Blog

A more thoughtful approach regarding when to take income from downside-protected insurance assets can make a massive difference in retirement outcomes for clients. In this case, it prevents the depletion of the client’s assets prior to their death, turning a zero balance into a healthy, $1.5MM portfolio.

History is full of periods of market volatility. Most recently, the extended bull market ended in spectacular fashion in 2019, ushering in a period of volatility that continues to make clients nervous. For those still working to accumulate wealth, it can be argued that this period represents an interesting buying opportunity. Taking advantage of that opportunity can expose clients to swings in both directions, causing some to think twice before committing assets. For others, including those closer to or in retirement, volatility is a threat to a successful retirement.

Volatility at the wrong time can turn what appears to be an adequate rate of return into a portfolio that could be exhausted before the client’s death. This suggests an obvious question: What’s the alternative? Exiting the market in an attempt to avoid market losses is not a viable solution, as market returns remain critical to a successful retirement over the long term. Asset allocation strategies can only do so much, leaving financial instruments with some level of downside protection as a critical element of addressing the risk of excess volatility and sequence of returns. Table 1, Volatility in Retirement, shows what volatility can do to a retirement portfolio in very clear terms.

Table 1: Volatility in Retirement¹

Individuals using life insurance products as part of their retirement planning strategy, however, may have an elegant solution at their disposal regardless of where they find themselves in their retirement planning journey. Clients still accumulating assets can use their life insurance position to either stay in or enter the market with the comfort of some level of downside protection. For those in retirement, a properly designed and funded life insurance strategy can both avoid negative volatility and participate in positive volatility, resulting in a very different retirement outlook.

Over the recent past, the insurance product of choice for this approach was often Indexed Universal Life (IUL), offering a 0% floor and some level of upside, limited by either a cap, spread, or participation rate. While those products remain an option, they are not the only option available from the insurance segment. Today’s insurance market offers not one, but three unique products that absorb or avoid some level of a market downturn while also offering some sort of positive return. They each have their own unique “value proposition” that may ultimately make one more suitable than the others for a specific client’s risk tolerance and other elements of their retirement planning.

• Whole Life: Guaranteed positive return each year. Modest additional upside
• Indexed Universal Life: Complete protection against market risk. Market-linked upside subject to a cap, spread or participation rate. Account values are subject to “losses” based on policy charges in years that hit the floor
• Buffered Strategies in Variable Life: Protection for some level of market risk before client account values are impacted. Market-linked upside subject to a cap. Caps in this segment are typically higher than those in the Indexed UL segment. Like the IUL segment, account values in this category may be reduced by policy charges in years that trigger the buffer.

Clearly, clients can position some of their assets in vehicles that can avoid some or all negative volatility. There is, however, a cost to that downside protection in the form of limits on the upside potential they offer.

What’s less clear is the impact any of the three approaches may have on retirement portfolios broadly, as well as how to think about using these products when in retirement. Table 2, The Impact of Downside Protected Assets addresses the first question of the impact on retirement portfolios.

Table 2: The Impact of Downside Protected Assets²

Table 2 shows the superior outcome for the client. By taking an equivalent, non-taxable distribution from a life insurance contract in the years following a down market, the client not only enjoys the same level of purchasing power, but also has a portfolio value that remains in excess of $1.5MM through age 90. The importance of this can’t be overstated in an era of elevated inflation and the spiraling cost of care later in life. That said, two elements of the strategy remain an open question: How to fund the life insurance strategy and which product type is the most suitable? Before those questions can be addressed, it is critical to understand how much additional capital would be required in the traditional investment portfolio to achieve a similar outcome? In the example used here, the client would need a starting account balance of $2,475,000 to support the desired income stream and a projected ending account balance at age 90 of $1,560,000.

With that additional capital requirement in mind, it is then possible to project how much capital the three insurance strategy alternatives, Whole Life, Indexed UL and a Buffered VUL might require to achieve the outcome shown in Table 2. ³

• Whole Life: $200,000
• Indexed UL: $170,000
• Buffered VUL: $130,000

From a client outcome perspective, all three of the insurance solutions deliver a positive outcome:

• The client’s income goal is met, including a small increase each year to offset some level of inflation
• The client’s assets are preserved, with a projected portfolio value over $1.56MM higher than the original plan
• Based on the lower capital requirements of the insurance strategy (As little as $130,000 versus $475,000), the client may also enjoy more net spendable income throughout the accumulation phase when compared to simply accumulating more assets in a traditional investment account.

There remains, however, one additional topic to consider and that is which of the three possible insurance solutions is the right one to use? As tempting as it is to try to identify an empirically superior solution, the reality is that the best product will vary depending on the client, their risk tolerance, and the rest of their portfolio. While three product solutions are mentioned specifically here, there are some additional nuances to consider based on the age of the client at policy inception.

First, for the younger client, a VUL that offers indexed or buffered strategies may, in fact, be the most appropriate. Given that this strategy does take some time to “season” clients in their 40’s are ideal prospects and would have enough time on their side to consider using traditional subaccounts at policy inception, with a subsequent transition to indexed or buffered strategies as they near retirement. For clients who may be a bit older, full exposure to downside risk may not be appropriate, making one of the downside protected strategies most suitable. Clients getting a later start may need to let the insurance policy “season” a bit longer or allocate more capital to the strategy.

Regardless of how those nuances play out, the end result is yet another powerful argument for the increased use of insurance products in the retirement planning process based on their unique risk/reward profile and favorable tax treatment.

The answer, of course, is no. That said, this is exactly what some clients may think is possible with the “Swiss Army Knife” approach to Indexed Universal Life case design. The typical illustration, regardless of the illustrative rate used, displays the maximum level income possible. One of the underlying assumptions in that illustration is nearly always the use of participating loans. While there is nothing inherently wrong with that approach, it does become a problem when the policy’s living benefit features are an important part of the sale.

When considering these products, most clients will undoubtedly be attracted to the value proposition of a single product that offers death benefit protection, supplemental retirement income and a backstop of benefits should they need care later in life. What they don’t understand, unless the advisor takes the time to fully explain policy mechanics, is all of these benefits effectively come from the same pool of money. Their expectation is that they have all three of these benefits and that they are independent from one another. The living benefits, in their mind, are in addition to any income they may take from the policy. The reality is that the use of loans to take income out of the policy effectively eliminates the client’s ability to access the living benefits like a Chronic Illness or Long-Term Care Accelerated Benefit Rider (ABR).

The primary reason behind this is in the fine print of these riders. Virtually all of them include a provision that requires a partial repayment of any outstanding loans with each benefit payment under the ABR. Even with a modest loan balance, the end result is a net payment to the client, reduced by the loan repayment, that is less than the income they are already taking from the policy. In addition, most ABRs have a provision that forbids taking loans and benefits under the ABR in the same year. Clients have to take one or the other. Figure 1, below, demonstrates how quickly an outstanding loan balance becomes an issue: The net benefit from the ABR can fall below that of the income they are already taking as quickly as the 4th year of the income phase. This essentially eliminates any increased income from the ABR, exactly the opposite of their expectation.

Fortunately, there is a solution. It requires changing the way income is illustrated and ultimately taken from the policy. Rather than illustrate income via loans from day 1, illustrate income via withdrawals to basis before any loans are taken. This immediately defers the onset of one of the factors driving this issue: The accumulation of a loan balance that has to be repaid when on claim. This is but one of a handful of case design and management best practices to follow as well:

1. Illustrate income via withdrawals. This defers the accumulation of a loan balance and produces a lower illustrated income.
2. Begin income later in life. This again pushes out the time when a loan balance will begin to accumulate, preserving meaningful ABR benefits.
3. If and when the clients needs care, resist the temptation to immediately file a claim. Given that most claims last for less than five years, simply beginning to take a larger income projected for five years via loans may produce a larger net payment to the client than available ABR benefits. This also avoids the paperwork and potential delays in accessing funds that can stem from even the most efficient claims process.

As effective as those strategies may be, they do not truly address the underlying issue of all policy benefits coming from the pool of money. For the client who truly wants all three of these benefits, a multi-policy solution that addresses all three needs is undoubtedly going to be a superior solution. It will, however, require a greater financial commitment, which some clients may not be able or willing to make. If that’s the case, then a properly structured and managed single product strategy is a great start to managing these planning risks.

Undoubtedly, there are clients with enough assets to pay for care should they need it later in life. That said, this may be one of those instances where just because you can, doesn’t mean you should. More often than not the decision to self-fund is due, at least in part, to not wanting to think about the possibility of needing care. It also completely omits the planning component by focusing strictly on the funding.

In terms of funding, simply transferring this risk to an insurance company is going to provide a significant discount. What is often not factored into the decision to self-fund, however, is the impact of taxes. Unless paying with cash from a checking account that doesn’t accumulate interest, every time the client liquidates an asset to pay for their care, they are creating a taxable event. At either capital gains or ordinary income rates, the tax burden this creates can grow quickly.

There are additional factors that can make this a more significant problem:

• The majority of Americans’ wealth is tied up in their qualified plan assets. Withdrawals from these accounts to pay for care are 100% taxable at the prevailing ordinary income rates at both the state and federal level.
• Consumers holding annuity assets often have these “earmarked” as the asset they will use to pay for care. The last in, first out tax treatment of these assets again results in a 100% taxable amount at ordinary income rates until such time as all gains are exhausted.
• The resulting increased income can also push the client into a higher tax bracket

Some might think that the taxes can be offset by deducting the cost of care. Maybe, but maybe not. There are two complicating factors here:

• Not all costs are deductible. Only the actual cost of care. In the case of an assisted living facility, that can exclude rent, as an example, which is the majority of the actual cost. If full time memory care is needed, then all costs, including things like rent, may be deductible.
• Even if the cost is fully deductible, there is the 7.5% of AGI threshold that needs to be met before any deductions can be taken. This also assumes the client is itemizing, and for the high net worth that is likely the case. For those of more modest net worth and a simpler financial life, the current standard deduction is high enough that they may not itemize their deductions.

So, what’s the moral of the story? Self-funding only makes sense if the real cost of the approach is superior to an insured solution. That determination needs to include all contributing factors to the cost of both self-funding and an insurance solution. Fortunately, there are ways to mitigate the taxes that may be triggered by either approach. In the case of an insurance solution, things like the Pension Protection Act and case designs with extended premium payment durations can be used to minimize or even eliminate taxes at the time of purchase. In the case of self-funding, finding loss harvesting and other strategies can reduce the net taxes due.

The crux of the matter is asking a very simple question of those who plan to self-fund: Have you thought about which assets you will use to fund care, and did you consider the tax ramifications of your strategy? The subsequent conversation may point to an insurance solution more often than you think.

Two factors, one already in place, the other on the horizon, will combine to erode assets left to IRA beneficiaries at an unprecedented rate. This “one-two punch” can be avoided with a straightforward planning approach designed to minimize the tax by shielding IRA assets from taxation.

Most are well aware of the massive amount of wealth held in retirement accounts. What may not be as well known outside the financial planning community is how significantly those assets will be eroded as they pass to the next generation. Simply considering the income tax implications points to the SECURE Act of 2019 as an accelerant of sorts. Most IRA beneficiaries no longer have the ability to “stretch” the distribution of the inherited IRA over their lifetime. Instead, the IRA has to be distributed over a ten-year period.

The second element of this planning challenge is on the horizon: The sunset of the Tax Cuts and Jobs Act (TCJA) at the end of 2025. While much of the discussion of the sunset focuses on changes to estate tax laws, for IRA beneficiaries the changes to income tax rates may be more important. Why? Just as they are being forced to take large, taxable distributions form their inherited IRA, the rate at which those distributions are taxed is due to increase when the TCJA sunsets.

This has major implications for both those who are in the ten-year distribution phase as well as those anticipating inheriting an IRA.

For those already in the process of distributing an inherited IRA, a quick look at the potential increase in income tax rates based on the TCJA sunset as shown in Table 1 indicates an increase of anywhere from 0% to 4% in marginal tax rates for taxpayers filing jointly as rates revert to 2017 levels. Depending on the rest of the client’s income tax planning, it may make sense to accelerate distributions of the IRA prior to the TCJA sunset to avoid these higher rates.

Those anticipating an IRA inheritance, further accelerating those distributions likely doesn’t help, as it would have to be on such a short timeline that the increased would undoubtedly result in the client jumping up to a higher income tax bracket. For these clients, the panning work has to happen before the inheritance is received.

In this case, the fact that approximately 36% of retirees who withdrew funds from a traditional IRA in 2021 used the money to reinvest or save. The likely cause of these distributions is undoubtedly Required Minimum Distributions that force the IRA owner to liquidate a portion of their IRA each year once they reach a certain age. The question for this discussion is what are these clients doing with the money? Where are they investing it?  From the perspective of the beneficiary anticipating receiving the IRA as an inheritance or the IRA owner concerned about so much of their hard-earned money being lost to taxes, a life insurance policy may be the best vehicle for a few simple reasons:

• Each premium dollar is immediately leveraged, increasing the amount that passes to the next generation.
• Life insurance proceeds pass income tax free and there are no rules around distributions once received
• Life insurance proceeds can also pass estate tax free with proper planning

In short, transforming the tax in efficient IRA into a tax efficient life insurance strategy can avoid the tax double whammy created by the SECURE Act and TCJA sunset by reducing the amount subject to taxation. This tried-and-true planning strategy is more relevant than ever given both current law and the apparent inability of Congress to pass meaningful legislation over the recent past.

1 https://www.wsj.com/articles/retirement-required-minimum-distributions-tips-11668797319 What to Know About RMDs and Retirement Planning, Nov. 27, 2022.

Best practices exist for a reason, as do products that may cost a bit more but offer superior value. In this real-life example, an insurance solution that is built for the business market would have streamlined a key component of buy/sell agreement management that could have prevented multiple days in tax and appeals court.

It comes as a surprise to no one that insurance assets need to be reviewed periodically. What may be a surprise is how significant a problem could result if you don’t. Case in point? 2023’s Connelly decision. The details of the case are worth understanding (Follow this link for more on the case), but there’s one element of the decision that is particularly important for anyone working with business owners: The court affirmed the IRS’s position that the proceeds of a life insurance policy that funded a buy/sell agreement were includable in the value of the business, rather than offset by the obligation of the business to redeem the deceased owner’s shares under the terms of their Buy/Sell agreement. This increase in the value of the business led to a $1MM increase in estate taxes.

While there are multiple issues involved, the most fundamental called out by the court in their decision focused on the business not following the terms of the buy/sell agreement. Specifically, the agreement called for a “Certificate of Agreed Value” that set the price of the business by mutual agreement on annual basis. Failing that, the agreement called for two or more appraisals to determine the fair market value of the business. Neither of these were done.

After the owner’s death, they parties involved agreed on a value, executed the sale, and proceeded to file the necessary estate tax return. The audit of the return uncovered the lack of compliance with the terms of the buy/sell agreement, resulting in the inclusion of the proceeds of the life insurance in the value of the business and the increased estate tax. The Connelly decision may not be the last word on this, as the Connelly family appealed, and the Supreme Court has agreed to take up the case.

In this case, the amount of life insurance, $3.5MM, was relatively close to the agreed upon value of $3.89MM the family used. This is rather surprising given that the buy/sell agreement was put in place in 2001 and the owner passed in 2013. Their problem would have been far worse if the policy were for significantly less than the deceased owner’s share of the business. The estate tax implications likely would not have changed, but their ability to execute the sale would have been severely compromised. This is where the danger of “outgrowing your business insurance” comes into play.

These business owners are undoubtedly not unique in their lack of periodic review of their buy/sell agreement, the value of the business and any related insurance policies. To make matters worse, there are both insurance solutions and valuation services available that can make that process as painless as possible. All it takes is using an insurance provider that offers products built for this specific purpose, not only insuring the value of the business today, but having a built-in mechanism for both periodic review and commensurate increases in coverage as the business grows.

The first step is to set the value of the business with a formal valuation. This is followed by implementing the funding with life insurance. In each subsequent year, the business owners execute the increase option, including a renewed formal valuation every third year. See Table 1, below, for a description of how this could play out.

The insurance company offering this product will do the valuation at no cost. The end result is a product and process that prevents the fact pattern of the Connelly case from occurring while ensuring the adequate funding of the buy/sell agreement. In short, preventing the business from outgrowing their insurance.

Splitting the Proceeds of a 1035 Exchange Unlocks Planning Opportunities

We’ve seen strategies for utilizing accumulation-focused insurance policies that have grown significant cash value become an effective repositioning strategy. The result is an updated insurance position that reflects the client’s current needs and leverages today’s modern products.

True insurance planning is far more nuanced than finding the best underwriting offer or the best price. It involves a perspective beyond a simple needs analysis. It requires understanding how insurance needs change over time and how to best manage a policy or portfolio of policies to deliver the most effective risk management strategies to the client. Today, that means insuring against risks beyond survivor income or estate tax liquidity, with the cost of Long-Term Care as the most significant threat to a successful retirement or a source of estate erosion, reducing the legacy left to loved ones.

That statement comes as no surprise to anyone paying attention to developments on multiple fronts in our industry. That said, simply stacking a new Long-Term Care Insurance policy on top of the client’s other insurance assets may not be the answer, particularly if there are existing insurance policies that may no longer match the needs of the client. More specifically, a personally owned life policy that was a great accumulator of cash but is now under-leveraged and lacks the modern features available from today’s insurance products represents a funding source for an updated insurance strategy. The challenge is how to reposition the policy’s cash values efficiently and for maximum benefit.

Those two outcomes, efficiency and maximum benefit, can seem to be competing intentions at times. An efficient update will minimize costs, both in terms of premium outlay as well as taxation. That typically means a 1035 exchange. That immediately limits product choice to single life products on the same insured. Splitting that exchange to fund multiple policies, perhaps one focused on legacy and another on Long-Term Care, can offer superior benefits, but they remain limited to a single insured. The “Goldilocks” approach, however, still utilizes a 1035 exchange, but follows that with a second transaction. One that funds a similar strategy on the other spouse.

That second transaction, a policy loan, allows for the cash-rich source policy to fund an updated strategy for the second spouse that mirrors the one put in place for the original insured. On the surface, this would seem to create a significant risk in the form of the policy loan that could hamper long-term policy performance. That particular issue is addressed by a planned repayment of the loan via a withdrawal. The end result is two policies, one on each insured, that provide both death benefit intended for their heirs as well as a ready source of funds should the need for Long-Term Care arise.

Consider the following fact pattern:

• A 65-year-old couple
• The husband has permanent life insurance with $400K in surrender value
• The wife has no permanent life insurance

The typical solution would involve a 1035 Exchange to a new policy on the husband’s life that includes Long-Term Care or Chronic Illness Benefits. The client would then fund a separate Long-Term Care strategy for the wife, paid for out of other assets. Alternatively, they could surrender the existing policy, pay any taxes due, and then fund a policy on both husband and wife.

In this case, however, a more effective solution may be available that begins with a 1035 exchange as discussed above, but rather than using other assets to fund a new policy on the wife, the existing cash surrender value on the new policy is used as the source of funds via a policy loan. Figure 1, Funding Two Policies from a Single Exchange, shows the flow of funds, including a critical component: The rapid repayment of the policy loan.

In this case, the loan repayment comes from the husband’s new policy itself. Utilizing the carrier’s ability to take a withdrawal, not to exceed cost basis, that is then used to repay the outstanding loan on the policy, effectively eliminates one of the potential downfalls of the strategy: The long-term health of the policy being compromised by a growing loan balance.

If we revisit our objective of minimizing costs and providing maximum benefits, the approach certainly meets the mark. In summary:

Existing Coverage:

• Total Life Coverage: $700K
• Total Living Benefits: $0
• Lives Covered: 1
• Account Value: $400K

Updated Coverage:

• Total Life Coverage: $744K
• Total Living Benefits: $349K
• Lives Covered: 2
• Yr 1 Account Value: $320,631
• Yr 2 Combined Account Value: $291,228
• Additional Outlay: $0

Admittedly, the account values are lower immediately after this transaction is executed. That said, based on current crediting rates, the combined account value exceeds $400K by policy year ten and continues to grow plus the loan balance is zero beginning in year two. In addition, there is no additional out of pocket for the client, zero taxes due, and a significant upgrade to the coverage is achieved by the addition of living benefits. In an environment where most clients are concerned on some level about the economy, finding creative ways to fund planning objectives is critical. This approach is perfectly suited to today’s economy and truly does deliver more value than a single life solution without living benefits.

With the cost of capital increasing dramatically as interest rates have risen, many commercial loans now have terms that are far less favorable, if not punitive. Fortunately, clients with life insurance assets have access to a “refinancing” strategy that can provide relief from higher rates in the near term and a long-term management plan.

With the current higher interest rate environment appearing to be more than a short-term phenomenon, clients with significant commercial loans are seeking relief from the interest burden they now bear. While shopping for a more favorable rate can certainly help, the reality is that today’s rates are so much higher than when many existing loans were originated, a slightly lower rate provides remains far in excess of the original loan terms.

Paying down these loan balances would certainly provide the interest rate relief clients are seeking, but these loans are often used to fund business expansion or other planning objectives that remain important to the client. Attempting to unwind a strategy designed to capitalize on a business opportunity to pay back a loan will often simply trade one pain for another: The pain of higher rates for the pain of missing out on the business opportunity they were pursuing. Some clients, however, may already own an asset that is perfectly suited to “refinancing” these loans at terms that are far more favorable than even the most well-qualified client can find in the market.

The asset? Cash value life insurance. In fact, this very same life insurance policy may have been the actual collateral used to secure the commercial loan in the first place. The available interest rates were far lower than those available on loans from some insurance policies. As rates have risen, however, the best use of the policy cash value may no longer be as collateral. It may be paying off the bank loan. There are two variables that have to be considered when considering the loan repayment:

Is the loan interest rate in the life policy more favorable than the bank loan? Even as bank loan rates have risen, they may remain lower than the rate available on the policy loan. The net cost of the policy loan, however, is likely to be lower based on the policy also receiving some sort of credit on the loan balance.
What’s the long-term performance impact of the policy loan? Larger loan balances can seriously impair the future performance of the policy.

For some, the answers to these questions will be favorable and a loan from the policy is a clearly superior option when compared to the terms now available from the bank. Unfortunately, that will not always be the case. Whole Life policies in particular frequently have much higher loan interest rates and large loan balances create a drag on policy performance that results in a risk of lapse in the future.

There is, fortunately, a potential remedy to the scenario described above. That remedy involves sourcing a new life insurance policy, funded by a 1035 exchange, that offers the low loan interest rate we are seeking and a strategy for maintaining long-term policy performance. In some instances, the client can extinguish the loan balance without having to pay out of pocket, leaving them out from under the bank loan they are currently struggling with and with an adequately funded policy.

To execute this strategy, there is a proper order of operations, so to speak, that needs to be followed if the life policy was, in fact, used as collateral for the bank loan. Trying to execute a 1035 exchange with the existing policy encumbered by a collateral assignment will typically not work. Instead, the following steps need to be followed:

1. Take a loan from the existing policy first. That loan is used to bay off the bank loan, allowing the bank to release their interest in the policy.
2. Once that is complete, a 1035 exchange to the new policy with more favorable terms can be completed.
3. With the new policy in force, the repayment strategy begins, using annual withdrawals up to cost basis to make loan payments until either the cost basis is exhausted, or the loan is extinguished.

See Figure 1: The Bank Loan Refinancing Strategy for additional details on how this strategy plays out.

As mentioned previously, in a perfect world this loan is completely paid off without the client having to make any out-of-pocket payments. Extremely high loan-to-value ratios or a lower cost basis may not allow for a complete repayment. In those instances, the client can pay off the balance of the loan from other assets. That said, they may not have to. By minimizing the loan balance, existing policy values and projected crediting may be enough to support the policy long-term. In either case, the client’s primary objective is met: They are no longer subject to today’s higher rates on their outstanding bank loan.

Varying economic conditions cause permanent life insurance products to fall in and out of favor. That’s not much of a problem for new insurance policies, but for in force policies it presents a major issue: Actual performance that does not meet expectations set at the time of sale. When that happens, a policy owner may not have great choices as they see to make the best of a bad situation. Unless, of course, their policy was purchased with just this possibility in mind.

Dealing with actual performance that does not meet the sales illustration or client expectations is all too familiar to those who have sold many types of life insurance. Declining dividend rates in Whole Life (WL). Market performance that didn’t materialize in Variable Universal Life (VUL). Index Cap and Participation rates that were unsustainable in Indexed UL (IUL). That doesn’t make any of these products inherently inferior or inappropriate. It does, however, point out that they can lack the flexibility needed to manage varying economic conditions. The exception? It may be Variable Life, but with a twist.

The rise of downside protected insurance products that also offer market-based returns has resonated with many consumers for easily understandable reasons. Primary among them is loss aversion. Once that is in place, however, the other side of the coin in the form of performance enters the conversation. In the case of IUL, actual performance can be severely limited by both the Cap and Participation rates, particularly as a segment matures and is subject to a renewal Cap or Participation rate. This is where performance can start to lag, and policy owners start to look for alternatives. Typically, that means either stay the course, or pivot to a new vehicle. Even if they are insurable and outside the surrender period, they are likely to be hesitant to commit to a similar strategy with a new product that is more well suited to the current economic environment.

A more graceful solution would avoid the need for underwriting and surrender charge considerations if it were already present in the very policy the client already owns.

Fortunately, that product exists. Numerous offerings in the VUL segment include “indexed subaccounts” based on the very downside protected indexing strategies found in IUL. In addition, buffered strategies that have become widely available in the Variable Annuity market have now made their way into the VUL market, offering a different balance of downside protection and upside potential than an IUL or indexed subaccount. Clients who own a VUL with these strategies are in an enviable position: Their solution to falling Cap rates, as an example, is built into the product they own.

If Cap rates, as an example, fall to the point that the upside potential of the strategy is no longer acceptable to the policy owner, they can simply change their allocation to a more suitable or attractive alternative from the menu of subaccounts available in their product. While it is tempting to think about this only in the context of wanting more upside potential, it could very well be predictability that the client is seeking in some instances. In that case, perhaps an allocation to the fixed account makes the most sense. Perhaps a bond fund allocation? Further, this is not an “all or nothing” decision and allocating a portion of their cash values across multiple subaccounts, each with its own unique risk/reward profile, may be the most appropriate course of action.

See Figure 1, below, for additional details on the difference between an IUL and VUL in these circumstances.

Figure 1: Strategies for a Falling Cap Rate

The point? There is never an empirically superior product type. The one that happens to be in favor today may very well be out of favor or perhaps significantly impacted by changing economic conditions within a few years. Rather than try to “time” the insurance market, perhaps it’s time to simply use a more flexible strategy that gives the clients a way to pivot when conditions change?

It’s a fact: Most business owners will execute a living buyout rather than have a business owner die prematurely. That singular fact makes it critical to have a buy/sell agreement in place that can provide protection from a premature death while simultaneously position the business owner for their eventual retirement.

In one of our industry’s more delicious ironies, the type life insurance typically used to fund Buy/Sell Agreements (BSAs), term insurance, is probably the least appropriate funding solution. The truth of the matter is that a permanent solution, with properly structured ownership, places a powerful financial planning tool in the hands of each business owner. A permanent life insurance solution can not only fund their BSA, but also provide supplemental, tax-favored retirement income, long-term care benefits and more.

The reasons for this trend can obviously be attributed to price in some instances, but there are other factors at play. A significant one is the perceived lack of control in most cases stemming from either another owner or the business itself controlling the policy. In most instances this can be traced back to a knowledge gap relative to the types of agreements beyond those two basis structures. Fortunately, in this particular instance, the solution not only addresses the fundamental issue outlined above, but it does so without having to increase the complexity of the agreement to the point it becomes unwieldy, if not prohibitive to administer.

If step one in this process of designing a more effective BSA is simply moving from term insurance to permanent, the next step is addressing ownership. In too many cases, the simplicity and ease of implementation that comes with a stock redemption plan, with the business owing the policies, receiving any death proceeds, and “redeeming” the shares of the deceased owner is too tempting. This not only eliminates the possibility of significant tax savings for the surviving owner, a topic for another discussion, but stilll places the business owner at a disadvantage relative to controlling all of their insurance assets as the company remains the owner and beneficiary of the surviving owner’s policy. Traditional cross purchase designs, while more advantageous from a tax perspective, still present the issue of lack of control: The other owner owns the insurance! While these two approaches can accomplish the ultimate goal of providing funding for the BSA when it is needed, it is far from an optimized solution.

That leaves the obvious question: If both of these types of BSA are less than ideal, what’s the answer? While each planning scenario is different and should be evaluated on its own merit, the “Cross Endorsement” structure checks man of the boxes discussed here:

Each business owner is the owner of the policy on their own life.
As a result, they control the death benefit, cash values and any living benefits the policy may provide.
A simple assignment form the secures the portion of the death proceeds needed to buy out the other business owner at their death.
More importantly, this also allows each owner to make full use of the policy as part of their retirement, long-term care and perhaps even estate planning if they, like most business owners, execute a living buyout.
Finally, at retirement this all happens without some sort of taxable event or an esoteric exemption to the transfer for value rules most do not understand, let alone plan for effectively.

Figure 1, below, shows the basic mechanics of this approach in terms of the flow of funds if one of the owners pass away. What it doesn’t do, is address how each owner can make the “highest and best use” of their policy. To do that, it is critical to move the owner beyond viewing this premium associated with their BSA funding strategy as an expense to something that creates an asset on their personal balance sheet. That effectively eliminates term insurance from the conversation.

The key subject matter areas to discuss with the owner as they consider how to structure their funding strategy with permanent insurance include:

• Their protection needs beyond the BSA. Specifically, is their personal insurance adequate? If not, simply increase the amount of coverage on the policy to an amount that covers both the business and personal need.
• Have the planned for the potential need for care as they age? If not, consider the use of a Chronic Illness or Long-Term Care Rider on the policy.
• Is their retirement plan adequately funded? If not, consider a policy designed to accumulate cash value while also providing a death benefit. This could also solve challenges like limitations on qualified plan contributions.

The beauty here is in the flexibility. Each owner can design their own strategy based on their needs. Once in force, simply filing the assignment secures the other owner’s interest in the death benefit in an amount equal to their obligation under the BSA.

As simple as this strategy is, there are some places where Business Owners may try to cut corners. Specifically, this arrangement does not eliminate the need for a formal, written BSA. Further, the BSA needs to be reviewed regularly, including updating the value of the business. If they want to pay for the coverage through the business, as most Business Owners do, there will likely be personal income taxes due on those funds, likely treated as compensation. There may also be tax due on the economic value of the assigned coverage. Both of these issues make the Business Owner’s CPA or other tax expert a critical part of the conversation.

There are additional benefits to the Cross Endorsement or “Living Benefits” Buy Sell Agreement, including:

• Personal ownership of your policy — The Business Owner names the primary beneficiary and controls the cash value. Any death benefit not committed to the buy-sell agreement can go to family or other personal beneficiaries.
• Younger and healthier owners aren’t required to pay premiums on older and less healthy business partners as they might be with a cross purchase buy-sell agreement.
• You can fund your own policy at a higher level to build greater cash value for your future use.
• Policy is portable — if the business ends or you retire, you still retain the policy and any cash value.
• As an individually owned policy, it may be protected against business creditors depending upon the laws of your state.

The bottom line? There is far more utility from a Cross Endorsement BSA funded with permanent insurance than is available from other agreement types or agreements funded with term insurance. We would all benefit from taking a moment to consider the rest of the Business Owners planning versus pursuing the path of least resistance.

There’s a lot of potential change on the horizon in the Long-Term Care and Estate Planning markets. Between a potential wave of state level LTC legislation plus the possible sunset of the estate tax exclusion levels embedded in the Tax Cuts and Jobs Act (TCJA), clients are facing a period of uncertainty than can have real consequences over the balance of the decade and beyond.

As important as both of those potential planning challenges are, the largest risk clients are facing is the very real need to have a plan for care in place as they age that includes both how they want to receive care as well as how to pay for it. Many are feeling this rather acutely as they care for their own aging parents.

For clients who may find themselves subject to estate tax if current estate tax exclusion limits expire, their Long-Term Care strategy needs to be flexible enough to not only position them to take advantage of any possible opt-out of state level LTC programs, but also address the potential TCJA sunset. It likely also involves pushing some of this risk off to the experts: Insurance companies. A well-conceived and executed solution will:

• Use the most cost-effective strategy to secure Long-Term Care coverage
• Allow for “ownership optimization” of the coverage in the event of the TCJA sunset that creates an estate tax liability

The primary objective is to provide robust LTC benefits as efficiently as possible. Assuming the client has beneficiaries, a life insurance solution likely offers the best value, with either the client or their loved ones receiving significant benefits. At the same time, the use of a joint life product that accumulates cash provides additional efficiency and flexibility.

• Fund a Survivorship IUL (SIUL) policy with LTC rider:
  • Covers both insureds with an individual pool of LTC
  • Provides Indemnity benefits
  • Offers a potential return on premiums instead of simply return of premium
  • Establishes or enhances a significant legacy if not needed for care
• When/If the client has future estate tax exposure:
  • Transfer ownership of the coverage to the client’s newly established ILIT. This reduces their taxable estate once the look-back period expires
  • Utilize trust language that allows access to LTC benefits during their lifetime. If there is a claim, this could remove additional assets from the client’s estate

For a pair of 55-year-olds, both in Preferred health, a properly-funded $1MM SIUL policy with a total LTC pool of $500K each has an annual premium of $10,890, well within the annual exclusion gift limit. If none of the risks we are seeking to hedge actually come to pass, their beneficiaries receive the proceeds. The tax-equivalent IRR on the proceeds assuming the clients pass at age 90 is 6.06%.*

The other question is what happens if they need care? If both clients exhaust their benefits during their lifetime, the IRR may increase given they would likely receive these benefits earlier in life.

How does the Hedge Play out?

Potential LTC Legislation

In the event the client’s state of residence enacts LTC legislation with an opt-out provision triggered by existing LTC coverage ownership, the clients may be eligible based on the true 7702B LTC benefits included in the policy. While the specifics of any future legislation are obviously unknown, it is possible that Chronic Illness Benefits under section 101(g) may not qualify for opt-out, making 7702B products a safe harbor of sorts.

Additionally, given that the final form of any legislation is yet to be specified, the ability to opt out and the requirements to do so are unknown at this time. This makes it critical to focus on the planning need first, with the goal of opting out of any future legislation as a possibility rather than the sole driver of the purchase of LTC coverage. A review of any proposed legislation in the client’s state of residence as part of the planning process is essential.

Potential Sunset of the Tax Cuts and Jobs Act

The only thing we know about the future of estate taxation, based on history, is that there will be change. In the event the client finds themselves with an unexpected estate tax exposure resulting from future changes, establishing an ILIT and subsequently transferring ownership of the policy to the ILIT removes the death benefit from their taxable estate after the look back period expires. The use of indemnity benefits on the Nationwide policy also unlocks an extremely estate tax friendly way to manage the benefits, that can remove additional assets equivalent to the benefits received plus interest from the client’s taxable estate. Please see Figure 1, below for additional details on this element of the strategy.

Unlocking the “Extra” Estate Tax Exclusion

Client Needs Long-Term Care

• Client buys $1MM life policy with LTC rider in their ILIT using funds earmarked for LTC
• Carrier pays indemnity LTC benefit to the trust ($20K/month for 50 months)
• Client borrows funds from trust to pay for LTC expenses
• Interest is capitalized annually
• The client passes away at exhaustion of benefits
• LTC Benefits Paid: $1,000,000
• Accrued Interest: $220,000
• Estate Debt to Trust: $1,220,000

At Client’s Death

• Estate Repays the Loan
• Total Amount in Trust: $1,220,000

Additional Details

• Trust Language must allow for LTC ownership as well as loans to the Grantor.
• Not all Insurance Companies allow their LTC products to be owned in an ILIT.
• There are very specific technical requirements for the loan to the Grantor.