When it comes to split-dollar plans, product selection is crucial for ensuring that the plan meets both the organization’s and the executive’s goals. These plans involve choosing life insurance policies that align with the parties’ risk tolerances and financial objectives. Let’s explore the key considerations and product options available for split-dollar arrangements.
Understanding Risk Tolerance and Goals
In a split-dollar arrangement, there are two primary objectives: providing retirement cash flows for the executive and repaying the organization’s premiums, often with interest. These goals can create differing risk tolerances. For instance, an executive might be willing to take on higher risk to maximize retirement benefits, while an organization might prefer a conservative approach to ensure the repayment of premiums.
Types of Life Insurance Products
Split-dollar plans require permanent life insurance policies, and there are several product types to choose from, each offering varying levels of risk and potential returns:
- Whole Life (WL) Insurance: This is a low-risk option with fixed crediting rates determined annually based on the insurer’s general account performance. It offers steady, predictable growth.
- Universal Life (UL) Insurance: Like whole life, UL policies have fixed crediting rates but offer more flexibility in premium payments and death benefit amounts.
- Variable Universal Life (VUL) Insurance: VUL policies allow policyholders to allocate cash value to separate accounts, like mutual funds. This option offers higher potential returns but comes with increased risk due to market volatility.
- Indexed Universal Life (IUL) Insurance: IUL policies credit interest based on changes in a major market index, such as the S&P 500, within a specified range or “collar.” This provides a balance between risk and return, offering protection against market downturns while allowing for growth potential.
Key Design Considerations
When selecting a policy type, several variables need to be carefully considered to ensure the split-dollar plan remains effective and compliant:
- Crediting Rates: Assumptions about crediting rates should be realistic and based on historical performance. For fixed products like WL and UL, current rates are a reasonable long-term assumption. For IUL, stress testing projections with lower rates help gauge potential impacts.
- Access to Policy Value: Executives can access the policy’s cash value through withdrawals or loans. Withdrawals permanently reduce the policy’s value and can have tax implications. Loans, on the other hand, keep the cash within the policy as collateral and charge interest, which can be offset by positive crediting rates.
- Applicable Federal Rate (AFR): The AFR is crucial in determining the interest on premiums paid by the organization, which are treated as loans for tax purposes. Setting a static AFR at implementation can mitigate variability and enhance the plan’s stability.
Managing Volatility
Several factors contribute to the volatility of a split-dollar plan, and managing these effectively is essential for the plan’s success:
- Crediting Rate Risk: Products like VUL carry significant crediting rate risk due to market fluctuations. UL and WL offer more stability, with IUL providing a balanced option.
- Borrowing Rate: Policy loans come in various forms, including with fixed, indexed and variable rates. Fixed rate loans offer the least volatility, while variable rate loans can fluctuate, impacting policy performance.
- AFR Fluctuations: To avoid compliance issues and adverse tax consequences, selecting a long-term AFR at the outset can stabilize the interest rate over the plan’s life.
Revising Existing Plans
If an existing split-dollar plan faces challenges, modifications can often address these issues:
- Policy Exchange: If the current policy lacks efficiency or is too volatile, consider exchanging it for a more suitable option. This can often be done on a tax-free basis if conditions are met.
- AFR Adjustment: Reevaluating the AFR terms, especially in a low-rate environment, can reduce uncertainty and enhance plan stability.
- Organization Protection: To secure the organization’s position, isolating the repayment obligation into a separate asset can ensure the return of premiums and interest.
The Better the Design, the Better the Benefits
Choosing the right split-dollar products and managing key variables are vital to the success of a split-dollar plan. By understanding the available options and carefully considering risk tolerance, crediting rates and access to policy values, organizations and executives can design a plan that meets their mutual goals.
Call us today at 972-318-1110 to schedule a consultation and take the first step toward a more secure financial future. Your peace of mind is worth the call.
