One of the many issues facing regulators in the Clayton Smart debacle was the surrender of thousands of Forethought life insurance policies by a Forest Hill preneed trustee. New light will probably be shed on this issue with revelations that Robert Nelms and Clayton Smart may each have been using the same financial management company: Security Financial Management Company. One needs to consider whether an investment advisor looked at the insurance being held by the preneed trust and boasted ‘we can do better’.
Preneed funeral contracts are generally funded by either insurance or trusts. Each has its advantages and disadvantages. However, the respective advantages are generally lost when the preneed trust holds insurance products as investments. (I will exclude cemetery preneed trusts from this discussion because cemetery merchandise is often delivered prior to the purchaser's death, thus making life insurance impractical.)
Insurance gets the nod as the preferable funding vehicle for portability, tax consequence (to the purchaser) and consumer savings (if you're under the age of 60-something and in relatively good health). Trust funding gets the nod for universal availability, long-term performance (if the trust has sufficient assets to permit diversified investments) and refund rights (okay, okay, put the state law variations aside for a minute). However, each type of funding has its unique 'costs', and combining them may cost the funeral home and consumer in the long run.
Trustees were first induced to accept insurance products in the late 1980s when annuities were purchased for trusts that could not comply with the retroactive application of Revenue Ruling 87-127. Many of these trusts lacked the information required to report income to the purchasers. As a grantor trust, preneed trusts could hold an annuity and have the contract's increase be deferred for tax purposes until the contract's maturity.
Once the camel's nose was in the tent, insurance companies began to market life insurance and annuities to death care companies as solutions to lagging trust performance. Corporate trustees often consign smaller preneed trusts to fixed income investments in a conservative approach to avoid market fluctuations. In this era of relatively low interest rates, insurance products can offer a better return than conservative bonds and government securities. And, there is the temptation of a commission on the conversion of the trust's assets to insurance.
However, insurance products represent problems to the corporate trustee. As demonstrated by Clayton Smart's short-sighted actions, cashing in life insurance before the purchaser's death will have a significant adverse impact on the trust's value. Cash surrender values on 70-something year old insureds are typically low. And if the trustee does hold the policy to maturity, how are the insurance proceeds to be taxed? Annuities simply defer the income aspect of the contract until maturity. Life insurance proceeds are not taxable to an individual beneficiary, but are those proceeds taxable to the trust? More than likely, the answer is yes. The proceeds must generally flow through the trust, thus adding time and cost to the administration.
Funeral directors need to consider that rolling a preneed trust into insurance is probably a one-way transaction. Once it has been done, it will be a matter of a few years before an investment advisor recommends that its time to cash those policies in. Two wrongs do not make a right. In many states, it would be difficult to justify a rollover in the first place. Funeral directors will only compound any error made if they change their minds and cash the policies in.