Case Studies Case Study In force The importance of Client expectations Range of outcomes Monitoring and adjusting
Case Study 1 Client s Goal: Retain private company in family. Projected liquidity need at second passing: $40MM net death benefit at all times Client Profile (Post significant Estate Planning ) Married Couple own multiple operating businesses Total Assets $132MM Liquid Assets $15MM Private operating Companies $108MM Use Assets $9MM Liabilities $2MM Mortgages $843 Other $1.1MM Net Worth $130MM Recurring Cash Flow $4.7MM What is the most efficient way to meet the clients goals given personality, assets, cash flow and risk appetite?
Options Presented 1. Do nothing estate tax liability would be $40MM given current planning in place 2. Pay annual premiums for life on two guaranteed universal life contracts. Combined annual premium would be $614M. Estimated associated annual gift tax of $223M. Total cost to age 100 - $33MM for $40MM Death Benefit 3. Finance premiums under a short pay scenario and pledge marketable securities with the goal of only having to pledge marketable securities for a period of time Assuming a 7% rate of return (sales material) the client s peak collateral pledge is $3MM accrues interest and retains net death benefit of $45MM at all times. This assumes $0 out of pocket Assuming 5% rate of return (stress tested sales material) the client s peak collateral pledge is $5MM - accrues interest - and has net death benefit of $45MM at all times. This assumes $0 out of pocket contribution Assuming 5% rate of return and stress testing interest rates client s peak collateral pledge is $6.5MM, accrues interest and has net death benefit of $40MM at all times. This assumes $0 out of pocket. In all performing scenarios Lender repaid in year 20 and net death remains at no less than $40MM at all times through age 100. Guaranteed scenario (typically not shown in sales material) ongoing need for collateral and in year 16 is <$34MM> death benefit net of loan is <$1.7MM>.
Example Model Lender s Analysis @ 5% Policy Type Indexed Universal Life Guaranteed Scenario Illustrated Scenario 0.00% Maximum Char 5.00% Current Charges Year Loan Draw Interest Annual Cash From Policy Year End Loan CSV @ Collateral Net Cash to Trust CSV @ Collateral Shortfall Net Cash to Trust Rate Capitalized Interest Balance 95% Shortfall 95% 1 $ 3,517,051 1.93% $ 68,727 $ - $ 3,585,778 $ 1,140,425 $ 2,445,353 $ 47,165,527 $ 1,140,425 $ 2,445,353 $ 47,165,527 2 $ 3,487,115 2.10% $ 150,778 $ - $ 7,223,671 $ 3,491,367 $ 3,732,304 $ 46,243,639 $ 4,360,141 $ 2,863,530 $ 47,259,749 3 $ 3,487,115 2.23% $ 242,374 $ - $ 10,953,160 $ 5,807,354 $ 5,145,806 $ 45,188,962 $ 7,437,247 $ 3,515,914 $ 47,095,269 4 $ 3,487,115 2.36% $ 346,054 $ - $ 14,786,329 $ 8,083,875 $ 6,702,455 $ 43,983,980 $ 10,715,070 $ 4,071,259 $ 47,061,402 5 $ 3,202,410 2.52% $ 460,230 $ - $ 18,448,969 $ 10,087,574 $ 8,361,396 $ 42,630,283 $ 13,964,120 $ 4,484,850 $ 47,164,255 6 $ 3,430,174 2.66% $ 590,581 $ - $ 22,469,724 $ 12,227,542 $ 10,242,182 $ 41,077,385 $ 17,626,229 $ 4,843,495 $ 47,391,639 7 $ 3,430,174 2.79% $ 731,506 $ - $ 26,631,404 $ 14,500,443 $ 12,130,961 $ 39,324,829 $ 21,720,328 $ 4,911,077 $ 47,769,138 8 $ 3,430,174 2.87% $ 875,231 $ - $ 30,936,809 $ 16,769,306 $ 14,167,503 $ 34,223,979 $ 26,098,939 $ 4,837,870 $ 45,135,831 9 $ 3,430,174 2.96% $ 1,031,888 $ - $ 35,398,871 $ 18,987,528 $ 16,411,343 $ 32,006,934 $ 30,771,076 $ 4,627,795 $ 45,788,862 10 $ 3,430,174 3.04% $ 1,195,194 $ - $ 40,024,239 $ 21,152,631 $ 18,871,609 $ 29,464,765 $ 35,758,751 $ 4,265,488 $ 46,547,947 11 $ - 3.10% $ 1,256,368 $ - $ 41,280,608 $ 20,576,478 $ 20,704,130 $ 22,285,448 $ 38,612,983 $ 2,667,624 $ 43,380,776 12 $ - 3.15% $ 1,316,804 $ - $ 42,597,412 $ 19,741,379 $ 22,856,033 $ 18,791,920 $ 41,446,428 $ 1,150,984 $ 44,177,942 13 $ - 3.12% $ 1,347,497 $ - $ 43,944,908 $ 18,858,017 $ 25,086,891 $ 15,011,252 $ 44,485,859 $ - $ 44,985,336 14 $ - 3.15% $ 1,401,970 $ - $ 45,346,879 $ 17,919,855 $ 27,427,024 $ 11,212,016 $ 47,742,095 $ - $ 46,091,829 15 $ - 3.11% $ 1,431,387 $ - $ 46,778,266 $ 16,934,176 $ 29,844,090 $ 7,027,788 $ 51,233,513 $ - $ 47,143,972 16 $ - 3.07% $ 1,455,360 $ - $ 48,233,626 $ 15,901,823 $ 32,331,803 $ 2,764,997 $ 54,977,402 $ - $ 48,467,429 17 $ - 3.10% $ 1,514,393 $ - $ 49,748,019 $ 14,829,709 $ 34,918,310 $ (1,803,330) $ 58,995,108 $ - $ 49,852,107 18 $ - 3.11% $ 1,569,446 $ - $ 51,317,465 $ 13,721,946 $ 37,595,519 $ (6,568,405) $ 63,307,075 $ - $ 51,425,898 19 $ - 3.11% $ 1,618,520 $ - $ 52,935,985 $ 12,589,860 $ 40,346,126 $ (11,711,003) $ 67,939,886 $ - $ 53,025,870 20 $ - 3.09% $ 1,659,347 $ (54,888,666) $ - $ - $ - $ - $ 13,297,764 $ - $ 51,346,940 Total $ 34,331,676
Time Passes Its time for the second premium payment Client has moved the minimum collateral needed to the pledged account. Client does not want to pledge additional collateral What are the options: 1) Unwind 2) Continue strategy and continue to accrue interest 3) Continue and pay interest 4) Reduce Death Benefit and continue Strategy (with or without accrual of interest) In options two three and four the collateral shortfall is the difference between the outstanding loan balance and the cash surrender value at a 95% advance rate. That collateral value would need to be grossed up to calculate a bond, cash or equity equivalent.
OPTION 1 Surrender the policies and payoff the loan Policy 1 CSV @ 100% $2,661,973 Policy 2 CSV @ 100% $2,477,296 Total Cash Value $5,139,269 Loan Balance $7,112,035 Accrued interest through $ 48,273 $7,160,308 Shortfall/Dollars that Client would need to liquidate to retire loan $2,021,040 Outcome $40MM projected estate tax liability remains Due to policy performance - there could be a taxable gain in policies that is taxed when surrendered. No Insurance coverage What if there is a change to health and a new policy unavailable? Note: that the projected shortfall on the original analysis was $2.4MM at the end of year two - the policy is performing favorable to plan.
OPTION 2 Continue strategy with capitalized interest Outcomes Collateral peaks at $6MM versus sales projections of $6.5MM due to policy performance thus far. If policy underperforms or interest rates deviate from projection collateral need will increase. Nothing paid out of pocket Loan repaid year 20 Insurance coverage continues through age 110 with minimum net death benefit of $53MM. Potential to pledge collateral in lieu of paying out of pocket. Collateral is a net number needs to be grossed up. Under the Guaranteed scenario net death benefit ends at year 13 primarily driven by increase in age and associated costs. Evergreen need for collateral
OPTION 3 - Continue Strategy and pay interest Outcomes In a performing scenario and the current LIBOR forecast collateral peaks at $2MM+ If policy underperforms or interest rates deviate from projection collateral need will increase. Nothing paid out of pocket Loan repaid year 20 Insurance coverage continues through age 110 with minimum net death benefit of $45MM. Out of Pocket expense through year 20 estimated to be $22MM Under the Guaranteed scenario net death benefit ends at year 13 primarily driven by increase in age and associated costs. At year 13 Interest paid out of pocket would be $14MM and collateral pledged $23MM If strategy performs total interest projected to be $22MM for $45MM of net death benefit $9MM favorable to pay for life cost of $31MM for $40MM net death benefit.
Option 4 Reduce Death Benefit with or without Accrued Interest IF the Death Benefit is reduced (typically within the first 7 years) it is highly likely that the policy will violate the Guideline Premium and Corridor Test which changes the policy from an insurance product to an investment product which eliminates the favorable tax treatment under 7702. IF there is a collateral assignment on a Modified Endowment Contract there is a deemed taxable distribution every year the policy has a gain typically taxed at ordinary income rates with penalty if under 591/2 whether or not cash distributed from policy. Please review with Tax Counsel as we cannot provide tax advice. Outcome Premiums paid $7MM Death Benefit reduced to $30MM for net death benefit of $22MM and decreasing if interest accrues. Assuming a 6% return cash value exceeds paid premiums in year 9. All gain is a deemed distribution typically taxed at ordinary income once the cash value exceeds basis. Insurance coverage continues through age 90 with a net negative death benefit at age 91 Often carriers do no send any reporting if there is no actual distribution and clients are unaware of the issue Could create an additional liability and a penalties both for age and non payment Loan cannot be repaid from the cash value of the policy premature death is a real but inadvisable solution In guaranteed scenario policy lapses year 13.
Case Study 2 Simplified Family Net worth Determined Estate Tax Need Pay for life Pledge to Finance $74MM $20MM $15MM $3MM Results (000's) Year Loan Rate Policy Return Spread Cash Contribution Loan Balanace Cash Value Collateral 1 6.58% 0.00% -6.58% $0 $ 1,375 $ 972 $ (452) 2 4.09% 0.00% -4.09% $0 $ 2,689 $ 2,253 $ (549) 3 3.23% 13.94% 10.71% $0 $ 4,022 $ 2,737 $ (1,422) 4 2.10% 8.10% 6.00% $0 $ 5,340 $ 4,260 $ (1,293) 5 2.03% 6.96% 4.93% $0 $ 6,563 $ 6,036 $ (829) 6 3.20% 9.93% 6.73% $0 $ 8,121 $ 7,498 $ (998) 7 2.93% 11.01% 8.08% $0 $ 9,411 $ 8,827 $ (1,025) 8 2.31% 7.78% 5.47% $0 $ 10,870 $ 10,925 $ (491) 9 3.48% 0.61% -2.87% $0 $ 13,586 $ 12,876 $ (1,354) 10 2.51% 11.06% 8.55% $0 $ 14,540 $ 13,607 $ (1,613) 11 2.51% 10.01% 7.50% $0 $ 14,843 $ 16,209 $ 556 12 2.51% Projected 0% NA $0 $ 15,221 $ 17,905 $ 1,789 13 2.51% NA 14 2.51% NA 15 Expected Payoff and Policy to remain in force to age 110
SUMMARY 1) Seemingly simple solutions have trap doors 2) Financing a policy can work the key is a 200-300 basis point positive arbitrage between tax deferred return in the policy and interest rate on the loan over time 3) Monitoring is essentially. Leverage is a magnifier small adjustments during the lifecycle of the strategy have asymmetric impacts 4) Modified Endowment Contracts have significant often misunderstood consequences. 5) Work with a team of experienced professionals