The ILIT Remixed
A Workshop With Vincent M. D'Addona
Reprinted from The Estate Analyst, September, 2007
By Robert L. Moshman, Esq.
n the early 1990s, estate-planning professionals learned a new technique and before long, irrevocable life insurance trusts utilizing survivor life policies became a mainstream approach. Has the ILIT lost some of its magic?1
Even if that is so, estate planners may be reluctant to stray from the reliable ILIT. What might change that mindset and remix estate planning by keeping life insurance inside the estate?
Let us take calculator in hand and adjourn to our ILIT workshop without further adieu. Fortunately, we are accompanied by wealth strategist Vincent M. D'Addona, whose number crunching led to revelations about the ILIT's future role in estate planning.
Estate-O-Metrics
How will an estate plan turn out? No one can foresee the future, but that doesn't stop us from trying our best for issues of life, money, or baseball.
Why baseball? Because it takes on great meaning...and will break your heart.2
As a result, sabermetrics, the objective study of baseball statistics, is used to predict outcomes and guide decisions.3
We use quantitative analysis to understand the economy (i.e., "econometrics"). And for everything else that matters, prognosticators from Las Vegas to Lloyd's of London can determine odds.
Sabermetrics tell us that the single most important variable in scoring a run is getting the lead-off runner on base. A baseball manager sets the batting line-up accordingly, e.g., putting Jose Reyes batting first to increase the odds of scoring runs.
So what can repeated observations about life and money tell an estate planner? Where in the estate planner's line-up should we place life insurance? Does it belong outside of the estate in an ILIT, or inside the estate, owned by the testator?
Since the early 1990s, the irrevocable life insurance trust (ILIT) has been a mainstay of sound planning and has inspired multi-flavored variations. Yet, for estate planners, like baseball managers, there are objective truths that guide our decisions. Our future decisions are guided by applying mortality tables, interest rates, and the time value of money.
Inside or Outside?
In a recent lecture presented to the American Association of Life Underwriters, Vincent M. D'Addona of Strategies For Wealth observed that the mortality curve on an underwritten life (or lives in the case of last-to-die insurance) is not fully understood or appreciated by the professional community of accountants, lawyers, and life insurance professionals.
There is a common belief that life insurance helps pay estate taxes with discounted dollars. Practitioners therefore believe that life insurance should be positioned outside of the estate ab initio.
But analysis reveals this is not the most effective approach. At or near life expectancy, life insurance arranged in the typical manner provides no more than a bond-like rate of return as a death benefit. Considering the conservative investment philosophy of life insurers, this is to be expected.
Insurance products that are designed to have low initial premiums have even poorer long-term results because there is a much smaller base for compounding future returns. In addition, many of those secondary guarantee products have high hidden costs for the guarantees. Every dollar that is used for premiums in early years of funding a life insurance policy creates a higher opportunity cost for wealth shifting in the short run.4
Assume a married couple with both spouses at age 50 purchases a $1-million survivorship life insurance policy with annual premiums of $12,500 and that dividends offset premiums after 18 years.
The total cost of the $1 million appears to be $225,000. That's a return of $1 for every $.22 investment. But that overlooks opportunity costs, argues D'Addona. Assuming a 7% return, those premium payments would be worth $456,000 after 18 years. And the couple may not recover those funds after 18 years because both spouses must die before benefits are paid. Statistically, in this example, the joint life expectancy is 37 years. That $456,000 is not being invested for an additional 19 years.
In contrast, observes D'Addona, life insurance arranged inside the estate can leverage that "bond like" return capability, and therefore act as a holding tank for money that is being held for a variety of purposes, including waiting for other higher value opportunities. "This creates empowerment through flexibility versus restriction," he said.
The $10-Million Example
"The only disadvantage to owning life insurance in the estate," said D'Addona, "is that it is in the taxable estate and would be in the estate at the death of the second to die. However, when looked at holistically, if I were worth $10 million in assets built by the sweat of my brow AND I had $10 million of life insurance on my life as well, one could say that if I were to die now and my wife were to die in the same moment (obviously from grief), our total gross estates would be $20 million leaving a net $10 million to my children. This is the same result as if I were worth $10 million and had $5 million of survivorship life and we both died in the same fashion."
Q: This is very persuasive. Can you clarify in greater detail how you get those results?
A: This math is based on a few straightforward principles, including the amount of life insurance one can BUY, and how much they can SPEND.
A $10 Million Estate Scenario – Using an ILIT vs Purchasing Inside The Estate*
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Ins Type
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Death Benefit
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Estate Value @ Death
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Tax
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Net to Heirs
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Outlay
For
Insurance
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Opportunity
For Other Wealth Shifting Strategies
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ILIT
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Survivorship
Life
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$5m
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$10m
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$5m
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$10m
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Lower and Restricted
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Low
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No ILIT
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Single Life
On Male
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$10m
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$20m
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$10m
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$10m
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Higher and Unlimited
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High
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Assumes spouse dies around the same time, and that values exceed unified credit limits.
We know that up to 100% of the value of an estate can be bought in individual life insurance. While survivorship life can be bought in similar quantities there is a fundamental problem in that there are natural limitations on how much someone would spend on the product. These limitations are generated by the gift limits of life insurance purchased outside of an estate. Because of the necessity of squeezing survivorship life insurance into a finite space, the policy, by necessity, is generally designed to have a flat, non-increasing death benefit.
Assuming that we are talking about asset values in excess of the unified credit, a $10-million estate with $10 million of single life death benefit added to it (because it is in the estate) is $20 million at the death of the male (typically the estate creator). If it should happen that the spouses die at roughly the same time, then $20 million times the estate tax rate (roughly 50%) leaves $10 million for the heirs.
This is also true of a $10-million estate (in excess of credits) in which we positioned survivorship life outside the estate. That is, $10 million, less the estate tax of $5 million, leaves a balance of $5 million. Then add the $5 million of survivorship insurance that was held outside the estate and the heirs still end up with $10 million.
This math produces effectively identical results when death occurs early and presumably simultaneously. In the scenario in which the male dies first and the female survives by any meaningful period of time, there is really no comparison. This is true in every other circumstance as well. And in the case where we have engaged in the aforementioned wealth shifting strategies, the wealth differential gap gets wider and wider as time passes in favor of "No ILIT".
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Life Expectancy – Based on 2001
Commissioners Standard Mortality Table
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Life Expectancy if Just Underwritten at
Preferred Class
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Male age 55
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26 yrs
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33 yrs
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Male age 65
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18 yrs
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24 yrs
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Female Age 55
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29 yrs
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36 yrs
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Female Age 65
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21 yrs
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27 yrs
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Q: Is there a percentage based on the size of the estate or the size of potential liabilities?
A: The answer then is that the client should buy (or at least be informed that he could buy) the maximum amount of life insurance that an insurer would issue on his or her life. This is limited to the greater of 15 times annual income and 100 percent of the estate size. There is an overall underwriting limit of about $120 million due to reinsurance limitations.
It makes sense to insure 100% of the estate size in contrast with 100% of the estate liabilities because life is long, far longer than common sense would dictate. Once a prospective client can acquire life insurance this means that death of the insured is less likely than if they could not acquire life insurance easily.
In other words, life expectancy for someone recently underwritten and approved will be more in line with today's actuarial assumptions. Clients should know these numbers so that they can put into context the fear versus likelihood of untimely death. When understood, wealth-shifting strategies become a critical component in the planning process.
Q: Do you foresee a future adaptation for insurance products and trusts?
A: Ironically, today's laws, insurance products (especially whole life) and well-designed trusts, all lend themselves to my planning mechanism.
No adaptation is required. The missing piece in the estate-planning conversation is how mortality actually occurs in real life (not in the mind of a scared estate owner). When this is added to the conversation it can become apparent that perhaps the way the industry treats life insurance and the structures and mechanisms it uses for its ownership do not solve the real problem. I would rather be in the position of solving an estate tax problem for the long AND short term than to be focused on the short term only and to hope that the estate holder believes that I've done a good job for the future, too.
Q: Under what circumstances would you fund an ILIT with term insurance? For instance, would this be a useful hedge for estates that are in transition, such as one with current liabilities but high net worth in the future? Should it be used only temporarily?
A: We use term as a holding tank for insurability. Term insurance has its name because it is only valuable for a term of years. As term has a low price and very high cost in the long run, we prefer to own as much as possible in the estate with the intention of converting it to a permanent (whole life) or quasi-permanent (universal or variable life) form of coverage. The sooner a client can engage in acquiring permanent coverage and begin engaging in wealth shifting, the better the results for the client and family will be.
Term Insurance Policies (according to a Penn State study) have a 99% probability of not resulting in death claims. Term premiums therefore result in a 100% loss 99% of the time. Its premiums would therefore be a poor asset for a wealth-shifting strategy but if thought of as a stop-gap measure for a finite and pre-determined period of time, then it is not a problem whether bought in or out of the estate. It is important to recognize that term insurance inside of an ILIT may not necessarily be converted to a permanent form of coverage because of the premium payment limitations set by the gift limits.
Q: What's the best or most surprising question you've fielded when giving estate-planning seminars on this topic?
A: The question is, "but they (the couple) could still die early and that would cause the death benefit to be taxed. Shouldn't we still put the single life coverage inside an irrevocable trust?"
I am always amazed by this question. This question occurs generally at the end of the presentation after there is general agreement that the principles espoused are fundamentally correct. I have no problem with the asking of the question, but it does tend to show how embedded the traditional thought process is in the legal, accounting, and life insurance communities and how vested practitioners are in the standard solution.
They are missing the critical understanding about mortality. There is a difference between an estate tax that is a problem and an estate tax that is not a problem. If I am worth $20 million and I am fundamentally illiquid and my wife and I happen to die triggering an estate tax-the $10 million tax is a problem. If I am worth $20 million and I happen to own $20 million of life insurance on my own life in the estate and my wife and I die triggering an estate tax, there will be a $20 million tax-but it will not be a problem. Even though the estate tax is larger in the highly improbable scenario described, 100% of the estate passes after tax to the heirs.
Vincent M. D'Addona, CLU, ChFC, MSFS, AEP, is a principal of Strategies for Wealth in New York City. He can be reached at
vdaddona@strat4wealth.com
or (917) 453-4008.
TECHNICAL REFERENCES
1
We continue the discussion begun in Moshman, "Has the ILIT Lost Its Magic?", The Estate Analyst (Aug., 2007).
2
"It is designed to break your heart. The game begins in the spring, when everything else begins again, and it blossoms in the summer, filling the afternoons and evenings, and then as soon as the chill rains come, it stops and leaves you to face the fall alone. You count on it, you rely on it to buffer the passage of time, to keep the memory of sunshine and high skies alive, and then, just when the days are all twilight, when you need it most, it stops." - A. Bartlett Giamatti.
3
Sabermetrics is the analysis of baseball through objective evidence, as championed by Bill James. SABR stands for the Society for American Baseball, which was formed about 30 years ago and now has over 7,000 members in 50 chapters across the U.S. and in Canada, the United Kingdom, and Japan all conducting serious baseball research.
4
Mr. D'Addona notes that "Premium financing or loan regime split dollar is a common response. However, interest payments whether accrued (rolled up) or paid, have the effect of defunding irrevocable trusts. This, therefore, is not a real solution."
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Vincent M. D'Addona, CLU, ChFC, MSFS, AEP, is a principal of Strategies for Wealth in New York City. He can be reached at vdaddona@strat4wealth.com or (917) 453-4008.
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