Fixing the Imploding Irrevocable Life Insurance Trust
Last August, a
Traditional Policies
Until the 1980s, individuals most often funded ILITs with guaranteed, whole life policies. This type of traditional policy provides lifetime guarantees to the insured with regard to the death benefit, and the issuing insurance company bears the investment risk. In this context, the fiduciary responsibilities of an ILIT trustee primarily involve reviewing the financial stability of the insurance carrier annually, making timely premium payments and issuing Crummey3 notices. Certainly, legal and tax issues can arise, for example if split-dollar or other loans are used, but generally the policies as a trust investment function in a straightforward manner with minimal liability for the trustee.
Non-guaranteed Policies
In contrast, flexible premium, non-guaranteed policies shift the investment risk to the policy owner, the trustee in the case of an ILIT, and don’t guarantee the length of the policy coverage. Carriers developed these policies in the 1980s, during an economic period of hyperinflation and high interest rates. The newly created product addressed consumer reluctance to invest in more expensive, traditional whole life policies with conservative investment returns. These universal policies retained popularity into the early 2000s.
With universal life insurance,4 the policy owner contributes the premium payment and, after the carrier deducts expenses, the carrier invests the balance of the premium at market rates to cover future costs. Agents prepared illustrations showing the length of coverage using typical interest rates at the time of the sale. When these products were developed, the 10-year
Low Interest Rates
During the past decade, interest rates have remained at historically low levels, well below the highs of the 1980s and 1990s, and often far below the illustrations for these policies at the time of sale. In the past three years, the 10-year
Risk of Lapsing
Today, these policies run the very serious risk of lapsing, creating a nightmare for trustees. As of 2014, as many as 40 percent of in-force flexible premium non-guaranteed policies were carrier illustrated to lapse during the insured’s lifetime or within five years of the insured’s estimated life expectancy.7 Adding to the distress, carriers this past year announced increased internal charges associated with the policies.8 This increase will further erode the policies.
Unless the ILIT grantor is willing and able to make significantly higher premium payments to maintain the desired length of insurance coverage, these policies may begin to implode. Trustees typically uncover issues with the viability of the insurance policies during the annual trust review process. Corporate fiduciaries have systems in place for these trust reviews, and this allows sufficient time to address problem policies. Inexperienced individual trustees may not become aware of problems until a crisis is reached.
Possible Solutions
Possible solutions involve both changes to the insurance policies and opportunities pursuant to the trust agreement or applicable state law. Options with regard to the policies include lowering the death benefit to extend the length of coverage to age 90 or 95, using the cash surrender value to purchase a new policy with a reduced death benefit (if the health of the insured allows) or considering the life settlement market. None of these is necessarily a satisfactory resolution because each option results in a reduced payment to the trust beneficiaries. Each option must be considered in light of the trustee’s fiduciary responsibilities and guidance provided by case law.
Duty of Loyalty
First and foremost, the trustee has a fundamental fiduciary duty of loyalty to the trust beneficiaries. In the context of an ILIT, this duty can prove challenging. Because the grantor created the trust and often continues to make decisions about premium payments on the insurance policies, the grantor may overlook the fact that, legally, he no longer has ownership and control over the policies. In truth, the trustee may have a closer relationship with the grantor than the trust beneficiaries. Ultimately, however, the trustee is responsible for ensuring that the beneficiaries receive the maximum benefit from the trust assets, and this fiduciary obligation can strain the relationship with the grantor. Depending on the terms of the trust and state law, if the grantor fails to make sufficient premium payments to sustain the necessary length of policy coverage, the trustee may have a fiduciary obligation to inform the beneficiaries. This may be the case despite the fact that the grantor wishes to keep the information confidential. The grantor may also be willing to take greater risks by shortening the length of policy coverage to a greater extent than the trustee with fiduciary responsibilities to the beneficiaries can justify.
Uniform Prudent Investor Act
Further, a majority of states have enacted a version of the Uniform Prudent Investor Act,9 and pursuant to this statute, the trustee has a duty to invest trust assets according to the prudent investor standard. This duty generally requires the trustee to invest as prudent investors would invest “considering the purposes, terms, distribution requirements, and other circumstances of the trust”10 and using “reasonable care, skill, and caution.”11 There’s an obligation to diversify investments unless the trustee “reasonably determines that, because of special circumstances, the purposes of the trust are better served without diversifying.”12 In the context of ILITs, a few states13 have added legislation allowing less strict standards for trustees of ILITs in recognition of the fact that these trusts are designed to hold life insurance policies. However, the majority of states and older trust documents don’t address the unique qualities of an ILIT, and in this context, the trustee is held to traditional standards.
Although there’s a paucity of case law addressing these fiduciary obligations in the context of ILITs, a 2009 case from
Both the trial court and
French v.
In French, the grantor executed two life insurance trusts.
Circumstances may arise in which options available with regard to the policies won’t resolve the issues. The grantor may not be insurable so the option of replacing the policy isn’t possible. Also, the family may be willing to take a calculated risk with regard to the policies and the insured’s life expectancy that may be untenable for the trustee. Fortunately, the document itself may offer a solution by providing a back door. For example, the trustee may have discretion to distribute the trust assets outright to the remainder beneficiaries during the life of the grantor. If the trustee exercises this discretion, it allows the beneficiaries to own the policies outright, free of trust, and take whatever risks they wish with regard to the policies, and the proceeds will still remain outside the grantor’s taxable estate. A downside to this option is that the policies will then be subject to the claims of the recipient’s creditors.
Some states, such as
In jurisdictions that have adopted the Uniform Trust Code (UTC), similar options may be available to change the trustee or trust situs or reduce the trustee’s liability for retaining the insurance policies through the use of nonjudicial settlement agreements. Under the UTC, the settlor’s consent isn’t needed for these agreements. This may provide broader applicability and flexibility in the context of second-to-die policies when one grantor has already died. However, a nonjudicial consent modification, rather than a nonjudicial settlement agreement, is necessary under the UTC to terminate the trust and distribute the policy to the remainder beneficiaries. This statutory provision requires the consent of the grantor, so both grantors must be alive to use this provision if the trust holds a second-to-die policy.
Decanting, the statutory authority of a trustee to distribute the trust assets to one or more beneficiaries by transferring the trust assets to a different trust, may also be an option. Twenty-one states have enacted this type of legislation. To have the most flexibility under a decanting statute, the trustee needs authority to distribute the trust assets to the beneficiaries. As a result, decanting to a different trust in the context of an ILIT is useful if there’s a reason that the trust beneficiaries shouldn’t receive the policies outright, such as creditor concerns or generation-skipping transfer tax goals or if another statutory provision isn’t available. Decanting to a new trust will allow amendments to the trust document, and these might include adding provisions for the appointment of an individual trustee or changing the trust situs and governing law to provide for reduced trustee liability if the current document doesn’t provide for these options. In any case, care must be taken to review all possible tax consequences of decanting.
Historically, grantors and trustees viewed life insurance as a “sure thing” from an investment perspective. That’s a dangerous assumption. The crisis with older, flexible premium, non-guaranteed policies drives home the challenges faced by the ILIT trustee and the necessity of reviewing the insurance policy as an investment. An ILIT trustee can only navigate this treacherous terrain through careful deliberation and documentation of options available with the policy or through the trust agreement and state law.
The solutions for fixing a broken ILIT can also inform conversations when a grantor creates a new ILIT. A grantor guidance letter regarding the purpose of the policy and performance expectations may prove invaluable when circumstances change. Whether to include trustee exculpatory language specific to insurance as a trust investment in the trust agreement is a critical consideration as well. As with any trust, the selection of an appropriate trust situs and flexible back-door provisions to provide for unforeseen circumstances also add value.
ILITs continue to play an important role in the estate-planning arsenal for high-net-worth clients. In today’s world of increasing fiduciary litigation, communication and documentation are critical, both at the time of trust creation and throughout the trust administration, to reduce risk and ensure that a trustee fulfills its fiduciary duty.
Endnotes
1.
2.
3. Crummey v. Commissioner, 397 F.2d 82 (9th Cir. 1968). This case discussed the requirements necessary for the grantor’s contribution to the trust to qualify as a present interest gift by providing the trust beneficiary with a right of withdrawal.
4. The term “universal life” is used throughout the article to describe flexible premium, non-guaranteed life insurance policies. This term includes policies that fit this definition, such as variable universal or adjustable life policies.
5. www.multpl.com/10-year-treasury-rate/table/by-month.
7.
8. Last summer, Aegon NV’s
9. The Uniform Prudent Investor Act (UPIA) is a uniform law created by the Uniform Law Commissioners in 1994. It’s been enacted in 44 states,
10. Ibid.
11. Ibid.
12. Ibid.
13. These states include
14. Unique and Hard-to-Value Assets, http://www.occ.treas.gov/publications/publications-by-type/comptrollers-handbook/Unique_and_Hard-to-Value_Asset_Booklet.pdf.
15. Ibid.
16. In
17. French v.
18. See also Noveletsky v. Metropolitan Life Ins. Co., Inc., 49 F. Supp.3d 123 (2014), which held under
19.
20. Under the UPIA, a corporate fiduciary, because of its special skills and expertise, is held to a higher standard than an individual trustee.
21. Culver v.
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