#18 | On Taxation
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Despite what some people think, life insurance’s tax advantaged status isn’t an act of God. It’s the direct result of the social function of our products. Life insurance is the grease in the gears for the most difficult transition imaginable. It allows families to continue to function when otherwise they would be crushed. At least, that’s the marketing story from groups like AALU. Reality is much less straightforward. The Wall Street Journal wrote an article last year discussing the increasing skew of life insurance sales towards highly affluent individuals for use in retirement and estate planning. Middle and lower income Americans are less insured than ever. Increasingly, life insurance companies are promoting products specifically designed and marketed for tax advantaged accumulation. Or, put differently, products that really exist only because of their tax treatment. Combine this trend with the burgeoning consensus that taxes on the rich are too low and I think it’s readily apparent that our tax status is more imperiled than ever. We can’t manage the challenge from without. But we can manage the challenge from within. And right now, I’m not sure we’re doing a great job of it.
The most obvious example is the explosion of Indexed UL and the legions of people selling it for tax free retirement accumulation. Googling (yes, it’s a verb) Indexed UL leads you to books and YouTube videos touting IUL primarily for its tax advantages. But IUL is hardly an exception – it just happens to be the flavor of the month. I saw a presentation recently about how to use life insurance to “live life in the 0% tax bracket.” If that’s not asking for more scrutiny, I don’t know what is. Life insurers regularly promote the use of their products for tax free income. Does tax advantaged accumulation serve a social purpose? Sure. That’s why the government gave us IRAs. Does the government think that every person should also pump money into life insurance to get tax free distributions? Probably not. I read recently that the benefits of a decision shouldn’t be judged simply by what accrues to a single person but, instead, should be judged as if everyone made the same decision. One client buying life insurance for tax benefits is a good thing. Everyone buying life insurance for tax benefits is a very, very bad thing.
Many of the “innovative” features in life insurance over the last few years hinge on making life insurance a more attractive tax free distribution vehicle. Overloan Protection Riders solve the problem of potentially triggering phantom income, but they essentially negate the functional consequences of using policy loans versus withdrawals. They let the policy follow the letter but not the spirit of the regulation. Wash loans arguably do the same thing. Variable loans in Whole Life and Indexed UL illustrate “arbitrage” returns for borrowing tax free from life insurance. A new Indexed UL product offers the ability to have an annuitized death benefit payout rather than a lump sum in exchange for dramatically reduced cost of insurance charges. Some people are lauding this as the next big thing. Maybe, but only if we don’t recognize that ideas like this reduce the social function aspect of life insurance’s death benefit and therefore jeopardize its tax status. All life insurance products couldn’t work like this because our tax advantaged status would almost certainly be revoked. Finally, we have a product line that is wholly and unabashedly built to skirt tax regulations for ultra-wealthy people – Private Placement Life Insurance. I’ve never seen a PPLI pitch that discusses the traditional need for insurance. There’s absolutely nothing wrong with PPLI and if I had loads of cash in hedge funds, I’d use it. But it carries risk because it’s only a matter of time before a savvy journalist finds out about it and tells a very easy story about rich people dodging taxes through yet another loophole.
But these are technical issues that, frankly, laymen in Congress aren’t going to take the time to understand. They’ll see that we’re following the letter and assume we’ve decided to follow the spirit as well. Short of a powerful, public and very embarrassing scandal, life insurance’s tax advantages will survive because of the common nature of the product. We’re boring. You know, like mortgages. But if we have a scandal like, say, what might happen with IUL litigation, then we may end up under the microscope. Our defense will have to be that we deserve to keep the tax benefits for everyone because we insure everyone, not just wealthy folks. That’s our social obligation and we only reap the tax rewards if we fulfill it. For the time being, though, life insurance companies seem much more focused on peddling Indexed UL and other products for tax free retirement income. If only life insurers could figure out how to efficiently and profitably serve the middle and lower markets. We have to justify our existence on social grounds before we can dabble in other things.
All of this is not to say that life insurance agents shouldn’t serve wealthy people. It’s the privilege of an agent to sell to whom he wants to sell. The dirty little secret of life insurance is that issuing a fully underwritten product with a $100,000 premium isn’t a hundred times more difficult than issuing a fully underwritten product with a $1,000 premium. It’s maybe ten times as difficult. Therefore, all agents try to sell big policies and the mass market gets ignored. Insurance companies are more than willing to cater to big agents and big sales. But insurance companies can’t just blithely assume that someone else will sell social good life insurance so that they can continue selling tax advantaged products. It’s up to insurers to make sure that the American public is insured. That means changing the way life insurance is built and distributed because obviously the current methodology has underserved the middle market. Only then can we count on life insurance to maintain its tax advantaged status.
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