Life Insurance in Retirement Plans

These are some of the challenges presented by the use of life insurance in a qualified plan

1.  Putting it in the plan is often marketed as allowing the insurance to be bought with pre-tax dollars.  But this is true only for the investment portion of the contract.  The participant still has to report and pay income tax each year on the imputed value of the life insurance death benefit protection typically using IRS Table 2001 rates (in the past referred to as “PS 58 cost”).  This represents the term cost of the insured death benefit, since it is taxed the life insurance is not being purchased with tax deductible dollars.

2.  Does the participant actually need life insurance and if so, for what purpose?  If it is to support the spouse and kids after death, then the insurance in the plan works just like insurance outside the plan, the insured death benefit proceeds are income tax free (assuming taxes paid each year per above) and the spouse is the primary beneficiary (no estate tax between spouses).

3.  If there are other participants they have to get the insurance with similar policies (no waivers by non highly compensated employees are allowed in a defined benefit as the employer pays the cost of the ancillary death benefit).  Participants must be counseled carefully or they will not perceive the value to the ancillary death benefit.  Frequently when they terminate employment they don’t take the policies. And the policy investments of the first few years goes are lost when the surrender charges are applied. 

In addition, it is a complicated process to move the insurance out of the plan in a tax efficient manner.  That is because the Cash Surrender Value (over and above the cumulative term insurance PS 58 costs) is taxable and is subject to 20% withholding as well.  Often the participant will purchase the insurance from the plan but that has also become more complicated since it must be for fair market value and that is not automatically equal to the Cash Surrender Value.

Tax-free rollovers of insurance policies must be carefully administered. IRAs cannot hold those policies.

The policies in some cases must be supplemented every year in which a benefit increase occurs.  Those benefit increases happen automatically as salaries increase. Failure to get such policies and keep increasing them as benefits increase will disqualify the plan.

4.  Under the Pension Protection adding life insurance to a defined benefit plan under Pension Protection Act increases the cost of benefits not because of the cost of the insurance, but rather because the internal rates of return on the policies are low... You can get a similar result by investing in short term government paper. Low investment returns force the employer to make larger contributions to provide the same level of benefit.

5. For plan purposes, the IRS requires that policies be valued differently than their actual surrender value. Using IRS Revenue Procedure. 2005-25 will mean that an insured defined benefit plan will likely be significantly underfunded upon plan termination, if the plan is terminated within the first 7 or 8 years and life insurance contracts were a significant part of the plan funding.  Example, after 5 years of paying $100,000 in premiums for life insurance, the surrender value of the policies may only be $200,000 (mostly due to surrender charges), but the fair market value under 2005-25 may be as high as $350,000, which is also the amount used for Pension Protection Act funding.  

6.  More expensive to administer because information must come from multiple sources and policies have to be valued at fair market value, not just cash value.