by Cynthia Harrington

The insurance industry is dusting off an old idea that addresses two societal trends. The first is the growing number of people approaching retirement age with insufficient savings. The second is the widespread fear among those who did save about the stock market decline and the drop in the value of their retirement assets.

The 412(i) defined-benefit plan answers both concerns. The target insured is a profitable business with from five to 10 employees. The business owner is around age 50, is highly compensated, and has too little saved to maintain her current lifestyle in retirement.

Enter the 412(i).

The contributions into the plan actually buy a level of guaranteed retirement income, so the annual payments are significantly higher than defined-contribution levels. According to New York Life, which launched the product in November 2003, there are several hundred thousand businesses out there that meet the profile.

“We target those individuals with profitable businesses and the ability to continue to pay the premiums,” said Frank Mucciardi, corporate vice president and product manager at New York Life Insurance Co. “These are doctors, lawyers and self-employed people who need to play catch up and fund retirement benefits in a relatively short period of time.”

The annual premiums buy a combination of an annuity and a whole life insurance policy. The whole life protects the insured’s beneficiaries in the event of death before retirement and before the annuitization phase. Premiums for both insurance products in the 412(i) are fully tax deductible, and the plans are exempt from the minimum funding requirements usually applicable to traditional defined-benefit plans, which can make the administration of a 412(i) plan simpler than that of a traditional defined-benefit plan.

In addition to other tax-qualified rules, the Internal Revenue Code imposes limits on the amount of life insurance that can be purchased in a qualified retirement plan. As a result, a 412(i) plan cannot be funded solely by life insurance.

Some of the controversy surrounding the 412(i) stems from plans’ compliance with the Internal Revenue Code. “I get asked about these occasionally by clients,” said Laura Tarbox, CFP and president of Tarbox Equities Inc., in Newport Beach, Calif. “But one of my big concerns is the number of articles that report the Internal Revenue Service questioning the 412(i) plans.”

A similar plan, the 419 or welfare benefits trust plan, was recently presented to a client of Erik Thurnher, MD, CFP and president of Physicians Fin­ancial Advisers, in Newport Beach, Calif. Thurnher and an insurance industry consultant reviewed the plan carefully before giving the client the green light to proceed with the product. “The documents revealed a highly questionable interpretation of the tax code,” said Thurnher. “It seemed that they picked and chose only parts of the code on which to structure the product.”

The abuses seem to appear in the mix of insurance and annuity within the plans. The greater the percentage of life insurance versus annuity, the greater the chance that the plan is not in compliance with IRS regulations. “That’s why we were so conservative when we set up our product,” said Mucciardi. “We structured it to be regimented to the tax code.”

While each plan is custo­m­ized to the client’s personal needs, as well as to those of the business’ employees, New York Life sets limits. In their plans, no more than 49.9 percent of the annual premium can be used to purchase the whole life policy, leaving no less than 51.1 percent to be deposited into the annuity. So for a $100,000 annual premium, a maximum of $49,900 would be used to buy whatever level of life insurance is available for a given insured.

Advisors point to high costs, low flexibility, and the IRS uncertainty as concerns about the plans. Tarbox investigated the products when teaching a class about pension plans. “I’m mostly concerned about the high costs and the restrictions,” Tarbox said. “Most of my clients can get enough in other retirement vehicles, and they retain the flexibility of investing the money.”

Mark Balasa, CPA, CFP, of Balasa Dinverno Foltz & Hoffman, in Schaumburg, Ill., reviewed the plans on the suggestion of an insurance broker in 2003. The plan complied with the regulations, and would have been invested in the general fund of the insurance company at rates set by the company.

“These are highly commissionable products, and I would not be comfortable with the level of surrender charges as a result,” said Balasa. “Besides, the insured is banking on the insurance company to be there to pay out. There are just too many elements of uncertainty.”

Returns within the plans are guaranteed, as are payouts. That keeps a cap on what the insurance companies can afford to pay. Most plans are structured with a guaranteed minimum, supplemented by earnings in the plans above the guaranteed floor. During the accumulation phase, the cash value of policies builds up within both the whole life and the annuity portions.

At New York Life, the dividends earned above the floor are credited against the following year’s premiums. The insured gets a notice of the exact amount of the level premium due that year. “For example the plan might guarantee a 3 percent return but earn 5 percent,” said Mucciardi. “The 2 percent difference goes to reduce that year’s premium for the owner. But essentially, within the plan, there’s only the 3 percent growth in cash value.”

Funds come out of the plan in several ways. If the insured dies during the accumulation phase, the beneficiary receives the full death benefit from the life insurance policy, as well as the full cash value of the annuity. Loans are not permitted under a 412(i) plan. Once the owner retires and begins payout on his policy, the employees can roll over their plans into an IRA or can buy out the 412(i) plan of the employer.

New York Life and Principal Financial Group both launched new 412(i) plans in November 2003. Northwestern Mutual also offers a product. “Our advanced planning and life products consultants are getting requests from CPAs in local communities to come out and educate them on this product,” said Mucciardi.

Not all advisors have clients in the target market. “My highly compensated clients already have a sufficient level of discretionary savings and don’t need to do something like this,” said Balasa.

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