Does a Switch from Increasing to Level Death Benefit Constitute a Material Change?

EAJoe

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I've recently come across several IUL illustrations proposed using the "IRA Rescue" strategy that are funded as either a 3-pay or 5-pay. I have a lot of problems with this type of policy design, but this one is particularly worrisome to me. In fact, there are only one or two carriers that will allow this to happen in their illustrations. I'm going to use Minnesota Life in this example.

These "IRA Rescue" designs use a 3 pay or 5 pay as I said earlier, typically with the client liquidating the IRA or other "tax hostile" plan over the 3 or 5 year schedules to fund an IUL policy which then generates "tax free income" for the rest of the client's life instead of taking taxable distributions from a qualified plan.

In order to avoid a TAMRA violation which would classify the policy as a MEC, these policies have an extremely high initial death benefit. Because the death benefit is so high, the net amount at risk is also exceptionally high, leading to much a higher cost of insurance. In this strategy, the policies are illustrated starting with an increasing death benefit option and then switching to a level death benefit option in the year following the final premium payment.

In the year following the switch in death benefit options, the face amount is drastically reduced in order to reduce the net amount at risk. In the attached example, the death benefit drops from $3,148,438 to $763,013 in the 5th contract year. This is where the problems start. Internal Revenue Code Section 7702A states the following in reference to a reduction in benefits and the 7 pay test:

(2) Reduction in benefits during 1st 7 years

(A) In general​
If there is a reduction in benefits under the contract within the 1st 7 contract years, this section shall be applied as if the contract had originally been issued at the reduced benefit level.

This would make one assume that because these contracts have a (significant) reduction in benefits in the first seven contract years, that the 7 pay test would be reapplied with the new, reduced death benefit, and the 3 or 5 premiums already paid, thus the policy would be a MEC.

How do they get around this? Well, they use section 7702A's "material change" rule:

(3) Treatment of material changes


(A) In general If there is a material change in the benefits under (or in other terms of) the contract which was not reflected in any previous determination under this section, for purposes of this section—


(i) such contract shall be treated as a new contract entered into on the day on which such material change takes effect, and


(ii) appropriate adjustments shall be made in determining whether such contract meets the 7-pay test of subsection (b) to take into account the cash surrender value under the contract.


(B) Treatment of certain benefit increases For purposes of subparagraph (A), the term “material change” includes any increase in the death benefit under the contract or any increase in, or addition of, a qualified additional benefit under the contract. Such term shall not include—


(i) any increase which is attributable to the payment of premiums necessary to fund the lowest level of the death benefit and qualified additional benefits payable in the 1st 7 contract years (determined after taking into account death benefit increases described in subparagraph (A) or (B) of section 7702(e)(2)) or to crediting of interest or other earnings (including policyholder dividends) in respect of such premiums, and


(ii) to the extent provided in regulations, any cost-of-living increase based on an established broad-based index if such increase is funded ratably over the remaining period during which premiums are required to be paid under the contract.

In these policy designs, the switch from an increasing death benefit option to a level death benefit option is treated as a material change. Because of this material change treatment, the contract is treated as newly issued. Because it is newly issued, they lower the death benefit to the minimum amount within the cash value corridor, and reapply the 7 pay test to this new contract, which has had exactly $0.00 of premium in the prior 7 years, thus they do not classify it as a MEC.

My question: is there any precedent for treating the switch from increasing to level death benefit as a material change? It seems to be pretty hard to argue that a mere switch in death benefit is an "increase in the death benefit under the contract or any increase in, or addition of, a qualified additional benefit under the contract," especially considering the fact that the policy was designed to have such a switch take place prior to issue.

I find the treatment of a switch in death benefit options as a material change to be questionable, at best. What are your thoughts on this matter? Is this a time-bomb of liability waiting to explode? Is there legitimate precedence or justification for treating the switch as a material change? I don't see how an agent or client could reasonably argue that their initial need for over $3,000,000 in death benefit protection suddenly changed to $763,013, especially when this change is illustrated prior to the policy's issue.

There are MANY reasons I'm not a fan of the "IRA Rescue" strategy they use, but this one stands out amongst the rest. Thank you in advance for any input!
 

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What I got from reading this is that material changes are treated certain ways based on two factors.

1. In General
2. Certain Benefit Increases

In general is the de-facto treatment, certain benefit increases is actually a subset of the general class.

The death benefit is the death benefit. The qualified additional benefits payable seems to refer to pensions or maybe ABR's, DI, and other riders.

Is it a material change? Well, it is a substantial change wouldn't you agree?

Material - important; essential; relevant.
Substantial - 1. of considerable importance, size, or worth. 2. concerning the essentials of something.


The answer seems obvious.

Unless there is a legal precedent that says otherwise. :yes:
 
The approach is very interesting and proves to be a technique to tweak the limits of the MEC exception. From a liability aspect definitely not worth the exposure. Just my thought.
 
EAJoe,

I certainly share your concerns. I wouldn't like to have my own recommendations hang on such a (little known) technicality, particularly without proof from the carrier that that would be guaranteed to happen. I'd want to see the illustration or company literature promoting this, because *I* wouldn't want the liability exposure on such a recommendation.

Aside from that, there are a few other things:
1) $210,000 per year for three years would be added as taxable income for this person. I'm sure they'll be at the highest tax-bracket for such distributions. They must have a reasonable concern / fear that their tax bracket would grow higher than 39.6% per year.

Are these NET premiums adjusted after estimated federal and state taxes?

2) Illustrated surrender values don't "break even" until year 7. Assuming the total $630,000 is after-tax distributions, that's a while before being able to access their capital. Of course, it's showing a level high interest indexed credit per year.

3) As far as needing a $3 million death benefit, I could see it - this (should) be a high income, high asset person. It could be used as "reverse mortgage protection", social security offset needs, etc. But I do share your concern about the dramatic reduction of death benefit needs. It just LOOKS like someone was "churning" for commissions.

I think it would make far better sense to stretch these premiums over a 7 year period, especially since they're already 62 (according to the illustration). Fund a SPIA with 7-year minimum guarantee, then use that income to fund the IUL. You avoid a lot of problems doing it that way.
 
EAJoe,

I certainly share your concerns. I wouldn't like to have my own recommendations hang on such a (little known) technicality, particularly without proof from the carrier that that would be guaranteed to happen. I'd want to see the illustration or company literature promoting this, because *I* wouldn't want the liability exposure on such a recommendation.

Aside from that, there are a few other things:
1) $210,000 per year for three years would be added as taxable income for this person. I'm sure they'll be at the highest tax-bracket for such distributions. They must have a reasonable concern / fear that their tax bracket would grow higher than 39.6% per year.

Are these NET premiums adjusted after estimated federal and state taxes?

2) Illustrated surrender values don't "break even" until year 7. Assuming the total $630,000 is after-tax distributions, that's a while before being able to access their capital. Of course, it's showing a level high interest indexed credit per year.

3) As far as needing a $3 million death benefit, I could see it - this (should) be a high income, high asset person. It could be used as "reverse mortgage protection", social security offset needs, etc. But I do share your concern about the dramatic reduction of death benefit needs. It just LOOKS like someone was "churning" for commissions.

I think it would make far better sense to stretch these premiums over a 7 year period, especially since they're already 62 (according to the illustration). Fund a SPIA with 7-year minimum guarantee, then use that income to fund the IUL. You avoid a lot of problems doing it that way.

I completely agree with your points, DHK. Minnesota Life will not provide anything in writing about their position on the death benefit switch as a material change. They mentioned that their attorneys and a consulting firm reviewed laws and rulings and came to the conclusion.

To answer your questions:

1) No, the premiums are not adjusted whatsoever. I didn't include it in this illustration because it was irrelevant to the question I was asking, but the advisors and FMO promoting this strategy illustrate a loan in the 2nd policy year for the client to pay the taxes on the prior year's distribution.

Aside from that fact that it is, in my opinion, reckless to take such a large policy loan so shortly after issue, it is fundamentally flawed. If I took a distribution from my qualified account today, July 13, 2016, to fund an IUL policy issued today, the taxes for this distribution would be due on April 15, 2017, which is prior to the first policy anniversary. The client would either have to file for an extension and pay a potential penalty, or take a huge policy loan before the first anniversary ever happens, preventing any potential indexed interest from being credited.

2) I don't like this either. This is a result of the unnecessarily high death benefit/net amount at risk in the first four policy years. They position the need to liquidate the "tax hostile" plans as quickly as possible to their clients because of their belief that taxes are going to go up. They convince the clients that it's better to pay the piper now, than risk paying more later.

3) Agree here again - someone with a net worth this high likely has a need for this much insurance. I would find it hard to justify as suitable, let alone in the client's best interest, to design a policy that dramatically reduces the primary benefit of the contract - death benefit. It is my understanding that most of the people buying these policies have little to no need for the actual life insurance portion, and are primarily doing it to generate "tax free income."

I actually ran the 7 pay scenario yesterday showing $90,000 annually for the first seven years. The 7 pay breaks even around the 5 year mark, and the cash value actually exceeds the 3-pay come year 10. I would never personally illustrate a policy for a client at the maximum allowed rate, I was using to to demonstrate their design choices.

One last thing I should mention: The 3 pay scenario has a target premium of ~$105,000, while the 7 pay has a target premium of ~$45,000. Think about that one for a minute. How can the insurance company afford to pay double the commission to the agent and FMO for the same net total premiums without it coming out of the client's pockets? Hint: They can't.
 

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That last one is certainly a much better situation for the client and for the agent for a liability standpoint.

As much as I'm for maximizing an agent's personal income and commission, it has to be done right for the client in a responsible and ethical manner. I'd still be quite happy with a $45,000 payday, doing it right for the client, that would stand up to scrutiny by others... and even getting introductions to others who are in a similar situation! I'd do that all day long and twice on Saturday!
 
That last one is certainly a much better situation for the client and for the agent for a liability standpoint.

As much as I'm for maximizing an agent's personal income and commission, it has to be done right for the client in a responsible and ethical manner. I'd still be quite happy with a $45,000 payday, doing it right for the client, that would stand up to scrutiny by others... and even getting introductions to others who are in a similar situation! I'd do that all day long and twice on Saturday!
The sad part is, the clients who are buying these policies are so deluded by the unrealistic number's they're shown that they are over the moon happy when buying the policy. Their agent "rescued" them from the tax boogey man, and they're going to get tax free income for the rest of their lives, in their mind. I foresee a huge wave of lawsuits when some very high net worth individuals realize that they didn't buy what they thought they were buying.

In fact, many of the agents selling these policies use a third party supplementary illustration software that skirts AG49 by showing an arbitrage greater than 1%, and never refers to the product as "life insurance," nor does it say anywhere that the illustrated values are not guaranteed. I'd be very interested to hear their state insurance commissioner's opinion on their use of this software. I don't he or she would be very pleased.
 
many of the agents selling these policies use a third party supplementary illustration software that skirts AG49 by showing an arbitrage greater than 1%, and never refers to the product as "life insurance," nor does it say anywhere that the illustrated values are not guaranteed. I'd be very interested to hear their state insurance commissioner's opinion on their use of this software. I don't he or she would be very pleased.

What software is that?
 
What software is that?
It's completely proprietary, and completely non-compliant in my opinion. It skirts the AG49 rules on illustrating greater than a 1% arbitrage on variable loan rates and index crediting.
 

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