The opening chapter of this book described the basic family needs that life insurance can meet. The manner in which settlement options can be adapted to a family’s various needs is outlined below.

Cleanup or Estate Clearance Fund. The first need in point of time, as explained in chapter 1, is a fund to meet the expenses that arise from the insured’s death and to liquidate the current outstanding obligations. These are claims against the insured’s probate estate and must be satisfied before any property can be distributed to the heirs. The size of the fund varies, but for estates of less than $600,000, it averages 15 percent of the probate estate. For larger estates the percentage is higher because of the progressive nature of death tax rates.

The conventional method of handling proceeds intended for estate clearance is to have them paid to the insured’s estate in a lump sum. This recognizes that payment of the claims against the estate is an obligation of the executor or administrator, and fulfilling this obligation requires cash within a relatively short time after the insured’s death. In recent years, however, for estates of more than $600,000 there has been a shift toward having the policy owned by the spouse or a life insurance trust. By making the life insurance proceeds payable to the spouse or the trust, funds can be made available to the insured’s estate either by purchasing noncash assets from the estate or by loaning money to the estate. Under the interest-only option the beneficiary may leave the proceeds with the insurer to earn interest until they are needed by the beneficiary or the executor. If the insurance is more than adequate for the needs of the estate, the excess can go to the insured’s dependents without having to pass through the probate estate and the attendant delay and expense. These advantages are especially important when the potential estate liabilities are large but unpredictable and a substantial amount of insurance is involved. While some insurers do not permit executors or trustees to elect life income settlement options, most are willing to make the interest option available to a trustee or an executor during the period of estate administration.

If the probate estate is modest and the insured’s spouse is the sole or major beneficiary of the estate, it may be advantageous to have the insurance intended for estate clearance payable to the widow(er) under the interest option with the unlimited right of withdrawal. He or she can use whatever portion of the proceeds is needed to pay the debts of the insured’s estate and apply the remainder to his or her own needs, perhaps in the form of a deferred settlement. This procedure will reduce the cost of estate administration, particularly the executor’s fee. It will also take advantage of the special inheritance tax exemption available in most states when insurance proceeds are payable to third-party beneficiaries, especially the insured’s widow(er) and children. This advantage is offset to the extent that payment of the insured’s debts out of the insurance proceeds enlarges the taxable distribution from the estate unless funds were made available through loans to, or asset purchases from, the estate. By using the interest option and a spendthrift clause, the insured can protect the proceeds from the beneficiary’s creditors.

The obvious disadvantage of this arrangement is that the beneficiary, through poor judgment, may pay claims that were not valid or, through stupidity or greed, refuse to use the insurance proceeds for the purposes for which they were intended. This behavior is, of course, more likely when the beneficiary is not the sole legatee of the estate, and it may result in forced liquidation at great sacrifice of valuable estate assets. Another risk in this arrangement, unless properly safeguarded, is that the widow(er) might die before clearing the insured’s estate, with the proceeds going to his or her estate or to minor contingent beneficiaries. Both situations would then make it impossible for the proceeds to be used to pay the insured’s debts. To guard against such an untoward development, it is possible to make the insured’s estate the contingent beneficiary if the widow(er) should predecease the insured or die within 6 months after the insured’s death. If the primary beneficiary survives the insured by six months, the children can become the contingent beneficiaries of any unused proceeds.

If the estate liabilities are large and a life insurance trust is going to be used for other purposes, the estate clearance fund can be made payable to the trustee in a lump sum or under the interest option (if permissible). A provision in the trust agreement authorizes the trustee to lend money to the estate or to purchase estate assets. Thus the trust may come to hold assets formerly held by the estate.

Mortgage Cancellation Fund. If there is a mortgage on the insured’s home, the insured usually attempts to provide enough insurance to liquidate the mortgage upon his or her death so that the family can continue to occupy the home. In some cases, the insurance is provided through a special mortgage redemption policy, embodying the decreasing term insurance principle.

If the mortgage can be prepaid, there is usually a provision for a lump-sum payment either to the insured’s surviving spouse or to his or her estate. This is predicated on the assumption that it takes less insurance to liquidate the mortgage with a single-sum payment than to provide a monthly income equal to the regular monthly payments. If the mortgage has no prepayment privilege or can be prepaid only with a heavy penalty, an income settlement can be arranged to provide funds in the required amount and frequency for the mortgage pay- ments. Either the fixed-period option or the fixed-amount option is satisfactory, although the fixed-period option would be difficult to use if elected before the insured’s death.

Emergency Fund. If a life insurance trust is not created, perhaps the most satisfactory arrangement for emergency funds is by electing the interest option with a limited or an unlimited right of withdrawal. The widow(er) is normally the beneficiary. Another method of making emergency funds available is through the fixed-amount option with appropriate withdrawal privileges. Under this arrangement a somewhat larger fund can be set aside than that needed for the regular installments.

Educational Fund. As indicated earlier, the fixed-amount option is ideally suited to liquidating proceeds intended to finance a college education or professional training. However, the interest option, with appropriate withdrawal privileges, can also be used to cope with inflation. The payments can be made directly to the student, to the educational institution on his or her behalf, or to an adult relative or friend.

Readjustment Income. The readjustment period is the interval of time—usually one to 3 years in duration—immediately following the insured’s death, during which income is usually provided at or near the level enjoyed by the family during the insured’s lifetime. In the dependency period thereafter, the income drops to a more realistic and sustainable level.

Theoretically, the income for the readjustment period can be provided through the fixed-period option, the fixed-amount option, or the interest option with the right of withdrawal. If a step-down within the period is contemplated, which may be advisable if the dependency period income represents a drastic reduction, the fixed-amount option can be used because it allows adjustments to the amount. Some estate planners provide the same contractual income in the readjustment period as in the dependency period, with the thought that the widow(er) can use the withdrawal privilege to cushion the financial shock during the readjustment period.

Dependency Period Income. Broadly speaking, the dependency period extends from the date of the insured’s death until the youngest child is self-sufficient or perhaps in college. In planning terminology, however, the dependency period is the interval between the end of the readjustment period and the youngest child’s self-sufficiency, usually assumed to occur at age 18, unless a child is mentally or physically handicapped.

In practice a combination of social security survivorship benefits and the interest on life insurance proceeds being held for other purposes frequently meets a substantial portion of the family’s income needs during this period. If not, additional income can be provided through the fixed-period or fixed-amount options. If, at the time the program is being set up, the youngest child is 6 years old and additional income of $600 per month is desired until the child is 18, it does not seem to matter whether proceeds in the amount of $68,530 are set aside under a fixed-period option providing $600 per month for 12 years or whether the same sum is set aside under a fixed-amount option providing $100 per month as long as the proceeds hold out, which would be exactly 12 years if there were no withdrawals from the fund and no excess interest over the assumed 4 percent rate were credited to it. Under most circumstances, however, the fixed-amount option will prove to be more satisfactory.

Perhaps most significant is that the right of withdrawal can be granted in connection with the fixed-amount option but not with the fixed-period option. In some cases, it may be unwise to give the beneficiary this privilege, but in general, it injects an element of flexibility into the settlement plan that may be urgently needed, particularly with the prospect of continued inflationary pressures. Moreover, moderate withdrawals will not necessarily shorten the period of income payments since the withdrawals may be offset in whole or in part by dividend accumulations and excess interest credits. Another argument in favor of the fixed-amount option is that provision can be made for increasing the size of the monthly payments to offset the loss of income from social security as each child reaches age 18.

Life Income for Surviving Spouse. In life insurance planning, it is necessary to break the widow(er)’s basic need for life income into two periods. One period runs from the youngest child’s 18th birthday to the widow(er)’s age 62, and the other starts at the widow(er)’s age 62. This breakdown is necessary because the widow(er)’s income from social security terminates when the youngest child reaches age 18 (unless a child is totally disabled) and does not resume until the widow(er) reaches age 62. (A permanently reduced benefit is available at age 60.) The period in between is usually called the social security gap or the blackout period.

Income during the blackout period can be provided by making the life income option operative upon the insured’s death or upon termination of the social security survivorship benefits. Alternatively, the interest-only option can be left in place until the surviving spouse needs more income and then converted to a life income option.

In most cases, after the blackout period, income to the surviving spouse will be provided by social security benefits and payments under a life income option, the only practical way of ensuring a definite income for the remainder of the widow(er)’s life. If a large sum of insurance is available and the beneficiary both is financially able and desires to preserve the principal for the benefit of contingent beneficiaries (such as children), the interest option can be used until the primary beneficiary’s death.

The primary beneficiary’s age and health should be considered before making a life income settlement option election. If the beneficiary is unlikely to survive very long because of poor health or very old age, choosing a life income option could result in a significant forfeiture. Selecting a period-certain guarantee would at least limit such forfeiture. The beneficiary is less likely to be concerned about a possible forfeiture if there are no children or grandchildren to receive such residual funds.