Perils Threatening IncomeEarning Ability

1
Perils Threatening Income-Earning Ability

• Death
• Disability
• Superannuation
• Unemployment

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

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.

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.

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.

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

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
  individuals income earning ability.
• 2. Human life value is the present value of
  income lost by dependents as a result of the
  persons death.

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.

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
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

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

12
Economic Value to Dependents

• Years Until Present Value of 10,000
  Age Retirement At 5 At 6 At 7
  At 8
• 20 45 177,740 154,588 136,055 121,084
• 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

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 individuals
  income
• part of income may be replaced from other sources
  (e.g. social security)

14
Needs Analysis Approach

• Amount of insurance that an individual should
  purchase is properly determined by needs
  analysis.
• 1. Huebners 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.

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

16
Lifestyles and Needs Analysis

• Needs will vary with individuals 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

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

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

19

3000
Figure 10.1 Needs Analysis Chart
1,603 OASDI benefit until younger child reaches
age 16 663.60 OASDI benefit until youngest
child reaches age 18
Unfilled Needs
1,200 per month from widows employment
632.60 per month widows OASDI benefit
20
Present Value - Future Income Needs
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.

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 individuals
  lifetime.

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

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 deceaseds 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.

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.

26
Marital Deduction

• Unlimited marital deduction protects individuals
  entire estate from the federal estate tax, but
  spouses 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.

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.

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 ones
  lifetime without tax consequences.
• 10,000 gift tax exclusion will be adjusted for
  inflation after 1998.

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.

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.

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

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.

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

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

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.

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.

37
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

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

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

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

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

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

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)

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

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