Life insurance can often be purchased under favorable terms and conditions through a qualified pension or profit-sharing plan. The insurance is purchased and owned by the plan, using employer contributions to the plan as a source of funds. Understanding their advantages can help anyone make the best possible policy-decisions.
- The premium is deductible by the employer as part of its annual contribution on behalf of covered employees.
- Life insurance products in a qualified plan can provide employees with retirement benefits at more favorable terms than would be available through individually purchased products.
- Lower premiums and higher dividends – In many cases, the economies of scale and efficiency of operation combined with a lower lapse rate make life insurance sold through a qualified plan highly cost effective for the insurer. This administrative savings can be passed through to the plan in the form of lower premiums and/or higher dividends than would otherwise be payable (even on individual products).
- Locking in present mortality standards – Upon retirement, the employee’s balance in the plan can be converted into an annuity for life at rates guaranteed today. When life insurance with a built in conversion to an annuity feature is acquired long before retirement, the employee may achieve more favorable guaranteed rates than might be offered in the future. The reason is that yearly payouts from life annuities may decrease as insurance companies adjust their mortality tables to account for longer life spans. But through life insurance purchased now, there is a rate guarantee that the annuity purchase rate will not increase in spite of longer life expectancies. Locking in at current rates may increase ultimate retirement income.
- No sales fees or other costs to purchase annuities – Unlike the case of a noninsured plan where the trustee must eventually sell trust assets (and incur attendant costs) and then purchase annuities to provide lifetime benefits (and incur yet another round of costs), when there is insurance in the plan, no extra fee or commission is paid for the purchase of lifetime annuities for retirees if done through the life insurance contract.
- Assuming that the insured plan participant is annually taxed on the Reportable Economic Benefit (REB) cost, the pure insurance portion of a qualified plan death benefit (i.e., the death proceeds less any policy cash values) is not subject to regular income tax. In other words the tax is not imposed on death benefits in excess of the cash surrender value immediately before the employee’s death. This makes it, dollar for dollar, a more effective means of transferring wealth than any other type of plan asset.
- A fully insured plan (Section 412(e)(3)) plan holding only life insurance policies and annuity contracts and meeting certain other requirements) is tax privileged. Fully insured plans generally are not subject to the Internal Revenue Code’s minimum funding standards and:
- are exempt from costly actuarial certification requirement—reducing the administrative overhead and complexity of a defined benefit plan; and
- generate a higher initial level of deductible plan contributions than a regular trusteed plan.
The Pension Protection Act of 2006 moved the provisions for fully insured plans from Section 412(i) to 412(e)(3) with no substantive changes. Note that although they are known as fully insured plans, they still must meet the incidental death benefit rules which limit the amount of life insurance that can be owned inside a qualified retirement plan.
- Some life insurance companies provide low cost installation and administrative services for plans using their investment products. This also reduces the employer’s cost for the retirement plan.
- In comparison to group term life insurance costs, life insurance within a qualified plan may be less expensive to the employee. This is because the employee can report the lower of the Table 2001 costs (see Figure 36.1; formerly P.S. 58 costs were used) or the insurance company’s rate (which in almost every case will be significantly lower than the reportable Table 2001 cost). That reportable amount can be lower than the reportable income under Table I for the same amount of group term insurance.
- From the employer’s perspective, life insurance within the qualified plan may be less expensive than comparable group term insurance because the employer in a qualified plan saves the conversion cost of group insurance. In a large group insurance plan of 1,000 employees, the group conversion charge may range from $60 to $100 per thousand. Overall, this could result in a significant charge against dividends.
- Greater amounts of life insurance can be provided to owner-employees through creative pension formulas than through group term plans. This is because there is more plan design flexibility in pension law than with respect to group term life law.
- Substandard risks can obtain insurance that might otherwise not be available on an individual basis. The additional diversification and spreading of risk available in a retirement plan often enables an insurer to accept a risk that would be turned down on an individual basis. This guaranteed issue leverage can be quite important where the owner-employee is the individual who is considered a higher than standard risk.
- Even if the life insurance company is not willing to issue life insurance on a guaranteed issue basis (generally starting at five or more insured lives), any ratings that must be paid are part of the employer’s contribution to the plan and, thus, income tax deductible to the employer. If the additional rating is significant, the fact that the employer can deduct it may be extremely important.
- Substandard ratings costs are not taxed to the insured employee. Not only is the employer paying the premium (through the plan) but the employer is also paying for any rating. Yet, in reporting taxable income, the employee reports the lower of Table 2001 (formerly P.S. 58) costs or the insurer’s standard term rates—no matter how high the actual rating paid by the plan.
- Life insurance in the plan transfers the death benefit risk to the insurer. This satisfies the moral obligation of the employer toward the family of the insured and will often provide significantly more dollars than if only the fund deposited to the employee’s account were distributed at death.
- In defined contribution plans, employees may elect to purchase insurance on the lives of certain relatives and even unrelated persons in whom they have an insurable interest. Within the statutory limits, the employee can buy as much as he wants to buy of the type of coverage he wants.4 This makes creative planning and “matching the product to the problem” more likely. For instance, a plan participant can purchase insurance on a business partner and use the proceeds to fund a buy-sell agreement.
- Life insurance within a defined benefit plan may create a larger deduction, even in plans that are maxed out. Furthermore, it is possible to maintain a large death benefit in a defined benefit plan even if a participant’s salary drops. For instance, if the plan’s benefit formula is based on the employee’s three highest consecutive years, the funding is based on those years even if currently the employee is earning significantly less. So the death benefit remains the same. Compare this with group coverage where the benefit drops if salary drops. In addition, life insurance within a defined benefit plan does not adversely impact the participant’s retirement income, as the plan will pay the same specified retirement benefit regardless of whether the plan holds life insurance. Compare this with life insurance inside of a defined contribution plan, where the life insurance costs soak up some of the retirement assets that would otherwise be available at retirement.
- A qualified plan may be used to incubate (some say season) a policy. In other words, the acquisition costs—the high upfront costs in the early years of the policy when outlays are not reduced by dividends—can be supported by the pension plan at the cost of reporting the economic benefit of the term insurance. Assuming the covered employee then purchases the policy from the plan for its full value after–say eight years—the employee may be receiving a policy with a lower premium than if he waited eight years and bought it on his own. If he has invested the money that he otherwise would have paid in premiums over those eight years, there may be enough to purchase the policy from the pension plan. However, the policy must be purchased for its Fair Market Value (FMV), which is generally the greater of the interpolated terminal reserve or Premiums plus Earnings less Reasonable Charges PERC (PERC) value—for more information see Chapter 26 “Life Insurance Valuation”. In some cases, especially if the policy is guaranteed no lapse universal life, the FMV may substantially exceed the cumulative premiums paid. Once the policy has been purchased from the plan, at that time the dividends or cash value may be considerable and may even be enough to suspend the premiums.
- At termination of employment for any reason or upon retirement, an employee can generally obtain an individual life insurance contract at original issue age rates. This makes coverage highly portable. It is also highly inexpensive in comparison to the conversion of group term insurance at the employee’s then attained age. A policy rolled out to the insured can often be kept in force with little or no outlay at retirement.
It is often possible in a defined benefit plan to pay out both a benefit of one hundred times and the auxiliary fund to the beneficiary of an older owner-employee participant.sured or making the ILIT an intentionally defective grantor trust with respect to the insured.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM