Are there hidden factors that your clients are not aware of in their financial plans that could cost them and those they care about drastic amounts of money?

How frequently should you be reviewing their life insurance policy with them? Although life insurance is sometimes erroneously portrayed as a ‘set it and forget it’ type of investment, the reality is that there are a variety of variables that can change along the way.

We have all heard of the common changes in life events, triggering updates in coverage needs or beneficiary changes. But what if the policy is owned by an irrevocable life insurance trust (ILIT) and managed by a third-party trustee?

(Related: Insurance Landmines Could Ruin Your Financial Plan)

Life insurance owned by a trust is a unique investment asset, one that requires critical attention on a regular basis. A lack of policy diligence and structured review processes can wreak havoc on policy performance, or even trigger modified endowment contract (MEC) status, which causes unexpected taxation on gains when the funds are withdrawn from a policy. An advisor in our office recently shared an unfortunate series of events that occurred within his own family.

A Real-Life Case Study

My father established trusts and purchased whole life insurance policies for my niece (25) and nephew (27) at the time of their birth. 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 to IUL.

When 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 notice to the Trust offering simplified underwriting reclassification once each had reached age 18. Worse yet, they revealed that both policies had inadvertently fallen into MEC status sometime 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 ever been looked at, combined with limited digital records, the natural reaction is let’s find out from the broker how this had occurred…. except in this case, he had been dead for years.

We are still working to assess the paper trail, but with limited digital records it makes everything more difficult to uncover. This is a perfect example of why it’s essential for your client to have a trusted partner that will continue to monitor policies far beyond the time commissions are paid.

Although there was good intent for setting up these policies within an ILIT, the niece and nephew in this scenario will be the ones who will suffer from a lack of proper monitoring and due diligence along the way – something over which they had no control over.

While situations vary, milestones should be set in place for routine, on-going policy review. These policies ran into issues within the first couple of years affecting taxation of withdrawals and conversions, but the sub-par smoker rates were never updated at the age of 18 thereby creating additional wasted costs. The policies have lost years of compound interest crediting, which could be withdrawn tax-free for future use by the niece and nephew, if the policies had not fallen into MEC status during the first few years.

Additional Variables to Consider

Other factors, such as a low interest rate environment could also 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, and premiums are often not fixed or guaranteed, and amounts could fluctuate.

Trustees in this situation are expected to act as a fiduciary, even though they are often not involved in the initial portfolio or life insurance policy selection process. In fact, once the trustee accepts appointment responsibility, they are expected to manage the life insurance portfolio to minimize risk to the beneficiaries. However, according to an article that appeared in an American Bar Association publication, “several states have enacted statutes that relieve an ILIT trustee of liability in managing life insurance as an investment.” 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 professional organization as trustee who is willing to communicate with the advisory team implementing the policy.

Your Client’s Plan is a Plan for a Reason

Performing consistent reviews is essential to ensure implemented structures are still meeting the intended goals and maintaining competitive pricing. Insurance products evolve, tax laws change, and there is a constant need to make sure your client’s financial plan is providing the right assets to the right beneficiaries, in the correct way at the proper time.

— Read Tax Overhaul Gave Clients With Irrevocable Life Trusts Work to Doon ThinkAdvisor.


Scott Diamond (Photo: Schechter)Scott Diamond is a wealth advisor at Schechter, a wealth advisory and financial services firm based in Birmingham, Michigan. He can be reached at (248) 731-9500.