15 year period, but this time we add a 1.5 percent annual management and expense charge (taken out not monthly, but at the end of the year). The actual yield is now 6.38 percent, and the resulting account value is now $252,871. This represents shrinkage of approximately 20 percent. Thus, our results are beginning to get quite far away from the eight percent average rate of return we saw in the original projection. Then, in Chart 4, we see the same variable rates of return presented in Chart 2, which are more realistic. Again, we have added a 1.5 percent annual management and expense charge (again taken out not monthly, but at the end of the year). Now, we see a much larger impact to the resulting account value. The actual yield is now 5.36 percent, but the account value is now worth $218,829. This is shrinkage of approximately 31 percent from our original benchmark of $317,217. Normally, variable life insurance policies have fees and expenses, and of course they have management fees associated 46 Journal of Gift Planning

7 CHART 1 CHART 2 CHART 3 CHART 4 with the sub-account investment choices. Money managers and investment or mutual fund companies must be paid for the services they provide. The situation would be further compounded if the mortality charges were deducted from these portrayals. The same issues apply to the mortality charges in a variable life insurance policy as in a universal life insurance policy. The range of approved charges can and will have a very significant impact on policy performance and the future standing and strength of the policy. What does all of this mean? The conclusion is that money and math are two completely different things. A recent popularity of Monte Carlo simulations has caused the investment community to look at the order or frequency of rates of return and the resulting impact on the account value. Thus, examining the simple average yield over a period of time does not give us a true or accurate indication of the end result. Whole or Permanent Life Insurance Whole or permanent life insurance is the last type of insurance we will examine. It is also known by many names: ordinary life insurance, cash value life insurance and others. Whole life insurance is the oldest type of life insurance and has been around, in its primitive form, for several hundred years. In its pure form, whole life insurance is the only type of true guaranteed life insurance, meaning that it has certain guaranteed elements. First, the initial death benefit is guaranteed, as with other types of life insurance, as long as the premiums are paid when due. Second, the premium is guaranteed to remain level throughout all of the years the policy is in force. Third, a whole life policy has a guaranteed cash value component. This cash value is guaranteed to increase every year, and once you have an amount of monies in this guaranteed cash value portion, that amount is guaranteed, and it is guaranteed to increase the very next year, and every year thereafter. A traditional whole life policy is designed to have the cash value increase every year, until a particular age Journal of Gift Planning 47

8 (sometimes age 95 or 100), and then the cash value equals the original death benefit. At this point, the policy has endowed. The guaranteed dollars in a whole life policy are guaranteed contractually, and are set aside in a reserve account by the issuing insurance company. In order to be in compliance with Department of Insurance laws and regulations, the insurance company must set aside these dollars for the protection of all of the policyholders. As with other types of insurance, whole life insurance has a mortality element which gets more expensive every year. However, as the insured gets older, the net amount at risk actually decreases because of the guaranteed cash value. As the guaranteed cash value increases, the net amount at risk for the insurance company decreases. During this time, and throughout the policy, it is the insurance company that is bearing the risk. The insured has transferred all of the risk to the insurance company. This is also the reason why the premiums are guaranteed. All of these guarantees alleviate the potential risk that the insured is assuming with other types of insurance. The guaranteed components of a whole life insurance policy assume that no dividends are ever paid by the insurance company. A dividend is a return of premiums paid, or in more global terms, return of the earnings of the insurance company. These earnings are credited to the policyholder and are over and above what is guaranteed. Dividends are not guaranteed, but most companies pay them. An insurance company s dividend payment fluctuates based upon certain variables interest rates, rates of return attained on a company s investment portfolio (of which a significant percentage is in fixed investments), the actual mortality experience of the insurance company and the expenses of the insurance company. The history of a company s actual dividend paid is not an indication of a future dividend payment, but it is very common for insurance companies to have paid a dividend every year for over 100 years during war, depression, poor stock market performance, inflationary periods, etc. Remember, the dividend is over and above what is guaranteed. Also very important to understand is that once a dividend has been credited to a policy, its value is guaranteed from that point forward. Thus, there can be no decrease in this value. Because of guarantees and dividends, whole life insurance policies can eventually have the premiums offset. What this means is that the dividends paid, and the then current values of the policy have enough internal value to pay the then current premium, thereby giving the policyholder the ability to not pay the premium. The premium is still due every year. However, it is being paid by the dividends and other values contained within the policy. It is these other values contained within the policy that allow the premium to be offset before the dividend itself is able to pay the premium. There is a tremendous amount of flexibility within the confines of a whole life insurance policy. Because the death benefit is permanent (as long as the premiums are paid when due), many strategies can be used to increase wealth, provide income, save taxes, and provide other potential benefits. For example, how many people would consider implementing a charitable remainder trust with a substantial amount of assets (that being a substantial percentage of one s wealth) without knowing that the wealth replacement value of the death benefit was not truly permanent? Of course, there are donors whose feelings about wealth replacement can be expressed as, I started out with nothing, so can they or whatever I leave them, it s more than I was left. Wealth replacement may also not be crucial for donors whose gift of several million dollars is only a fraction of a total net worth of several hundred million. But for all of those others who do care about wealth replacement, the permanency of the death benefit is very important. In another scenario, people who implement charitable remainder trusts often use part of the new and perhaps increased income stream from the trust to purchase life insurance. Traditionally, the life insurance is the vehicle that provides wealth replacement. However, when a donor needs or wants higher levels of income, she may consider less expensive insurance. She may consider blended insurance policies, inadequately funded universal policies or some thing less than ideal. The solution may only be less expensive on the surface, in terms of the premium cost. Another donor, who already had whole life insurance, could 48 Journal of Gift Planning

9 consume 100 percent of the income stream from the charitable remainder trust. While he wouldn t be replacing the asset or wealth to the next generation, he would be maximizing his income, enjoyment, lifestyle, etc. Thus, the life insurance death benefit could be used as a capitalized asset; capitalized in that it is thereby releasing the equity in other assets. Remember that if the whole life insurance was acquired in earlier years, there may very well be a higher death benefit currently than when the policy was first acquired. That higher death benefit can be important in a planned giving scenario. A guaranteed death benefit with whole life insurance may make additional wealth creation and philanthropic strategies available in later years. Gift Planner Beware A future article will analyze some of the "creative" scenarios in which life insurance products are currently being promoted as charitable gifts. However, a basic knowledge of the products should already provide clues for determining when scenarios really are too good to be true. When reviewing a gift proposal that includes insurance components, be sure you understand who is bearing the risk. Donors who take a traditional view of insurance as a risk management strategy may be surprised to learn that the risk they thought they had transferred to an insurance company is actually being born by the charity they support, or by themselves. The charity and/or the donor may be comfortable bearing some risk, but everyone should be fully informed. In any proposal, ask questions about the underlying assumptions. What type of insurance products are involved? What variables are assumed? And what would happen in a worst case scenario if those variables play out differently? What would be guaranteed under the worst case assumptions? While life insurance in general can be one of the most powerful financial instruments and a powerful tool in planned giving, it is far too often misunderstood and misused. In conclusion, many types of insurance can be used in many types of ways. It is of the utmost importance for everyone involved to be fully educated and have a clear understanding of all of the various advantages and disadvantages of a given product and strategy. Eric L. Abramson is a wealth strategist and financial consultant. He is associated with Certified Financial Services, LLC, in Paramus, New Jersey. His work encompasses tax, gift and estate planning, as well as charitable planning and philanthropic strategies. Mr. Abramson specializes in educating families, individuals, donors and nonprofits in developing financial and economic strategies for wealth creation, enhancement and preservation. He shares his experience in the insurance and investment communities with professional advisors, law firms, accounting firms and others throughout the United States. Journal of Gift Planning 49