A Bigger Bang for your Life Insurance Buck
Variable-life policies can be even more productive than traditional life for solving fairness issues.
Family business owners frequently agonize over the question of how to divide their estate equitably among their children when some of the heirs do not work in the business. In many such cases, the husband and wife own the business jointly; when one dies, the spouse will receive the other's share free of estate tax. But what will happen in the next generation if not all the children are involved in the business and don't wish to become involved after both parents are gone? How can the parents divide their estate equitably when some of the children are non-participants? And how do the parents ensure their children will have the cash to pay the hefty estate taxes on the business after it is passed along to them?
Business owners are finding that a relatively new insurance product—variable-life second-to-die—solves these problems and offers significant advantages over traditional life insurance. Like traditional insurance, variable-life second-to-die policies provide enough liquidity upon the death of the second parent to enable family members active in the business to pay estate taxes, as well as generate cash for equalizing the inheritance of inactive family members. However, variable-life policyholders are allowed to determine how their cash values will be invested and have a variety of funds to choose from.
To illustrate, take the case of Gerald Miller, who founded a manufacturing company 30 years ago which today is worth $10 million. Miller, 64, knows that his wife will be provided for after his death, because three of their four children will continue to operate the business. However, the fourth child is on a tenure track at a nearby university and has made it clear he has little interest in switching careers.
In his estate planning, Miller is faced with the problem of how to distribute his assets equally while providing the $5.5 million the estate will have to pay in taxes after his demise. His son, the professor, would prefer cash over stock since he has little interest in the business. Along with lack of interest, he has little familiarity with the business. His brothers therefore feel it would not be appropriate for him to receive an equal share in the family company—25 percent—which would give him a strong voice in how it is run.
Working with a financial advisor, Miller discovered that he could use life insurance as an asset to help achieve his estate planning goals. Miller bought $8 million in variable-life second-to-die insurance. By establishing a trust to purchase the policy, he effectively removed it from his estate, thus reducing the potential amount of estate taxes his heirs would have to pay.
Upon the death of the second spouse, the policy provides $8 million of tax-free insurance proceeds. With this, the trust will purchase $5.5 million in stock of the company from his estate, providing the liquidity necessary to pay the estate taxes. The trust also would hold $2.5 million in cash from the insurance proceeds. The estate retains the rest of the company's stock, worth $4.5 million. The total worth of the trust and estate is now $12.5 million, even after paying all estate taxes.
After the second death Miller's estate will thus be distributed exactly as he had planned: The active children will divide the ownership of the business three ways, each receiving $3.3 million in stock; the one inactive son will get $2.5 million in cash—the equivalent of what he would have received if the stock had been divided four ways.
While Miller could have achieved the same distribution with a traditional life insurance policy combined with an irrevocable trust, he chose a variable-life second-to-die policy for several key reasons. As with a traditional second-to-die—or survivorship —policy, Miller benefits from the lower premiums, which can be as little as half the premium of two single life policies.
In addition, a variable-life policy offers the substantial benefit of flexibility. The insurance company holds the policy in an account that is separate from its general assets, because the investments are considered securities. Since separate-account assets are insulated from general-account assets, it is believed that courts will protect variable-life policies from the claims of general creditors. Thus, if the life insurance carrier experiences financial difficulties, the segregated assets would not be touched.
The “variable” aspect of the policy, moreover, had great appeal to Miller because, like many business owners, he likes to make his own investment decisions. Unlike other life insurance products, variable-life policies give holders control over fund allocation and distribution. Because of the wide diversification of investments, variable-life policies frequently show a higher rate of return.
General fund portfolios for other life insurance products are usually regulated as to the types and amounts of certain investments. Typically, only about 5 to 10 percent of general fund portfolios are invested in equities. The rest is invested in bonds, mortgages, and other fixed-income assets. By contrast, a variable-life policy allows business owners such as Miller to determine an asset mix from a much broader range of options—equities, fixed-income, international securities, real estate, and so on.
As investors know, equities have historically outperformed fixed-income investments. Since 1926, there hasn't been a 20-year period in which bonds have outperformed equities.
Variable-life policies also allow policyholders to switch investments at any time, as often as they want. Because of these features, the policies cost a little more to administer. The costs are generally from 25 to 50 basis points, or one-quarter to one-half of 1 percent of the annual yield. But if the impressive equity performance of the past continues, the yield will be more than enough to offset the charges.
Managing the investment of life insurance cash values will particularly interest savvy business owners who have long made similar decisions regarding their own investments. If they succeed in generating higher earnings by smart investment, policyholders can lower their total outlay or provide a higher cash value and death benefit.
A variable-life policy can be more responsive than fixed investments to trends in the investment climate. But there needs to be appropriate asset allocation—that is, diversification—between fixed and variable investments. A mixture of equities and bonds over the long term can produce a better return without a substantially greater risk.
Mark I. Solomon and Thomas N. Spitzer are managing partners of M Financial Group in Portland, OR. Through its 90 member firms nationwide, the company helps family business owners create wealth transfer programs and succession plans.