This article is reprinted with permission from Sullivan, Cotter and Associates.
Every once in a while, a new life insurance product or approach enters the market that will revolutionize our thinking. More often, an existing concept is repackaged and promoted as something that will revolutionize our thinking. How can you differentiate between the two?
Life insurance has often been marketed as a tax-efficient way to minimize or avoid the solvency risk and "substantial risk of forfeiture" required by traditional deferred compensation designs in tax-exempt organizations. Split-dollar life insurance was once the answer: What could be better than the employer paying premiums, then getting those premiums back later? For many participants in these plans — and the sponsoring employer — it was too good to be true, with many employers taking large financial losses and participants not receiving the anticipated benefit.
A new wave of life insurance approaches is now entering the market with a range of features. While the marketing literature may indicate that the benefits of the life insurance approach outweigh those of more common 457(f) approaches used for deferred compensation, there is always a trade-off among complexity, investment risk, expenses and taxation. Some features of life insurance products may compare favorably to 457(f) plans, but certain features are often sacrificed, including simplicity, and the approach may only be beneficial within a certain range of economic scenarios (e.g., low interest rates, consistent investment growth).
Because of the complexity and nuances involved with life insurance arrangements, it is critical for employers to fully understand these arrangements prior to their adoption as an employer-funded or voluntary program. An independent, unbiased review and an objective explanation of the proposal are recommended to ensure a balanced assessment of the proposed life insurance arrangement compared with other approaches.
Employers and individuals should be asking the following key questions when reviewing life insurance proposals.
Question 1: Does the life insurance approach achieve the organization's objectives?
A key objective may be to meet competitive life insurance coverage and deferred compensation market practices. Targeting each benefit individually may be more effective — and simpler — than trying to use a combined approach through a life insurance policy. A combined approach often requires the policy to have a very high level of life insurance to support the targeted deferred compensation level, at a level that may be more than the individual needs or wants to carry. The high level of life insurance is also accompanied by higher mortality expenses and may require a more onerous underwriting process.
Some organizations may be looking to offer the life insurance approach as an additional investment vehicle for individuals who have maximized deferrals to 401(k), 403(b) and 457(b) plans — at least $34,000 in annual deferrals in 2012. While the program may be voluntary, the organization should acknowledge that allowing the insurance broker access to employees may be seen as an implicit endorsement of the approach, and disappointment from any negative outcomes may be directed toward the organization — even if the initial messaging is clear that the individual is responsible for determining whether or not to participate. Organizations should ask themselves the following: Is providing this voluntary program worth taking on the additional responsibility of monitoring the offering or taking on potential reputational risk?
Question 2: Is providing life insurance through the employer better than individuals purchasing coverage on their own?
The personal insurance market offers many different insurance designs that can be tailored to each individual's life insurance needs. However, it may be possible to provide better pricing and access to better investment options within employer-provided coverage. The advantages to the individual should be compared with the administrative cost and risks involved.
Question 3: Have I been provided the right information?
Executives and, more recently, physician groups have become key target markets for life insurance providers, and human resource leaders are often asked for access to these individuals. The initial marketing material provided to HR may provide compelling comparisons to other approaches. However, it is important that the right information be carefully reviewed prior to allowing access to physicians and other employees, particularly since those individuals may consider the product to have been endorsed by the employer.
An independent review can provide the right information: a balanced assessment of the risks and rewards, results under multiple scenarios and the impact of unexpected events.
Question 4: Are comparisons to other approaches fair?
Life insurance comparisons often focus on certain features and scenarios that make the life insurance policy look better than more traditional approaches. This may include using high investment returns, low interest rates, "best case" tax treatment of life insurance and "worst case" tax treatment of the alternative. While assumptions may be defensible and the tax treatment may reflect one possible scenario, an independent review can be a surefire way of providing a fair comparison of all the features.
Question 5: Are the investment return assumptions appropriate? What happens if we experience another period of stock market volatility or if performance is worse than expected? What if tax rates change?
Of course, none of us can predict the changes in the investment market, and any estimate of future returns is likely to end up missing the mark. Since the projected results are significantly affected by the investment return assumption, it is important to consider multiple investment return assumptions to determine the range of possible outcomes.
Even with multiple scenarios showing the impact of fixed investment return assumptions, market volatility can cause significant changes in the expected outcome. Life insurance arrangements are more sensitive to market changes than more traditional deferred compensation designs.
Changes in tax rates are likely to change the relative merits of different approaches. Furthermore, many life insurance approaches hinge on the current tax treatment of life insurance. It is important to consider the impact of changes in tax rates and tax treatment of life insurance in evaluating options.
Question 6: Will the participants understand the policy features?
Life insurance can be very complex. It is important that participants understand the benefits, risks, costs and limitations of participating.
Many approaches need premiums to be paid and the policy to be held for 10 to 15 years, or more, in order to provide beneficial results. Often, life insurance illustrations show what happens if an individual participates until a specified retirement age. However, the policy may have very different results if the individual participant stops making premium payments at an earlier date.
There is a greater chance of disappointment with the program if participants don't understand it or if they don't fund the policy for as long as expected.
Question 7: What might affect a participant's ability to receive income from the life insurance policy?
Some products allow participants to take withdrawals from the policy to supplement other sources of retirement income. However, withdrawals are only permitted if there is sufficient cash value in the policy. If policy performance is poor, participants may not be able to take withdrawals. Participants may even be required to choose between paying additional premiums to keep the policy in force at an advanced age when they are financially less able to do so, or surrendering the policy and incurring a significant tax liability.
It is prudent to periodically consider the available alternatives for providing retirement benefits or deferral opportunities to ensure that the organization is providing good value to participants while meeting organizational objectives. However, it is important to consider all of the implications to the organization and participant through an independent review, asking the right questions and getting the complete answers you need.
Every once in a while, a new life insurance product or approach enters the market that will revolutionize our thinking. More often, an existing concept is repackaged and promoted as something that will revolutionize our thinking. How can you differentiate between the two?
Life insurance has often been marketed as a tax-efficient way to minimize or avoid the solvency risk and "substantial risk of forfeiture" required by traditional deferred compensation designs in tax-exempt organizations. Split-dollar life insurance was once the answer: What could be better than the employer paying premiums, then getting those premiums back later? For many participants in these plans — and the sponsoring employer — it was too good to be true, with many employers taking large financial losses and participants not receiving the anticipated benefit.
A new wave of life insurance approaches is now entering the market with a range of features. While the marketing literature may indicate that the benefits of the life insurance approach outweigh those of more common 457(f) approaches used for deferred compensation, there is always a trade-off among complexity, investment risk, expenses and taxation. Some features of life insurance products may compare favorably to 457(f) plans, but certain features are often sacrificed, including simplicity, and the approach may only be beneficial within a certain range of economic scenarios (e.g., low interest rates, consistent investment growth).
Because of the complexity and nuances involved with life insurance arrangements, it is critical for employers to fully understand these arrangements prior to their adoption as an employer-funded or voluntary program. An independent, unbiased review and an objective explanation of the proposal are recommended to ensure a balanced assessment of the proposed life insurance arrangement compared with other approaches.
Employers and individuals should be asking the following key questions when reviewing life insurance proposals.
Question 1: Does the life insurance approach achieve the organization's objectives?
A key objective may be to meet competitive life insurance coverage and deferred compensation market practices. Targeting each benefit individually may be more effective — and simpler — than trying to use a combined approach through a life insurance policy. A combined approach often requires the policy to have a very high level of life insurance to support the targeted deferred compensation level, at a level that may be more than the individual needs or wants to carry. The high level of life insurance is also accompanied by higher mortality expenses and may require a more onerous underwriting process.
Some organizations may be looking to offer the life insurance approach as an additional investment vehicle for individuals who have maximized deferrals to 401(k), 403(b) and 457(b) plans — at least $34,000 in annual deferrals in 2012. While the program may be voluntary, the organization should acknowledge that allowing the insurance broker access to employees may be seen as an implicit endorsement of the approach, and disappointment from any negative outcomes may be directed toward the organization — even if the initial messaging is clear that the individual is responsible for determining whether or not to participate. Organizations should ask themselves the following: Is providing this voluntary program worth taking on the additional responsibility of monitoring the offering or taking on potential reputational risk?
Question 2: Is providing life insurance through the employer better than individuals purchasing coverage on their own?
The personal insurance market offers many different insurance designs that can be tailored to each individual's life insurance needs. However, it may be possible to provide better pricing and access to better investment options within employer-provided coverage. The advantages to the individual should be compared with the administrative cost and risks involved.
Question 3: Have I been provided the right information?
Executives and, more recently, physician groups have become key target markets for life insurance providers, and human resource leaders are often asked for access to these individuals. The initial marketing material provided to HR may provide compelling comparisons to other approaches. However, it is important that the right information be carefully reviewed prior to allowing access to physicians and other employees, particularly since those individuals may consider the product to have been endorsed by the employer.
An independent review can provide the right information: a balanced assessment of the risks and rewards, results under multiple scenarios and the impact of unexpected events.
Question 4: Are comparisons to other approaches fair?
Life insurance comparisons often focus on certain features and scenarios that make the life insurance policy look better than more traditional approaches. This may include using high investment returns, low interest rates, "best case" tax treatment of life insurance and "worst case" tax treatment of the alternative. While assumptions may be defensible and the tax treatment may reflect one possible scenario, an independent review can be a surefire way of providing a fair comparison of all the features.
Question 5: Are the investment return assumptions appropriate? What happens if we experience another period of stock market volatility or if performance is worse than expected? What if tax rates change?
Of course, none of us can predict the changes in the investment market, and any estimate of future returns is likely to end up missing the mark. Since the projected results are significantly affected by the investment return assumption, it is important to consider multiple investment return assumptions to determine the range of possible outcomes.
Even with multiple scenarios showing the impact of fixed investment return assumptions, market volatility can cause significant changes in the expected outcome. Life insurance arrangements are more sensitive to market changes than more traditional deferred compensation designs.
Changes in tax rates are likely to change the relative merits of different approaches. Furthermore, many life insurance approaches hinge on the current tax treatment of life insurance. It is important to consider the impact of changes in tax rates and tax treatment of life insurance in evaluating options.
Question 6: Will the participants understand the policy features?
Life insurance can be very complex. It is important that participants understand the benefits, risks, costs and limitations of participating.
Many approaches need premiums to be paid and the policy to be held for 10 to 15 years, or more, in order to provide beneficial results. Often, life insurance illustrations show what happens if an individual participates until a specified retirement age. However, the policy may have very different results if the individual participant stops making premium payments at an earlier date.
There is a greater chance of disappointment with the program if participants don't understand it or if they don't fund the policy for as long as expected.
Question 7: What might affect a participant's ability to receive income from the life insurance policy?
Some products allow participants to take withdrawals from the policy to supplement other sources of retirement income. However, withdrawals are only permitted if there is sufficient cash value in the policy. If policy performance is poor, participants may not be able to take withdrawals. Participants may even be required to choose between paying additional premiums to keep the policy in force at an advanced age when they are financially less able to do so, or surrendering the policy and incurring a significant tax liability.
It is prudent to periodically consider the available alternatives for providing retirement benefits or deferral opportunities to ensure that the organization is providing good value to participants while meeting organizational objectives. However, it is important to consider all of the implications to the organization and participant through an independent review, asking the right questions and getting the complete answers you need.
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