Monday, February 1, 2016

No. 141: The Age 100 Problem in Cash-Value Life Insurance

The two most important income tax benefits enjoyed by owners of cash value, whole life insurance policies are (1) the inside interest is income tax deferred and (2) the death benefit is income tax exempt. Also, the policyholder's ability to fold the income tax deferred inside interest into the income tax exempt death benefit may be considered a third income tax benefit of life insurance. Almost always missing from discussions of the income tax treatment of life insurance is "the age 100 problem," which I believe has not been resolved.

The Terminal Age
The pricing of a life insurance policy is based in part on a mortality table, which shows death rates (probabilities of death) by age. The terminal age of a mortality table is the age at which the table shows no survivors among those insured. Stated another way, the death rate in the year prior to the terminal age is 1 (or 100 percent, or 1,000 per 1,000).

Five mortality tables have been widely used during the history of the life insurance business in the U.S. They are the American Experience, the 1941 Commissioners' Standard Ordinary (CSO), the 1958 CSO, the 1980 CSO, and the 2001 CSO tables. The terminal age is 96 in the American Experience table, 100 in the 1941 CSO, 1958 CSO, and 1980 CSO tables, and 121 in the 2001 CSO table.

An Example of the Problem
Alfred "Alf" Landon was born on September 9, 1887. He served as governor of Kansas from 1933 to 1937. He won only Maine and Vermont when he ran against President Franklin Delano Roosevelt in 1936. (The saying that grew out of that election was "As Maine goes, so goes Vermont." I was seven years old at the time. My father disliked FDR, probably voted for Landon, and probably persuaded my mother to do so.)

Landon's name appeared in an Associated Press story on September 8, 1983, the day before his 96th birthday. The story also appeared in The New York Times the next day. The headline was "Alf Landon, at 96, Eligible to Collect Life Insurance." Undoubtedly his policy was based on the American Experience mortality table. John Caspari, who was in the advertising department at Northwestern Mutual, was quoted as saying: "It is unusual for someone to outlive the mortality tables." The story said that Landon was eligible to collect $33,156 on his 96th birthday, but that he "planned to allow the sum to continue earning interest." (Caspari, with whom I occasionally spoke, retired in 2002 and died in 2012 at age 69.)

I was intrigued by the story, because I thought Landon might have an income tax problem whether he took the money at age 96 or not. If he asked Northwestern to hold the money until his death, I thought it could be argued that he had constructive receipt of the money for income tax purposes when he asked the company to defer payment until his death. He died on October 12, 1987, about a month after turning 100. I do not know whether Landon and his beneficiaries avoided the income tax problem.

Articles about the Problem
I wrote two articles about the age 100 problem; they are in the January 2001 and May 2001 issues of The Insurance Forum. They were prompted by two unsolicited letters I received. One was from a man who expressed the startling belief that an insured who reaches the terminal age would receive nothing.

The other letter was from a man who said he was in his upper 80s, was in excellent health, expected to live to the terminal age, and had policies in two companies totaling $5 million. He wanted his beneficiaries to receive the money income tax exempt after his death, but he feared he would have taxable income if he survived to the terminal age. He asked the companies how he could avoid the income tax problem, but he did not get straight answers.

In the January 2001 article, I explained the problem. I also said I planned to conduct a survey of major companies.

In the May 2001 article, I reported on the survey. I asked 20 companies to confirm they would pay the death benefit at the terminal age, and I asked them how the insured could avoid the income tax problem. Only three companies responded. They confirmed they would pay the death benefit. They also said the policyholder could elect to postpone the payment until the insured's death, but they did not mention the issue of constructive receipt. The low response rate was my first knowledge that most companies were reluctant to talk about the age 100 problem.

Recent Exploration of the Problem
Recently I have been exploring the age 100 problem for the first time since I wrote those articles in 2001. Everything I have found thus far relates to the definition of life insurance in the Internal Revenue Code and in pronouncements by the Internal Revenue Service (IRS).

The need to define life insurance for income tax purposes grew out of abuses by life insurance marketers who figured out clever ways to use the favorable income tax treatment of life insurance as a sales promotion device. One example was the "minimum deposit plan." (It should have been called the "maximum commission plan.") The policyholder would borrow as much as possible each year under the policy's loan clause, and pay as little as possible each year to cover the loan interest and keep the policy in force. The policyholder would then take an income tax deduction for the loan interest. The plan was promoted as a method by which to change nondeductible life insurance premiums into deductible loan interest payments. It also had the effect of changing a level premium, level death benefit whole life policy into an increasing premium, decreasing death benefit, one-year renewable term policy. Also, the plan allowed agents to collect commissions for a whole life policy rather than the relatively small commissions for a one-year renewable term policy.

Another example of the abuses grew out of the development of universal life insurance. The policyholder would buy a policy with a small amount of life insurance protection and put large amounts into the savings component to take advantage of the favorable income tax treatment of the inside interest.

Variable Universal Life Prospectuses
I am not aware of anything in life insurance policies about the age 100 problem, but the problem is mentioned in prospectuses for variable universal life policies. Those discussions illustrate the difference between the weak disclosure requirements imposed by insurance regulators and the strong disclosure requirements imposed by securities regulators.

A current prospectus issued by New York Life Insurance and Annuity Corporation (NYLIAC), for example, mentions the availability of a "life extension benefit rider" that would extend the policy beyond the terminal age. However, it warns that the policyholder "may be subject to adverse tax consequences" and "a tax advisor should be consulted."

Also, an IRS revenue procedure became effective August 23, 2010 (Rev. Proc. 2010-28). The IRS had issued a notice in 2009 inviting comments. Here is one of the questions the IRS asked in the notice:
If a preexisting contract actually matures at age 100, such that the cash surrender value and death benefit under the contract are the same, is the insured taxed at that time on the maturity value of the contract under the doctrine of constructive receipt?
The IRS received numerous comments, one of which was a 22-page letter from the American Council of Life Insurers (ACLI). The ACLI included, on pages 17-19 of the letter, a discussion of the doctrine of constructive receipt. The ACLI cited, among other things, a Treasury regulation about the doctrine. The ACLI pointed out that, at age 100, there would be no constructive receipt because the policyholder would forfeit a number of "valuable rights," such as "the forfeiture of annuity purchase rate guarantees." The ACLI expressed the opinion that it would not be appropriate to impose requirements "to address a concern that may exist under the constructive receipt doctrine."

In the adopted revenue procedure, the IRS alludes to the question it had asked about constructive receipt. However, the adopted procedure does not appear to address it.

General Observations
In its comment letter, the ACLI explains why it believes that the doctrine of constructive receipt does not apply when the insured reaches age 100. I am not convinced by the ACLI's arguments.

Undoubtedly many whole life policies are in force today based on the American Experience mortality table with its terminal age of 96. And undoubtedly huge numbers of policies are in force with a terminal age of 100. (We are a long way from having policies approaching the terminal age of 121 in the 2001 CSO table.) In short, I still do not know what the ubiquitous "tax advisor" could tell a policyholder who inquires about how to avoid a potentially devastating income tax problem at age 96 or 100.

My wife and I are in our 80s. All the policies on our lives have a terminal age of 100. They are whole life, do not define "life," and say nothing about the age 100 problem. In late January we wrote to the four companies about the problem. We hope to receive "straight answers." I plan a follow-up to describe what we learn from the companies.

Available Material
I am offering a complimentary 37-page PDF consisting of the two-page January 2001 article, the two-page May 2001 article, one page of excerpts from a current NYLIAC prospectus, the 8-page IRS request for comments in 2009, the 22-page comment letter from ACLI in 2009, and the two-page IRS Revenue Procedure 2010-28. Email and ask for the February 1, 2016 package about the age 100 problem.