So, after writing about the poor state of charity owned life insurance in Part I, why is life insurance regularly utilized in charity planning and what’s my take on it? This discussion will focus solely on the economic dynamics of a life insurance policy from a “dollars in, dollars out” internal rate of return perspective on a premium to death benefit basis.
In 2009 I coincidentally had the opportunity to work with three different couples where the husband was age 73 and the wife was age 71. In each instance I was retained for trust owned policy audit work pertaining to the clients’ estate planning. However, in each circumstance, the clients were also charitably inclined so I took the opportunity to discuss the role of insurance in charitable planning and related the following numbers. I initially discussed the concept with one of the couples whose estate plan called for donating $3,000,000 of the estate to a local charity upon death. There was already some concern about sufficient liquidity for paying federal estate taxes and taking $ 3,000,000 off the top would likely only exacerbate the situation. In such a plan, charity and the IRS would get their pound of flesh with no consideration to liquidity requirements of the business or the children as successor owners.
For a reasonably healthy couple this age, survivor life insurance is priced at roughly $20,000 per $1,000,000 for a new policy with guaranteed death benefit and guaranteed premiums paid every year. Also, these couples are all in the top income tax bracket and I’ll use a combined federal, state and local rate of 40%. We’ll also assume that if a tax exempt entity owns the policy, whether it is the ultimate charity of choice or a family foundation, the full annual premium is tax deductible. At 40% the real annual cash flow is $12,000; no different than a donation of cash for any other purpose. Let’s look at the internal rate of return (IRR) of the full premium and the net cash flow (CF) to death benefit (DB) at a few different intervals:*
Duration Ages CF to DB Premium to DB
15 years 86/88 19.6% 14.0%
20 years 91/93 12.3% 8.1%
25 years 96/98 8.3% 5.0%
30 years 101/103 6.0% 3.1%
The 50th percentile actuarial life expectancy for a 71/73 year old couple is 22 years when this hypothetical transaction would result in a 10.4% IRR on Cash Flow to Death Benefit or 6.4% IRR on Gross Premium to Death Benefit.
This is a net guaranteed rate of return which I will argue is a non-duplicable transaction on a risk adjusted basis. So here is the argument; if there is charitable intent, cash flow and the commitment to premiums, why not consider layering in life insurance as a part of a comprehensive charitable plan for the right clients/donors? By incorporating a guaranteed life insurance policy with a quality life insurance carrier, one can conceivably decrease the investment risk of an endowment portfolio without mitigating return or increase the return on a portfolio with out increasing the risk.**
My wife and I created a Family Foundation some years ago and from the money we contribute annually, some flows through to our ongoing interests and some is retained to build an endowment. When I consider the endowment portion of the Foundation, I have to choose investment options. Upon realizing that at life expectancy, premiums put into a $1,000,000 guaranteed survivor life policy would return roughly 6% on a premium to death benefit basis and over 7% on a cash flow to death benefit basis for a guaranteed transaction, it made sense to allocate a small portion of the annual giving or endowment funds to such a policy. In addition, if my wife and I go down together in the near term, the full $1,000,000 comes into the Foundation to accomplish our goals though we didn’t have time to build it up.
In almost every other financial portfolio the professionals and common sense suggest diversification, so why not in a charitable endowment portfolio? I wouldn’t suggest allocating a large percentage of such a fund towards life insurance premiums but committing some of the income off the assets or even some of the endowment fund principle to a properly created and properly managed plan will likely make a meaningful difference.
One thing to keep in mind for those advisors or donors who feel queasy about committing to a potentially decades long premium stream is to evaluate a guaranteed short pay premium scenario or even a guaranteed single pay insurance policy.
In summary, for any given client/donor situation, bringing options to the table for consideration is rarely a bad idea. We look forward to hearing from you whether you concur or want to challenge any part of my comments or to discuss in more depth what we see happening in real life in the market.
* illustrating IRR on after tax cash flow is not intended to argue for repositioning current charitable giving cash flow from investments to insurance premiums but to encourage in increase in charitable giving cash flow. Otherwise, traditional investment IRR on after tax cash flow would have to be calculated as well to have an apples to apples comparison.
** The diversification argument does, however, argue for repositioning some current cash flow from traditional investments to life insurance when leveraging cash flow for endowment giving purposes.