Why I Hate Split-Dollar Life Insurance | White Coat Investor

I get an email a couple of times a year from a doctor asking me to evaluate a benefit his hospital is offering him called “split-dollar” life insurance. I hate these stupid things. The first reason I hate it is that just to tell you why I hate it I will first have to spend hundreds of words explaining to you what this thing is and how it works.

I’m convinced that almost nobody understands how this works. I don’t think the employer understands it. I don’t think the employee understands it. And I’m not even convinced that the guy selling it (and yes, there is a guy selling it) understands it any further than how much commission he will be paid to sell it.

There are so many moving parts here and so much flexibility that a talented insurance salesman has a plethora of ways to hide what is really going on. So I think it is important to start, right here at the beginning, and tell you what is really going on.

A Cash Value Life Insurance Policy is Being Sold to Your Employer

That’s it. Once you understand that, you can always return to it when you get lost in the details. Why do cash value life insurance policies get sold? Because they pay big commissions. Why do they get bought? Usually, because an agent convinces the purchaser that it will help them to achieve their goals. But the truth is that for almost every purpose you can use a cash value life insurance policy for, there is a better tool available.

For example, suppose your goal is to retain a really good employee. What are the possible ways you could do so? Well, you could treat her really well. You could also pay her really well. You might even offer a nice set of benefits. The benefits are even better at retention if they somehow place golden handcuffs onto the employee. Examples of this include vesting of the 401(k) match or stock options that gradually vest. Those are pretty straightforward benefits, however. Basically, you’re just getting paid more money if you stick around. Very simple. The employer doesn’t have to spend time and money hiring and training someone else and the employee gets paid what they’re worth without having to go find another job.

However, once you get beyond these sorts of straightforward “show me the money” benefits, the value of a benefits package comes down to whether or not the employee would buy this thing on their own if the employer didn’t provide it. The best benefits are those the employee cannot get herself (such as a retirement plan like a 401(k)) or which the employer can often provide cheaper than the employee can buy it on the open market, such as health insurance. But if you sat around and thought about which benefits you would rather an employer provide you rather than just paying you more, the list would likely be very short and a cash value life insurance policy would probably not be on it.

Employees don’t actually want these things. How many of you when you interviewed for a job asked “Is there a split-dollar life insurance plan?” If that number isn’t 0%, it certainly rounds there. So why in the world would an employer see giving employees something they don’t want as a way to retain them? It doesn’t make any sense, except once you consider what is going on, which is:

A Cash Value Life Insurance Policy is Being Sold to Your Employer

All right. Let’s get into the details a little bit. There isn’t actually such a thing as a “split-dollar life insurance policy.” There is a life insurance policy, and then there is a split-dollar contract which specifies how the policy premiums will be split up between the employee and the employer and how the policy benefits of the policy will be split up between the employee and the employer.

Sounds straightforward enough right? That is until you add it to one of the most complex financial instruments out there — a universal life insurance policy, which just became an order of magnitude more complex. Wondering why you, as a smart person, are having a hard time wrapping your head around all of these moving parts? Do you think this complexity favors you or the person designing the policy? I’ll give you two guesses and the first one doesn’t count.

There are typically two arrangements here. Let’s go through them one by one.

#1 Economic Benefit Plan

An economic benefit plan (economic benefit arrangement, endorsement plan, etc)  is the classic use of a split-dollar arrangement. In this scenario, the employer is the owner of a universal life (although it can be done with whole life too) policy, the employee is the insured, and the employee gets to name the beneficiary. While there are an infinite number of variations, the premiums are often paid completely by the employer. However, the employee is required to pay taxes on the value of the insurance as if it were a term life insurance policy. So the employer does not have to pay tax on the premiums (since they are a business asset) and the employee gets some life insurance for the cost of the tax on an annually renewable term (ART) policy with the same face value. If the employee dies, the death benefit is split between the company (which generally gets either the total premiums paid or the cash value, often whichever is highest) and the beneficiary gets whatever is left, if anything.

If the employee leaves the employer, one of two things happens.

1. The policy is surrendered and the cash value goes back to the employer or
2. The employee becomes the owner of the policy. If the employee buys the policy from the company, she pays the employer the cash value and again the employer is made whole. Alternatively, the employer gives the policy to the employee (usually with some vesting requirements) and the cash value of the policy becomes a tax deduction to the company and fully taxable income to the employee.

This is considered a “non-equity” arrangement, where the employee (really their beneficiary) only gets a portion of the term life insurance death benefit.  So what are the benefits of this arrangement in the event the employee dies?

• Insurance agent: Gets a big fat commission
• Employer: Gets to provide discounted (50-70% off) ART life insurance to the employee, hopefully retaining them longer as a result. The employer doesn’t have to offer this to all employees as it isn’t covered by ERISA law. The cash value grows tax-deferred too so the employer gets a low return on their cash.
• Employee: Gets to feel good about having a life insurance policy for their beneficiary.
• Beneficiary: Gets almost all of an ART life insurance policy death benefit

So the benefit for the employee, at least in the first few years, is that they get almost all of an ART life insurance policy death benefit for 20-50% of the real cost. The benefit for the employer is that his only cost is the opportunity cost of the money that went into the policy since he was made whole at death.

Sounds pretty good right? So what is the problem? Well, let’s say the employee doesn’t die and the employer does NOT gift the policy to the employee at separation. Who scores under this scenario?

• Insurance agent: Still gets a big fat commission
• Employer: Ended up with an investment with a crummy return
• Employee: Gets to know he had life insurance just in case. Also has the option to buy a universal life policy if he still has a life insurance need and is no longer insurable.

Is the employee really going to stay in a job she doesn’t like for that benefit? Probably not.

What About an Equity Arrangement?

Still not confused? Great. Let’s make it even more complicated. We’re still in the “Economic Benefit Plan” category, but instead of having a non-equity arrangement, where the employee is only entitled to part of the death benefit, let’s make it an equity arrangement where the employee also gets some sort of access to the cash value. Now the employee can borrow against the cash value or even possibly withdraw some of it as a partial surrender. This option presumably only shows up in plans where the employer is planning to give you the cash value anyway, otherwise, you would have to pay the loan back at the time of company separation. Obviously, borrowing against a life insurance policy is tax-free but not interest-free. Partial surrenders are great. There is obviously going to be less life insurance then, but you can take the cash and do whatever you want with it. However, instead of it being tax-free as it often is with a cash value life insurance policy since it represents premiums paid, these partial surrenders are fully taxable at ordinary income tax rates since it is a form of compensation to the employee. If it is just going to come to me as fully taxable income anyway, why not just pay it to me as a cash bonus? Yes, it was growing in a tax-protected way, but it was at such a low rate of return it’s hard to get excited about that. I would have rather had the money and been able to invest it in traditional investments instead of having it stuck in a life insurance policy. Lots of moving parts here.

So who scores under this version where the employee vests into the cash value over 5 years, then separates from the employer without dying?

• Insurance agent: Still gets a big fat commission
• Employer: Gets nothing other than possibly encouraging an employee who doesn’t understand what is going on to stick around longer.
• Employee: Has part of her compensation tied up for 5+ years in an investment with a crummy return. Not exactly the same as stock options for Google employees.

As you can see, the person who really makes out well here is the insurance agent. Thus, we see what is going on:

A Cash Value Life Insurance Policy is Being Sold to Your Employer

#2 Loan Plan

But wait, there’s more. Instead of an economic benefit arrangement (either non-equity or equity), you can also have a “loan arrangement,” or “collateral assignment” or “split-dollar loan” or “loan regime.” In this plan, the employee owns the policy and pays the premiums instead of the employer. The employee still chooses the beneficiary. However, the employee pays the premiums using money loaned by the employer.

Yup. As if it wasn’t complicated enough before, now we’re adding a loan to the mix. The employee has to either pay interest to the employer on the loaned funds or more commonly, pay the taxes due on this interest being forgiven. The interest rate can at times be below current market rates if interest rates have risen since the policy was put in place. So the agreement is usually written such that if the employee dies the employer is made whole from its loans by the death benefit and the rest of the death benefit goes to the beneficiary. If the employee separates, one of two things happens depending on how the agreement is written:

1. The employer is made whole by the employee. If the employee wants to keep the life insurance policy, she can make the employer whole using other funds, but I suspect most of the time the policy is surrendered to make the employer whole.
2. The employer forgives the loans, at which point the amount forgiven becomes a deduction to the employer and taxable income to the employee.

Even more complicated, but really just a variation on the themes above.

Whew! 1900 words so far and you’re just now starting to wrap our heads around this thing. Let’s get into the questions that most people have about these plans.

Should You Take an Offered Split-Dollar Plan?

Let’s say you’re an employee or a prospective employee and you’re being offered this plan. Should you take it? Obviously the devil is in the details since every one of these policies and contracts is unique. But most of the time the answer is yes. I’m no big fan of cash value life insurance, but if someone else is going to buy a policy for me, I’m certainly going to take it. These policies aren’t great investments, but they do have value. Worst case scenario, you get the equivalent of a very discounted term life insurance policy. Now if you have zero need for term life, maybe even that isn’t a great deal but hey, leave it to your mother, niece, or favorite charity. However, I would do one other thing before I took the plan. I would ask the employer if they would just give me a higher salary (or more CME dollars or some other benefit I valued more) instead. The answer is usually going to be no, but it doesn’t hurt to ask.

Should You Keep the Policy After Separation?

One of the worst parts of getting involved in these plans is that at some point you are probably going to be faced with a difficult decision — whether or not to keep the policy in force after you separate from the employer. That usually means you are now taking over the entire premium, so it’s no longer the freebie it used to be. However, the crummy return years may now be water under the bridge. That would likely be the case if it were a whole life policy.

However, these policies are usually universal life policies and one unfortunate feature of a universal life policy is that the cost of insurance increases each year as you age. More and more of your premium each year is eaten up by the cost of the insurance, which is basically the cost of an annually renewable term policy. At a certain point, the cost of the insurance exceeds the premium and starts eating into the cash value. If you live a long time, the “investment component” of the policy hasn’t performed very well, and especially if you’ve borrowed a bunch of money against the policy, the cost of the insurance can eat up the entire cash value and you may have to either start paying huge premiums to keep the policy in force or surrender the policy, lose the insurance you were counting on, and maybe even be stuck with a huge tax bill.

So as a general rule, the face amount on a universal life policy is decreased throughout life to minimize the cost of the insurance. People really aren’t buying these things for a big life long death benefit. If for some reason you really want a big life long death benefit, you’re probably going to want either a whole life policy or at least a guaranteed universal life policy, but those are not common in split-dollar life insurance arrangements.

So what are the circumstances where you might want to keep this policy (or buy it off the employer)? Well, if you really need the life insurance you should probably keep it. Maybe you’re not financially independent and you’re uninsurable for example. You might also keep it for a little while if you expect to be in a high tax bracket for a few more years and then in a lower one. Maybe you surrender it for an ordinary income tax gain in a lower-income year. Maybe you just really like the value proposition of a cash value life insurance policy (something with a low return that you can borrow against that gets pretty good asset protection in many states and provides some sort of death benefit).

Should an Employer Offer This Benefit?

This question has never been brought to me before, but I think it is the most important one in this post. I think the general answer here is “no.” I don’t think it is a great benefit. I think you’re better off offering something your employees will value more, at least those who understand what they are really getting. Remember the key point of this post:

A Cash Value Life Insurance Policy is Being Sold to Your Employer

There are a few benefits to this benefit for the employer, however. In the iteration where the employee basically gets a discount of an ART policy, the employer can offer that benefit at no out of pocket cost to themselves, although there is an opportunity cost since the employer only gets the premiums paid back (or the cash value if it exceeds the premiums paid, but that at a pretty low return). In the iterations where the employee vests into some of the cash value, the employer has the opportunity to offer some “golden handcuffs” without having to comply with ERISA law as they might with a vested 401(k) match. Without ERISA law, the employer can pick and choose which employees to offer this to. However, I think it is probably far easier to just put a simple bonus structure in place or possibly even use vested stock options.

Are There Special Circumstances?

As usual with a cash value life insurance policy, there are some special situations where its value might be quite a bit higher for an individual than it is for the general population. Consider somebody with an estate tax problem, for instance. In this situation, the cash value life insurance policy can be placed into an Irrevocable Life Insurance Trust (ILIT), so in essence, the employee’s “retention bonus” is now paid directly to her heirs and stays out of her estate. While state estate tax exemptions can be lower, very few physicians will ever have an estate larger than the federal estate tax exemption and thus this technique is not a significant benefit for the vast majority.

The Bottom Line

Overall, I’m not a fan of this method of compensating employees and I hate that so many doctors are now having to waste their time trying to understand how this benefit works. If you are an employee and you are offered this, you should probably take it if you can’t talk the employer into giving you something better. Most should also plan to convert any “equity” they have in it to cash by surrendering the policy within at least a few years of separating from the employer. If you are an employer, you need to realize that

You are Being Sold a Cash Value Life Insurance Policy

and most likely, inappropriately.

What do you think? Have you been offered one of these policies as an employee? How did it work out for you? Have you, as an employer, been approached by an agent to put this sort of a plan in place for your group or hospital? What did you end up doing? Comment below!

 

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