Pension rescue and the fair market value of a permanent life insurance policy.

• Author: Smucker, David K.

"Pension rescue" (1) is a sales concept used to help sell life insurance to certain participants in profit sharing plans. In general, it purports to be a way of getting a very large life insurance policy out of a qualified retirement plan for a significantly discounted price.

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The common fact pattern for a pension rescue sale involves a client who is the owner of a closely held business, who has built up a sizable balance in his or her profit sharing plan, who now has other retirement resources but is facing a large estate tax liability, and who wants to find a way to get the money out of the plan at a significantly discounted value. As described in more detail below, the discount is achieved by purchasing a special kind of life insurance policy. The transfer for that significantly discounted value "rescues" the discount in value from taxation--thus the name. The problem with pension rescue is that it is based on a valuation of the life insurance policy that may not hold up to IRS scrutiny.

The following case study is hypothetical and does not portray a particular person or situation. All references to premiums, cash values, interpolated terminal reserves, and other values are not based on a particular life insurance policy. They are provided only to illustrate the pension rescue concept.

Henry had been a successful real estate sales representative for many years. When he was SS, he was approached by a life insurance producer who explained the pension rescue concept. At the time, Henry had $3 million in his profit sharing plan. Pension rescue sounded like a wonderful idea. Henry used $2 million from his profit sharing plan to purchase a special kind of life insurance contract that had a disappearing cash value. The policy had a death benefit of $4 million.

Ten years after the policy was issued, when Henry was 65, the cash surrender value had dropped to $700,000. Believing that the cash surrender value was the policy's fair market value (FMV), Henry had his profit sharing plan sell the policy to his irrevocable life insurance trust (ILIT) for $700,000. Henry was thrilled. He had to use $700,000 of his lifetime gifting exclusion to fund the ILIT for the sale,2 but he avoided having to pay income tax on the $1.3 million discount from the premium to the cash surrender value and had removed the entire $4 million death benefit from his estate. But as this article will show, that may not have been the correct outcome.

The Popularity of Pension Rescue

There has been a resurgence in the popularity of pension rescue.' Three developments have contributed to it:

1. The Department of Labor amended Prohibited Transaction Exemption 92-6 (PTE 92-6) to allow a plan that owns a life insurance policy on a participant's life to sell the policy to the participant's trust. (4)

2. Producers and clients believe that the cash surrender value of a life insurance policy is approximately equal to its interpolated terminal reserve (ITR, explained later), and that the ITR is the policy's FMV.

3. The insurance industry introduced no-lapse guarantee universal life insurance (NLG UL). As alluded to in Henry's example, the characteristic of those policies critical to the pension rescue concept is that the cash value decreases and eventually disappears altogether.

This article examines the interrelationship of several areas associated with pension rescue and NLG UL insurance:

* A basic description of NLG UL insurance;

* The mechanics of pension rescue or IRA rescue;

* The determination of the FMV of a life insurance policy;

* The role of the life insurance company in determining a policy's FMV; and

* The situation in which the pension rescue concept might leave the client.

In the process, this article examines the fundamental weakness in the pension rescue concept.

No-Lapse Guarantee Universal Life Insurance

Stock market declines since the beginning of this century have made variable life insurance unattractive to many investors. In addition, low interest rates have decreased the appeal of traditional universal life insurance. Real estate values are down. Having been battered by those unfavorable conditions, many life insurance buyers have developed an appetite for death benefit guarantees. The life insurance industry responded with NLG UL insurance.

The primary guarantees in a traditional universal life policy are the guaranteed minimum interest crediting rate and the guaranteed maximum mortality costs and administrative costs. In NLG UL, the life insurance company makes a secondary guarantee to the policy owner: If the policy owner pays the premiums as designed in the policy illustration, the insurance company will pay the death benefit even if the crediting rate drops below the guaranteed rate and even if the cash value disappears. In fact, in an NLG UL policy the cash value does disappear; it is taken up by the additional policy reserves NLG UL requires. In the end, the insured gets what is wanted--death benefit coverage until policy maturity. (5) NLG UL is essentially pure death benefit coverage for life.' It is stripped down, bare-bones death benefit coverage. Cash-value accumulation is not a factor. It is very attractive to people who need the coverage and who have been battered by the declining economy. As stated above, for pension and IRA rescue, the critical trait of NLG UL is its disappearing cash value.

The pension rescue concept may work with other products, but it works best with a single premium paid into an NLG UL policy, which is the only product that combines a guaranteed limited payment stream, a guaranteed death benefit--subject to the claims-paying ability of the insurer--and the all-important decreasing cash value. A qualified plan could use a regular universal life policy and not pay the premiums, which...