Module 4: GROUP CARVE-OUT PLANS
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Most employees have a basic need for life insurance protection, even if only to provide for funeral costs. Employer-sponsored group term life insurance arose from this basic need and has grown tremendously from when the first contract was issued in the early 20th century to its current in-force level of more than four trillion dollars. It accounts for more than 40 percent of the existing life insurance in the United States and represents the only life insurance on the life of many breadwinners. Group term life insurance is, unquestionably, an important source of needed coverage for many people and an expected employee benefit.
Group carve-out plans augment this important employee benefit by purchasing additional coverage, usually in the form of universal life policies, on the lives of key personnel.
Upon completion of this Module, you should understand:
enables the key executive to overcome the group term life insurance limitation resulting from the nondiscrimination requirement;
makes formerly non-portable life insurance coverage fully portable and continuable beyond retirement;
enables the key executive to avoid Table I imputed income costs for group term life insurance coverage in excess of $50,000; and
policy cash values grow tax-deferred and may be accessed by the executive to provide additional retirement income.
Review of Group Life Insurance
Group life insurance is a major component of many employee benefit plans. In fact, to encourage employers to provide employee benefits such as a group life insurance plan, the federal government has granted these plans favorable tax treatment. In this review, we explore the features of group life insurance, explain how benefits are determined and examine the advantages of group insurance for both employers and employees.
Features of Group Life Insurance
The function that group life insurance serves is identical to the function of an individual plan in which a beneficiary receives the proceeds of a policy. In the case of group life insurance, if the covered member dies, his or her beneficiary will receive a stated amount of death proceeds.
Group life insurance, like individual plans, may be either of the term or permanent variety. Unlike individual coverage, however, group life insurance has a number of distinct features:
Master policy for entire group
Lower overall costs
No individual selection of benefits
Minimum participation standards
Low rates based on stability of the group
Master Policy for Entire Group
A significant characteristic of group insurance is that a single master contract or master policy is used and is the only contract required, regardless of the number of persons included in the coverage. The master policy outlines the contractual relationship between the policyholder (the employer) and the insurance company. No individual underwriting or risk evaluation is involved; the insurer looks at the group as a whole and applies its selection standards to the group.
Group life insurance is available at lower rates than individual insurance. In general, the administrative, operational and selling costs associated with group life insurance are less than those of individual plans. These savings are passed on to group policyholders in the form of lower premiums.
No Individual Selection of Benefits
Another characteristic of group life insurance is that benefits are predetermined according to certain schedules the insurer establishes. This prevents individuals from electing their own benefit levels-unhealthy persons would tend to elect high coverage amounts whereas healthy individuals might insure themselves only minimally-a situation that would lead to adverse selection against the insurer and undermine the principles of group underwriting. Predetermined benefit schedules also prevent the employer from selecting against the insurer in favor of certain employees. This does not mean that the employer has no choice in determining benefit levels; rather, the selection must be in line with the insurer's group benefit schedules. Most often, these schedules are based on earnings, employment position or flat benefit.
Just as established benefit schedules help prevent adverse selection, so do participation standards. Typically, insurers require that a minimum number of individuals eligible to participate in the group plan must do so to maintain the group coverage. If only older employees or those who were in poor health participated in the plan, the risk to the insurer would be greatly increased. Consequently, most insurers require that at least 75 percent of eligible employees participate when a plan is contributory and, for plans that are noncontributory, all eligible employees must be covered.
Low Rates Based on Group Stability
Unlike individual life policies that are rated on the insured's age, health and other characteristics, group life insurance rates are based, in part, on the stability of the group. As people enter and leave the group, this flow of insureds allows the group to operate effectively. However, groups with high employee turnover or no departures are not especially attractive to an insurer. If turnover is high, administrative expenses increase. If turnover is low, the group will age, mortality will increase and insurance company costs will increase.
Standard Group Life Provisions
To a large extent, the design of a group life insurance plan and the provisions it contains are a result of IRS requirements and the group insurance laws of the state in which the contract is written. Though these laws vary from state to state, there is enough uniformity among most group contracts to identify standard provisions. Here are some of the major provisions:
The actual death benefit in force on any one insured employee is established by a schedule of benefits included in the group policy the employer elects. Typically, these schedules provide for both minimum and maximum amounts for individual insureds and must conform with any limits state law establishes.
Effective Date of Coverage
After a group policy is in effect, new employees must satisfy a probationary period-usually 30 to 90 days-before they can enroll in the plan. After the probationary period has been satisfied, employees are given 31 days to enroll in the plan. Those who do not sign up during the enrollment period but apply at a later date, generally must submit proof of their insurability.
Who Pays Premiums
As with other group plans, a group life plan may be either contributory or noncontributory. A contributory plan calls for employees to share the premium cost with the employer; a noncontributory plan is one that is paid entirely by the employer. A contributory group life plan usually specifies that the employee's share of premium payments will be collected on a payroll deduction basis.
Beneficiaries and Settlement Options
An individual insured under a group life plan may name anyone as beneficiary of the death proceeds and is allowed to change that designation as desired. If the named beneficiary does not survive the insured and no other beneficiary has been named, most group plans allow the insurer to pay the proceeds to a surviving member of the insured's family or, as a last resort, to the insured's estate. In these cases, the proceeds are not paid to the employer.
As is the case with individual life insurance policies, the insured under a group life plan (or his or her beneficiary) can elect to have the proceeds paid in a lump sum or under an installment certain basis, according to the schedule or table in the group policy.
The vast majority of group life plans are term plans. When an employee retires, leaves the job, ceases to be an eligible member of the group or the plan itself is canceled, his or her coverage ceases, and there are no cash values available to purchase paid-up insurance. However, almost all group term life policies contain a conversion privilege, which allows an individual insured to convert the group coverage to an individual permanent policy with the same face amount.
There is a growing trend among employers to offer more than just a conversion privilege. Instead, many employers are now offering portable group term life insurance. This means that employees can take their insurance with them. The insurance coverage remains a term life benefit with no cash value.
31-Day Continuation of Coverage
Most group life contracts stipulate that an insured's death benefit is still payable if, within 31 days of terminating employment or plan cancelation, the insured dies. This provision gives an individual an extra 31 days of coverage before he or she must elect the conversion option or while waiting for coverage to become effective under another employer's plan.
Some employers offer insurance to employees' dependents as part of a group life plan. In these cases, the cost of the additional coverage usually is paid for by the employee and the amount of coverage available for any one dependent is fixed (and usually much less than the employee's coverage). Covered dependents of a deceased employee may or may not have the same rights to continue coverage. For example, a surviving spouse may be able to elect continued coverage but surviving children may not.
Waiver of Premium
Typically, group life plans provide a waiver of premium provision, which continues coverage but waives the cost of premium payments for employees whose active employment has come to a halt because of a total disability. Certain restrictions usually apply in these cases.
Benefits for Older/Retired Employees
Another provision contained in some group policies is a reduction formula that affects the amount of life insurance benefits available to insured employees once they reach a certain age (such as age 70), reflecting the increase in the cost of insurance at advanced ages. The provision reduces the amount of coverage available while the older employee is still working and may cancel the coverage entirely once he or she retires.
Accelerated Death Benefits Rider
Many insurers offer an accelerated death benefits rider to group life insurance policies. This rider allows the early payment of some portion of the policy face amount if the insured is terminally or chronically ill.
For example, a $100,000 policy that provides for a 75 percent accelerated benefit would pay up to $75,000 to the terminally ill insured, with the remaining $25,000 payable as a death benefit to the beneficiary when the insured dies.
How Group Life Insurance is Written
Theoretically, the same kinds of life insurance plans that are available for individuals also are available for group insurance. However, in practice, group life insurance is written as either term or paid-up permanent. Some plans also are based on universal life. Let's briefly review each.
Group Term Life
By far, the majority of group life plans are written as annually renewable term insurance. As the name implies, coverage and premium are established for one year, after which the employer, as policyholder, can renew the protection without evidence of insurability and the insurer, after reviewing the group's experience rating, may adjust the premium. Group term policies provide death protection only; there is no cash value accumulation under these plans.
Group Paid-up Life
Despite its advantages, group term does have a drawback: the absence of cash values and the subsequent loss of insurance protection when an employee leaves the group or retires. Retiring employees may find that the cost of converting their group term coverage to an individual policy is unaffordable; and, because the term insurance has no cash value that can be used to purchase paid-up coverage, they may lose all life insurance protection. For some, the answer may be group paid-up insurance.
With group paid-up, a certain amount of insurance is specified and is written with a combination of accumulating units of whole life and decreasing units of term. Each year, a portion of the premium purchases a unit of paid-up insurance. As the paid-up coverage increases, the term portion of the coverage decreases. Usually, the employer pays the term cost and the employee pays for the paid-up units. The result, over time, is a declining cost to the employer while the employee has paid-up permanent insurance available when he or she retires or otherwise terminates employment. In addition, the cash value belongs to the employee and may be borrowed or used as collateral for a loan, just as they can with individual cash-value life insurance policies.
Group Universal Life
A group life insurance product that has gained rapid popularity since its introduction is group universal life (GUL). The coverage usually is paid for by the employee (with after-tax dollars), but at group premium rates that are lower than similar insurance purchased on an individual basis. (These premium payments are usually collected on a payroll deduction basis.) In addition, coverage usually is issued without the employee having to provide evidence of insurability, at least up to certain limits. It is permanent insurance protection with cash value accumulation, and is flexible to conform to the employee's changing needs.
Income Tax Treatment of Group Life
One of the reasons an employer installs a group life insurance plan is to provide a benefit to its employees on a tax-advantaged basis. However, it is important to keep in mind that this favorable tax treatment is only given to group term insurance. To encourage employers to offer group life plans, current tax laws treat such plans favorably, as long as they conform to certain requirements.
General Tax Rules
The tax treatment of group insurance plans is spelled out in Section 79 of the Internal Revenue Code. The general tax rules regarding group life insurance are as follows:
The cost of the first $50,000 in group term life insurance benefits that an employer provides to an employee is not taxable to the employee. The cost of employer-provided benefits in excess of $50,000 is taxable income to the employee, in accordance with the table shown here.
The premium the employer pays for the cost of group life coverage is deductible by the employer, within the bounds of reasonable business deductions. Any premium an employee pays is not tax-deductible by the employee. However, if the employee has more than $50,000 in coverage, any premiums he or she pays can be allocated to the excess coverage, thereby reducing the amount he or she would otherwise be taxed.
The death benefit proceeds payable under a group life plan are received income tax free by the beneficiary. If the proceeds are paid in installments, the interest portion of each installment payment is taxable to the beneficiary. (This is consistent with the treatment of death proceeds payable under an individual life insurance policy and applies whether the group plan is term or permanent.)
Retired employees whose past employers continue to provide them with group term insurance coverage are taxed in the same way as active employees.
During the last decade, accelerated death benefits have become an important source of income for chronically ill individuals and for people suffering from AIDS and other terminal illnesses. If certain requirements are met, accelerated death benefits received from a life insurance contract on the life of a terminally or chronically ill individual before the individual's death can be excluded from income. However, for a chronically ill individual the exclusion applies as long as the proceeds are used to pay the cost of qualified long-term care services and the treatment is not covered by insurance or other program.
Group term proceeds will be includable in the deceased employee's gross estate if the employee possessed any incidents of ownership or if the proceeds are payable to his or her estate. The employee can avoid all direct incidents of ownership by absolutely assigning rights under the policy to a third party, provided the insurer and state law permit the assignment.
There may still be estate problems after the assignment if the employee dies within three years of the assignment. The proceeds are includable for estate tax purposes unless the employee's incidents of ownership were assigned at least three years prior to death, or if it can be proven that assignments within three years were not made in contemplation of death.
Basic Aspects of Group Carve Out
Group Term Limitations
To understand the nature and advantages of group carve-out plans, it is necessary to appreciate the requirements and limitations of group term life insurance. Although group term life insurance occupies an important place in many individuals' plans, it has certain requirements and limitations that may affect its ability to meet the long-term insurance needs of many executives. Group carve-out plans overcome these limitations and provide additional benefits as well.
Some of the significant limitations of group term life insurance include:
Coverage must be provided on a nondiscriminatory basis
Coverage is adversely affected, i.e., reduced or terminated, at retirement
Coverage is lost upon termination
Table I imputed income costs apply to group life insurance coverage over $50,000
Coverage Must Be Nondiscriminatory
Coverage under the group term life insurance policy must be provided on a nondiscriminatory basis. In a group term life insurance plan that is considered discriminatory, key employees may face less advantageous tax treatment, and the employer's premium payment may be taxable income to the participants.
Coverage Adversely Affected at Retirement
The employees' group term life insurance coverage at retirement usually is either reduced or eliminated. If coverage continues beyond retirement, its cost may become prohibitively high. Even if the employee chooses to convert the group term life insurance coverage at retirement to permanent life insurance, the resulting premiums may be extremely high at a time when the typical retiree's income has diminished.
Coverage Lost Upon Termination
Coverage under the group term life insurance policy is not portable. If the executive leaves the employer, the coverage ceases.
Table I Costs Over $50,000 Are Taxable
Significant life insurance amounts provided through a group term life insurance policy may be an inefficient method of maintaining coverage because of "imputed income". Employees are required to report the value of group term life insurance coverage in excess of $50,000. The IRS then imputes a value to that "excess coverage". The imputed values are contained in Table I. These "Table I costs" are based on government rates shown here that may be higher than the actual coverage cost.
Group Carve-outs Can Offset Disadvantages of Group Term
Each of these limitations inherent in group term life insurance can be offset through the use of a group carve-out plan.
Replacing Coverage in Excess of $50,000
In a group carve-out plan, the employer replaces existing group term life insurance coverage in excess of $50,000 with individual universal life insurance coverage on selected executives. The universal life insurance may be declared rate, equity-indexed or variable, depending upon the wishes of the individual executive.
The employer continues to make premium payments for the group term life insurance coverage that remains and also makes premium payments on the universal life insurance policy. The employer's premiums paid for the universal life insurance policy are at least at the minimum premium level. Often, the universal life insurance policy's minimum premium approximates the premium cost for an equal amount of group term life insurance.
Additional Premium Payments
If the employer makes universal life insurance premium payments equal to the minimum premium, the plan functions much like the group term insurance plan. However, unlike group term insurance, both the employer and the executive may make additional premium payments into the universal life insurance policy. The result of these additional premiums is an increase in cash values and extended coverage. In addition, these additional premiums can provide post-retirement life insurance protection and/or supplemental retirement income.
If the executive were to leave the employer's service, the group term life insurance would cease. However, the universal life insurance would continue, and the executive, as policyowner, would take it with him or her. The subsequent premiums would be the policyowner's responsibility.
Benefits of Group Carve-Out
The group carve-out plan solves the problems inherent in group term life insurance by offering several benefits, including selectivity, portability, an avoidance of additional imputed income and the opportunity to maintain coverage beyond retirement.
Similar to other nonqualified plans, the employer may select an executive or class of executives to participate in the group carve-out plan. Ordinarily, an entire class of executives-for example, all vice presidents-is selected to participate. This selectivity enables the employer to provide more meaningful recognition and rewards to chosen executives.
Coverage Extended Beyond Retirement
It would be more than a little unusual if an executive's life insurance needs changed radically between the day before and the day after retirement. The executive's ownership of the universal life insurance policy that replaced the group term insurance in excess of $50,000 means that the executive can continue the coverage beyond retirement, possibly without additional premium payments.
Similar to the maintenance of coverage beyond retirement, the executive's universal life insurance policy provides coverage that is portable. Coverage continues even the executive's service with the employer terminates.
Table I Costs Eliminated
The Table I cost is the income that is imputed to the executive for tax purposes and which represents the value of group term life insurance in excess of $50,000.
Group Carve-Out Advantages
There are five principal advantages that inure to the employer that installs a group carve-out plan:
reduction in group term life insurance discrimination concerns;
no cost increase;
ability to limit participation;
current employer tax deduction; and
encouragement of executives' active participation.
Reduction in Group Term Discrimination Concerns
For group insurance to meet the definition of group term life insurance and qualify for special tax exclusion by employees, it must meet conditions relating to the:
nature of the death benefit;
group for whom it is provided;
employer's participation; and
nondiscriminatory method of determining insurance amounts.
If a group term life insurance plan fails to meet these conditions, participants will be unable to exclude the value of the first $50,000 of term life insurance from their current income. This is an important condition for employers, because the senior executive group may have life insurance needs that are substantially greater than those of other employees.
The group carve-out plan removes the nondiscrimination concern by eliminating group term life insurance coverage in excess of $50,000 for the executives chosen to participate.
No Cost Increase
It is likely that there would be no increase in employer cost to provide an identical amount of life insurance coverage as a combination of group term insurance and universal life insurance, unless the total death benefits are increased or the employer chooses to make supplemental contributions. Normally, the universal life insurance policy's minimum premium is comparable to the cost for the same amount of group life insurance.
In fact, the use of a group carve-out plan may actually decrease the employer's overall costs to provide life insurance to its employees. In the typical employee census, the senior executives normally have the highest level of group term life insurance and also tend to be the oldest employees in the group. By removing these older executives from the group insurance census for group term life insurance amounts in excess of $50,000, the average age per $1,000 of group term life insurance may decrease. This decrease could favorably affect group term life insurance rates overall for the group.
Ability to Limit Participation
Unlike group term life insurance, the separation of coverages into a base amount of $50,000 of group term life insurance and a universal life insurance policy for the remainder permits the employer-if it chooses-to provide significantly increased life insurance benefits to selected executives. Because the group term life insurance coverage provides a base coverage amount of $50,000 on all executives, there is no employer concern about the group plan being discriminatory.
Current Employer Tax Deduction
The employer receives a current income tax deduction for the entire premium paid for both the group term life insurance and the employee-owned universal life insurance policy. The group term life insurance premium is deductible as an employee benefit, and the employer-paid portion of the universal life insurance policy premium is deductible to the employer as compensation. Accordingly, the premium for the universal life insurance policy is included in the executive's income for tax purposes-just as the Table I costs would be if the entire life insurance coverage were provided under the group policy.
Executives Encouraged to Participate
Because the universal life insurance policy generally provides both a competitive and tax-deferred rate of return coupled with FIFO tax treatment of withdrawals, the executives often make additional premium contributions to the universal life insurance policy. The policy represents an attractive and tax-wise investment alternative.
Split-Dollar Approach to Cost Recovery
An employer may seek to recover its premium payments for the universal life insurance policy issued under the group carve-out plan. An employer looking for premium cost recovery can accomplish that by employing a split-dollar approach to the universal life insurance policy.
This approach splits the death benefits between the employer and the executive's personal beneficiary. If the executive dies during the plan, the employer's portion of the death benefit is equal to the greater of the cumulative premiums it has paid or the policy's cash value. The amount of the death benefit that exceeds the employer's share is payable to the executive's beneficiary.
Under this approach, the employer also owns its portion of the cash value. This fund is available for business needs and emergencies. If the executive lives to retirement, the employer can use the cash value of the policy to fund a special retirement plan for the employee if it chooses.
Advantages for the Executive
The advantages to the employer, however substantial, are not as significant as the advantages that inure to the executive under a group carve-out plan. They include:
an opportunity to maintain death benefits beyond retirement;
the tax-deferred accumulation of voluntary contributions;
the ability to use cash values to supplement retirement income.
Death Benefits Beyond Executive's Retirement
A serious drawback to group term life insurance is its termination upon retirement. In most cases, if the executive elects to continue the coverage it must be converted to permanent life insurance at the executive's then-current age. Because life insurance premiums are age-based, the executive's premium for the converted coverage may be substantial just at a time when his or her income is reduced.
Under a group carve-out plan, the portion of the insurance provided by universal life may continue beyond the executive's retirement. Although the executive may be required to pay ongoing premiums, those premiums generally are much lower because they are based on the executive's age at the time the group carve-out plan began-possibly many years before the executive's retirement.
Tax-Deferred Accumulation of Voluntary Deposits
Because the employer pays the group carve-out premium for the universal life insurance policy equal to the policy's minimum premium, policy costs that are levied on a per-policy or per-thousand dollar basis are paid by the employer. For that reason, the executive's voluntary deposits in excess of the minimum premium produce generally greater returns than the policy's interest crediting rate would appear to offer.
A particular universal life insurance policy providing a $500,000 death benefit to a 45-year-old insured for a $2,580 minimum premium has a cash value at age 65 of $7,500 at a crediting interest rate of 6.75 percent. If the executive makes additional voluntary premium deposits of $6,000 each year for the 20-year period, the cash value at age 65 would increase to $282,000, an increase of $274,500. In other words, the $6,000 voluntary contribution made each year accumulates to almost $275,000, an approximately 7.3 percent annual return, rather than the 6.75 percent interest crediting rate.
When we consider that the growth in the policy's cash value is entirely tax-deferred until it is withdrawn, the 7.3 percent return may be much higher considering the executive's marginal income tax bracket. Finally, the FIFO tax treatment afforded any withdrawals from the policy (provided it is not an MEC) makes the executive's voluntary premium deposits a wise and tax-efficient investment strategy.
Unlike group term life insurance, the universal life insurance policy purchased pursuant to the group carve-out plan continues in force even if the executive's service with the employer does not. If the executive leaves the employer's service for any reason, the executive takes the policy.
Supplement Retirement Income
The universal life insurance policy purchased under the group carve-out plan may be used to provide supplemental income for the executive at retirement. The supplemental income, because of the FIFO nature of life insurance policy withdrawals and the ability to change to policy loans once basis is reached, may be received by the now-retired executive entirely free of income taxes.
Continuing the earlier example:
The executive made voluntary premium contributions of $6,000 yearly for 20 years. The executive could arrange to receive, through a combination of cash value withdrawals and policy loans, an income of $25,500 each year for the 10 years following retirement. The executive received that income without any income tax liability though the funds received are substantially greater than the executive's cost basis. Furthermore, the life insurance policy can be expected to remain in force until the executive's age 100 and, at age 85, will still pay a death benefit of $100,000. Clearly, the group carve-out plan has provided important benefits to the executive participant.
The premium paid by the employer for the life insurance provided under both the base group term life insurance policy and the universal life insurance policy is income tax-deductible: the group insurance premium is deductible as an employee benefit, and the universal life insurance premium the employer pays is deductible as compensation to the policyowner executive. The premium the employer pays for the universal life policy is considered a bonus to the executive and is therefore deductible to the employer. However, as a bonus, it is taxable to the executive.
Taxable Income Generally Less than Table I Costs
Although the premium is taxable to the executive as income, it is expected that the taxable income to the executive would be less than the Table I costs that would have been incurred if the group carve-out plan had not been implemented.
From the earlier example of the 45-year-old executive with the $500,000 group carve-out universal life insurance policy, the $2,580 premiums the employer paid over the 20-year period result in additional taxable income to the executive of $51,600.
If, instead, the same additional $500,000 had been provided through group term life insurance, the Table I cost would have resulted in an additional $80,700 of imputed taxable income to the executive. In this case, the group carve-out plan saved the executive the income tax due on $29,100 — the difference between the employer-paid universal life insurance premiums and the Table I costs.
Premium is a Bonus for the Executive
Because the premium the employer pays for the universal life insurance policy issued under the group carve-out plan is bonused to the executive, the executive is required to include the bonus in income for tax purposes. The tax treatment of the life insurance policy is the same as the treatment afforded any personally purchased life insurance policy-tax-deferred cash value and FIFO withdrawal treatment.
Tax Deferred Savings for the Executive
For the high-income executive, tax deferral — especially when coupled with FIFO tax treatment of withdrawals — is highly desirable. The benefits of tax deferral are readily apparent. Let's briefly examine the difference in accumulation between tax-deferred savings and currently taxable savings. Over a long period of time, the tax deferred nature of the savings makes a significant difference in the overall growth of the plan.
Despite the fact that the executive's tax liability is lower under a group carve-out plan than under group term life, some executives may still object to the taxable income such a plan creates.
If this is the case, the employer may choose to pay a double bonus, also known as a gross-up bonus. Under the double bonus approach, the employer pays bonus of the universal life insurance policy premium to the executive and then an additional amount equal to the tax liability on the bonus. The result of this double bonus is that the executive's after-tax cost is reduced to zero.