It's become a familiar story for advisors: Their affluent clients, who once planned to enjoy a comfortable retirement and leave a legacy, are now facing a changed reality. The financial crisis has left them feeling they have to choose between their well-being and their children's inheritance.

The situation is challenging for both clients and advisors. But advisors have an often-underutilized option to offer-wealth replacement using life insurance. While life insurance has long been a tool for adding some padding to certain portfolios, enhanced concern from clients breathes new life into this strategy.

A MOUNTING NEED

This strategy can work particularly well for clients who are 55 or older, with a net worth of $2 million to $5 million. In the past, with their investments performing well and their estate likely to fall under the estate-tax exemption, advisors didn't see a strong need to offer life insurance as a strategic part of these clients' portfolios.

This has changed now that security has been lost, and many portfolios have eroded significantly. In the 10th Annual Phoenix Wealth Survey, the percentage of people who said their wealth was "extremely" or "very" secure for the long term dropped to a scant 28% in 2009, down from 45% in 2007.

Fears about retirement also reached their highest level in the history of the study, which surveys individuals with $1 million or more in net worth, excluding their primary residence. Their top two concerns: outliving assets and having to modify lifestyle.

REPLACING THE FEAR

The addition of life insurance to a portfolio can benefit clients in a variety of ways. It can:

1) free up assets that are otherwise allocated for protection and legacy goals, enabling clients to maintain their lifestyle;

2) guarantee a legacy;

3) "replace" wealth for heirs in cases where death occurs soon after market losses;

4)provide immediate wealth enhancement; and

5) offer some tax advantages, since the death benefit is typically transferred income tax-free.

In many cases, these objectives can be achieved by redirecting a relatively small portion of assets and/or income to pay premiums. Further, clients receive benefits that address their financial picture and provide some much-needed peace of mind. They gain predictability and stability and-by employing non-correlated assets to help transfer wealth-can further diversify and even hedge against potential adverse fluctuations that can occur when they die.

Let's look at a hypothetical scenario that shows how legacy capital management using life insurance might work. Tom and Sue Carlson are both 65 years old. Their portfolio stands at $5 million, down from $8 million. The expected growth of the portfolio is 7%, before taxes. For taxes, let's assume 75% of growth is taxed as capital gains at a rate of 20% and the other 25% is taxed as income at a rate of 35%, for an overall effective tax rate of 24%. Tom and Sue want to establish a separate, cost-effective legacy strategy for their son that will not be subject to market risk.

Their advisor suggests they purchase a survivorship universal life with guarantee policy, with a $3 million death benefit. Since both Tom and Sue are in good health and would qualify for favorable insurance rates, the annual premium for this would be around $44,000, only 0.9% of the initial portfolio value. Now let's see how that approach works out:

* First, the death benefit immediately increases the "legacy value" of the portfolio by $3 million (less premium), and will guarantee a legacy as long as the policy remains in force.

* If Tom and Sue invested the premiums on their own instead of buying the policy, the after-tax rate of return at year 25, when Tom and Sue are 90 years old, would be approximately 5.3%. The death benefit internal rate of return (IRR), however, would be about 7%, with a difference of nearly $700,000.

It's important to remember that the timing of death and subsequent payment of the death benefit bears no correlation to the timing of the financial markets. That means life insurance can help provide a hedge against potential adverse fluctuations, should death occur during a market downturn, and balance out potential volatility from more traditional estate assets such as stocks, bonds and real estate.

THE RIGHT POLICY

While the Carlsons chose a survivorship policy, one or more single-life policies are also options. Let's consider a scenario where Tom and Sue wanted the death benefit to be payable on Tom's death and cash value that could be accessed should their needs change.