Sales may be down, but advisors are still using survivorship insurance.
Insurance companies expected the Economic Growth and Tax Relief Reconciliation Act of 2001 to hurt sales of survivorship policies, and they were right. Research by LIMRA International, the life industry's trade association, shows that 20% fewer policies were written in 2002 than in 2001, with sales for the first half of this year off 14% from the same period last year. Total premium dollars also have declined.
Although it has come to be used in many ways, carriers originally designed survivorship coverage to provide funds for paying a couple's federal estate tax, a bill that is generally triggered at the death of the surviving spouse-hence the alternative moniker, second-to-die insurance. EGTRRA repeals the tax in 2010, after raising the estate-tax-free amount from $1.5 million (effective January 1, 2004) to $3.5 million per individual. But thanks to what is arguably the most second-guessed tax-code provision in history, the law reinstates the levy in 2011 for those whose net worth tops $1 million.
The loop-de-loop makes it impossible to know what the client's tax toll will be, bringing uncertainty to the insurance-planning table. It's tough enough trying to get clients to do estate planning. "When you throw in the uncertainty, that leads people, in a lot of cases, not to act" and slowing sales, says Les Lovier, life-marketing vice president at AXA Financial in New York City. The industry's lone (but smart) response in product design has been to waive policy surrender charges in years when there is no estate tax, to mitigate customer cost in the event that the insurance isn't needed for its ostensible purpose.
In financial planning circles, meanwhile, survivorship insurance has become something of a hot-button topic. The fee-only crowd will tell you that the policies are oversold by insurance agents in search of lucrative commissions. As with any life policy, there are loud, opposing opinions about the wisdom of utilizing variable products, which let clients subject the cash value to the vagaries of the financial markets. Regardless of your stand, advising clients about survivorship insurance today is different than it was before EGTRRA, starting with the educational initiatives. "I haven't necessarily altered how I use the product, but a standard communication to clients now is that the laws are going to be continually changing, and therefore we need to really understand why we're using the product," says advisor Saul Simon, president of Simon Financial Group in Piscataway, N.J.
Taxes Don't Go Away
Inform clients about the carryover-basis regime that replaces the federal death tax in 2010 and which, conceivably, would take effect under a final repeal of the tax. In this paradigm, assets pass to heirs with the decedent's basis-no step-up to the value at death as current rules provide. When the property is sold, therefore, the heirs will owe capital gains tax on all the growth. "Even if the client has a modest asset base that has appreciated, you're still talking about a tax of 20% (after 2008) plus inheritance tax, depending on the state," says Ellen Fairbanks, a certified financial planner licensee with MD&A Financial Management Co. in Pittsburgh.
Similarly, clients planning to pass large retirement plan balances to heirs should be reminded that the future portends significant income tax-forget death tax. Heirs' withdrawals from tax-deferred accounts are ordinary income. "The notion of stretch IRA, which all of us preach, presumes that the kids are more interested in saving taxes than in benefiting from the money in the account," says Herb Daroff, a planner with Boston's Baystate Financial Services. "I don't know about anyone else's kids, but mine want to go after the cookie jar. A second-to-die policy gives them the freedom to access the funds without losing 35% or more to federal and state income taxes," Daroff says.
These are not necessarily problems for smaller estates, of course, and some are letting their survivorship policies lapse. "I'm letting a couple of them die right now for clients with less than $2 million," says John Henry McDonald, president of Austin Asset Management Co. in Austin, Texas.
Another way out of a policy that is no longer deemed necessary is to sell it to a life settlement company, says Diane Pearson, director of financial planning at Legend Financial Advisors Inc., in Pittsburgh. One couple had purchased coverage five years ago, based on their net worth at the time. Since then, the estate-tax exclusion has escalated above their wealth while their variable policy's cash value fell to $35,000 in the bear market, after $75,000 of premiums had been paid. "So we went to a life settlement company that purchased the policy from them for $58,000," Pearson says, explaining that the company will receive the payout at the second death. "It's terrible to say, but the clients might have gotten more money for the policy if the wife, who is 82, had not been so healthy," Pearson says. It's the opposite of buying life insurance, where good health helps.
For many clients, however, the risk of taxes ruining their legacies is too great to ignore. This is particularly true in cases where wealth is concentrated in illiquid assets. "Survivorship insurance still makes sense for small-business owners, as well as for people who own real estate," Pearson says. Passing away with no provision for whatever taxes may be due could force disposal of the illiquids at fire-sale prices-not an optimal solution for the individuals you undoubtedly hope to inherit as clients.
Some who continue to use the coverage take a flexible approach to manage the tax uncertainty. "We will build a formula into the estate planning documents that says, 'If I have an estate tax liability, then X occurs. If I don't, then give some or all of (the survivorship policy proceeds) to my private foundation or favorite charity,'" says estate planning attorney John Jeffrey Scroggin, of Roswell, Ga. "It's comforting for clients to be able to say, 'If the law goes against me, I've got the policy for estate tax liquidity. If the law goes with me, I've got that covered, too.'"