Why Policy Reviews Are Critical
Lack of policy diligence and structured reviews can wreak havoc on a policy’s performance.
Why Policy Reviews Are Critical By Scott Diamond
Are there hidden factors in your client’s financial plan that could cost him and those he cares about large amounts of money? How frequently should your client be reviewing his life insurance policies? As you know, life insurance is not a "set it and forget it" type of financial instrument—it can be affected by various things along the way.
Life insurance owned by a trust is a unique investment asset, one that requires attention on a regular basis. Lack of policy diligence and structured review processes can wreak havoc on policy performance, even triggering MEC status, which causes unexpected taxation on gains when the funds are withdrawn from the policy.
An advisor in our office recently shared an unfortunate series of events that occurred in his family:
"My father established trusts and purchased principal whole life insurance policies for my niece (25) and nephew (27) when they were born. With the subsequent evolution of Index Universal Life (IUL) products providing collared equity returns, tax-free compounding and transparent pricing, this was truly a no-brainer, win-win exchange with an IUL policy.
"In the final process of completing tax-free 1035 exchanges, we were first informed that these policies had been underwritten with ‘smoker-rate charges’. The policies amazingly had never been adjusted to ‘non-smoker rates,’ despite annual notices to the Trust offering simplified underwriting reclassification once my niece and nephew had reached age 18. What is worse, we were told that both policies had inadvertently fallen into MEC status within the first couple of years of their existence when the trust accepted an automatic policy rider that was deemed a material change.
"Since it had been so long since these policies had been looked at combined with the presence of limited digital records, the natural reaction from us was: ‘Let’s find out from the broker how this occurred.’ However, in this case, the broker had been dead for years.
"We are still working to assess the paper trail, but with limited digital records available, it is difficult to uncover everything. This is a perfect example of why it’s essential to have a trusted partner who will continue to monitor policies far beyond the time commissions are paid."
Although there was good intent in setting up these policies within an irrevocable life insurance trust (ILIT), the niece and nephew in this scenario are the ones who will suffer because of a lack of proper monitoring and due diligence along the way, although this is something over which they had no control. While situations vary, milestones should be set in place for routine, ongoing policy reviews.
These policies had problems within the first couple of years, which affected the taxation of withdrawals and conversions, but the sub-par smoker rates were never updated when the niece and nephew turned 18, creating additional costs. The policies have lost years of compound interest crediting, which could be withdrawn tax-free for future use by the niece and the nephew if the policies had not fallen into MEC status during the first few years.
Other issues to consider
Other factors, such as a low interest rate environment, could trigger the need for a policy review. Lower interest rates mean that the policy is receiving lower crediting rates, which could require additional premiums to be paid in order to keep the policy performing as intended. Different types of policies available today offer flexibility, premiums are often not fixed or guaranteed and amounts could fluctuate.
Trustees in this situation are expected to act as fiduciaries, even though they are often not involved in the initial portfolio or life insurance policy-selection process. In fact, once trustees accept appointment responsibility, they are expected to manage the life insurance portfolio to minimize risk to the beneficiaries.
However, according to the American Bar Association, "several states have enacted statutes that relieve an ILIT trustee of liability in managing life insurance as an investment."1 In those states, the trustee is treated more like a custodian than a fiduciary from a liability standpoint. Therefore, it is important to appoint an individual or a professional organization as a trustee who is willing to communicate with the advisory team that is implementing the policy.
Conducting regular reviews is essential to ensure implemented structures are still meeting the intended goals and to maintain competitive pricing. Insurance products evolve, tax laws change and there is constant need to make sure your client’s financial plan is providing the right assets to the right beneficiaries, in the correct way and at the proper time.
Scott Diamond is with Schechter, a wealth advisory and financial-services firm that advises wealthy families about financial matters, including institutional quality investment advisory services, alternative investments, advanced life insurance planning, income and estate taxes, business succession and charitable planning. To learn more, visitwww.schechterwealth.com or call 248.731.9500.
Topics: Running Your Practice