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In the business market, top performers often command a more robust suite of benefits than the rest of the company. Unfortunately for some, that is not always the case. In fact, on a percentage basis, the top performers often lag the rest of the company in three fundamental areas. Fortunately, this “Benefits Gap” can be solved, either within the benefits plan itself or with individual solutions. Read on for the details!

Where’s the Gap?

The Benefits Gap shows up in three areas most frequently:

• Retirement Planning
• Disability Income Protection
• Life Insurance Protection

Even if the client “already has” these benefits in place at their employer, a quick look at the benefits relative to the client’s income surfaces a significant shortfall. Also important: If the client is relying solely on employer sponsored plans that are NOT portable, personally owned insurance is the only way to address this issue without leaving the client exposed should they change jobs.

How to Close the Retirement Gap?

Closing the gap ultimately comes down to having a supplemental retirement plan. In the employee benefits setting, that can be accomplished via a deferred compensation plan or other bonus plan. Absent an employer that is willing to contribute additional funding, it’s up to the individual to make up the difference. In that case, evaluating the client’s “asset location” or the tax efficiency of their overall retirement plan, often points to the need for a larger allocation to assets that, when properly structured, are not subject to ordinary income or capital gains tax. An increase in that allocation can not only close the retirement gap, but also provide the critical tax diversification that allows clients to respond appropriately to future changes in tax rates in retirement.

Figure 1: The Retirement Gap

How to Close the Disability Gap?

It really all comes down to having a supplemental disability insurance plan that integrates with the client’s group coverage. In the employee benefits setting, that can be accomplished via an executive carve out that offers additional, personally owned and portable disability insurance protection to the executives in the organization. Absent an employer that is willing to implement a plan, it’s up to the individual to make up the difference. In that case, leveraging today’s modern application and underwriting processes can allow for implementation of significant amounts of coverage with minimum interruption of the client’s busy schedule.

Figure 2: The Disability Gap

How to Close the Life Insurance Gap?

Having a supplemental life insurance plan is ultimately how to close the gap. In the employee benefits setting, that can be accomplished via an executive carve out that offers additional, personally owned and portable life insurance protection to the executives in the organization. Absent an employer that is willing to implement a plan, it’s up to the individual to make up the difference. In that case, leveraging today’s modern application and underwriting processes can allow for implementation of significant amounts of life insurance with minimum interruption of the client’s busy schedule.

It’s tempting to use an “apples to apples” approach when considering the premium deposit used to fund an Asset-Based LTC solution. Given the availability of a tax-free 1035 exchange when an annuity is the source of funds, it’s critical to take any tax taxes due on the surrender of the annuity into account when determining the amount available to fund the strategy.

We all know how important it is to keep things simple for clients. Covering the essential components of a planning strategy as efficiently as possible increases understanding and improves the quality of their decisions.

In the Asset-based Long-Term Care (ABLTC) segment, however, there is a detail that must be considered that is often overlooked: Source of funds. Specifically, clients need to understand the pros and cons of using non-qualified funds versus qualified funds, annuities versus brokerage accounts and the like when funding their care planning strategy.

This becomes even more important when we consider the tax ramifications specific to each funding source, particularly when considering non-qualified annuities. Why call out non-qualified annuities specifically? Simple: There’s an opportunity to avoid a taxable event altogether by selling an annuity-based ABLTC product. The availability of a tax-free 1035 exchange into an annuity-based ABLTC product unlocks the power of the Pension Protection Act and changes the true cost of the care planning strategy.

These cases can play out in a couple different ways. The most common is a “Money Purchase” approach that starts with the existing annuity’s cash value. That amount is used as the single premium to purchase an ABLTC solution. The tax issue is often overlooked and has a material impact on the decision-making process. More specifically, the single premium used to fund a life-based ABLTC product should be discounted by the taxes due on the liquidation of the annuity. That net amount is then used as the single premium on a life-based solution, while the full amount can be used to fund an annuity-based product. Please see Table 1 for an example.

 

Table 1: Impact of Taxes on Non-Qualified Annuities

 

¹ Tax Rate Assumptions: 24% Federal, 10% State, for a combined 34%

Table 1 shows the significant difference in the net premium available to fund a care planning strategy with funds from a non-qualified annuity based on the type of ABLTC product being considered. While the full amount is available to an annuity-based product. the lower amount net of taxes is what is truly available to fund a life-based care planning strategy.

The resulting impact of an increased premium on available LTC benefits is obvious: With more funds deposited into the annuity product, the corresponding benefits may be richer. Does this mean that an annuity-based product is always going to outperform a life-based product? Absolutely not. It will increase the frequency of the annuity-based solution delivering superior benefits, however.

The fundamental question that needs to be answered is if the increased funding into the annuity-based solution is offset by the superior leverage typically found in life-based products? In this case, with a 35% combined tax rate assumption, the life-based product would have to deliver a 20.48% greater monthly benefit per dollar of premium for the total monthly benefit to equal the benefits available from an annuity-based solution This is demonstrated by the following calculation:

• Life-Based Premium: $166,000
• Annuity-Based Premium: $200,000
• Shortfall: $34,000
• Shortfall as % of Life-Based Premium: $34,000/$166,000 = 20.48%

Consider a sample case, with the following case design parameters:

Male, age 70

• Couples Discount
• 6-year Benefit Period
• 3% COLA
• Maximum Monthly Benefit

Revisiting the cash flows from Table 1, above, now including the corresponding monthly benefit amounts, shows not only the superior outcome of the annuity-based solution for this case, but also how it could have been “hidden” if the reduced, after-tax deposit amount was not used. Please see Table 2 for additional details:

 

Table 2: Impact of Taxes on LTC Benefits

 

¹ Tax Rate Assumptions: 24% Federal, 10% State, for a combined 34%

Table 2 shows how case design is impacted by the source of funds. Not taking the taxes due on the surrender of the annuity into account could easily lead to a sub-optimal recommendation. At first glance, it appears that the life-base solution is superior. However, that design has a hidden cost of an additional more than $34,000 in taxes as seen in the column titled Life-Based ABLTC, Taxes Considered.

This effectively reduces the amount available to fund the life-based strategy. A review of the additional two columns showing the impact of taxation point to the annuity as the superior solution in terms of monthly benefit. In this case, a monthly benefit at age 80 that is $1,032 or 11.15% higher in an annuity-based solution.

Other Considerations

While the primary metric in a care planning case is usually the monthly benefit amount, there are other factors at play. The death benefit that may pass to beneficiaries if not accelerated for care is likely the most significant. Not only are death benefits from the life-based products typically larger, but they are also tax-free to the beneficiaries. Liquidity is typically superior in an annuity-based versus life-based product. These factors will need to be considered as part of the decision-making process.

Another important point to consider is the use of a COLA Rider. Annuity-based products like the one used in this example may perform better without a COLA Rider. The current crediting rate of the annuity, if used to project future benefits, can result in a greater monthly benefit. That amount, of course, is not guaranteed, while the benefits available from the COLA Rider are contractually guaranteed. Given the nature of the sale, the guaranteed benefits are likely more appropriate as well as being directly comparable to those from a life-based solution.

All of the above as well as the ultimate outcome is dependent not only on the use of the appropriate premium amounts, but also the age of the client, use of a COLA Rider and the like. None of that however changes the bottom line need to use the annuity value net of applicable taxes when running proposals.

A potential complication is the annuity with a surrender value in excess of the premium needed to fund the strategy. Fortunately, most annuity carriers, including those that offer annuity-based ABLTC products, also offer other annuity products and may be able to execute a “split 1035 exchange” upon receipt of the funds. This would allow a portion of the exchanged funds to be allocated to the annuity-based ABLTC product with the balance being deposited into a different annuity product from the same carrier. While more complicated, the surrendering company may be able to facilitate a split exchange involving two different receiving companies, creating additional flexibility for clients in this situation.

Underwriting comes into play as well. Annuity-based ABLTC products may offer a simplified underwriting process that is also more accommodating of some health conditions.

Next Steps

Fortunately, taking the impact of taxes into account in these scenarios involves only two additional pieces of data and a bit of math: When working with non-qualified annuities, always calculate the net premium amount using the cost basis and an income tax rate assumption when not utilizing a 1035 Exchange. Use the resulting net proceeds available to fund a life-based product and run proposals for both life-based and annuity-based products accordingly. The results may surprise you!

If you’ve worked in the business market, you are undoubtedly familiar with Section 162 Bonus Plans. Rather than the traditional life insurance focused approach, this fresh approach delivers something that may be perceived as even more valuable: Long-Term Care coverage.

Life insurance has long been used as an Executive Benefit, with myriad strategies for structuring agreements that can further corporate objectives around employee recruitment and retention. Despite the high usage rate of life insurance products, this use case has not carried over into the Asset-Based Long-Term Care (ABLTC) product segment. Given the forces in play that shine a light on the need for more effective care planning strategies and funding solutions, the benefits offered by an ABLTC solution may be more valuable than life insurance in the eyes of key employees.

The combination of personal experience with their loved ones needing care, the increasing cost of care and the rising tide of state level legislation focused on Long-Term Care has created an environment where employee and employer alike can benefit from implementing a plan. These benefits may also expand to include reduction of taxation of both the business and employee relative to Long-Term Care legislation, making the coming years particularly interesting for Executive Benefit offerings in this product segment.

Given their relative simplicity and utility across multiple business entity types, Section 162 Bonus Plans stand out as an attractive structure for businesses evaluating implementing an ABTLC plan for their key employees. Please see Figure 1: Section 162 Bonus Plan Mechanics During Employment for additional details on these arrangements.

 

Figure 1: Section 162 Bonus Plan Mechanics During Employment

 

In the example outlined in Figure 1, the employer gives its employee an annual bonus amount equivalent to the annual cost of the policy premium. The employee owns the policy and will need to pay income taxes on the bonus, just as they would for any compensation received from their employer. The employer may also choose to compensate the employee with a bonus that covers the annual premium plus the income taxes due by the employee. This is commonly referred to as a double bonus. To incentivize longevity with the company, the employer may choose to spread premium-payment bonuses over five, 10, or more years, as well as restrict access to the policy in other ways that incent the employee to remain with the company. If the employee stays with the company for the required amount of time, they will own a fully funded policy

During the balance of the employee’s career, they continue to enjoy the valuable coverage, knowing that they have an important piece of a comprehensive financial plan in place. Should they need care before or in retirement, the benefits from the policy flow as outlined in the top section of Figure 2: Section 162 Bonus Plan Mechanics at Claim and/or Death. Given that the employee owns the coverage personally, they receive the benefits directly from the insurance company per the terms of the life insurance policy. Depending on how their particular claim ultimately plays out, there will likely be some level of remaining death benefit that would be paid to the employee’s named beneficiaries at their death, as illustrated in the bottom half of Figure 2.

 

Figure 2: Section 162 Bonus Plan Mechanics at Claim and/or Death

 

It’s important to note that this is but one approach to offering these benefits as part of a key employee’s benefits package. Businesses interested in further evaluating a plan should fully investigate alternative funding strategies that may be more advantageous for their business entity type or support other objectives they may wish to accomplish by offering a plan.

Tax Considerations:

• Bonus amounts are generally tax-deductible to an employer
• Bonus is considered taxable to the employee
• Long-term care benefits are generally received income tax-free
• Death benefit is income tax-free to the beneficiary
• Death benefit amount may be included in employee’s estate for federal estate tax purposes

Table 1, Section 162 Bonus Plan Cash Flows, shows the cash flow requirements for the business allocating $10,000 per year to an ABLTC Benefit Plan for one employee, as well as the net cost to the employee under a single bonus arrangement. As stated previously, the company could elect a double bonus structure that would increase the outlay by the company but would reduce the employee Net After-tax Cost to $0.

Table 1: Section 162 Bonus Plan Cash Flows

The Long-Term Care benefits associated with these cash flows will vary based on any number of factors, but assuming a 55-year-old male with a couple’s discount, this policy should provide a monthly benefit amount of approximately $6,000.

It’s also possible for the employee to elect to contribute some of their own assets to the policy, resulting in richer monthly benefits and/or a longer benefit period.

Possible Additional Benefits to the Business and Employee

In an era that sees an increasing number of states either implementing or evaluating state-mandated Long Term Care plans, there are additional potential benefits to both the business and the employee implementing an ABLTC Executive Benefit plan. In states like California, the taxes associated with the pending legislation include not only a payroll tax paid by the employee, but also a tax paid by the business. Given that both parties are facing some sort of possible expense related to the public long-term care option via taxation, there may be a greater appetite for allocating those dollars to a benefit offering that would be viewed positively by the employee.

While the specifics of the California legislation remain to be determined, private coverage that qualifies for an opt out of the public plan could directly address some of the major challenges this type of legislation presents to highly compensated individuals. Primary among these is the total amount paid in tax over an employee’s career. For highly compensated individuals, even a modest tax rate can translate to a massive total tax burden over their working years. Implementing a private LTC insurance plan, however, could offer two compelling advantages: Likely superior benefits and a guaranteed cost. These advantages may also be available to the business if their employee opting out of the public option also eliminates the portion of the tax paid by the business. In addition, employees will likely place much more value on a benefit from their employer that provides superior economics and benefits, reinforcing the intent of these types of Executive Benefit Plans.

The bottom line of this discussion is rather straightforward: Today’s job market is putting pressure on businesses to offer compelling benefit packages. State level Long-Term Care plans are forcing employees to purchase Long-Term Care in some fashion, by either participating in a public option or acquiring private insurance. There is a larger need for this kind of coverage with each passing year as the cost of care increases. While it is impossible at this time to determine what, if any, actual cost savings may be available to a business by implementing an ABLTC Section 162 plan, the superior relative value of the plan in the eyes of the participating employees makes offering this type of benefit rather than subjecting the business and the key employees to an unwanted and punitive tax a much more effective use of the business’s capital.

The conventional approach to designing accumulation-focused Indexed Universal Life strategies involves minimizing the death benefit. Often, this is combined with using the maximum AG49 compliant illustrated rate to squeeze every dollar of projected income out of the product.

The conventional approach to designing accumulation-focused Indexed Universal Life (IUL) strategies involves minimizing the death benefit. Often, this is combined with using the maximum AG49 compliant illustrated rate to squeeze every dollar of projected income out of the product.

While that can produce a compelling illustration, it may not be the most effective approach in the real world. That thought process is often the reason for things like stress testing or reducing the illustrative rate, even if it results in a reduced illustrative income. The truth is there is another, perhaps more meaningful alternative design that can deliver more consumer value from virtually any Indexed Universal Life product.

This more balanced approach to case design can deliver:

• An increased initial face amount, meaning more coverage for the client’s loved ones
• A corresponding increase in the lifetime maximum available under any Accelerated Benefit Riders
• Additional funding capacity that allows the client to increase their contributions to the “Tax-free Bucket” in their retirement plan should their investable cash flow increase. All without asking the client for another dollar of premium.

Check out the results below:

What’s the Bottom Line?

An additional $248,387 in coverage, an increase of over 61% versus a traditional design. The product includes a Chronic Illness ABR that is now based on a 61% larger face amount, putting more cash at the client’s fingertips when they need it most:

Traditional Design: $404,941 Maximum Lifetime Benefit
Balanced Approach: $653,328 Maximum Lifetime Benefit, an 81% increase

How does this Impact Illustrated Income?

Over $14,000 in additional funding capacity per year. Remember, all the testing that limits how much premium you can contribute “rolls” forward. By the 10th policy year there is a whopping $140,000 of additional funding capacity.

What’s in it for the Advisor?

As the face amount increases, so does the Target Premium. Using this consumer value packed approach increases Target Premium by 61%!

What Products Work with this Approach?

This strategy likely works with the majority of accumulation focused IUL and VUL products. Case design will be a manual process. Increasing the face amount from a maximum accumulation solve by 50% might be a good starting point.

The Role of Life Insurance in an Asset Location Strategy

Asset Allocation has been part of the investment professional’s asset management strategy for decades. More recently, a considerable amount of attention has been focused on a natural extension of that approach: Asset Location.

While the two terms are extremely similar, their meaning is quite different:

• Asset Allocation: The selection of a diversified portfolio of stocks, bonds, cash and alternatives aligned with an investor’s time horizon and risk tolerance.
  Asset Location: The placement of assets in taxable, tax-deferred and tax-free accounts with the goal of minimizing taxes

Where is Asset Location Being Talked About?

A quick Google search uncovers any number of hits from asset managers and the like, but if we look at where most consumers may ultimately go for information on a topic like this once they are exposed to it, two sources stand out:

Investopedia: Minimize Taxes With Asset Location
Fidelity: Are you invested in the right kind of accounts? See how tax-smart asset location can potentially help improve after-tax returns.

Fidelity goes so far as to outline the tax treatment of various assets as part of their effort to educate their clients as seen in Figure 1.

Asset Location – Figure 1

 

You will likely notice one very important omission in both of those articles and Figure 1: Both Fidelity and Investopedia have neglected an asset class that should play a large role in the Asset Location conversation: Cash Value Life Insurance. This omission is not just common, it’s nearly universal. The asset management community largely has no idea how life insurance fits in this approach they have already embraced and are using with their clients.

We’ve known for years that life insurance’s unique value proposition positions it as an analog to things like Roth IRAs that have the following characteristics regarding taxation:

Tax-free: Will be invested after tax, but you will not pay taxes on any distributions from these assets.

Of course, life insurance has a significant advantage: The income-based limitations that can prevent clients from utilizing Roth IRAs don’t exist for life insurance.

If we investigate the account types that fall into the tax-free category further, as seen in Figure 2, the advantages of life insurance over alternatives becomes even more clear:

Asset Location – Figure 2

What’s the Bottom Line?

In short, positioning cash value life insurance as a tax-free asset in an asset location strategy is an ideal way to introduce clients to the unique tax treatment of life insurance. It solves a challenge they face in terms of income-based limitations and the like that can prevent them from utilizing more traditional tax-free assets that offer market returns.