For years, insurance companies have tried to develop a product that delivers the benefits of annuities and life insurance without the pitfalls. Annuities offer growth, but in the event of the owner’s death, that growth is subject to federal income taxes. Life insurance provides a federal income tax-free death benefit, but traditional policy expenses can mitigate growth of the account value.

Take an average variable annuity, for instance, which charges around 1.25% annually for mortality-and-expense risk. Consider adding a guaranteed minimum withdrawal benefit or an enhanced death benefit guarantee and you’re now approaching 2.4% in average annual fees.

To maximize income tax deferral, many annuity holders retain these products and pass away with their annuity investments untouched. They intend to leave these assets to heirs, who are then obligated to pay federal income tax on the earnings.

In this situation, the annuity balance can be significantly depleted by taxes before it is passed on. Annuities can be very useful tools for accumulating wealth and providing income, but inefficient vehicles for wealth transfer upon death. On the other hand, life insurance includes management fees and cost of insurance (COI) coverage — unnecessary burdens when the ultimate goal is accumulation.

Consider this scenario: Steve is a 65-year-old male with more than $7 million in assets. He has adequate income to maintain his current lifestyle and his main concern is passing money onto his heirs. He has $1 million in a money market account intended for his son and he is considering moving the money into a variable annuity or purchasing a traditional life insurance policy.

If he purchases a variable annuity, a gross account value of $1,275,000 after five years would leave a death benefit of only $1,178,750, assuming a 35% tax bracket for his son — that’s nearly $100,000 in federal income tax.

Should Steve choose the life insurance policy, the COI on his contract will increase as he gets older. If it is under-funded, the COI will begin to deplete Steve’s assets. It’s even a possibility his policy could run out of cash-value and lapse without benefit, unless he begins paying additional (and often times hefty) premiums into the policy. He could also purchase a “no-lapse rider” offered by many insurance companies, but would incur additional costs, lowering the growth of the account. This is a daunting situation, especially considering he believes his son’s inheritance is protected and would grow at a reasonable rate.

Numerous affluent investors like Steve face this same situation. In fact, 2005 marked the second consecutive year that U.S. millionaire households increased by 11%. Many of these aging clients have funds they intend to pass on to their children, grandchildren, other close family members, or religious and charitable organizations.

These individuals are increasingly overwhelmed with the task of directing numerous wealth managers. Ideally, products used by this high net worth group should provide privacy, control, flexibility, tax-favored investing and asset growth with financial protection for heirs.

Most of the assets earmarked for heirs have little to no chance of being needed as income for this group. These funds may be sitting in annuities, managed accounts and mutual funds with a transfer on death (TOD). The funds may also reside in CDs, savings bonds, treasury bills or antiquated pass book accounts with payable on death (POD) provisions.

Variable life products can be good vehicles to effectively transfer wealth. However, buyers of many of these products must deal with pricing transparency issues, vague illustrations, unexpected price increases and the possibility of running out of cash value. Also, the products may be improperly designed for the goal, as when planners must suggest a certain amount of insurance for tax deferral purposes, creditor protection (depending on the state) and federal income-tax-free death benefits.

The Solution

Fortunately, some new variable life products help to address these issues by providing the measurable financial growth expected from an annuity and the tax-efficient wealth transfer benefits found with traditional life insurance. These products work to solve the life insurance problem of diminishing returns, while also addressing the tax shortcoming of annuities.

The best among them work more like asset management vehicles than traditional life insurance policies, while still providing a federal income tax-free death benefit. This is achieved with what I refer to as a “cash-driven” (as compared to “death benefit-driven”) policy structure.

One policy in particular funds the minimum amount of death benefit needed to remain classified as life insurance by using an age-variable death benefit factor. This daily calculation ensures a minimum is spent on insurance and a greater amount is left to work in the market.

Other features with some of these new products include fee transparency, commission-based and fee-based versions, no surrender charges and a no-lapse design (as long as outstanding loans do not exceed account values).

These wealth transfer solutions allow the client to spend the least and reinvest the most while efficiently investing funds on a tax-deferred basis. For affluent clients who require solutions that go beyond the conventional use of life insurance, these products are worth exploring.

Marc S. Whitehead is the managing member of HFS Distributors in Mobile, Ala. He may be reached at .