The Uniform Prudent Investor Act (UPIA) stipulates how trustees should perform their fiduciary duties in managing trust assets. Section 2(c) of UPIA provides criteria that the trustee must consider in investing and managing trust assets, including, “the possible effect of inflation or deflation.” In other words, the trustee must protect the purchasing power of assets. Given that life insurance is generally purchased to provide death protection over a 10 to 50-year time horizon, how can a policy with a nominal level death benefit that cannot increase satisfy the requirement of protecting purchasing power? Part 1 of this two-part article examines UPIA and historical rates of inflation over various periods. It also explores the effect of inflation on the purchasing power of life insurance at life expectancy and wraps up with a discussion on the implications for ILIT trustees.

Introduction

While several articles have addressed the applicability of the Uniform Prudent Investor Act (UPIA) to trust-owned life insurance (TOLI), particularly commenting upon one or more of the four court cases involving UPIA and TOLI—including the two-part article I cowrote with Randy Whitelaw, entitled “The Four UPIA-TOLI Cases, and One Involving the UTC, and Their Astonishing Implications for ILIT Trustees,” published in Leimberg Information Services (LISI) Newsletters 1234 and 1256—none, to the best of my knowledge, have addressed, with respect to life insurance, the trustee duty prescribed by UPIA Section 2(c)(2) to consider when investing and managing trust assets “the possible effect of inflation or deflation.”

Life insurance generally has a planning time horizon of from 10 to 50 years. The compounded annual rate of inflation over the last 10 and 30 years has been 1.6 percent and 2.4 percent, respectively. However, with emphasis on minimum premium outlay, many ILITs have been funded with either guaranteed universal life insurance or minimally funded universal life type policies and, with term insurance policies that are more appropriate for temporary needs rather than the permanent nature needed for funding an ILIT. Since these policies can only deliver at the death of the insured the initial nominal face amount of the policy, their purchasing power is seriously eroded. In this two-part article, we’ll examine this dilemma and the possible breach of fiduciary duties, as well as possible solutions, and ways to prevent the problem in the first place. Part two, will be published in February 2021.

The Uniform Prudent Investor Act

The Uniform Prudent Investor Act,[1] hereinafter referred to as UPIA, approved and recommended for enactment in all the states by the National Conference of Commissioners on Uniform State Laws at its Annual Conference of July 29 – August 5, 1994--and subsequently approved by the American Bar Association on February 14, 1995—has been adopted, in some form or another, by almost all states.[2] UPIA draws upon the revised standards for prudent trust investment promulgated by the American Law Institute in its Restatement of the Law (Third) of Trusts: Prudent Investor Rule (1992),[3] hereinafter referred to as Restatement of Trusts 3rd.

Reinstatement of Trusts 3rd, in Section 227, General Standard of Prudent Investment, Comment on Basic Duties of the Prudent Investor e, General requirement of caution, notes as follows;

In addition to the duty to use care and skill, the trustee must exercise the caution of a prudent investor managing similar funds for similar purposes. In the absence of contrary provisions in the terms of the trust, this requirement of caution requires the trustee to invest with a view both to safety of the capital and to securing a reasonable return.

“Safety” of capital includes not only the objective of protecting the trust property from the risk of loss of nominal value but, ordinarily, also a goal of preserving its real value—that is, seeking to avoid or reduce loss of the trust estate’s purchasing power as result of inflation. This objective will also normally tend to protect the purchasing power of the income flow in the future.[4]

Subsection (c) of UPIA Section 2, “Standard of Care; Portfolio Strategy; Risk and Return Objectives,” provides a list of eight criteria a prudent trustee must consider in the administration of trust assets and reads as follows:

Among circumstances that a trustee must consider in investing and managing trust assets are such of the following as are relevant to the trust or its beneficiaries…[5]

Subsection (c)(2)—the second item in the list of eight criteria a prudent trustee must consider, following subsection (c)(1) that states “general economic conditions,” states:

[T]he possible effect of inflation or deflation.[6]

This is the codification of Section 227 e of Restatement of Trust 3rd, as stated above, and, of course, deals with purchasing power risk.

Purchasing Power Risk

Inflation has been relatively low for the last couple of years, with inflation rates of 2.1 percent, 1.9 percent and 2.3 percent for the years 2017, 2018, and 2019, respectively, as measured by the consumer price index for all urban consumers (CPI-U).^[7] The compounded annual rates of inflation ending in the year 2018 for the last 10, 20, 30 and 50 years has been 1.6 percent, 2.1 percent, 2.4 percent, and 3.9 percent, respectively.^[8] In fact, the compounded annual rate of inflation for the 100-year period from the end of 1919 to the end of 2018 has been 2.7%.^[9] During that same 100-year period “[i]nflation rates ranged from a high of 15.6 percent in 1920 to a low of negative 10.5 percent in 1921.”^[10]

A life insurance policy is purchased to provide death benefit protection over a 10 to 50-year time horizon. Given the examples of the long-term average rates of inflation mentioned above, the expectation that purchasing power will remain constant is an unrealistic and unattainable expectation. Yet, if a policyowner purchases a policy type with a constant level death benefit that cannot increase in any way but will remain the same nominal face amount throughout the life of the policy, they are either assuming a decreasing need for the amount of life insurance required over time or they are thoroughly ignoring the erosion of purchasing power caused by inflation.

To demonstrate the erosion of purchasing power over time due to inflation consider the following example: Assume that the rate of inflation is two and one-half percent (2.5 percent) per year. Also, assume we have a 55-year-old female, with a life expectancy of age 91, who purchases a level death benefit type of policy with a face amount of $1 million. Assuming this 55-year-old female dies at her life expectancy age of 91, what is the purchasing power of the $1 million policy at her life expectancy? With two and one-half percent (2.5 percent) inflation, the answer is $411,094. In fact, with a level death benefit type of life insurance product, she would have had to purchase a policy at age 55 for $2,432,535 to have $1 million of purchasing power at her life expectancy of age 91.

Tables 1, 2 and 3 show the purchasing power risk for a $1 million level death benefit life insurance policy with two and one-half percent (2.5 percent) inflation for various insureds at their respective life expectancy. Table 1 shows the value of $1million at life expectancy, and the amount of insurance that would have had to be purchased at the insured’s issue age in order to have $1 million of purchasing power at life expectancy, for female insureds of various select ages. Tables 2 and 3 show the same data for male insureds of various select ages, and for joint female and male insureds for second to die policies, with the life expectancy of that of the second to die, for various select ages, respectively.

The solution to the purchasing power risk in irrevocable life insurance trusts (ILITs) is to either purchase initially a larger face amount of life insurance than currently needed, or, to purchase types of life insurance policies wherein the death benefit face amount has the potential to increase over time in order to attempt to keep pace with inflation. This would suggest the purchase of either participating whole life polices, with dividends applied to purchase paid-up additional insurance; or substantially funded variable universal life policies, or, perhaps, indexed universal life policies.

Implications for Trustees

It is obvious from the examples above that purchasing power risk, or inflation, can seriously erode the values of trust assets, particularly level death benefit life insurance policies, and needs to be seriously considered by trustees.

To the best of my knowledge, there are no overall studies, or data, on life insurance in trusts. Indeed, there are no reliable studies regarding trustees of ILITs, although it has been estimated that up to 90 percent of trustees for ILITs are nonprofessional trustees, such as brothers-in-law, golfing buddies, and friends and other accommodation trustees.[11]

The TOLI Center (TTC), a firm based in St. Louis with a national clientele, has provided fee-based policy administration and risk management services to skilled and unskilled trustees, trust companies, attorneys, affluent family groups and ILIT beneficiaries since 1992. TTC has maintained portfolio statistics on life insurance policies they administer. They currently administer approximately 2,500 policies contained in 1,715 ILITs, according to George P. Whitelaw, managing director of TTC.[12] The average face amount of policies administered by TTC is $3,096,777[13].

Whitelaw also commented, “very few TOLI policies are designed with increasing death benefit.”[14] He further notes “[m}ost universal life policies are level death benefit. Typical whole life dividend selection is to have dividends buy paid-up additions but policies also have dividends reduce premiums and buy term.”[15] (By the way, according to TTC data released on 2020 TOLI Portfolio Statistics in April 2020, approximately 36.5 percent of universal life, indexed universal life and variable universal life policies were carrier illustrated to lapse within 5 years of life expectancy, and 14 percent of guaranteed universal life policies have compromised guarantees.)[16]

The TTC statistics represent extremely sophisticated and mostly skilled professionals as trustees. Given that, according to Whitelaw, most policies in the ILITs that TTC administers are level death benefit, one wonders what that statistic is for the vast number of ILITs administrated by amateur trustees? More importantly, why are ILIT trustees ignoring the duty to protect the purchasing power of trust assets when it comes to life insurance policies? What, if anything, can be done to correct the situation?

The answers to the first two questions posed above are based on empirical information acquired over my 40 plus year career from actual experience and many conversations with other professionals. The answer to the question “what is that statistics for the vast number of ILITs administered by amateur trustees?” is, who knows? However, the suspicion is the percentage of life insurance policies with only a level death benefit amount is greater than the experience of TTC.

Why are trustees ignoring the duty to protect the purchasing power of trust assets, prescribed by UPIA Section 2(c)(2), when it comes to life insurance? Or, perhaps, the broader question, is why are trustees ignoring much of UPIA requirements when it comes to life insurance? These questions have to be answered in the context of both the professional and amateur trustee but really boil down to ignorance and lack of life insurance expertise.

In part two of this article, we will look at how trustees tend to ignore UPIA standards in general when it comes to life insurance, and look at restructuring ILIT assets to ensure trustees are complying with their duties under the UPIA.

This article was originally published by Leimberg Information Services, Inc., and is reprinted with permission.

Gary L. Flotron, MBA, CLU, ChFC, AEP, is the associate director for financial planning programs and an adjunct faculty member at the College of Business Administration of the University of Missouri, St. Louis, where he teaches courses in estate and trust planning, employee benefits, and life insurance. He is also the consulting principal of G. L. Flotron & Associates and specializes in the areas of trust-owned life insurance, estate and business planning, and executive and employee benefit plans. The American Bar Association Real Property, Trust and Estate Law just published Gary’s book titled Understanding Life Insurance and Rethinking Policy Management and Evaluation: Explaining the Unexplainable and is available at www.americanbar.org/products/inv/book/392915013/.

[1] National Conference of Commissioners on Uniform State Laws, Uniform Prudent Investor Act, Chicago, Illinois, 1985.

[2] According to Uniform Law Commission website, 43 states have adopted the Uniform Investor Act. www.uniformlaws.org/committees/community-home?CommunityKey=58f87d0a-3617-4635-a2af-9a4d02d119c9.

According to the Federal Deposit Insurance Corporation (FDIC) website under Trust Examination Manual, Appendix C—Fiduciary Law, Uniform Prudent Investor Act, 42 states have adopted UPIA and 7 states have adopted a “quasi” form of UPIA. However, the FDIC website claims Mississippi and Louisiana have not adopted UPIA. www.fdic.gov/regulations/examinations/trustmanual/appendix_c/appendix_c.html#_toc497113666. The Uniform Law Commission website includes Mississippi, although Mississippi is shown as the last state to have adopted UPIA in 2006. From this information the author concludes that 49 states—plus the District of Columbia—have adopted some form of UPIA with the exception of Louisiana.

[3]Reinstatement of the Law Third, Trusts, Prudent Investor Rule, The American Law Institute, Washington, D.C., 1992.

[4] Ibid, Section 227 Comment e, pages 17-18.

[5] Supra note 1, pages 5-6.

[6] Ibid, page 6.

[7] Bureau of Labor Statistics, Consumer Price Index, Calendar Year Historical, 2015-2019, U.S. City Average, https://www.bls.gov/regions/southwest/data/consumerpriceindexcyhistorical_southwest_table.htm.

[8] Compounded annual rates of inflation based on calculations of Consumer Price Index, All Urban Consumers – (CPI-U), U.S. City Average, from a table sent to the author by the U.S. Department of Labor, Bureau of Labor Statistics.

[9] Ibid.

[10] Ibid.

[11] E. Randolph Whitelaw and Henry Montag, The Life Insurance Policy Crisis: The Advisors’ and Trustees’ Guide to Managing Risks and Avoiding a Client Crisis, The American Bar Association, Chicago, Illinois, 2016, footnote 4, page 3.

[12] Email to author from George P. Whitelaw, July 28, 2020.

[13] “2020 TOLI Portfolio Statistics”, The TOLI Center, St. Louis, Missouri, 2020, page 1.

[14] Email to author from George P. Whitelaw, May 27,2020.

[15] Ibid

[16] Supra note 13, page 1.