Personal Trustees of Life Insurance Trusts Beware
Personal Trustees of Life Insurance Trusts Beware
If your clients serve as trustees or if your clients have set up life insurance trusts, this discussion is of great importance to you as their advisor. We have observed that the most common trustees of life insurance trusts are individuals who know little about the job. They are often placed into the position due to cost or convenience, with little regard for the liabilities they face. This practice is unlikely to change. When people set up irrevocable life insurance trusts (“ILIT’s”), their main purpose is to structure the insurance ownership to avoid a negative impact on their estate taxes. That’s all. No more assistance is needed --- they think. While professional trustees including banks fully understand what they are supposed to be doing, these entities tend to charge more than the client is willing to pay. After all, while the client is alive, there really isn’t anything to do except pay the premium. Right?
Well, there is a Little More to This Story...
Few grantors of trusts seem to fully understand that the trustee is the new owner of the
insurance and that the grantor needs to avoid making decisions that can violate a key purpose of the trust – which is separate ownership and management. So, while it makes sense to hire someone who won’t charge a fee for doing almost nothing, few people understand that the trustee is actually expected to do much more than pass the premium along to the insurance company. Specifically, let’s use the word that says it all: fiduciary. And if that isn’t enough, we need to add that trustees have investment duties which are outlined in the Uniform Prudent Investor Act (“UPIA”). For you lawyers, check out the case, Cochran v. Key Bank, which clearly demonstrated the trustee’s duty to monitor and manage trust investments including life insurance.
The trustee is expected to manage the life insurance throughout the years prior to the death claim. That function would be easy if the coverage was term, but term insurance is not the best product to use when it comes to paying estate taxes, which are likely to occur years after most term policies terminate. Most term policies are gone by ages 70-80. The preferred products for ILIT’s are cash value policies that come in several forms: fixed universal life, whole life, indexed universal life, and variable life. Also, coverage may not be on a single life. Survivorship products, which are based on two lives and pay the death benefit upon the second death, are significantly less expensive and enjoy widespread use.
So, where can things go wrong? Key areas are policy funding, policy modifications, cash value allocations, and policy upgrades. Let’s look a little closer.
Typically, a premium pattern is set up at the outset of the policy. It is often a level amount
for a selected number of years, with the intention of funding the coverage for the life of the insured(s). When guaranteed no lapse coverage is used, the policy’s guarantees can be reduced or eliminated if premiums are not paid on a timely basis. In one study, over 30% of guaranteed life insurance policies had compromised the policy’s guarantees within the first 4 years of ownership. Here’s what’s even more surprising: one of the main causes was early payment of premiums! Trustees may not even know that they have failed the timing test and may not know how to cure the problem until it is too late. This makes it critically important for trustees with these guaranteed products to stay on top of the premium payments and the policy’s status with the carrier.
Whole Life May Not be That Much Safer
For other policies, such as whole life, the failure to pay a premium on time can trigger a policy loan to cover the missed premium. That is not particularly uncommon, and it is often a standard part of the initial policy design where “automatic premium loan” is selected. However, once owners start down this path, they can find themselves with very large loan amounts that are fully covered by the cash value but which destroy the intended economics of the policy. This will limit flexibility in the future if changes are warranted and it reduces the death benefit dollar-for-dollar. Skipping premiums on policies other than whole life can diminish the intended cash value, even if no loan is triggered. This is often not even noticeable, but the policy may be set up for a lapse unless larger premiums are added in the future.
It’s not Just the Health of the Policy
Closely related to managing premiums to keep coverage in force for life is the question of whether client health in the future warrants a
different premium pattern. For example, what happens if the insured suffers a decline in health? This could reduce life expectancy. Why does that matter? Well, you might be paying too much premium, because the selected premiums were intended to fund coverage to an age that is clearly later than the revised life expectancy. We worked with a wealthy client who was diagnosed with terminal cancer. His family might have paid their annual premiums of $160,000 because they didn’t want coverage to lapse. However, upon analysis of the policy, they learned that the cash value allowed them to skip the next two premiums and still keep the full coverage in force. Paying those premiums would have cost the family $320,000. Who would the beneficiaries have blamed for that? The trustee of course.
And Current Rates are Not Helping
A more common funding problem has been caused by declining interest and dividend rates. For variable policies, this could be caused by disappointing investment performance. For whatever reason, many policies are now underfunded. The cash values are below initial projections, and there is less likelihood of the policy remaining in force as long as planned. By catching this early, clients can employ several approaches. For example, they can increase premiums to correct the funding shortfall, or they can decrease the death benefit to an amount that would be fully funded with the current premiums. Either way, the trustee must be active and careful. Lapsed coverage is something that may cause a beneficiary to bring legal action against the trustee. Similarly, an intentional reduction of the death benefit to keep coverage in force as long as intended could also trigger beneficiary action. We will leave it up to the lawyers to help the trustee navigate this problem, but it is likely that one of the key steps will be to gain some buy-in from
the beneficiaries before dropping a death benefit.
Sometimes a policy modification is in order. For example, a policy may have been issued on a rated basis or on a smoker basis. Trustees should keep current with the health status of the insured in case the amounts charged for coverage could be reduced due to better health or stopping smoking. These modifications may not seem like much, but with so many policies turning out to be underfunded due to various causes, trustees need to be careful to avoid the appearance of not paying attention to every detail.
How is the Cash Value Managed?
Both indexed and variable policies require ongoing management of the investments that make up the cash values. Indexed policies often offer several different index approaches and a fixed account. Wise allocation among these choices is a given on the list of trustee responsibilities. The need for active allocation multiplies when we are looking at variable policies which can have dozens of fund choices needing periodic review. Yes, the trustee may want to rely on a professional wealth manager for the allocations, but the ultimate decision remains with the trustee. There is always going to be some extra risk for the trustee when a policy becomes underfunded, and it is not evident that the trustee did what was required to keep the investments allocated properly. Yes, that may be a matter of opinion, but doing nothing over a long period of time is pretty self- evident of a failure to manage properly.
This is perhaps the area where AdvisorServe has been most active. Objectives change, client health changes, and newer and better policies become available. A good trustee will regularly look for ways to serve the beneficiaries of a trust. The life insurance industry is quite creative in developing new products to address client needs. This is most clear to us when we are reviewing policies that are demanding premiums far in excess of what can be found in newer competitive products. Insurance rates are generally lower due to longer life expectancies. Premiums can also be lower due to more efficient ways to fund death benefits without huge cash values, for example.
We have frequently encountered whole life policies delivering increasing cash values and increasing death benefits, but requiring very high premiums. In many situations we have been able to deliver similar or higher death benefits with significantly lower premiums. While the give-up might be in the form of cash value, most policies ultimately pay the specified death benefit without regard to the cash value. To put it another way, the life insurance company keeps the cash value when paying out death claims. Conversely, we can keep the premiums where they are, but then raise the death benefits on a new policy, sometimes to a level that is twice as high. Here again, a good trustee will watch what the trust owns and keep it current.
Trustees need to understand that they are not simply doing their friend the grantor a favor. They must understand that they have become a fiduciary to others --- the beneficiaries. Sure, it is pretty common and often an honor to be named a trustee, but significant responsibility
comes with that honor. In a good way, the trustee can add another voice and new ideas to make sure that the insurance trust works in the best possible way. However, with the responsibility also comes liability. That liability can become an expensive legal liability if any beneficiary comes to the conclusion that they were not well served. This is an obvious result if life insurance fails to deliver its benefits for any reason. It may be a less apparent result until beneficiaries believe mismanagement has occurred to their detriment.
Keeping it Simple for the Trustee
For this reason, AdvisorServe believes that the best thing trustees can do is conduct periodic policy reviews with documentation of their efforts. This will certainly be more proactive than the common approach, but the simple act of requesting a policy audit can give the trustee important information he or she needs to know. What is uncovered can be of great value to the beneficiaries, and open the door to improving or protecting what is in the trust. It can also protect the trustee from unexpected challenges and liability.
So, whether your clients are trustees or have designated unsuspecting friends or relatives in that role, advisors should encourage their clients to closely track those insurance policies for much more than meets the eye.
AdvisorServe can help. Give us a call.