ILITs and the Michigan Prudent Investor Rule

Take-Away: Michigan’s Prudent Investor Rule requires that a trustee take into consideration the impact of inflation on the trust assets’ purchasing power. That fiduciary obligation can pose a problem for the trustee of an Irrevocable Life Insurance Trust (ILIT) which holds a life insurance policy that does not grow it’s death benefit over time.

Background: The Uniform Prudent Investor Rule was adopted in 1994 by the Uniform Law Commissioners. It was based on the revised standards for prudent trust investments that appeared in the 1992 Restatement of the Law (Third) of Trusts [Sections 2(c) and 227] that identified eight criteria a prudent trustee must consider, including among them general economic conditions, taxes, and inflation and deflation. With regard to inflation, while that has been fairly tame over the past 10 years (1.6%), inflation over a longer period of time it has been at a larger pace: 2.1% over 20 years, 2.4% over 30 years, and 3.9% over the past 50 years. In the context of managing trust assets for inflation, consider that a life insurance policy that is held in a trust is intended to provide death benefit protection over a 10 to 40 year time horizon. Consequently, the purchasing power of a life insurance policy’s death benefit is usually eroded over time due to inflation if the policy’s death benefit is fixed, either because it is a term life insurance policy, or it is a guaranteed universal life insurance policy that is funded with minimum premium outlays.

Example: The trustee of an ILIT that holds a life insurance policy has a duty to assure that the policy’s death benefit purchasing power is not eroded over time due to inflation, in keeping with the Uniform Prudent Investor Rule’s criteria. Assume an ILIT trustee purchases a $1.0 million life insurance policy on the life of a male, age 45. The insured’s life expectancy at age 45 is to age 88. With a 2.5% annual inflation rate (admittedly illogical as the inflation rate varies from year to year) the purchasing power of that death benefit when the insured dies at age 88 is only $345,839. If the goal was to actually provide a purchasing power of the death benefit of $1.0 million when the insured dies at age 88, the purchased life insurance policy when the insured is age 45 should be for a face amount of $3,037,903, not $1.0 million.

Michigan Law: Multiple provisions of the Estates and Protected Individuals Code (EPIC) impose the prudent investor rule as a default provision to be followed by a fiduciary.

MCL 700.1502: (1) A fiduciary shall invest and manage assets held in a fiduciary capacity as a prudent investor would… To satisfy this standard, the fiduciary must exercise reasonable skill, care, and caution. (2) The Michigan prudent investor rule is a default rule that may be expanded, restricted, eliminated, or otherwise altered by the provisions of the governing instrument.
MCL 700.1503: (1) A fiduciary’s investment and management decisions with respect to individual assets shall be evaluated not in isolation, but rather in the context of the fiduciary estate portfolio as a whole and as a part of an overall investment strategy having risk and return objectives reasonably suited to the fiduciary estate. (2) Among the circumstances that a fiduciary must consider in investing and managing fiduciary assets are all of the following that are relevant to the fiduciary estate or its beneficiaries:
General economic conditions;
The possible effect of inflation or deflation

(c) through (h)are omitted here

MCL 700.7803: The trustee shall act as would a prudent person in dealing with the property of another ,including following the standards of the Michigan prudent investor rule. If the trustee has special skills or is named trustee on the basis of representation of special skills or expertise, the trustee is under a duty to use those skills.

Practical Observation: The purchasing power of life insurance held in an ILIT might be overlooked because there is a natural emphasis on the minimum outlay per dollar of death benefit. This, in turn, pushes the policy selection towards either term life insurance, guaranteed universal life insurance that functions primarily as level premium term insurance to specific age, or minimally funded, level death benefit universal life insurance. These policy types either have no cash value, or nominal cash value, yet it is the cash value that supports the death benefit and provides the permanent insurance protection acting as a possible hedge against inflation.

Addressing the Problem: The loss of purchasing power of life insurance is a problem that cannot be blissfully ignored by the ILIT trustee. The Uniform Prudent Investor Rule provides at Section 4: Within a reasonable time after accepting a trusteeship or receiving trust assets, a trustee shall review the trust assets and make and implement decisions concerning the retention and disposition of assets, in order to bring the trust portfolio into compliance with the purposes, terms, distribution requirements, and other circumstances of the trust, and with the requirements of this Act. The same duty is prescribed in EPIC. [MCL 700.1505.] There are some steps the ILIT trustee can take to reduce its exposure to breach of trust claims. Those steps include:

Treat the Rule as a Default Rule: The easiest way for the ILIT trustee to avoid the problem posed by the prudent investor rule is to require that the ILIT instrument treat the Michigan prudent investor rule as a default provision and require that the trust instrument expressly relieve the ILIT trustee from having to follow the prudent investor rule as it applies to the insurance policies held in the ILIT.
Buy More Death Benefit: The more expensive, and least likely solution, is for the ILIT trustee to simply purchase a larger face amount of life insurance than is currently needed. If the annual insurance premiums are funded solely with gifts from the settlor-insured, that solution is not likely to be accepted by the settlor-insured.
Exchange Policy for Universal Life Policy: Another possible way to address the erosion of the death benefit’s purchasing power by inflation is either to purchase the type of life insurance policy where the death benefit amount has the potential to increase over time in order to keep pace with inflation, or exchange an existing life insurance policy for a better performing life insurance policy. [IRC 1035] Examples of these types of performing life insurance policies would be an ILIT funded with variable universal life policies or indexed universal life policies.
Buy Whole Life: Perhaps the most practical approach would be for the ILIT trustee to purchase a participating whole life policy with policy dividends applied towards the purchase paid-up additional life insurance on the insured’s life. While the automatic purchase of additional life insurance may not completely offset the erosion of the purchasing power of the policy’s death benefit caused by inflation, using policy dividends to purchase additional insurance can mitigate the erosion of the policy’s purchasing power.

Michigan Legislative Initiatives A couple of years ago the Michigan Bar’s Probate and Estate Planning Council had offered to the state legislature a proposed Bill that would have relieved individual ILIT trustees from liability for their failure to follow the prudent investor rule. There was some opposition from the insurance industry to the proposed Bill, and the Bill has since effectively disappeared from the Legislature’s consideration. The Bill had been offered in recognition that many ILIT trustees are nonprofessional individual family members who only hold their fiduciary position as an accommodation to another family member, most of whom are completely unaware of their fiduciary duties, which leads to the reality that the ILIT trustee faces more breach of trust exposure than he or she is aware of with regard to underperforming life insurance policies, or the loss of purchasing power of the level death benefit policies held in trust due to inflation. In short, those individual ILIT trustees continue to serve with significant liability exposure for claims of breach of trust.

Conclusion: Often ILITs are created, funded, and then forgotten about, other than the annual exclusion gifts into the ILIT which are used to pay the annual policy premium. Overlooked, or ignored, is the fact that ILITs are still subject to Michigan’s prudent investor rule with its fiduciary duty to manage trust assets to preserve their purchasing power. As such, an ILIT is not a ‘set it and forget it’ type of investment vehicle. All of which is a long-winded way of saying that probably only a professional who is sensitive to fiduciary duties, should serve as trustee of an ILIT, and not Uncle Ned.