Most family members who take on the role of managing a trust have no idea what they'll need to do. Financial planners can protect clients asked to take on this responsibility by advising them to review the responsibilities with their own lawyers to ensure that they understand the risks. The clearer the language in the trust, the easier it will be for your client.
For example, if a trust states that money can be used for a child's health, education and welfare, does that include buying a car to get to class? Clients should never accept the role of trustee unless they understand the document fully.
If your clients are trustees already, they must keep up to date on the strength of the insurer and have independent insurance experts analyze the value of the policy every year, making changes as recommended. It's essential to advise clients not to rely only on the insurance agent who sold the policy to monitor its performance.
This would be true at any moment, but these are not usual times. The S&P 500 started 2001 at 1,320 and started 2011 at 1,257.
Yet many policies for non-term life insurance, especially variable policies, sold over the past 10 years were based on an assumption that the stock market would grow 6% to 8%. Few expected a decade of flat returns. The result is many life insurance policies may now be underfunded, meaning they won't provide the expected benefits. As a trustee, your client will need to reevaluate potential options.
At least once a year, trustees should ask an insurance carrier to provide an in-force statement detailing performance and stipulating whether the premium would still result in the original death benefit. Most clients will need help analyzing the statement from the carrier.
You, in turn, may want to consult an insurance advisor. A complete analysis will include projected cash values based on realistic expectations for stocks and an estimate of how long the policy will remain in force under various market scenarios.
It's also necessary to check an insurance carrier's ratings. While there are no prominent cases where this has been tested legally, a trustee could in theory be required to pay the face value of a policy if an insurer defaulted. Failures are rare, but this last decade has been the first time since the early 1900s when stocks didn't grow from the start to finish of a 10-year period. Marking a calendar for an annual review and keeping up to date on the carrier is prudent.
Of the five principal rating companies - A.M. Best, Standard & Poor's, Moody's Investor Services, Fitch Ratings and Weiss Ratings - Weiss is considered the toughest grader and is the only rating company that is not paid by insurers. Rating terms can be confusing; for example, an "A++ superior" rating from A.M. Best is roughly equivalent to an "Aaa exceptional" rating from Moody's. Another way to check the status of an insurance company is with the National Association of Insurance Commissioners.
There are four basic options if a policy is not performing or a carrier is failing or downgraded. These are to buy a new policy, convert to a different kind of policy, pay higher premiums for the existing policy or stay the course.
Buying a policy from a carrier with a superior rating is likely to cost more money. Cashing in cash value in excess of basis - the amount of premiums paid into the policy, minus any dividends paid or previous withdrawals - is taxable as ordinary income.
Increases in life expectancy have brought down costs, so if the insured person is healthy, the price may be reasonable. To make sure the purchase meets tax-code requirements for an exchange of policies, be sure a tax expert reviews the transaction.
Consider converting to a different type of policy, perhaps term insurance from whole, guaranteed universal from variable, or universal or variable universal, depending on the purpose of the trust. For example, if the trust owns a variable universal life policy with uncertain performance, one may want to switch to a policy whose performance is guaranteed - whole life or traditional guaranteed universal life.
On the other hand, a variable universal life policy often can outperform more traditional whole life policies. If the insured person is now significantly older or in poorer health, a new policy may not be an option. The trustee may need to ask the person who established the trust to add money in order to pay the higher premiums.
Doing nothing and hoping performance or a carrier's rating improves is the worst option. Too much is at risk to make this choice for clients.
Many states have adopted regulations known as the Uniform Prudent Investor Act, which holds trustees to a fiduciary standard. They must invest and manage trust assets as a prudent investor would by considering the purposes, terms, distribution requirements and other circumstances of the trust.
Trustees must exercise reasonable care and skill, remain loyal to the beneficiary and exercise prudence by diversifying the trust's investments to minimize the risk of large losses. The language of some trusts doesn't require diversification, but all trustees should be sure of their obligations.
If your client is considering accepting a role as a trustee, it's essential to advise that the document be worded that way. The client might also ask for language stating that he or she can only be sued for gross negligence.
The recent case in Indiana of Stuart Cochran Irrevocable Trust vs. KeyBank highlights the risk that trustees face when dealing with prudent management of trust-owned life insurance. In that case, a trustee was sued by the beneficiaries of an irrevocable life insurance trust for alleged violation of Indiana's Uniform Prudent Investor Act, as well as breach of trust.
KeyBank was exonerated. A decisive factor in the ruling by the Indiana Court of Appeals was that KeyBank hired and relied on the recommendations of "an outside, independent entity" to evaluate the decision-making in the case.
If a policy is in danger of lapsing, and the trustee does nothing, he or she could easily be considered to have failed in his or her duty. For example, let's say your client's sister asks her to be a successor trustee after she passes away.
Your client is flattered by her trust. The sister dies, and your client becomes a co-trustee with her brother-in-law, who begins spending the money quickly, even though there are three children in line to inherit some of the estate.
As a fiduciary, your client may need to intervene to protect the rights of the children, even going to court. If she fails to act, she could be sued for failing to oversee the other trustee.
Jay J. Freireich is a member of the wills, trusts and estates practice of Brach Eichler in Roseland, N.J.
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