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 carve-out policy is owned by the 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.