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"Private" Pension Plans Good Idea or Not?


Guest BobParks
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Guest BobParks

As an alternative to a qualified plan some planners have recommended a "private pension plan" using life insurance products. I have several cases where nothing: integrated, age weighted, cross tested, ageless etc., "works" but the owners need and want to start setting money aside. An article touting the "private pension" in lieu of a qualified plan caught my eye.

The Business Journal of San Jose carried an article entitled "Plan wisely for retirement" "Small business may benefit from private pension plans" by David Burros, CPA, CFP. The URL is http://www.amcity.com/sanjose/stories/0427...98/smallb1.html

Life insurance policies in Texas enjoy the same creditor protection as a qualified plan and everywhere insurance enjoys income tax deferral. However the consumer press reported many sales presentations have been marginally within the law. In response Texas passed strict rules requiring clear labeling of illustrations as being life insurance policies.

I'd be interested in seeing what other planners think of the technique and what alternatives are available.

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The traditional thinking is the client should use all of the tax-deductible tax-favored vehicles available (like qualified plans) before using after-tax fax-favored vehicles (insured private pension plans, tax-deferred annuities, etc.).

However, qualified plans come with a price, namely the cost of covering other employees and administration.

After-tax tax-favored products come with a price, namely being limited to the insurance product offered. (Qualified plans have "almost complete" investment flexibility -- "almost" because certain investments like collectibles aren't allowed.)

If the ONLY FACTOR is maximize the owner/minimize everyone else, then I agree that there comes a size where the qualified plan route isn't the most advantageous. Probably when 50% to 75% of the contribution goes to the owner is that point (as indicated in the article).

However, the value of the client's business is perhaps his/her largest asset. To the extent they believe that providing benefit to their employees enhances that value means that we shouldn't ignore the cost of providing some benefits to employees. (Of course, it is entirely the client's call. If the client believes that employees are a dime a dozen, then the pension plan, if any, should reflect that belief. If the client believes that employees are valuable, then the pension plan, if any should also reflect that belief.)

Also, the article indicated that 85% of Fortune 500 companies have non-qualified pension plans covering their executives. Of course, they have qualified pension plans covering all employees (including executives), as well. The Non-qualified plans are a supplement for the executives.

Now, since the private pension plans are funded through a specially designed high quality insurance product, according to article, I would ask why these products are not the mainstay of the qualified plan arena?

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Guest ezollars

Why aren't insurance policies a major component of qualified plans? Simple--expenses.

That is, any cash value insurance policy is made up of four components - mortality cost, earnings, administrative costs and agent compensation costs. Only one of those moves up the value if you don't die . The term insurance/mortality cost is needed because it's an insurance product--that is what gives it its tax advantaged status. The administrative costs are on top of the administrative costs of the plan itself.

Since a qualified plan doesn't need the insurance coverage to shelter the earnings, putting that inside the plan simply drags down the rate of return. And other costs are normally glossed over in insurance products (and, if looked at, may be surprisingly high since they normally aren't discussed).

Many of the COLI products are intentionally structured to have a positive impact on the bottom line in the short term, which (based on discussions with others that have examined such products) may be paid for by relatively poor long term performance. But if you are a public company where everything depends on this quarter's bottom line, you don't want to take a P&L "hit" on this executive compensation plan, even if it turns out to be more costly in the long term.

If the company in question doesn't care about book earnings (and many small companies frankly don't and have no reason to), they may be better served looking at more traditional policies if they really believe that corporate owned life insurance policies underlying a nonqualified plan make sense.

Frankly, in most small companies I suspect it makes a *LOT* more sense for the major shareholders to simply acquire such policies personally.

Finally, you must remember that all life insurance policies used to provide current income (meaning, cash value borrowed from) will run the risk of "collapsing" later on (with disasterous tax consequences) if the owner borrows too heavily (including simply living too long) or the investments fail to meet expectations. So you have to carefully monitor such a policy over time to be sure it will be able to do what the initial projections said it would do.

And, frankly, every person that "buys in" to this deal needs to understand the potential (even if unlikely) possibility that he/she may face a choice of either paying in additional premiums or facing a massive tax bill late in life. These issues are why, in many states, the use of the term "private pension plan" is prohibited when life insurance agents attempt to sell these plans.

[This message has been edited by ezollars (edited 09-06-98).]

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I agree with ezollars that putting insurance inside a qualified plan to "take advantage of the tax-deferral" because of insurance is not cost-effective. (In other words, it wastes money.)

I've seen it make sense outside of a qualified plan, through COLI or individually purchased by the owner.

I understand COLI is still being used to fund executive benefits. It was used extensively about 15 years ago, where tax loopholes allowed borrowing to create extremely high internal rates of return -- usually in the 20-25% range. Of course, that was in the large corporate environment, where 30-50 year time horizons could be used. (At that time, I was on the analysis side doing actuarial analysis and the numbers were legitimate -- had I been on the sales side, I would have retired by now.)

Finally, I was unaware that the use of the term "private pension plan" is illegal in some states. Good! (By the way, do you know which states?)

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Guest BobParks

One of the better life insurance companies Northwestern Mutual maintains a web site with weekly sales related articles.

This week they have posted an article touting the advantages of a "private pension." The URL is http://www.northwesternmutual.com/business...wners/news.html.

In the discussion they mentioned the "Reverse Split Dollar" concept as a method. I would advise caution and a review by a tax lawyer. The IRS has never ruled directly on a RSD.

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Guest ezollars

Additionally, the article doesn't really do justice to split dollar itself, since the real knack is figuring out how to get *out* of the split dollar arrangement. And it seems to imply the use of an equity split dollar arrangement, though the IRS has said in a much discussed PLR that *does* create current taxable income to the beneficiary. Though I know many in the insurance industry disagree, I happen to think the IRS *is* right on that issue.

And, if you don't use equity split dollar, then there seems to be a real tax problem that crops up when we try and transfer the policy to the insured at retirement. At this point we seem to take tax deferred (and hopefully eventually tax free) growth and make it immediately taxable. If the executive simply owns the policy (and, therefore, pays tax on the premiums paid rather than merely the PS-58 costs), then the inside build-up never becomes a problem.

Also, I've seen theoretical discussion about whether or not the IRS might eventually end up applying the below market rate interest rules to split dollar arrangements (since part of the structure is a "loan" of sorts to the covered individual).

In essence, I think you have to realize that all forms of split dollar have tax and economic issues that have to be dealt with.

And, frankly, I happen to feel that the term "private pension plan" to describe what is simply executive life insurance is an inherently misleading term.

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