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Life Insurance Policies • PFS Update • More on College Savings Plans Editor: Sarah
Phelan, J.D. Editor's note: Sarah Phelan is Technical Manager of the AICPA Personal Financial Planning Team. The authors' views, as expressed in this column, do not necessarily reflect the views of the AICPA. Official positions are determined through certain specified committee procedures, due process and deliberations. If you would like further information, contact Ms. Phelan at (201) 938-3717 or sphelan@aicpa.org .
What Every CPA Needs to Know about Life Insurance Life insurance is just one of the many products used to implement and secure a client's financial plan. With more than $1 trillion of life insurance death benefits purchased each year, it is clearly an important product to understand and assess on behalf of clients who might turn to their accountants for advice or even purchase. Life insurance products have gone through a complete transformation in the last 20 years or so, and a policy purchased in 1975 bears little resemblance to one available today. This product revolution has been accompanied by an unprecedented level of competition, aided by policy illustrations. While computerized illustrations in many ways enabled the development and propagation of today's high-tech policies, those same illustrations were at the heart of class action and individual lawsuits against the life insurance industry and its agents during the 1990s—and financial reparations for "under-performing" policies have to date exceeded $6 billion. As accountants expand their practices into financial planning in general and contemplate obtaining the appropriate licenses to be able to place the products necessary for implementation of financial plans, it becomes important that the accounting community have a better understanding of life insurance and the illustrations that presume to represent life insurance policies.
Policy Illustrations Policy illustrations were first conceived as a practical way to show a client how a policy works. They include numerical examples that demonstrate how the payment of a (generally) level premium creates cash value, which in turn supports the affordable death benefit for the life of the insured, no matter how long he might live. The problem is that the numbers suggest a prediction or even a promise of future policy values. With the enormous flexibility within Universal Life (UL) and Variable Universal Life (VUL) policies to "pay whatever premium you like," policy illustrations conveyed a sense of security and optimism, without making certain that the policy buyer understood the risk that had been shifted when a premium less than that which would guarantee the death benefit was chosen as the paid premium. It was quite common in the 1980s to see policy illustrations suggesting that just seven premium payments would be sufficient to maintain a policy for as long as the insured lived. This projection was based on interest-crediting rates in the 1214% range, which were in turn supported by the high level of inflation and high interest rates in the U.S. economy during that period. As inflation abated and interest rates followed a similar course, policy-crediting rates also fell, and so-called "seven-pay" policies became "14-pay" to maintain the insurance. While the text within the illustrations warned buyers that things could change and "more or fewer premiums may be required," the numerical illustrations overwhelmed the written narrative, to the point that few buyers could understand why they were not a fair representation of the policy they purchased.
What CPAs Need to Know While today's policy illustrations are required to reflect both guaranteed and nonguaranteed values, illustrations have also been bloated by well-intended regulation to 14 or more pages, containing unrelenting columns of numbers and inexplicable narrative. Indeed, a policy illustration does contain valuable information. But what must be examined and understood are the underlying assumptions, which are typically not disclosed (and in any case, can be changed virtually at will by the insurance company). A UL or VUL policy illustration is based on five elements that presume to determine the value to the policy owner: the assumed face amount (or death benefit), the assumed premium, the number of premiums anticipated or proposed, the assumed crediting rate (or investment return) and the assumed "scale" of insurance charges that will be levied against the policy over the insured's life. (Note the frequent use of the term "assumed.") While the main characteristic of a UL or VUL policy illustration is its flexibility, this also means that virtually everything is assumed in the illustration. Only a minimum rate (typically, four percent) is guaranteed within a UL contract and within the guaranteed interest general account alternative of VUL contracts that offer this option. Also, the policy itself refers only to the guaranteed maximum policy charges that can be assessed in a UL or VUL policy. (The illustration dynamics of second-to-die forms of UL and VUL are basically the same, and will not be further distinguished in this article.) If everything is based on assumptions, when external factors change, the policy values begin to deviate from the original illustration. Nowhere does change affect a life insurance policy more than in VUL. These policies are considered registered products, which in turn require special licensing and regulation. Because all of the investment risk (and opportunity) is shifted to the policy owner, it is especially important that a prospective buyer appreciate that the policy illustration does not reflect the inevitable variability the underlying cash value funds will experience. Illustrations of VUL will calculate values (including "solving" for premiums) based on whatever assumed investment return the agent or client chooses (not to exceed an annual rate of 12% gross) and then use that rate as a constant projection factor over the lifetime of the insured. This mismatch of reality and expectation is of greatest concern when the buyer's focus is to obtain the "best" deal. This is typically characterized as the lowest price for the needed life insurance. But, because the price of these types of policies will not be truly known until the death of the insured—and the historical "look back" of the stock market over many years—additional analysis must be conducted. If, as an alternative to the assumption of constant investment returns, a VUL illustration were calculated on the basis of historic market returns, some very interesting realities come to light. The lowest level premium to sustain $1 million for the lifetime of a 60-year-old female in excellent health might be quoted as low as $13,000 a year, based on the assumption of a constant 12% gross rate of return. However, applying the broad market returns of the last 40 years in the calculation of policy sufficiency over the next 40 years indicates that the policy would have lapsed for lack of sufficient cash value by age 85, several years before the life expectancy of a large number of healthy 60-year-old females. Even more dramatically, when Monte Carlo Simulation is applied to determine a probability of success for the $13,000 premium against randomized historic returns, there is less than a 20% probability that the policy will sustain to age 100. (Age 100 is a typical target for sustaining a policy, especially with ever-lengthening life expectancies in the general population.) Certainly, someone who is reasonably able and willing to handle the investment risk in a VUL policy should not expect 100% assurance that the policy will work with a minimal premium; at the same time, however, 20% is too low a chance. Probably somewhere between 60% and 80% would be most appropriate. And when that requirement is worked into the calculation of a sufficient premium, the premium has to be at least 30% more than the previously calculated minimum annual premium to reflect the desired probabilities of success. (In second-to-die policies, the premium generally needs to be at least 40% more than the calculated minimum annual premium.)
Meeting the Client's Needs How should a practitioner proceed to make recommendations to a client? The first thing to do is not request a series of illustrations from a number of companies and then try to figure out which is the best deal. Rather, first determine the amount of insurance appropriate for the situation. (There are many useful tools available on the Internet and from insurance carriers themselves on needs determination.) Once the amount of insurance has been determined (and for which there is client agreement), the second task is to determine the type of life insurance that will likely meet the client's needs. Short-term needs (such as securing short-term financing or backing a limited-term buy-sell agreement) are best served with term life insurance. Needs that are 15 years or longer (such as estate tax liquidity or replacing income in the event of premature death) should be addressed with some form of cash-value life insurance, to the extent that the client can accept the higher early premiums. Fully funded whole life is a good choice for those clients with little tolerance for premium sufficiency surprises. (Whole life's guaranteed premiums, however, are quite high; while dividends can help reduce the premium expense, they are not guaranteed. Also, cash values are subject to the claims of creditors in the event of carrier insolvency.) At the other end of the spectrum are VUL policies, whose investment risks—and opportunities—are entirely the client's and whose funding may need to be significantly higher than anticipated from a "competitive" illustration. However, for those who are tolerant of the potential risks, VUL offers a unique upside potential that is fueled by exactly the type of overfunding needed to compensate for variability. (VUL cash-value accounts are not as susceptible to carrier failures—accounts are not included in the insurer's general assets.) UL policies are probably a good middle ground for those clients who want premium payment flexibility (something whole-life policies do not have), but who are reluctant to take equity risk with their life insurance policies. Caution: UL policy values are subject to the claims of carrier creditors in the event of insolvency and there is not as much "upside" potential with a UL versus a VUL. As always, the client's tolerance for risk will dictate the appropriate product selection. Having determined the amount and type of insurance with which the client is likely to be comfortable, the final step is to review with the client the funding options and the risks associated with paying premiums less than that which an insurance company is willing to guarantee. It is perfectly appropriate to try and "fine tune" the premium payment to maximize benefits (or keep premiums as reasonable as possible), as long as the client understands the underlying risks associated with this strategy. Ultimately, the client's risk tolerance will be the best indicator of both the type of policy, as well as the appropriate way to fund such a policy.
Conclusion Life insurance products have made a giant leap in technology and sophistication in the last 20 years, commensurate with a more complex economy and tax structure. Understanding and assessing life insurance proposals has always been a daunting task. Policy illustrations could be useful to understand how a particular policy works with a particular flow of premium and other assumptions about the future. But the reality is that the very nature of a numeric illustration compels clients to look to the illustration for a sense of what the future holds. Yet, what the illustration does not do (especially for UL or VUL) is reveal the extent to which the illustration is so dependent on assumptions that are unclear and sometimes even unidentified in the illustration. If CPAs will follow the process of determining how much and what kind of life insurance is appropriate for their client's "style," and how best to structure payments for the policy consistent with the client's tolerance for risk, they would be taking a giant step in the right direction of serving their clients' insurance needs. From Richard M. Weber, MBA, CLU, Financial Profiles, Inc., Carlsbad, CA
PFS Update: PFS Designation and MEP System The AICPA PFP Executive Committee and the PFS Credential & Exam Committee, along with the National Accreditation Commission, developed and implemented new guidelines for the Personal Financial Specialist (PFS) designation, effective Jan. 1, 2001. Candidates are using the new PFS Application/Assessment Tool, an online tool posted at pfs.aicpa.org. This tool, the latest step in implementing the multiple entry points (MEP) system, has been successfully used by more than 100 new applicants. The tool, along with instructions on how to complete it, can be downloaded from the Website. Under the MEP system, candidates for the PFS are evaluated on a point system, with a total of 100 points required to attain the PFS credential. The system covers three areas:
More information regarding the new point system is at pfs.aicpa.org, including a downloadable PFS Candidates Handbook.
Readers have raised several inquiries concerning the column, "College Savings Vehicles," TTA, January 2001, p. 53. The authors address the readers' concerns in question-and-answer form, but the answers do not take into account the recently enacted Economic Growth and Tax Reconciliation Act of 2001. A follow-up article addressing any applicable tax law changes and tax planning strategies will be published in a subsequent issue of The Tax Adviser. Question: The initial beneficiary of a College Savings Plan (CSP) can be any individual (regardless of familial relations). However, if a contributor decides to change the beneficiary, he can do so by selecting another member of the original beneficiary's family. What is the specific meaning of the term "beneficiary's family" and where is this defined? Answer: As stated previously, a CSP can be transferred to anyone who qualifies as a member of the designated beneficiary's family. Sec. 529(e)(2) defines the term "member of the family," with respect to any designated beneficiary, as:
For purposes of determining who is a member of the family, a legally adopted child is treated as a child of such individual by blood. Also, the terms "brother" and "sister" include a brother or sister by the halfblood (Prop. Regs. Sec. 1.529-1(c)). Question: It was stated that funds from CSPs can be withdrawn penalty-free to pay for higher education expenses. Does "higher educational expenses" include more than just tuition, such as student supplies? Answer: Qualified higher education expenses are generally defined as tuition, fees, books, supplies and equipment required for the enrollment or attendance of a designated beneficiary at an eligible educational institution (Sec. 529(e)(3)). Room and board will also qualify for a student enrolled at least half-time and enrolled or accepted for enrollment in a degree, certificate or other program that leads to a recognized educational credential awarded by an eligible educational institution. Required expenses are school-specific; what may be considered required for one school may not be required for another. For example, the article cited a computer as an example of a school supply; however, this is only true if the institution requires its students to purchase computers. Question: A donor can make a gift of up to $50,000 ($100,000, if a joint election is made) without incurring gift tax by electing to pro rate the gift over a five-year period, using the annual exclusion for each of those years. There is an exception if the donor dies during the five-year period. How does that exception work? Answer: If the donor were to make this election and then die during this five-year period, the excess contributions would be includible in his estate. Under Sec. 529(c)(4)(C), the amount includible in the estate would be the portion properly allocable to the periods after the date of death. This amount is determined by looking to how the excess contribution is treated. Because the excess gift is treated as occurring ratably over the five-year period beginning with the calendar year in which the excess contribution is made, the amount includible in the estate is the total gift less the pro rata amount of the contribution considered allocable to the period before death. For example, on Jan. 1, 2001, a donor contributed $50,000 to a CSP and made the special five-year gift tax exclusion election. If this donor dies on Dec. 31, 2004, $40,000 will be allocable to the period before death. Consequently, the remaining $10,000 will be includible in the donor's estate. Question: The article discusses nonqualified withdrawals and says that penalties generally range from 10% to 15%. When is the penalty more than 10% and why? Answer: Most states charge the Federally mandated penalty of 10% of earnings on withdrawals for ineligible purposes. Currently, only North Carolina charges a penalty of 15% of earnings. While most states charge the 10% penalty only on the earnings portion, Michigan charges a 10% penalty on the entire amount of the nonqualified withdrawal. Other states, such as Wisconsin and Montana, charge the 10% penalty on the earnings portion but also charge an additional flat fee. For example, Wisconsin will charge a $25 termination fee. However, Wisconsin's CSP program provides that a nonqualified withdrawal may only be made after the beneficiary reaches the age of 18 and does not attend college, withdraws from college or does not use all of the money in the CSP. Montana, however, allows a nonqualified withdrawal to be made at any time, but it will charge a $100 fee for the nonqualified withdrawal if the account is less than three years old. Question: Which state CSP has the highest maximum contribution amount? Answer: As of October 2000, Rhode Island significantly revised its plan and made the maximum contribution amount equal to $246,023 for 2001. As of this writing, Rhode Island's CSP currently provides for the highest maximum contribution allowable by any state. |
