Page 305 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

Chapter 6. Employee Benefits and Perquisites 291

until children reach age 18 or, more liberally, age 22, assuming college education), and the
surviving spouse period. In addition, amounts can be established for a mortgage fund (or a
separate term insurance policy can be purchased), educational expenses of dependents, and
an emergency fund to cover unexpected financial liabilities.
The ages, as well as the needs of the survivors, are critical in this analysis, as are the
investment philosophy of the survivors. The more conservative, the larger the corpus or
amount of money needed. In determining the needed amount at any point in time, it is help-
ful to remember this formula: given the assumed rate of return, one can easily calculate the
corpus by dividing the living expense by the interest rate. Thus, an annual income of
$200,000 would require a $5,000,000 corpus assuming a 4 percent, tax-free return.
Expenses can essentially be separated into stable and declining needs categories. For exam-
ple, settlement expenses, emergency funds, and adjustment-period income are essentially stable.
However, mortgage coverage and income for dependent children by definition are declining
needs. Thus, one could argue for some amount of permanent life insurance and another piece
of term insurance to meet the 10 to 12 times pay while the children are young (and the execu-
tive is in the midthirties) versus the two to four times pay immediately prior to retirement. In
addition, as was done in the case of estimating income loss, some estimate of the impact of infla-
tion on dependent needs and possible investment growth opportunities on the paid death
benefit need to be taken into consideration to estimate the needed amount of insurance.
Identifying such expenses by year (including some assumption for impact of inflation)
and then calculating a present value (using a reasonable but conservative investment rate
assumption) makes it possible to calculate an amount, which after netting out the value of
current capital investments, indicates the amount needed for life insurance. This approach
assumes the last dollar has been spent the minute before all the above needs have been met.
If an inheritance for children is also expected, its value must be factored in as well.
For many, this will mean purchasing whole life insurance to provide dollar protection
needed for the entire life, and some form of term insurance to meet those needs that do not
span the entire life (e.g., period of dependent children). For some, whole life insurance is one
of the few ways in which they can actually accumulate some savings and then use this cash
value to increase their net worth by borrowing against it. The reason this is attractive is that
the interest rate charged is often significantly less than that available through commercial
banking institutions. Thus, a person with a $1,000,000 face value policy and a cash surrender
value of $500,000 would be able to increase gross earnings $5,000 a year for every 1 percent-
age point that interest earned exceeds interest paid. Furthermore, the level of protection
remains the same at $1,000,000. This consists of $500,000 life insurance (i.e., $1,000,000 less
$500,000 loan) and $500,000 in investments.
Furthermore, some borrow against the cash surrender value to pay the premiums. While
there are some restrictions on how much can be borrowed for this purpose and when it can
be borrowed, this feature can be very attractive. Of course, still others take the increase in
cash-surrender value to purchase additional life insurance.
Obviously, the longer the executive lives and provides the needed income, the less is
needed in the amount of insurance. Without adequate planning, the coverage (especially that
provided by the basic company formula of a multiple of pay) either exceeds or falls short of
need. This is illustrated in Figure 6-1 in a situation all too typical for many individuals—
underinsured early in life and overinsured in later years.