ch10 by M5a54xY6


									Perils Threatening Income-Earning Ability





Risks Arising From Uncertainty of Time of Death

The individual faces two risks that arise from
uncertainty concerning time of death:

1. Premature death (death while others
   remain dependent on individual’s income)

2. Superannuation (the risk of retiring
   without adequate assets to cover living
   expenses during retirement)

            Death and Superannuation

The risks of death and superannuation are
mutually exclusive and complementary events:

 1. If individual dies prematurely, he or she
    will have no need for retirement funds.

 2. If individual lives until retirement,
    provision for premature death will not be

     Objectives in Managing Personal Risks

1.   To avoid deprivation of the individual and
     those dependent on him or her in the event
     of loss that terminates income.

2.   From personal financial planning,
     sometimes the goal of transferring the
     maximum wealth possible to dependents.

Identifying Risk of Loss From Premature Death

Premature death is a source of loss in two

1. Death triggers expenses associated with
   death itself (funeral expenses and other
   death costs).

2. Death causes loss of income that the
   individual would have earned.

              Measuring Risks
      Associated With Premature Death

Two approaches have been suggested for
evaluating the risk of premature death:

1. Human life value

2. Needs analysis

               Human Life Value

The human life value concept is generally
credited to Soloman S. Huebner.

1. Human life value concept is based on the
   individual’s income earning ability.

2. Human life value is the present value of
   income lost by dependents as a result of
   the person’s death.

                Present Value

Any attempt to measure human life value must
consider the “time value of money” or the
concept of “present value.”

1. “Time value of money” refers to fact that
   $1 today is worth more than a year from

2. Money invested at some positive rate of
   return will be worth more in the future.

 Time Value of Money (Present Value)

  $1.00     +   (1.00 X 6%)   =   $1.06

  $1.06     =    $.943396

   $1.06    =    $.889962

        Present Value of $1 in N Years

Year       6%        8%       10%        12

    1 $0.94340$0.92593 $0.90909 $0.89283
    2 0.89000 0.85734     0.82645    0.79719
    3 0.83962 0.79383     0.75131    0.71178
    10 0.55839 0.46319    0.38554    0.32197
    20 0.31180 0.21455    0.14864    0.10367
    30 0.17411 0.09938    0.05731    0.03338
  Present Value of $1 Annually for N Years

Year       6%        8%       10%       12%
  1 $0.94340 $0.92593 $0.90909 $0.89286
  2    1.83339   1.78326   1.73554   1.69005
  3    2.67301   2.57710   2.48685   2.40183
 10    7.36009   6.71008   6.49506   5.65022
 20 11.46992 9.81815       8.51356   7.46944
 30 13.76483 11.25778      9.42691   8.05518

            Economic Value to Dependents

    Years Until          Present Value of $10,000
Age Retirement     At 5%      At 6%       At 7%     At 8%
 20         45    $177,740$154,588   $136,055 $121,084
 25         40     171,590 150,462    133,317  119,246
 30         35     163,741 144,982    129,476  116,545
 35         30     153,724 137,648    124,090  112,477
 40         25     140,939 127,833    116,535  106,747
 45         20     124,622 114,699    105,940   98,182
 50         15     103,796 97,122      91,079   85,594
 55         10      77,217 43,600      70,235   67,100
 60          5      43,294 42,123      41,001   39,927

  Difficulties With Human Life Value Concept

1. Indicated value depends on estimate of
   future changes in income.
2. Indicated value varies with discount rate.
3. Indicated value does not necessarily
   represent a measure of loss.
    • no one may be dependent on the
      individual’s income
    • part of income may be replaced from
      other sources (e.g. social security)
          Needs Analysis Approach

Amount of insurance that an individual should
purchase is properly determined by “needs
1. Huebner’s life value approach looks at
   income that would be lost.
2. Needs approach attempts to identify the
   allocation of that income and the purposes
   for which it would have been used.

                 Needs Analysis

Needs analysis has three basic steps
1.   Identify the needs that would arise or
     continue following death of the individual
2.   Identify resources that would be available
     (social insurance benefits, employer-
     provided benefits, savings)

3.   Measure difference between 1. and 2.

         Lifestyles and Needs Analysis

Needs will vary with individual’s situation and
lifestyle. Identifiable lifestyles include:
1. Single individual without dependents
2. Single individual with dependents
3. Childless couples
4. Couples with children - both employed
   outside the home
5. Couples with children - only one employed
   outside the home
               Classification of Needs


Fund for Last Expenses    Funds for Readjustment
Emergency Funds           Dependency Period Income
Mortgage Payment Funds    Life Income for Spouse
Educational Funds

        Classification of Income Needs

Income needs may be classified into three
groups, representing different periods:

1. Readjustment income following death
2. Income during dependency period
3. Income for spouse when children are
    • “blackout period”
    • retirement

                                      Figure 10.1
                                      Needs Analysis Chart

        $1,603 OASDI benefit
        until younger child               Unfilled Needs
        reaches age 16

        $663.60 OASDI benefit   $1,200 per month
        until youngest child    from widow’s
                                employment       $632.60 per month
        reaches age 18                           widow’s OASDI

        Present Value - Future Income Needs

                   OASDI      Income                            Present
         Needs    Benefits     From    Projected      6%       Value of
        Projected Projected Employment Income      Discount    Projected
 Ages     at 3%     at 3%      at 4%    Deficit     Factor      Deficit

 25/3/1  $40,000 $16,800     $20,000      3,200    0.94340       $3,019
 26/4/2   41,200  17,304      20,800      3,096    0.89000        2,755
  *****     *****   *****       *****      *****       *****       *****
39/17/15  60,504  25,412      34,634        459    0.41727          191
40/18/16  62,319  16,772      36,019      9,528    0.39365        3,751
41/19/17  64,188  17,275      37,460      9,454    0.37136        3,511
42/20/18  66,114        0     39,958     27,156    0.35034        9,514
  *****     *****   *****       *****      *****       *****       *****
   60    112,554        0     78,922     33,633    0.12274        4,128

              Estate Liquidity Need

1. A federal transfer tax, called the estate tax,
   is imposed on transfers at the time of

2. Amounts passed to heirs other than a
   spouse that exceed $600,000 are subject to
   the tax.

3. To avoid forced sale of assets to pay the
   estate tax, life insurance may be needed to
   provide liquidity.

                Estate Planning

The process through which one arranges
one's affairs for the most effective
accumulation, management, and disposition of
capital and income.

The greatest shrinkage of the estate has
historically come from the federal estate tax,
which applies to assets held at the time of
death and certain gifts made during the
individual’s lifetime.

                 Taxable Estate

Rates in 1999 began at 37% on taxable estates of
$650,000 - go to 55% on estates over $3 million.
 • The taxable estate is the gross estate minus
   allowable deduction.
 • Tax is subject to a credit that reduces the tax
   actually payable.
 • This credit against tax is commonly referred
   to as an estate tax exemption.
 • $625,000 estate exempt from tax in 1998.
 • Subject to increase to $1 million in 2006.
 • Family business deduction
                 Taxable Estate

Taxable estate is determined by deducting
allowable exemptions from the gross estate.
Gross estate includes the fair market value of
• all real and personal property owned at the time
  of death, including interest in property owned
  jointly with another.
• proceeds of life insurance on deceased’s life if
  deceased possessed incidents of ownership.
Incidents of ownership means such ownership
rights as the right to change beneficiaries, borrow
cash value, or withdraw cash values.

Gross estate is subject to certain deductions in
determining the portion that is taxable.
  credit for state and foreign death taxes.
  marital deduction, which is unlimited.
    • applies only to the part of the estate that
      actually passes to a surviving spouse.
    • If a person dies "intestate" the estate is
      distributed according to state law.
    • In many states, a spouse receives 1/3 and
      2/3 is divided equally among the children.
    • This distribution deprives the estate of the
      full benefit of the marital deduction.
                Marital Deduction

Unlimited marital deduction protects individual’s
entire estate from the federal estate tax, but
spouse’s estate will be subject to the federal
estate tax.
 Property left to a surviving spouse becomes a
  part of the spouse's estate and is taxed without
  marital deduction when he or she dies.
 Strategy: arrange for the distribution of that
  estate in a manner that will maximize the use of
  the unified estate-gift tax credit.


Bill Smith has an estate in the neighborhood of
$1.3 million.
  If he leaves his entire estate to Mary, it will
   pass without estate tax liability, but the tax is
   merely deferred.
  If Bill dies in 1999, $650,000 of his estate
   could pass to children or other heirs without
   tax liability.
  The remaining $650,000 may pass to Mary, or
   it may pass to the children or other heirs
   subject to the estate tax.

In addition to using the marital exemption and
maximizing the unified credit, a third strategy
is by making gifts prior to death.
 Annual gift tax exclusion of $10,000 per
  donee, whereby assets may be transferred
  during one’s lifetime without tax

 $10,000 gift tax exclusion will be adjusted
  for inflation after 1998.


A common tool for implementing estate planning
strategies and for the administration of an estate.
 Arrangement under which the holder (trustee)
  undertakes the management of another's
  property (called the corpus of the trust), for
  benefit of designated persons.
 The most widely used trusts are
    • the testamentary trust, which is a part of the
      will and takes effect after death, and
    • the living or inter vivos trust, established
      during the lifetime of the creator and which
      may be revocable or irrevocable in nature.

                Testamentary Trust

Will not reduce estate taxes at death of the
testator, nor will it reduce estate settlement costs.
 Trust property remains in the estate of the
  testator until distribution after will is probated.
 Used to leave property to heirs other than a
  spouse (to maximize tax credit), but also
  provides for a surviving spouse.
    • The spouse is the beneficiary of the trust;
    • other heirs are remaindermen.
Property in trust is not subject to the marital
deduction, but uses all or part of the unified credit.

            Living (Intervivos) Trusts

Revocable                Irrevocable
inter vivos trust        inter vivos trust
The creator reserves     The creator
the right to terminate   relinquishes right to
the trust and acquire    terminate the trust and
the property.            acquire the property.
The revocable trust      An absolute and
does not reduce the      irrevocable trust takes
estate tax liability.    the property out of the
                         grantor's estate

        Irrevocable Life Insurance Trust

Irrevocable Life Insurance Trust (ILIT) is used to
avoid the incidents of ownership in a life
insurance contract.
 Life insurance is purchased and managed by a
  trustee, subject life insurance trust agreement.
 Premiums are paid from funds transferred to
  the trust as gifts but not withdrawn by trust
  beneficiaries. (Crummey powers)
 Key feature is the willingness of beneficiaries
  to not withdraw the gift, which they must have
  the right to do if it is to qualify as a gift.
    Risks Associated with Superannuation

Two parts to the retirement risk

 • Individual will not have accumulated
   sufficient assets by the time retirement

 • Assets that have been accumulated will not
   last for the remainder of his or her lifetime

       The Risk of Outliving the Accumulation

•   Some strategy is needed to guarantee that the
    individual will not outlive the assets

•   Conventional tool for this problem is a life

        Estimating the Accumulation Need

1.   Monthly income needs during retirement
     are projected by some assumed rate of
     inflation together with social security
     benefits, which are deducted from needs.

2.   If pension benefits will be available,
     projected pension benefits are also
     deducted from projected need.

3.   Remaining monthly need is converted to
     an annuity purchase price to determine
     total future capital need.
         Risks Associated with Disability

1.   Unlike the case in life insurance, disability
     income need is not limited to those with
2.   Income need may even be greater for the
     person without a spouse (no second
     income, need to hire a care provider).
3.   If breadwinner dies, income stops but
     expenses also decline.
4.   In event of disability, income stops and
     expenses will likely increase.
     Probabilities of Death and Disability

           Probability of     Probability of
           Death Before      90-Day Disability
Age           Age 65          Before Age 65

25             24%                 54%
30             23%                 52%
35             22%                 50%
40             21%                 48%
45             20%                 44%
50             18%                 39%
55             15%                 32%
60              9%                  9%
        Needs Analysis for Disability Risk

1.   Follows same pattern discussed in
     connection with life insurance, in which
     anticipated needs are projected

2.   Adequate medical expense coverage
     should be available to meet increased
     medical expenses

3.   Program should include provision for
     continued contributions to retirement
     Resources Available to Meet Disability Risk

1.    Workers compensation benefits for work-
      related disabilities

2.    Compulsory Temporary Disability Benefits
      in California, Hawaii, New Jersey, New
      York, Rhode Island and Puerto Rico

3.    Social Security benefits for total and
      permanent disabilities

4.    Employer-provided sick leave or cash
       Addressing Unmet Disability Needs

1.   Subtract available resources from needs

2.   Most important disability income need is
     long-term disability for both occupational
     and nonoccupational disability to
     supplement Social Security benefit

3.   Some people will also need short-term
     coverage for disabilities that are not
     covered under Social Security

         The Medical Expense Exposure

1.   Personal risk management program is
     incomplete without protection against
     medical expenses

2.   Major consideration should be protection
     against catastrophic loss

 Managing the Risk of Unemployment

Limited options for transferring the risk

 • State unemployment programs exist in
   all states

 • Unemployment insurance is available
   on a limited basis in connection with
   installment credit; usually greatly

         State Unemployment Insurance

1.   Previous employment in a covered

2.   Involuntarily unemployed

3.   Continued attachment to the labor force
     (willing and able to work)

 Benefits Under State Unemployment Insurance

1. Benefits related to previous earnings
   • Typically 1/26 of previous earnings
   • About 50% of normal earnings but
     subject to statutory maximum
   • State maxima in 1998: from $180 to $573

2. Benefits payable for a maximum period
   • Maximum is 26 weeks in 44 states
   • Longest maximum in any state is 39
        Retention and Risk Retention

   Authorities recommend an emergency
   fund equal to from 3 to 6 months expenses

 • comprehensive education
 • specialized working skills
 • a career that is relatively immune to
   fluctuations in employment

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