Journal of Financial Planning - March 2005

"Financial planners should not entice folks into early retirement using the high returns of equity investments and flawed financial math."

Insuring a Good Defense

by Peter Katt, CFP, LIC

I really wanted to devote my first column this year to a completely positive life insurance idea and comment, but like most Super Bowl winners and NBA champs, it is good defense that makes the difference-this applies to helping your clients avoid life insurance/annuity mistakes. Three specific issues have come to my attention that I think you should be aware of now. I hope I can experience some letup in the long line of slick promotions with poor results and give you a two-thumbs-up idea before the year is over.

Death Futures

Lately, I have had numerous requests to evaluate proposals to buy life insurance for the sole purpose of selling the policy in two years (when the contestable period has ended) to a life settlement firm. Some of these proposals even include financing the premiums by a third-party lending institution using a non-recourse note. This death-futures lottery purports to provide profits for the insured and life settlement firm (and lender if premium financing is part of the scheme). This can be true only if the life insurance policies are not being priced correctly, the insured's health deteriorates more rapidly than what is standard for the passage of two years, or in the insurance company's hunger for premium dollars liberal underwriting causes them to hand out standard offers to impaired risks like treats at Halloween. Such head-in-the-sand underwriting creates instant mispriced life insurance.

Agents target the wealthy over age 60. There is no attempt to focus on any need for the life insurance. Instead the discussion is only about how much money the prospect can make by agreeing to become an insured-buyer-seller.

Let's look at the case of George. I recently spoke with George's CPA about the salable universal-life plan. Age 77 with some health issues, George was approached by a life insurance agent he has known for years. The salable universal-life plan has George buying a $5.5 million policy on his life with an annual target premium of $350,000. George was told he would keep the policy for only two years, paying the $350,000 premium for two years. The agent represented that after two years he would arrange for George to sell the policy to a life settlement firm for $1.4 million. But if the sale of the policy doesn't work out, the agent guarantees to buy the policy himself for $753,375 (premiums paid plus 5 percent). This policy has an embedded life expectancy of about 11 years for George, as a standard insured, when the policy is bought. The cash value after two years will be about $175,000 and there may be surrender charges.

If George's health is unchanged, a legitimate life settlement firm is not going to buy George's policy for $1.4 million. To do so would provide the life settlement firm a likely return of only 1.2 percent. George's life expectancy would have to fall four years because of a new health issue for a life settlement firm to pay $1.4 million. And if George has a standard-rated policy bought two years before, with a drop in life expectancy of four years at age 79, it is in George's interest to retain the policy himself. It doesn't seem to make much sense for George to buy a large life insurance policy in order to speculate on a substantial decline in his own health.

The only thing certain in this scheme is the agent receiving about $250,000 in commissions for the sale of the policy. If the agent then lucked out and the insured's health declined so the policy could in fact be bought, the agent would receive another commission of around $140,000 on arranging the purchase of the policy. What I would not count on is the agent showing up to buy the policy from George for $753,375.

The death-futures schemes that also include premium financing are more complicated. Go to www.peterkatt.com under ÒLife Insurance Perspectives' for the November 2004 issue to read about them. It is an ethical abomination to solicit well-off elderly persons to convince them to buy large life insurance policies they don't need or want, only to relinquish the policies to profit-seeking third parties in two years.

Personal Equity Plan: Another Tax-Avoidance Scheme

I have reviewed personal equity plans for three doctors in the past year. Again, life insurance is the funding asset. At least for the plans I have reviewed, a pretend loan from a third party is used to claim legitimacy for the payment of large tax-deductible interest payments by the doctors' corporations to the insurance company. A lot of work went into creating a paper trail for the personal equity plan to make it appear that the medical corporation is obtaining a loan from a third-party lender to justify tax-deductible loan-interest payments. But, in fact, the loan shows up in the doctor's life insurance policy as an unscheduled premium. These unscheduled premiums are booked by the doctor's life insurance policy as collateral loans and the medical corporation pays 12 percent tax-deductible interest on the unscheduled premiums/collateral loans to the insurance company. The doctor's salary is reduced by a like amount and he or she also pays some of the premium personally with after-tax funds.

These maneuvers are truly goofy. They should be immediately obvious except that the boldness of this scheme initially left me uncertain about what I was seeing. But then I assisted a doctor with terminating his plan. Many impressive documents are needed to release various security interests between the insurance company, medical corporation, and doctor but no one actually received any money. The third-party lender received nothing, the medical corporation received nothing, the doctor paid nothing, and the policy loan went poof. This convinced me that there simply isn't a lender, and therefore there isn't a loan, that appears to exist only to justify a large tax deduction for the payment of premiums. This result is very similar to a leveraged split-dollar scheme that was smashed by the Internal Revenue Service in 1994. I think the same insurance company was involved.

I'm not sure the IRS has caught up with this one yet. Regardless, if you have a client in a personal equity plan, you should have them get out of it and hope it gets by the IRS. If not, the corporate interest payments will probably be treated as constructive dividends. For more details and personal-equity-plan case study, go to www.peterkatt.com under Life Insurance Perspectives for the December 2004 issue.

Variable Annuity Retirement Riches

A professional acquaintance with many years' experience in the investment world has provided me with details of what is apparently a very popular scheme to convince 50-something workers to retire early based on projections that their accumulated company retirement funds will replace their working income. Sam is 55 years old, earning $40,000 with $500,000 in company retirement accounts. He responds to a financial advisor's advertisement promising early retirement without loss of income.

During their meeting, the advisor calculates that Sam can safely receive retirement income of $40,000 and that this income will not be subject to pre-age-59- 1/2 penalties because of IRC Section 72(t). (The maximum amount of income that Sam can currently receive under 72(t) is $31,000, not $40,000, but it is my understanding that financial advisors ignore this changing limit when they need a higher income amount to close the deal. A higher retirement income amount under 72(t) isn't an issue the IRS pays much attention to because they collect taxes on the retirement funds earlier when more income is received. There is no issue of a loss of tax revenues involved).

The news that Sam can retire with the same income is followed by even better news. The advisor shows Sam historical investment returns of 15 percent from an aggressive mutual fund to substantiate a ledger that cautiously depicts a 12 percent constant yield. This ledger depicts Sam receiving annual retirement income of $40,000, with his retirement nest egg growing to over $5 million when he and his wife are 88. Some advisors would use this very large retirement fund balance to recommend that Sam and his wife also buy life insurance to pay the estate taxes they will face.

Sam moves his company's retirement funds to the advisor firm's IRA rollover account, which then buys a variable annuity. Sam begins annual withdrawals of $40,000 from his VA. Because robust investment results are needed to produce enough income to make early retirement attractive, the advisor likely recommends that Sam's VA be invested in aggressive equity sub-accounts. The income to which the advisor is referring comes from capital withdrawals from the VA sub-accounts. Sam and many like him have lost substantial amounts from their nest eggs because of stock price declines during recent years. Many Sams are going back to work at much less attractive jobs because they gave up their careers early.

But don't think what is happening to these early retirees is an anomaly due to the bursting of the 1990s stock bubble. An underfunded early retirement using aggressive and arithmetic mean investment return assumptions is very risky at any time. This isn't a timing problem. Sam represents a composite of early retiree funding. My firm ran a stochastic analysis of the probability that Sam's nest egg of $500,000 would be able to provide him with the promised $40,000 a year for life, assuming he uses an all-equity investment strategy. Using a 12 percent arithmetic mean (actual average from 1928 to 2003), minus VA expenses and a standard deviation of 20.4 percent, we found a 38 percent probability that Sam or his wife will outlive their retirement income. If a 10 percent arithmetic mean is used, the probability is 53 percent, and if we add a 3 percent cost-of-living adjustment to the retirement income, the probabilities of outliving their retirement funds are 63 percent at 12 percent mean and 79 percent at 10 percent mean. Outliving retirement funds doesn't completely explain the enormousness of the problem, as early retirees potentially face years of uncertainty as retirement funds are receding.

Financial planners should not entice folks into early retirement using the high returns of equity investments and flawed financial math. The Sams of the world should retire early only if their desired retirement income (with COLA, if they want it available) can be provided via government bond yields.

Reprinted with permission by the Financial Planning Association, Journal of Financial Planning, Volume 18, Issue 3, March 2005.

Peter Katt, CFP, LIC, sole proprietor of Katt & Co., is a fee-only life insurance adviser located in Kalamazoo, Michigan (269.372.3497).