10-1

Perils Threatening Income-Earning Ability

Death

Disability

Superannuation

Unemployment

10-2

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)

10-3

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 used.

10-4

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.

10-5

Identifying Risk of Loss From Premature Death

Premature death is a source of loss in two ways:

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.

10-6

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

10-7

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.

10-8

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 now.

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

10-9

Time Value of Money (Present Value)

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

$1.00 = $.943396

$1.06

$0.943396 = $.889962

$1.06

10-10

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

10-11

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

10-12

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 $121,08425 40 171,590 150,462 133,317 119,24630 35 163,741 144,982 129,476 116,54535 30 153,724 137,648 124,090 112,47740 25 140,939 127,833 116,535 106,74745 20 124,622 114,699 105,940 98,18250 15 103,796 97,122 91,079 85,59455 10 77,217 43,600 70,235 67,10060 5 43,294 42,123 41,001 39,927

10-13

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)

10-14

Needs Analysis Approach

Amount of insurance that an individual should purchase is properly determined by “needs analysis.”

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.

10-15

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. above

10-16

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

10-17

Classification of Needs

CASH NEEDS INCOME NEEDS

Fund for Last Expenses Funds for Readjustment

Emergency Funds Dependency Period Income

Mortgage Payment Funds Life Income for Spouse

Educational Funds

10-18

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 grown

• “blackout period”

• retirement

10-19

Unfilled Needs

$1,200 per monthfrom widow’semployment $632.60 per month

widow’s OASDIbenefit

$1,603 OASDI benefituntil younger childreaches age 16

$663.60 OASDI benefituntil youngest child reaches age 18

Figure 10.1Needs Analysis Chart

$3000

10-20

Present Value - Future Income Needs

Ages

NeedsProjected

at 3%

OASDIBenefits

Projectedat 3%

IncomeFrom

Employmentat 4%

ProjectedIncomeDeficit

6%Discount

Factor

PresentValue of

ProjectedDeficit

25/3/1 $40,000 $16,800 $20,000 3,200 0.94340 $3,01926/4/2 41,200 17,304 20,800 3,096 0.89000 2,755***** ***** ***** ***** ***** ***** *****

39/17/15 60,504 25,412 34,634 459 0.41727 19140/18/16 62,319 16,772 36,019 9,528 0.39365 3,75141/19/17 64,188 17,275 37,460 9,454 0.37136 3,51142/20/18 66,114 0 39,958 27,156 0.35034 9,514

***** ***** ***** ***** ***** ***** *****60 112,554 0 78,922 33,633 0.12274 4,128

153,768

10-21

Estate Liquidity Need

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

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.

10-22

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.

10-23

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

10-24

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.

10-25

Deductions

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.

10-26

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.

10-27

Example

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.

10-28

Gifts

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 consequences.

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

10-29

Trusts

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.

10-30

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.

10-31

Living (Intervivos) Trusts

Revocable inter vivos trust

The creator reserves the right to terminate the trust and acquire the property.

The revocable trust does not reduce the estate tax liability.

Irrevocable inter vivos trust

The creator relinquishes right to terminate the trust and acquire the property.

An absolute and irrevocable trust takes the property out of the grantor's estate

10-32

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.

10-33

Risks Associated with Superannuation

Two parts to the retirement risk

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

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

10-34

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 annuity

10-35

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.

10-36

Risks Associated with Disability

1. Unlike the case in life insurance, disability income need is not limited to those with dependents.

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.

10-37

Probabilities of Death and Disability

Probability of Probability ofDeath 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%

10-38

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 program

10-39

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 benefits

10-40

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

10-41

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

10-42

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 overpriced

10-43

State Unemployment Insurance

1. Previous employment in a covered occupation

2. Involuntarily unemployed

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

10-44

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 weeks

10-45

Retention and Risk Retention

RETENTION

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

REDUCTION

• comprehensive education

• specialized working skills

• a career that is relatively immune to fluctuations in employment