Group term life insurance: the old way or the new way? (Pesonal Financial Planning)by Godfrey, Joseph E.
Group Term Life Insurance (GTLI) in its traditional form is one of the most common employee benefits offered in companies. Recent data from The American Council of Life Insurance for 1990 shows that GTLI in force in the U.S. has grown from $13,000 of total coverage under only 12 certificates in 1912 to more than $3.754 trillion of coverage under 141 million certificates issued under 707,000 master policies as of 1990.
The typical employer sponsored GTLI plan often makes up a rather significant portion of coverage during an employee's working years, since the cost is generally deemed to be modest. Free post-retirement coverage used to be a great benefit for employees and executives, but tax law changes and the new FASB SFAS 106 rules on accounting for post- employment benefits have reduced its attractiveness. As a result, most companies are reducing or eliminating this benefit at retirement or age 65.
There are significant advantages clients can reap by reviewing how the GTLI promise is delivered during the working years. Instead of group "trip insurance" to age 65, which delivers nothing when a person retires except canceled rent receipts, he or she can pay for something (a "carve out" or "supplemental" plan) and end up with more. This is true regardless of whether the client works for a large multi-national corporation or a small, closely held business. By doing things more efficiently, the planner helps position the client to have future planning flexibility.
Innovative ways of providing life insurance protection can be provided for rates approximating GTLI, but with a valuable cash enhancement option that generate very high internal rates of return on any incremental difference.
The Old Way
Before presenting the new way, we need to review the old way. Premiums for traditional GTLI are fully tax deductible for employees of regular C corporations. The employees' taxable income has absolutely nothing to do with the premium paid by the employer.
Assuming that the plan is non-discriminatory, there is an exclusion for the first $50,000 of employer provided coverage, and the employee has taxable income under IRC Sec. 79 for the current economic benefit of coverage in excess of $50,000. This value is measured by the government mandated Table I rate. The imputed income charge is offset by whatever the employee contributes toward the cost of the employer's plan to determine the net amount to be shown as additional compensation on Form W-2.
For partners, S corporation shareholders, and sole proprietors, premiums are not tax deductible, nor do they receive the first $50,000 free. Partners, S corporation shareholders, and sole proprietors pay the entire premium for their group term life insurance with after tax dollars. This is exactly the same as employees in corporations who buy supplemental, contributory life insurance with their own after tax money.
The Old Way of Providing Supplemental Coverage
For purposes of reviewing and analyzing a model, in Figure 1 we use data for an actual company's contributory group life plan. First, we compare the annual imputed income under Table I versus the company's actual employee contribution rate under the existing plan. These five- year bracketed rates are fairly representative of what many large corporations charge employees. They are also indicative of what a sizeable CPA or law firm might be charging partners for coverage.
Analysis shows the deal being offered is that younger employees can buy GTLI (generally specified as a multiple of pay) in large amounts for somewhat less than the government's current imputed income for the coverage. When coverage is provided free, i.e., there are no employee contributions required, the tax leverage is the benefit from the employee's reduced cost on Table I taxable income rather than the contribution rate. Both of these approaches, however, fall in the domain of what we call the old way.
The New Way
The new approach to providing GTLI protection is the group carve out approach, either for executives only or for all employees, where the amount of coverage above $50,000 is delivered in a new, better, and different way. This can be especially attractive in smaller companies, although the idea is transferable to large companies as well.
Group carve out plans for companies need to be analyzed from both the corporation's and employee/executive's perspectives to see their cost effectiveness. By carving out the amounts of coverage in excess of $50,000 and delivering the excess amount differently, the company can reallocate premium payments from group term insurance (which has no residual value) into permanent insurance, which has cash value and allows for future planning flexibility. This gives the employer some of the tax leverage it previously had when there was a modest cost for employees before retirement, and no employees cash cost after retirement (although SFAS 106 has called for the current recognition of the accounting cost). The employee, under the carve out approach, changes the government mandated Table I tax cost, which had no cash value or other living benefits, into taxes on the premium for the cash value policy. The internal rate of return on the cash value generated by any modest incremental cost differential over traditional free GTLI coverage is very attractive as a benefit enhancement.
The employer's cost for GTLI is the actual group life premium billed, less any employee contributions. It is a "blended" rate for all employees, and cannot properly be used when analyzing coverage costs for specific people. To make a reasonable cost estimate for a specific employee's situation, we have found it useful to assume the price the employer pays for GTLI coverage to be some stated percentage of the national benchmark, the New York "Unisex" or "manual" rate. This is a generic, non-specific cost for one year term insurance on a group basis, and does not take into account sex, health, smoker status, medical history, or any other factor except age. The amount of the discount off this manual rate is based on the industry classification, with a low risk industry like accounting having a higher discount factor than a riskier manufacturing operation.
For our example we assumed a 50% discount off the benchmark rate that is a reasonable method by which to approximate the cost of delivering this benefit. There are several different ways to deliver the coverage amount in excess of $50,000. Our preference is for the company to make a 100% tax deductible payment on the carve out policy premium under Sec. 162 as an "ordinary and necessary expense of carrying on a trade or business," assuming that total compensation is reasonable. This company-paid premium would be treated as a bonus with the additional compensation going on the employee's Form W-2, where it will be fully subject to federal, state and local income taxes, FICA and Medicare taxes, etc.
We are using age 45 to be in the "middle age" range. We are assuming $200,000 of insurance that is two times the manager's annual salary of $100,000. Male rates are higher than female rates. We illustrated non- smoker rates; smokers pay higher rates. Some carriers also offer "unisex" pricing which blends male and female rates, and some offer "unismoke." Preferred risk rates are offered on more than 60% of representative cases, so that is what we showed. Please note that the new plan costs are modestly higher initially. This difference in cost can be treated in several ways:
* If the employer wants to remain in a "cost neutral" position, it can have the excess premium cost be fully paid by the employee with after tax dollars, so that the company's cost will be identical to the that of continuing under a regular group term plan;
* The company can pay the modest premium increase and charge it to the employee's salary account and the effect is that the employee pays the tax only, which is what we have illustrated here; or
* The company can give the employee enough bonus income to pay the tax cost, so the employee has no after tax cost for the life insurance program.
For this "one life" model we illustrate a 15-year graded premium whole life policy from a top rated mutual company. This policy form keeps the difference in premium between the term and permanent coverage to a modest level and can help make the switch more attractive. The premiums and cash values are all guaranteed. Dividends are used to reduce the premium outlay to keep company cost down. To be more conservative, we reduced the interest component in the dividend formula 2.00% (200 basis points) below the carrier's current rate after the third year. Other possible policy forms, including universal life, could also be used, depending on the client's preference for guarantees versus flexibility.
The insurance coverage that we describe is a "non-qualified" employee benefit. Flexibility is further enhanced because coverage can differ in amounts offered to various employees. There is no minimum and no cap on the amount of coverage available, assuming the employee is receiving reasonable compensation.
Please note in Figure 2 that because of the ever increasing cost of term insurance, the premium difference between the two plans begins to decrease by the eleventh year. You will also note that the employer's "cross-over" point occurs in year 18 when the discounted group premiums begin to exceed the total cost of the continuing $50,000 free (to the employee) term coverage plus the cost of the carve out policy. The differences become even more dramatic as age continues to increase. The employer comparison was done on a pre-tax basis.
From the Perspective of the Employer
Figure 3 compares the after-tax cost to the executive of $200,000 of GTLI with $150,000 of Graded 15 whole life carve out coverage. We used after-tax costs for the insurance since we wanted to look at the tax free build up of cash, and we needed to be on a comparable basis. We assumed a 40% marginal bracket for federal, state and local income taxes, FICA and Medicare Taxes, etc. In this analysis the financial planner can see that it may be in the client's best interest to invest cumulatively $7,121 extra dollars over the remaining working lifetime of twenty years in order to create $48,248 total cash value, plus future retirement planning flexibility. The $48,248 of cash value could purchase a guaranteed paid up policy of $80,011; or another option would be to continue paying premiums. The 25th year premium net of the dividend is $645, which generates a total cash value increase of $3,825. By the 28th year, the dividend would exceed the premium, which means the excess dividend could be used to buy additional insurance, or paid in cash to provide retirement income to the policy owner.
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