Rules Blur Risks of Federal Deposit Insurance

George J. figured his money in Mechanics National Bank was safe and federally insured. But when the Paramount-based bank failed last month, he lost about $30,000--nearly one-tenth of his life savings.

What happened to George, who asked that his real name not be used, serves as a reminder and a warning to all those who are fleeing the stock and bond markets for the apparent safety of banks and thrifts: Federal deposit insurance rules are complex. If you have more than $100,000 in a single bank or thrift, as George did, you need to be careful that you follow the rules exactly--even if the money is in trust or retirement accounts and you’ve been assured that it’s fully insured.

Under FDIC rules, you can keep more than $100,000 in a single bank and still get full FDIC insurance. Indeed, a family of four could have as much as $2.2 million in a single bank with every dollar federally insured, says FDIC senior counsel Claude Rollin. But there are specific rules governing how accounts must be set up to obtain the additional insurance coverage. One mistake and the FDIC insurance is lost.

Moreover, if one or more of the members of this hypothetical family were to die, the FDIC insurance coverage changes dramatically. If, for example, both parents died suddenly, the insured portion of this family’s deposits would immediately drop from $2.2 million to $200,000.

Failure to heed the rules can be costly. In the last two years, about 62,000 depositors have lost more than $1.5 billion in 162 bank failures, according to the Federal Deposit Insurance Corp. Depositors now lose money in 81% of bank failures, FDIC officials add.

Notably, deposit insurance regulations were changed in 1991 in a way that makes losses on uninsured accounts more likely, says Allan Whitney, an FDIC spokesman. The technical change essentially bars regulators from extending protection to uninsured deposits, as they had sometimes done in the past. In 1991, depositors lost money in less than 17% of bank failures, he notes.

Currently about $6 billion, or 23.5%, of the $2.5 trillion deposited in the nation’s banks and thrifts is not protected by FDIC insurance, FDIC officials say.

While a portion of that money is intentionally left in uninsured accounts, a substantial portion is left unprotected because consumers and bankers find it increasingly difficult to understand the rules governing federal deposit insurance, experts say.

Particularly at risk are retirees who maintain their life savings in “separately titled” bank accounts, FDIC officials say. Often, these retirees set up “living trusts” that are supposed to provide tax and estate planning benefits, as well as extend greater deposit insurance protection to the funds within the trust. What few know, however, is that the wording of most living trust documents makes them ineligible for this added FDIC coverage, says FDIC senior counsel Rollin.

That’s because living trusts generally stipulate circumstances that would bar the beneficiaries of the trust from getting their money. For instance, the trust document may say that the children cannot receive their interest in the trust until they complete college. But, any contingency other than age--i.e., the child cannot receive funds until he or she has reached the age of 18 or 21--makes the trust ineligible for the separate FDIC coverage.

“A living trust is the most dangerous account you can have in a bank. And you’ll never hear that from your banker,” says another FDIC official, who asked not to be named. “This is the dirtiest little secret in banking today.”

Other types of trusts are also problematic, as George can attest.

He set up a simple revocable trust at Mechanics, naming his niece as the beneficiary for the $100,000 account. Bank officials assured him that because the money was in trust for his closest living relative, it was separately insured. But in fact, revocable trust accounts are separately insured only when they benefit your child, grandchild or spouse.

If the trust beneficiary is your mother, niece, cousin, brother, sister, friend or business associate, it does not qualify for separate FDIC coverage. The upshot: If you have other accounts in the bank, the amounts in those other accounts are added to the amount in trust. You risk losing the portion of the combined amount that adds up to more than $100,000. That’s how George lost about 10% of his life savings.

Notably, the error that tripped up George, who is 93 years old, is common. Last year, the four federal agencies that regulate banks and thrifts co-signed an “advisory on FDIC insurance coverage” that acknowledged an increasing problem with bank and thrift employees providing erroneous information about deposit insurance to bank customers.

The memo specifically mentioned a depositor who lost money in a revocable trust. After the loss, this victimized depositor surveyed 32 financial institutions, asking branch officers the same question: Would a trust account that names his mother as a beneficiary be separately insured from his own deposits at the bank? In every case, he was given the same inaccurate advice: “Yes, the account is separately insured.”

Individuals who have questions about FDIC insurance can request a booklet titled “Your Insured Deposit” from the FDIC’s Office of Consumer Affairs, 550 17th St., Washington, D.C. 20429.