A Potential Insurance Pitfall

Life insurance and annuities can be useful tools, but like other financial planning tactics, they should only be employed in the context of your overall financial and estate plan. This is especially true of their role in a particular, and frequently pitched, wealth-transfer strategy that utilizes a single-premium immediate annuity (SPIA) in conjunction with life insurance.

The strategy is designed for individuals with a large estate and a large IRA balance that won’t need to be tapped in retirement for living expenses. In a nutshell, it calls for such clients to purchase a SPIA inside of their IRA and use the guaranteed income to pay the premiums for a life insurance policy held outside of their estate, typically in an Irrevocable Life Insurance Trust (ILIT). Since the life insurance proceeds would be free of income and estate taxes, clients would likely be able to leave a much larger legacy than if they had left just the IRA to their heirs. It sounds great – unless it’s misapplied.

Like in so many other areas of personal finance, each planning situation that involves insurance or an annuity is unique. Structured the correct way, solutions that incorporate these products can make sense in certain circumstances.

The Pitfall

Unfortunately, this particular strategy is often inappropriately pitched by unscrupulous insurance agents eager to generate commissions and secure profits at the expense of your best interests. That’s not to say that all insurance agents are misguided, or that all annuities are bad.

Let me walk you through a specific case where it was proposed recently, and provide you with some information so you, and your advisor, can determine if this strategy is the right solution for you. In addition, you may find some helpful guidelines for evaluating life insurance illustrations in general.

The Pitch

I recently recommended that a client, a couple in their mid-60s we’ll call Clark and Lois, work with their existing insurance agent to get quotes for long-term care insurance and Medicare supplements. I naively assumed that the insurance agent in question would focus on the task at hand and provide the couple with the requested information. I envisioned a scenario where we would all have a deep and abiding relationship with said insurance agent, and work happily together long into the future.

But instead of receiving what they had asked for, Clark and Lois left the insurance agent’s office with armloads of proposals, many unanswered questions and a big headache.

The plan proposed by the insurance agent was for Clark to purchase a hefty 20-year period-certain SPIA inside of his IRA, and then use the income to purchase a universal life insurance policy on Lois’ life. Clark, unfortunately, had recently experienced some health problems. The policy called for a substantial annual premium, plus an even larger initial lump-sum premium payment in the first year. Presumably, the death benefit of the life insurance policy would grow substantially, and Clark and Lois’ children would receive the income tax-free life insurance proceeds instead of that nasty ol’ IRA, rife with taxes.

The Problems

When a client dumps this type of proposal on my desk with an understandable sigh of exasperation, I believe in asking the following questions before diving into the nuts and bolts:

  • Are you prepared to lock in an annuity rate during this period of historically low interest rates?
  • How do you feel about losing access to a large sum of money?
  • Will this strategy materially impact your ability to maintain your desired standard of living during retirement?

There are some additional items to be on the lookout for when you’re being pitched for this life insurance strategy. You may find that these suggestions will also apply to many different situations where life insurance proposals are involved.

  • Death benefit period: One easy way for an insurance agent to minimize the life insurance premium is to reduce the guaranteed coverage period. In this particular example, although the illustrated non-guaranteed values provided a death benefit to age 121, the guaranteed coverage expired when Lois reached age 98. That’s all fine and dandy – until Lois is 97.8 years old. Based on life expectancy tables (compiled from research by Buckingham’s Jared Kizer and DFA’s Peng Chen) Lois has a 50 percent chance of living beyond age 90 and a 25 percent chance of living beyond age 96. In my opinion, the minimum guaranteed coverage period should last until age 105, preferably until 121. Which brings me to my next point.
  • Guarantees: Since this life insurance policy was proposed for legacy planning, rather than using a traditional universal life insurance policy to cover Lois’ life, consider a more appropriate product. A no-lapse survivorship universal life (SUL) policy has a contractually guaranteed lifetime death benefit payable upon the second death. Legacy planning should NOT be based upon flimsy non-guaranteed projections, but upon contractual guarantees. Clark was in poor health, but many companies will still issue a SUL policy even if one of the parties is uninsurable. However, this agent’s company didn’t offer no-lapse SUL products. And because the agent is not held to a fiduciary standard, they had no legal obligation to tell Clark and Lois that another broker would have been able to shop the coverage to find the best product for them at the most affordable rate.
  • Tax rates: Another tempting “shortcut” for insurance agents is to understate tax rates on life insurance and annuity illustrations. In this case, the agent used a 15 percent tax rate, which was grossly inaccurate. As a result, if Clark and Lois had implemented this strategy, they would have had to pay taxes on the SPIA income above what was shown.
  • Ownership: There was no mention of this policy being owned by a trust. Although the creation of a trust can greatly lengthen the process of implementing this strategy, making it unattractive to an agent trying to close a deal, it’s prudent for these types of policies to be owned by an ILIT. Doing so would not only keep the insurance proceeds outside of Clark and Lois’ estate, should it ever exceed the federal estate tax exemption limit, but may also provide creditor protection and clarity in distributing the insurance proceeds.

The Possibilities

Fortunately, if you don’t want to jeopardize your retirement lifestyle to leave a legacy, there are simpler alternatives to consider:

  • Post-retirement Roth conversions: By doing Roth conversions during retirement, when you presumably are at a lower marginal tax rate, your heirs would receive a tax-free Roth IRA instead of a traditional IRA on which taxes would be owed. In addition, you would still have access to the funds in the Roth IRA if an unexpected expense arose, or if it (happily) looks like you’re going to live longer than planned.
  • Scrap the annuity: If you determine that utilizing a life insurance policy is the best way to meet your legacy planning goals, rather than losing control of a large sum of money in an annuity, you could simply pay the ongoing life insurance premium from cash flow or by liquidating investments. Sure, it isn’t tax-efficient to withdraw IRA funds to pay life insurance premiums, but this would at least increase the chances that you wouldn’t be required to pick up a side job to make ends meet during retirement.

Furthermore, as Larry Swedroe points out in his book, The Only Guide You’ll Ever Need for the Right Financial Plan, “In general, the research indicates it is preferable to delay annuitization until the mid 70s or early 80s.”

  • Dynamic approach: Another approach is to factor your legacy planning goals into a Monte Carlo simulation, analyze the outcomes and adjust the plan as markets generate higher or lower returns than expected. Along the way, you may be required to lower your retirement spending or work longer to increase the chances of funding your legacy goal.

Although life insurance and annuities can be effective in certain circumstances, they should only be considered in light of your financial and estate plan as a whole. It is also important to clearly understand how your financial advisor or insurance agent is compensated, and whether or not that advisor operates as a fiduciary. With proper guidance, you can avoid some common insurance pitfalls that could threaten the financial future of you or your descendants.

If you are unclear about whether a proposed planning strategy involving insurance or annuity products is right for your financial plan, engage a qualified advisor. Because each situation can have a number of different solutions, the BAM Risk Management team is standing by to provide case design and review.

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The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2014, The BAM ALLIANCE

Kent Schmidgall, CFP®

Wealth advisor Kent Schmidgall grew up in a family business environment, where he graduated from pulling weeds in the landscaping (and riding the factory cranes) as a child, to eventually becoming the Controller. After the family business sold in 2007, Kent decided to pursue other opportunities and served as a financial advisor with Northwestern Mutual for five years. In 2013, he joined Buckingham as a Wealth Advisor, where he finds great pleasure in being able to deliver advice that’s in the best interest of his clients. He also enjoys being surrounded by others that share his passion for evidence-based investment planning.

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