Some Pointers On Using Variable Universal Life In SERPs

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The flexibility of variable universal life insurance results in its use in many marketing applications, one of them being use in supplemental executive retirement plans.

As you may recall, in a SERP, the client heavily funds the policy during the pre-retirement years to maximize a level lifetime income during the post-retirement period. The heavy funding minimizes cost of insurance charges, enabling greater accumulation to occur.

Following are some ideas about how to structure such plans to achieve maximum benefit for your client.

First, consider using the Option 2 death benefit during the accumulation phase of the product. (Note: Under Option 2, the death benefit equals the sum of the specified amount and the account value.)

Here is the advantage to this approach: In most cases, the death benefit under Option 2 allows for the highest possible premium funding during the accumulation period.

Granted, the death benefits are higher than they would be with an Option 1 (level) death benefit plan; but the net result of using Option 2 is the greatest possible cash value buildup.

Next, when the policyholder reaches retirement age, suggest switching the VULs death benefit option to Option 1. This will minimize future COI charges. Once that is done, your client can start taking distributions.

Finally, bone up on how to handle those distributions. In the post-retirement years, these are usually handled as partial withdrawals to basis and as policy loans thereafter.

Assuming the VUL is not a modified endowment contract (under Section 7702A of the Internal Revenue Code), none of these payments would be subject to federal income tax under current tax law.

However, if the contract terminates prior to the insureds death, the full gain in the policy would be taxable. The insured would receive the gross cash value less the outstanding indebtedness.

Such situations are one of the greatest concerns to marketers. Here is why:

Since each income payment after a certain point is borrowed, the net cash value could well be a small portion of the cash value. The tax bill could thus be well in excess of the insurance policy proceeds. In fact, it is entirely possible there would be no net proceeds at all. In a VUL where there are no underlying guaranteed accumulations, the likelihood of such occurrences is even greater.

Therefore, it would be best to encourage your client to avoid such situations.

The condition that will most likely cause the policy to terminate is the policy loan reaching its maximum. Most VULs provide for a maximum ratio of loaned cash value to total cash value–say, 90%. When this ratio is exceeded, the VUL goes into a grace period, and will lapse unless the ratio is reduced to below the maximum.

Three critical factors can result in the maximum being exceeded:

–The owner takes out new policy loans as part of the targeted income stream of payments;

–The owner allows indebtedness to grow constantly, and along with it, loan interest accrual; and

–The policy experiences unfavorable investment performance and monthly deductions reduce the policy account value even more.

What can be done to eliminate the likelihood of lapse and the resulting large tax hit?

New approaches exist that automate the rescue process. The general idea is to create a situation, at the point at which the indebtedness is becoming dangerously large, where the following conditions apply:

–No further premium may be paid into the policy;

–Future death benefits will be minimized;

–Indebtedness in existence at the time of “option exercise” will continue with loan interest accruing;

–The unborrowed cash value would be transferred to the general account;

–No new policy loans (other than capitalization of interest) would be allowed; and

–The policy will terminate only upon death or surrender.

Such a feature enables the policyholder and his financial advisor to avoid one of the most dreaded nightmares associated with a financial plan–a large tax liability with no funds available to pay it.

, FSA, MAAA, CLU, is president of Actuarial Strategies, Inc., Bloomfield, Conn. E-mail him at caryl@actstrat.com.


Reproduced from National Underwriter Life & Health/Financial Services Edition, April 8, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.