A Cautionary Tale for Trust Owned Life Insurance (TOLI)

Life insurance may often be central to a insured’s plans. It can help provide for surviving family, build cash values, provide liquidity to pay estate taxes, and help provide a source of funds for family liquidity. In many situations, an insured chooses not to directly own the life insurance. Instead, their planning is executed through a trust which, among other assets, might own a life insurance policy on the client and/or the client’s spouse. An insured will oftentimes utilize a trust to keep the life insurance proceeds outside of the estate. In other cases, it is for professional management to assure that the survivors are cared for. In still other situations, an insured might want the privacy offered by a trust.

This post explores the various items trustees need to be sensitive to.  In particular, it focuses on areas where trustees might be exposed to potential liability and suggests ways in which corrective measures can be implemented to reduce exposure.

The Facts

  • The Pennsylvania Bar Association states the vast majority of trust owned life insurance (TOLI) is not performing as expected.
  • Of all in force TOLI policies, 70% do not have a life insurance advisor assigned for purposes of servicing the policy.
  • According to a survey conducted by Trusts & Estates Magazine 83.5% of professional trustees have no guidelines and procedures for TOLI.
  • Guaranteed insurance policies are losing their guarantees.

Facts about Universal Life Insurance

  • 7.2% – Average as sold interest rate
  • 4.7% – Average current crediting rate
  • 27.7% – Holdings projected to lapse
  • 9.7% – Lapse before life expectancy
  • 12.7% – TOLI with No Lapse Guarantees
  • 9.2% – TOLI with No Lapse Guarantees in effect

With over $18 trillion of assets under management, it is nearly impossible for a trustee to specialize in every asset class or type. Typical functions of a trustee involve the investment management activities, which includes quarterly performance reviews, Morningstar ratings, asset class benchmarks, portfolio rebalancing Monte Carlo simulations, and style drift studies.

Where challenges can occur is with the management activities of trust owned life insurance (TOLI). In many cases, beyond Annual Crummey Letters, procedures and guidelines have not been established by a trustee to monitor performance benchmarks and guidelines of not only policy cash values, but the performance and mortality cost(s) of the policy relative to what is available in the marketplace. This can oftentimes be attributable to general knowledge of the life insurance industry and the difficulties in obtaining necessary information from carrier(s) to make an informed decision.

Concern with Universal and Whole Life

Since 1984, the crediting and dividend rates of universal and whole life insurance policies have continued to decrease year after year. According to Contingencies Magazine published by the American Academy of Actuaries, “the premium needed to fund a policy at 4% interest is 150% greater than the premium needed at 6% interest.”

The impact of this on a life insurance policy can have many adverse affects and increase liability for a trustee if left unmonitored. In a scenario where a policy is performing historically at 2% less than what it was originally illustrated could result in any of the following scenarios (1) the policy will require additional premium for the coverage to continue as originally proposed, (2) the length of time the coverage will last is reduced (e.g. instead of the policy lasting to age 100, it may only last to age 90), (3) the policy will require premium payments for a longer period of time, or (4) there is a reduction in death benefit.

Concerns with Variable Universal Life

Variable Universal Life (VUL) allows a policy owner to participate in the gains and losses of the stock market. The cash value of the policy is invested in an array of mutual funds and, based on the performance of the investment(s), can have a positive or negative affect on the cash value and overall policy performance.  When illustrating a VUL, most advisors will use an 8% to 12% rate of return to determine how much premium is needed to fund the policy, based on the goals of the client and overall objective of the policy.

This graph depicts the average rate of return of the S&P 500 based on the year in which a VUL policy was acquired. For example, if a policy was purchased in 1997, the S&P 500 would have returned an average of 5.25% annually. The advantage of VUL is the client would not have to pay any taxes on the growth, provided the policy has remained inforce due to the tax benefits of the life insurance contract.  However, the 5.25% return does not assume any charges for mortality and expenses incurred by the policy, which can typically be 2% to 5%. Assuming policy expenses of 2%, a VUL purchased in 1997 would have had an average rate of return of 3.25%. As a result, there would be a significant difference between what was originally proposed and what has actually occurred.

In conclusion, variable life insurance appears to be a “good deal”, but because of lack of understanding and management of the policy and its performance, it typically falls short of meeting the client’s goals and objectives.

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