Category: Annuities

Categories
Annuities Fixed Index Annuities Retirement Income Planning

Indexing Strategies to Eliminate Stock Market Risk

Chain Reaction In Business Concept, Businessman Intervening Dominos Continuous Toppling and Protecting Assets

This article was originally published in, and has been reprinted with permission from, Retirement Daily.

It’s no secret that I’m a huge fan of fixed annuities as part of a retirement income plan. The purpose of including fixed annuities in a retirement income plan is to reduce the risk of your investment portfolio. Two features of fixed annuities that have traditionally made them a preferred investment choice when compared to similar-duration CDs are higher interest rates and tax-deferred growth.

There are two types of fixed annuities that can be used to reduce investment portfolio risk:  fixed income annuities and fixed index annuities. This article will discuss how fixed index annuities can be used to reduce stock market risk.

What is a Fixed Index Annuity?

A fixed index annuity, or FIA, is a fixed annuity that offers a minimum guaranteed interest rate and potential for higher earnings than traditional fixed annuities based on the performance of one or more stock market indexes. FIAs can include lifetime income either with a minimum guaranteed withdrawal benefit (“MGWB”) or an optional income rider. Issue ages for most FIAs are 0 to 80 or 85.

There are two types of FIAs – single premium and flexible premium. A single premium FIA is a one-time investment whereas a flexible premium FIA allows for ongoing additions. Some insurance carriers place annual limits on the amount of premiums that can be added to their flexible premium FIAs.

When you purchase a FIA, you’re given the opportunity to allocate your initial premium between a fixed account and one or more indexing strategies. You can typically change your allocation during a 30-day window prior to each contract anniversary. The fixed account pays a fixed rate of return that currently ranges between 1% and 2%, depending upon the FIA.

Indexing strategies earn interest based on the performance of a defined stock market index, with the Standard & Poor’s 500 Index being the most popular offering. The measuring period for most indexing strategies is one year, however, two-year strategies are also available.

Fixed index annuities are subject to a declining surrender charge schedule that’s standard in all deferred annuities and is generally five to ten years. FIAs are meant to be held for the long term. Surrender charges help insurance carriers invest in longer-term bonds with higher yields and to recover initial fixed costs for setting up the contract. They also help actuaries price their deferred annuity products efficiently.

The majority of FIAs allow free withdrawals of up to 10% of the contract value or the initial premium beginning in the first or second year. Surrender charges apply only to excess withdrawals.

Losses are Eliminated and Positive Returns are Limited with a Fixed Index Annuity

Unlike a direct investment in an index where you participate in gains as well as losses, there are two basic differences when you allocate funds to an indexing strategy within a FIA:

  • If the index’s return is negative, no loss is posted to your account.
  • If the index’s return is positive, interest is credited to your account subject to a cap.

With a FIA, you don’t participate in losses. This is sometimes referred to as the “power of zero.” You also don’t participate in gains to the extent that the performance of a particular indexing strategy exceeds that of a defined cap.

FIA Indexing Strategy Examples

I will illustrate how FIA interest crediting works with some examples. Let’s assume that you invest $100,000 in a FIA and one of the indexing strategies that you choose is the S&P 500 one-year point-to-point strategy with a cap of 4%. Here are three different scenarios that occur during the first three contract years:

Year #1 – Return = 3%
Since the return is positive and it’s less than the cap of 4%, you’re credited with 3%, or $3,000, increasing your FIA account value to $103,000.

Year #2 – Return = 9%
Once again the return is positive, however, it exceeds the cap of 4%, therefore, you’re credited with 4%, or $4,120, increasing your FIA account value to $107,120. Although this is $5,150 less than the value of $112,270 through a direct investment in the S&P 500 Index, this needs to be balanced against the potential for loss.

Year #3 – Return = -12%
Since the return is negative, no interest is credited and you maintained your FIA account value at $107,120. Had you invested directly in the S&P 500 index instead of using a FIA indexing strategy, you would have realized a loss of $13,472, reducing your investment value to $98,798.

Gains are Retained with a Fixed Index Annuity

Unlike other types of investments, FIAs are unaffected by stock market declines. Although gains from increases in indexing strategies are limited by cap rates, they’re locked in.

The ability to shelter gains from subsequent losses isn’t available with most other types of equity investments. This benefit can be especially important for retired individuals who don’t have a long-time horizon to recover from sizable stock market losses.

The best way to illustrate this is with a multi-year example comparing an investment in the S&P 500 Index with a fixed index annuity S&P 500 indexing strategy for the duration of retirement using the following five assumptions:

  • Investment of $1 million at age 65
  • Annual withdrawals of $50,000 from age 65 to 90
  • Annual rates of return per the “Return” column
  • S&P 500 one-year point-to-point strategy with a cap of 4% and 7-year declining surrender charge schedule
  • Free annual withdrawals of 10% of the contract value in the first 7 years

There’s “good news, bad news” for the S&P 500 Index investment. The good news is that it participates in 100% of the positive year returns. This includes nine years when returns are 10% or greater and 20 out of 21 years when the returns exceed the FIA S&P 500 indexing strategy annual cap of 4%.

The bad news for the S&P 500 Index investment is that it participates in 100% of the negative year returns. While there are only five negative return years, three of which are single-digit, the first three years are all negative returns:  18%, 12%, and 3%, respectively. This results in a decrease in value from $1 million at age 65 to $574,000 at age 67. After a one-year uptick to $608,000, the value of the S&P 500 Index declines until it reaches $0 at age 88 after a final withdrawal of $14,000.

The fixed index annuity S&P 500 indexing strategy is the winner. Although annual returns are limited to 4%, which is less than the S&P 500 index returns in 20 out of 21 positive return years, interest crediting of 0% in the five negative S&P 500 years preserves the FIA S&P 500 indexing strategy value for the duration of retirement without reduction for losses.

There’s a total net increase in value of $385,000 with the FIA S&P 500 indexing strategy, or $221,000 greater than the S&P 500 Index total of $164,000. This results in total withdrawals of $1.3 million or $136,000 more than the S&P 500 Index. Furthermore, values of the FIA S&P 500 indexing strategy exceed those of the S&P 500 index each and every year by $85,000 to as much as $276,000.

Conclusion

Defensive investment and protection strategies are the key to the success of a retirement income plan. Just like a HECM mortgage strategy can be used to protect against sequence of returns risk, fixed index annuities can provide a buffer against stock market risk. Both strategies are timely given the current 12+-year bull market.

If you don’t want exposure to losses with a potential decrease in available investments to draw upon throughout retirement, are unsatisfied with taxable CD rates, and are seeking tax-deferred growth with an opportunity to participate in the upside potential of the stock market, then you may want to consider diversifying into one or more fixed index annuities.

Categories
Annuities Charitable Remainder Trust HECM Reverse Mortgage Income Tax Planning Medicare Retirement Income Planning Reverse Mortgage Roth IRA Social Security

6 Proven Retirement Income Planning Strategies Beginning at Age 62

This article was originally published in, and has been reprinted with permission from, Retirement Daily.

When you contemplate your life, you can usually pinpoint pivotal moments that changed the trajectory of who you are today. Often times, there are one or more magical moments that you will never forget.

In the retirement planning world, age 62 is that moment. Until then, you accumulate assets for some unspecified future date when you will transition from working full time to perhaps part time, and then, in most cases, fully retire. Your primary source of income, i.e., employment, will eventually come to a grinding halt.

Beginning at age 62, several things will begin to quickly unfold that will require you to change your retirement planning mindset from asset to income accumulation. You will need to figure out how to convert the assets that you worked hard to save into a predictable income stream beginning on a specified date, or within a range of dates, that will enable you to match your projected financial needs in retirement. Furthermore, you will need to develop various strategies for creating after-tax retirement income in order to optimize the longevity of your assets for the rest of your life. Needless to say, this is no small task.

This article provides an overview of six proven strategies that can be implemented beginning at age 62 that are at the core of the transition from retirement asset to retirement income planning. Strategies #4 and #5 should be considered before age 62 whenever possible and strategy #6 when applicable. Most important, all potential strategies should be evaluated as part of a holistic retirement income plan.

Strategy #1:  Defer Social Security Start Date

You can start your Social Security retirement benefits as early as age 62 or as late as age 70. Unless you’re no longer working and have no other sources of income or you have a life-threatening illness, it generally isn’t advisable to start receiving Social Security at age 62. This is due to the fact that benefits may be 30 percent less than what they would be at your full retirement age which is between 66 and 67 depending upon the year you were born.

Your Social Security benefits will increase by 8% per year plus cost-of-living adjustments for each year that you defer your start date between full retirement age and age 70. Social Security can be used to insure your, and, if married, your spouse’s longevity risk.

The decision regarding when to begin receiving Social Security retirement benefits should be carefully analyzed, especially if you’re married. In addition to locking in the amount of your benefit, you are also potentially establishing the amount of your spouse’s monthly payment in the event that you die first.

Strategy #2:  Gain Unrestricted Access to Home Equity

As discussed in my 5 Key Financial Metrics When Evaluating a HECM Reverse Mortgage article, housing wealth, although it represents about one half of an average household’s net worth, is often ignored as a retirement income planning tool. There are numerous strategies that can be used to provide readily available tax-free liquidity to pay for planned and unforeseen expenses throughout retirement by monetizing a portion of the equity in one’s home.

Several of the strategies can be used in conjunction with home equity conversion mortgages, or HECMs, the most popular reverse mortgage program. You can qualify for a HECM beginning at age 62. All homeowners age 62 or older with or without a mortgage should evaluate a potential HECM for its ability to provide unrestricted access to an increasing tax-free line of credit without the downsides of a home equity line of credit, or HELOC.

When implemented early and used strategically to unlock illiquid home equity, a HECM reverse mortgage can be used to increase after-tax cash flow at opportune times throughout retirement while providing peace of mind.

Strategy #3:  Reduce Medicare Part B and D Premiums

Medicare Part B and D premiums are determined using modified adjusted gross income (MAGI) from your federal income tax return two years prior to the current year. Assuming you enroll in Medicare when you become eligible at age 65, your MAGI from two years prior, or age 63, will determine your Medicare premiums at 65. 2021 Medicare Part B monthly premiums range from $148.50 to $504.90 per person depending upon tax filing status and 2019 MAGI

Medicare Part B and D premium planning should begin at age 62 when you’re one year away from having your income determine your premiums when you turn 65. You should incorporate the Medicare income brackets into your income tax projections every year for the rest of your life to determine the amount of your projected Medicare Part B and D monthly premiums. Using this information, you can develop strategies to reduce your projected MAGI and associated premiums.

You need to always keep in mind when planning Medicare premium reduction strategies that it’s a year-by-year proposition given the fact that premiums are determined using your MAGI from two years prior to the current year. If your income in a particular year is projected to experience an unusual spike that’s attributable to a one-time or infrequent event that will otherwise optimize your projected after-tax retirement income for several years, it will usually make sense to pay the increased Medicare Part B and D premiums in that year. Examples include a sizable strategic or market-sensitive Roth IRA conversion or an unusual increase in a business owner’s income that will enable a larger qualified business income (QBI) deduction that will result in a large amount of income tax savings.

Strategy #4:  Roth IRA Conversion Window of Opportunity

A multi-year, or staged, Roth IRA conversion strategy is a great example of a retirement income planning technique that should ideally be implemented beginning 20 years before retirement. A ten-year window of opportunity begins at age 62 for doing a Roth IRA conversion, creating a greater sense of urgency for implementing this strategy. This corresponds to the ten years prior to the age 72 commencement of lifetime annual required minimum distributions, or RMDs, from retirement plans.

Roth IRA conversions beginning at age 62 will reduce your annual RMDs for the rest of your life. This can, in turn, potentially reduce your annual taxable income, Medicare Part B and D premiums, taxable Social Security benefits, and net investment income tax. To the extent that this occurs, this will increase after-tax retirement income and contribute to the overall goal of optimizing asset longevity. Reduced RMDs also reduce the survivor’s exposure to the widow(er)’s income tax penalty for couples.

Reduced RMDs can also reduce the value of taxable retirement plan accounts at death and, in turn, reduce taxable income for non-spouse beneficiaries. Given the fact that most non-spouse beneficiaries are subject to a 10-year payout rule for taking distributions from retirement plans and IRA accounts, a reduction in the value of taxable accounts will often result in less tax liability for children and other non-spouse beneficiaries.

Per Strategy #3, taxable income from Roth IRA conversions needs to be balanced against potential higher Medicare Part B and D premiums beginning at age 63. The reduction in RMDs and associated lifetime income tax savings beginning at age 72 can more than offset increased Medicare Part B and D premiums between age 63 and 72 if done strategically.

Strategy #5:  Lock in Sustainable and Potentially Tax-Favored Lifetime Income

The fifth strategy – locking in sustainable and potentially tax-favored lifetime income, has gained in popularity as a result of the virtual demise of corporate pension plans. Besides Social Security, opportunities for receiving a sustainable lifetime income stream with built-in longevity insurance to reduce the risks associated with the stock market have dwindled in the private sector.

Immediate and deferred fixed income annuities are a natural fit for filling this gap in a holistic retirement income plan beginning at any age. Purchase of fixed income annuities takes on more urgency at age 62 due to the fact that the income start date for the majority of fixed income annuities will occur by age 72, leaving less time for deferred growth and increased lifetime income. The income start date is subject to the RMD rules when purchases are made from qualified accounts and traditional IRAs.

Income optimization is the appropriate benchmark that should be used when evaluating fixed income annuities for inclusion in a retirement income plan. The goal is to design a comprehensive strategy that uses the least amount of assets to purchase the greatest amount of sustainable after-tax lifetime income that’s projected to pay for expenses not covered by Social Security, pensions, and distributions from investment and other assets.

Fixed income annuities come in three flavors:  single premium immediate annuities (SPIAs), deferred income annuities (DIAs), and fixed index annuities (FIAs) with income riders. SPIAs and DIAs enjoy a unique income tax advantage when purchased in a nonqualified, or nonretirement account.

Unlike FIAs with income riders that distribute ordinary income that’s fully taxable, SPIAs and DIAs are annuitized. Periodic payments include income and a return of premium, or investment. When held in a nonqualified account, the return of premium portion of each payment, which can be 50% or greater, is nontaxable. Once 100% of one’s investment has been received, future payments are fully taxable.

Strategy #6:  Achieve Sizable Tax Savings and Tax-Favored Lifetime Income When Selling Highly Appreciated Nonretirement Assets

The sixth strategy, although it can be used by anyone at any time, tends to be implemented by individuals in their 60’s. Generally speaking, they’re the ones with highly appreciated nonretirement assets who are looking for a tax-favored lifetime income exit plan. This includes real estate, investment securities, and businesses.

This strategy is designed to reduce or eliminate income tax liability attributable to the capital gain that owners will realize from the sale of the highly appreciated asset by transferring a portion, or all, of the ownership of the asset from one or more individuals to a charitable remainder trust, or CRT, prior to the sale while providing tax-favored lifetime income. A CRT, which is a tax-exempt trust, is a long-standing IRS-blessed strategy when properly structured.

There are six benefits associated with a CRT:

  1. The capital gain on the sale of assets owned by a CRT is exempt from taxation.
  2. CRT funding creates a sizable income tax deduction equal to the projected remainder interest of the CRT that will eventually pass to one or more charities.
  3. The proceeds from the sale of CRT assets can be reinvested to provide a lifetime income stream for the beneficiaries.
  4. Most of a CRT’s annual income will be taxed at favorable long-term capital gains tax rates.
  5. A CRT is an excellent philanthropic tool since the remainder interest of the assets will be distributed to one or more chosen charities following the death of the surviving lifetime income beneficiaries.
  6. CRT assets avoid estate tax.

Six Proven Strategies

The six strategies that are highlighted in this article are proven strategies for creating and optimizing after-tax retirement income that can individually and collectively prolong the longevity of one’s assets in retirement. Each strategy can be implemented beginning at age 62 as part of a holistic retirement income plan.

Deferring Social Security start date (strategy #1) is a time-sensitive strategy. Once you start receiving Social Security, with some limited exceptions, it’s an irrevocable decision that, with the exception of potential cost of living adjustments, will lock in the amount of your periodic and lifetime payments and can also affect your spouse’s payments.

Gaining unrestricted access to home equity (strategy #2) through a HECM reverse mortgage should be implemented at age 62, the qualifying age, whenever possible to optimize the growth of, and after-tax distributions from, the credit line. Planning for reducing Medicare Part B and D premiums (strategy #3), which is an annual strategy, should be implemented beginning at age 62 since income from your federal income tax return beginning at age 63 will be used to determine your Medicare Part B and D premiums when you’re 65.

Roth IRA Conversions (strategy #4) and locking in sustainable and potentially tax-favored income (strategy #5) should be considered before age 62 whenever possible since there’s no restriction on the start date and earlier vs. later implementation can optimize after-tax lifetime income in retirement.

Achieving sizable tax savings and tax-favored lifetime income when selling highly appreciated nonretirement assets (strategy #6) is dependent upon (a) owning highly appreciated assets such as real estate, investment securities, or a business and (b) a desire to sell those assets.

Let the magic begin!

Categories
Annuities Retirement Income Planning

How to Enjoy a Guilt-Free Retirement

Blaming you. Anxious man judged by different people pointing fingers at him. Negative human emotions feeling

This article was originally published in, and has been reprinted with permission from, Retirement Daily. 

Tilney, a highly-regarded financial planning firm in England where workers are automatically enrolled in employer pension plans unless they opt out, surveyed 1,300 employees in 2018 regarding what they planned to do with their pension when they retire. The results were as follows:

  • 40% said they didn’t know what they would do.
  • 22% said they expected to keep most of it invested, taking some withdrawals.
  • 10% would potentially cash it all in.
  • 10% would use the pension to buy an annuity.

When the word “annuity” was removed as an option and replaced with a “pension that provided a guaranteed income for life,” 79% of respondents said that this was more appealing than a plan where the value and income varied each year. This was the result despite the disclosure that a traditional investment plan offered the prospect for higher returns.

Annuitized Income Enables Guilt-Free Spending in Retirement

David Blanchett and Michael Finke’s recent research paper, Guaranteed Income:  A License to Spend, confirms Tilney’s survey results. Their ThinkAdvisor article, Why Annuities Work Like a “License to Spend” in Retirement, which summarizes their research, discusses the behavioral costs that may be experienced by retirees who fail to annuitize. Two of their key findings are as follows:

  • Retirees who are behaviorally resistant to spending down savings may better achieve their lifestyle goals by increasing the share of wealth allocated to annuitized income.
  • An annuity can not only reduce the risk of an unknown lifespan, it can also allow retirees to spend their savings without the discomfort generated by seeing one’s nest egg get smaller.

Annuitized income, whether the source is pensions, fixed income annuities, or Social Security, enables guilt-free spending in retirement. To the extent that the start date for Social Security benefits is delayed resulting in a higher lifetime benefit, this increases the enjoyment.

Income Annuities May Give Retirees a Psychological License to Spend

Perhaps Blanchett and Finke’s most interesting finding, which also confirms Tilney’s survey results, is that annuities may give retirees a psychological “license to spend” their savings in retirement. Blanchett and Finke cited the fact that “Surveys reveal a clear preference among retirees to live off income, and many don’t feel comfortable spending down assets to fund a lifestyle.”

Blanchett and Finke found that retirees who hold more of their wealth in guaranteed, or sustainable, income spend significantly more each year than those who depend on traditional investments. Specifically, retirees with similar wealth who have sustainable income will spend twice as much each year in retirement. Per Blanchett and Finke’s article, “every $1 of assets converted to guaranteed income will result in twice the equivalent spending compared to money left invested in a portfolio.”

Timing of Converting Assets to Sustainable Income

Assuming that you don’t want to depend exclusively on an investment portfolio for your retirement needs and you would like to include a “psychological license to spend” strategy with sustainable income as part of your retirement income plan, when should you purchase fixed income annuities?

The timing of fixed income annuity purchases, as well as purchase amounts, types of annuities, and location, i.e., nonqualified vs. qualified account, is best determined as part of a holistic retirement income plan. The objective of a retirement income plan is to optimize projected after-tax lifetime income to pay for projected inflation-adjusted expenses during different stages of retirement.

Income optimization, rather than investment return, is the appropriate benchmark that should be used when evaluating fixed income annuities for inclusion in a retirement income plan. The goal is to design a comprehensive strategy that uses the least amount of assets to purchase the greatest amount of sustainable after-tax lifetime income that’s projected to pay for expenses not covered by Social Security, pensions, and distributions from investment and other assets.

Enjoy a Guilt-Free Retirement

My personal experience as a financial advisor specializing in analyzing, recommending, and implementing retirement income planning strategies for clients for the last 12 years confirms David Blanchett and Michael Finke’s research. Clients who have retirement income plans that include a sustainable income component are more confident about their prospects for a successful retirement, less fearful of running out of money, and more likely to enjoy a guilt-free retirement.

In the unsolicited words of one of my long-time clients, “At 70 years old it’s good to reflect back on how a great financial advisor has set my wife and I up for a steady income stream so we can enjoy these senior birthdays very comfortably regardless of the stock market or politics that can affect a person’s retirement years.”

Furthermore, the earlier a “psychological license to spend” strategy with sustainable income is implemented as part of a holistic retirement income plan, the sooner pre-retirees and retirees are able to sleep better at night. The title of a recent Kiplinger article, Retirees with a Guaranteed Income are Happier, Live Longer, says it all.

Categories
Annuities Deferred Income Annuities Income Tax Planning Retirement Income Planning

Nonqualified Fixed Income Annuities: A Timeless Tax and Retirement Income Planning Opportunity

Fixed Income Annuities: A Timeless Tax and Retirement Income Planning Opportunity

This article was originally published in, and has been reprinted with permission from, Retirement Daily.

President Biden’s American Families Plan includes proposed increases in the top marginal income tax rate from 37% to 39.6% and the top long-term capital gains tax rate from 23.8% to 43.4% for households with income over $1 million. Both changes would negatively impact investment returns for affected individuals.

Stock market-based investment strategies, with their exposure to higher ordinary and long-term capital gains tax rates are being reevaluated by investors and financial advisers alike. One strategy that is attracting more attention that will be virtually unscathed by the proposed tax increase is longevity insurance, more commonly known as fixed income annuities.

Three Types of Fixed Income Annuities

Fixed income annuities provide sustainable lifetime or term certain income and, as such, are well suited for retirement income planning. There are three types of fixed income annuities:  single-premium immediate annuities (SPIAs), deferred income annuities (DIAs), and fixed index annuities (FIAs) with income riders.

Each of the three types of fixed income annuities serve a different purpose within a retirement income plan. Two of the three options, SPIAs and DIAs, are tax-favored when purchased in a nonqualified, or nonretirement, account. This makes them an excellent choice for those in higher tax brackets who are seeking to maximize after-tax sustainable income.

SPIAs can be an appropriate retirement income planning solution if you are retiring soon or are retired and have an immediate need for sustainable income. Income distributions can be as frequent as monthly or as infrequent as annually (depending on the options available from the insurer), as long as the first benefit is paid within one year of the contract’s purchase date.

DIAs are a better fit than SPIAs in most retirement income planning scenarios due to their deferred income start date. Deferral of your income start date increases the amount of your periodic income payment since the insurance company will be making payments to you for a shorter period of time assuming a lifetime payout.

100% of income distributions from FIAs with income riders are taxed as ordinary income whether they are in a retirement or nonretirement account. While their flexible income start date and potential death benefit are attractive features, income tax savings is not a strong suit of FIAs with income riders.

DIAs and SPIAs Unique Income Tax Advantage

DIAs and SPIAs enjoy a unique income tax advantage when they are purchased in a nonretirement account. Unlike FIAs with income riders that distribute ordinary income that reduces the accumulation value of the annuity contract, DIAs and SPIAs are annuitized.

The annuitization period is defined by the contract and is either a defined term, e.g., 10 years, or lifetime. Lifetime DIAs and SPIAs provide for an optional minimum payout period or lump sum payable to the annuitant’s beneficiaries to guarantee a minimum total payout.

The income tax advantage of DIAs and SPIAs is attributable to the allocation of each annuitized payment between income and a return of premium. The portion that is deemed to be a return of premium is your cost, or basis, and is nontaxable. Annuitization is analogous to amortization of a mortgage. When you make a mortgage payment, each payment is allocated between deductible interest and nondeductible principal.

In the case of a DIA or SPIA, the amount of each payment that is considered to be a nontaxable return of premium is calculated by applying an “exclusion ratio” to each monthly payment. The exclusion ratio is actuarially calculated by dividing the investment in an annuity contract by the total expected lifetime payments.

SPIA Tax Savings Illustration

To illustrate the income tax advantage of nonretirement DIAs and SPIAs, suppose you are a woman, and you purchase a SPIA for $100,000 when you are 65 years old. Let us further assume that the insurance company determines that you have a 22-year life expectancy, and they will pay you $475 a month for the rest of your life. Your lifetime payments are expected to total $125,400 ($475 x 12 x 22).

Your exclusion ratio is calculated by dividing your premium, or investment, of $100,000 by your expected lifetime payments of $125,400. The result is that 79.75%, or $379, of each of your monthly payments of $475 will be nontaxable for the first 22 years. 20.25%, or $96, of each  monthly payment will be taxable. Even though your annual payments will total $5,700, the insurance company will report taxable income of only $1,154 for the initial 22 years.

What happens if you survive your 22-year life expectancy? You will continue to receive monthly payments of $475 for the rest of your life, however, 100% of your monthly payments will be taxable as ordinary income. This makes sense since your nontaxable payments for the first 22 years will have totaled $100,000 which is equal to your original investment.

Nonretirement DIAs and SPIAs Can Optimize After-Tax Retirement Income

DIAs and SPIAs, like all fixed income annuities, provide sustainable lifetime income. When purchased in a nonretirement account, they distinguish themselves further as a retirement income planning solution since their after-tax income is predictable.

Income tax rates have minimal impact on the amount of after-tax income from DIAs and SPIAs due to their exclusion ratio. Furthermore, any increase in marginal income tax rates will not affect most annuitants’ after-tax periodic payments until cost basis has been recovered. As illustrated, this will not occur until the annuitant survives her life expectancy beginning on the annuity purchase date.

The ability to optimize after-tax income from nonretirement DIAs and SPIAs can also result in spillover income tax and other savings. This includes the potential reduction of taxable Social Security benefits, reduced exposure to the 3.8% net investment income tax, increased potential deductibility of medical expenses, and the opportunity to reduce marginal income tax rates and Medicare Part B premiums. Each of these things individually and collectively can result in additional increased after-tax retirement income for the duration of retirement.

Nonretirement fixed income annuities, with their sustainable lifetime income and tax-favored status, offer a timeless tax and retirement income planning opportunity.

Categories
Annuities Deferred Income Annuities Fixed Index Annuities

Take Some Chips Off the Table and Add Them to Older Income FIAs

This article was originally published in, and has been reprinted with permission from, Retirement Daily.

Every year since 2014 when I purchased a fixed index annuity (FIA) with an income rider in my SEP-IRA, I have added $20,000 to it. Furthermore, I plan on continuing to do this until I retire.

Why did I purchase a FIA with an income rider in my SEP-IRA in 2014 and add to it each year? For the same reasons that I am making the recommendation to do so today.

Stock Market Euphoria is Cause for Evaluation

As I write this article, the Dow Jones Industrial Average (DJIA) is hovering at just below 31,000 after reaching an all-time high of 31,653.48 on February 22nd.  The DJIA increased 13,440 points, or 74%, since its Covid low of 18,213.65 just 11 months ago on March 23, 2020.

While Covid-19 cases, hospitalizations, and deaths have all recently dropped and more people are getting vaccinated which has contributed to the sizable stock market increase, the party and associated euphoria will not last forever. With the exception of last year’s first quarter drop, the stock market has been on steroids since hitting a low of 6,469.95 on March 6, 2009 after declining 52% in 17 months beginning in October, 2007.

The DJIA has increased 480% in the last 12 years, or 40% per year on average, which is obviously not sustainable. Do the terms “bear market” or “reversion to the mean” ring a bell?

Pivot Into Sustainable Income

I have been extolling the virtues of making sustainable income the cornerstone of a retirement income plan since 2009 when I began specializing in retirement income planning. The 52% stock market decline in 17 months, combined with the elimination of secure lifetime income provided by private pension plans, created a perfect storm for implementing this strategy.

While my clients are happy with the 12-year increase in their portfolio values, I know from many years of experience that this state of exuberance is often short-lived. The reality is that their equity allocation is greater than what is targeted for their portfolio in several cases.

As a retirement income planner, I look for windows of opportunity for my clients to transfer slivers of their investment portfolio from the unpredictable fluctuation of the stock market to fixed income annuities that are designed to provide sustainable income that they can depend on throughout retirement.

There are three types of fixed income annuities that can be employed for this purpose:  single premium immediate annuities (SPIAs), deferred income annuities (DIAs), and fixed index annuities (FIAs). Some FIAs have an income payout feature built into them while others require purchase of an income rider.

Add to Older Income FIAs

All payouts from fixed income annuities are calculated using mortality credits, or life expectancy, and current interest rates. If you invest in a SPIA or DIA today, your payout will be relatively low compared to three or more years ago because of declining interest rates. In the case of DIAs, this is true whether it is a new or an existing contract.

Income FIAs that were purchased between 2009 and 2018, including the one that I chose for my SEP-IRA in 2014, provide a unique opportunity for increased sustainable income payouts when new premium dollars are added compared to current SPIA, DIA and income FIA offerings. This is because the income payout for FIAs is calculated using a formula and the variables used to calculate the payout were more favorable and less likely to be tied to performance of the underlying contract accumulation value as is often done today.

The following four variables are responsible for higher income payouts in older income FIAs:

  • Higher interest rates in the growth phase
  • Wider availability of compound interest crediting in the growth phase
  • Ability to extend initial growth phase interest crediting from 10 to up to 20 years
  • Premium bonuses offered for longer periods of time, as much as five to seven contract years in some cases

Besides the more favorable variables, there was greater availability of flexible vs. single premium contracts. Funds cannot be added after the first contract year to a single-premium FIA. Flexible premium FIAs, on the other hand, allow for subsequent investments after the initial contract year. Some flexible premium FIAs do, however, place caps on the amounts of annual additions. Finally, qualified, or retirement plan annuities, such as my SEP-IRA, are subject to annual contribution limits.

Exercise Option to Extend Income FIA Growth Phase Interest Crediting

In addition to adding new premium dollars, anyone with an income FIA that was issued between 2009 and 2018 who has not begun taking income distributions should exercise their option to extend the initial growth phase interest crediting if this is available.

With the growing popularity of income FIAs beginning in 2009, a larger number of contracts offering the ability to extend interest crediting beyond 10 years are in play. If you have one of these contracts and have not started your lifetime income, it behooves you to exercise your interest crediting extension option.

This is a no-brainer since the crediting of additional interest, which can be for up to 10 years in some cases, will increase your income payout amount. The increase could be substantial if, for example, your contract provides for 8% compound interest crediting, you extend the growth period from 10 to 20 years, and you defer your lifetime income withdrawal start date.

Opportune Time to Purchase or Add Funds to Fixed Income Annuities

This is a great time to purchase or add funds to fixed income annuities as part of an overall retirement income plan given the continued escalating stock market highs. Shifting a portion of one’s investment portfolio to sustainable lifetime income at opportune moments is a proven long-term strategy, especially if you are within 20 years of, or in, retirement.

Employing this strategy can enable you to accomplish two important goals shared by all individuals doing retirement income planning: portfolio risk reduction and decreased likelihood of running out of money in retirement.

Surveys as well as personal and client experience show that having predictable retirement income results in reduced short- and long-term stress levels, fewer cases of insomnia, and less health issues in general. This unequivocally trumps the often short-lived euphoria associated with increasing portfolio values in a bull market.

Categories
Annuities Deferred Income Annuities Long-Term Care Retirement Income Planning Roth IRA Social Security

5 Lifetime Valentine’s Day Gifts for Your Spouse

Valentine day background with red hearts, top view - Image

The mad scramble is on. With Valentine’s Day just around the corner, what should you buy your spouse to show him/her your everlasting love and appreciation? Forget about traditional gifts such as roses and chocolate that are short-lived and just as quickly forgotten.

Here are five unique ideas you won’t find on Amazon that are designed to fulfill you and your spouse throughout your life. A word of caution:  Brush up on your presentation skills since each one will likely be met with dead silence or outrage depending upon the mood of your spouse.

VD Gift Idea #1:  Eliminate Your Mortgage by Retirement

One of the biggest cash flow challenges for many retirees is their mortgage. When you apply for a mortgage while you’re working, the mortgage amount and associated monthly payment is determined using your employment income.

Although your employment income generally increases, so do your expenses. When you retire, your guaranteed sources of income that are available to cover your mortgage payments are often a small percentage of your former employment income.

Given this common scenario, you should design a plan to eliminate your mortgage by retirement whenever possible. This can include an increase in your monthly payment amount, making bi-weekly payments, or using a portion of bonuses to reduce your outstanding balance. Your plan should be part of an overall strategy that includes various savings vehicles.

VD Gift Idea #2:  Defer Your Social Security Start Date

When your spouse dies, you can generally receive 100 percent of his/her Social Security retirement benefit if (a) the amount exceeds your benefit and (b) you have reached your full retirement age, which is between 66 years and two months and 67 depending upon when you were born. This is the good news.

The bad news is that the monthly amount that you receive for your lifetime could be significantly less than what you would otherwise qualify for depending upon when your spouse began collecting his/her benefits. The difference could be as much as 77% if he/she began collecting benefits at age 62 vs. waiting until 70.

Assuming that your Social Security benefit will be greater than your spouse’s, you’re in good health, you have other financial resources, and your goal is to maximize your spouse’s benefit in the event that you predecease him/her, it behooves you to defer your Social Security starting date as long as possible, up to age 70.

VD Gift #3:  Start a Staged Roth IRA Conversion Plan

While there are several benefits of a staged, or multi-year, Roth IRA conversion plan, one of the least publicized is the ability to reduce a widow or widower’s income tax liability. This is due to the fact that surviving spouses who don’t remarry are subject to higher income taxes.

Distributions from Roth IRA accounts, unlike traditional 401(k) plans and IRAs, generally aren’t taxable. A staged Roth IRA conversion plan can be used when both spouses are alive to convert otherwise taxable assets to nontaxable assets. Although income tax will probably need to be paid on the conversion amounts, the amount will be less in many cases than what will be payable by the surviving spouse, especially if income tax rates increase which is likely after 2025.

VD Gift #4:  Include Sustainable Lifetime Income in Your Retirement Plan

When you retire, you want to minimize sleepless nights by knowing that you have, and will continue to have, sufficient income to cover your expenses. Designing a plan that will provide you and your spouse with sustainable after-tax income streams to cover your non-discretionary expenses throughout different stages of retirement is an effective way to accomplish this goal.

There are five reasons for including sustainable lifetime income in your retirement plan that will benefit you and your spouse:

  • Hedge against longevity
  • Match income to projected expenses
  • Protect against the sequence of returns
  • Increase cash flow from potential income tax savings
  • Simplify your financial life

VD Gift #5:  Create an Extended Care Plan

I saved this idea for last since, although it’s potentially the most beneficial one, it’s also likely to be met with the most resistance. Previously suggested as a birthday gift for parents, it’s also suitable for one’s spouse on Valentine’s Day.

Extended care is the least understood and most under-planned for life event. When it’s needed, extended care takes its biggest toll on family and friends in the absence of a plan. Studies have shown that providing extended care for an individual who is chronically ill can have a devastating effect, both emotionally and financially, on caregivers.

An extended care plan may or may not include long term care insurance. When included, long term care insurance provides a predictable, readily available, tax-free source of funds that can be used to pay for a portion, or potentially all, of one’s extended care expenses without disrupting one’s retirement income plan.

The Gifts That Keep on Giving

While the foregoing Valentine’s Day gift suggestions aren’t traditional and won’t provide immediate gratification, each one is designed to fulfill you and your spouse throughout your life. Furthermore, all of them will eventually be appreciated by both of you, even after the other is gone.

If you’re looking for the ultimate gift, include each one as part of a comprehensive retirement income plan. Financial advisor sold separately. Finally, don’t forget the card. Happy Valentine’s Day!

Categories
Annuities Deferred Income Annuities Fixed Index Annuities Retirement Income Planning

Uneasy About the “A” Word? You’re Not Alone

The Letter A as a polished golden object over white background with clipping path for quick and accurate isolation.

Tilney, a highly-regarded financial planning firm in England where workers are automatically enrolled in employer pension plans unless they opt out, surveyed 1,300 employees in 2018 regarding what they planned to do with their pension when they retire. The results were as follows:

  • 40% said they didn’t know what they would do.
  • 22% said they expected to keep most of it invested, taking some withdrawals.
  • 10% would potentially cash it all in.
  • 10% would use the pension to buy an annuity.

When the word “annuity” was removed as an option and replaced with a “pension that provided a guaranteed income for life,” 79% of respondents said that this was more appealing than a plan where the value and income varied each year. This was the result despite the disclosure that a traditional investment plan offered the prospect for higher returns.

Income Optimization is the Appropriate Benchmark

Annuities have long been misunderstood. Fixed income annuities in particular are often rebuffed by investment professionals with little or no annuity education whose goal is to maximize investments under management and who don’t practice holistic retirement income planning.

Their use of investment returns as a frame of reference results in inevitable non-apples-to-apples comparisons to traditional equity-based investment portfolios. These individuals fail to acknowledge the fact that it’s impossible to calculate the return of a fixed income annuity until an annuitant has passed.

Income optimization, rather than investment return, is the appropriate benchmark that should be used when evaluating fixed income annuities for inclusion in a retirement income plan. The goal is to design a comprehensive strategy that uses the least amount of assets to purchase the greatest amount of sustainable after-tax lifetime income that’s projected to pay for expenses not covered by distributions from investment and other assets.

Purchasing Guaranteed Lifetime Income is Unnatural

In addition to being misunderstood, the concept of purchasing guaranteed lifetime income, especially when the income start date is deferred, is unnatural for most people. That’s generally the case until they realize that’s exactly what they’re doing with Social Security. In order to receive Social Security retirement benefits, you must purchase them.

What do I mean? Either your salary is reduced by a deduction for Social Security tax or, if self-employed, you’re subject to a self-employment tax until the maximum Social Security wage base, currently $132,900, is reached. Social Security withholding and/or self-employment tax is used to fund Social Security retirement benefits. In essence, you’re purchasing your benefits.

It’s more difficult to pull the trigger when you purchase sustainable lifetime income with a fixed income annuity because you’re not exchanging a lump sum for an investment of equal value unless you purchase a fixed index annuity (FIA). Instead, you’re entering into a contract in which a promise is made by a life insurance company to pay you a periodic income stream for life or a specified number of months or years beginning at a future date.

The contract is irrevocable in the case of single premium immediate annuities (SPIAs) and deferred income annuities (DIAs), i.e., your premiums won’t be returned to you by the insurance company unless you’re within the “free look” period. This is generally 10 days following the purchase date with up to 30 days for seniors in California.

Fixed Income Annuities Designed for Sustainable Lifetime Income

When presented in the context of retirement income planning, fixed income annuities have proven to be the most appropriate and natural commercial solution for providing sustainable lifetime income. The three types of fixed income annuities can be used individually, or in combination, to provide a hedge against the unpredictable stock market.

Fixed income annuities are often used in conjunction with other sources of guaranteed income such as Social Security and private or government pensions to allow retirees to sleep better at night. Nonqualified SPIAs and DIAs enjoy a competitive edge since a portion of each income payment is nontaxable.

Fixed Income Annuity or Pension That Provides Guaranteed Income for Life?

Assuming that you’re planning for retirement, would you rather purchase a lifetime fixed income annuity or a pension that provides guaranteed income for life? This is one decision you don’t have to worry about making since they both provide the same benefit, i.e., sustainable lifetime income that’s unaffected by the fluctuations of the stock market.

Categories
Annuities Income Tax Planning Retirement Income Planning

Leverage Your Assets for Retirement

Little girl climbing the wall

When you buy a house, typical financing is a mortgage equal to 80% of the purchase price. This enables you to purchase a much more expensive home than you would otherwise be able to do without the mortgage. The goal is to increase your equity in the property over time through a combination of paying down the mortgage and appreciation.

The foregoing strategy is a classic example of using leverage. Why not do the same with your investment assets that are being accumulated for retirement?

Accumulation of Assets is the First Step

When you plan for retirement, you need to design a plan that will enable you to have enough after-tax income to pay for projected inflation-adjusted expenses for the rest of your life. Although accumulation of assets is essential for this purpose, it is only the first step.

A retirement plan isn’t complete unless it includes strategies for converting investment assets into income. The strategies need to leverage assets to provide an optimal amount of annual after-tax income that will match expenses during different phases of retirement.   

How to Leverage Assets for Optimal Income

Leveraging assets for optimal income is a two-step process. The first step is asset placement. It begins in the asset accumulation phase, with the payoff coming in retirement.

What is asset placement? Asset placement is the positioning of investment assets so that lifetime distributions from those assets can be maximized after taking into consideration funding and distribution income tax consequences.  

As discussed in my What’s Your $1 Million Payday Really Worth? MarketWatch article, the answer to the question, how long will your $1 million last, will be quite different depending upon whether you’re taking withdrawals from taxable, tax-deferred, or tax-free investment accounts.

While it’s tempting to make pre-tax contributions to a traditional 401(k) plan, greater after-tax retirement withdrawals are possible using a Roth 401(k).  Although not as tax-efficient as a Roth 401(k), placement of a portion of investment assets in nonretirement accounts can also maximize distributions in retirement.

Income Sustainability

The second, and key, step in leveraging assets for optimal income is sustainability. When you retire, can you count on income being paid for the rest of your life?

The answer is generally “yes” if you’re talking about Social Security or a pension. How do you create sustainable lifetime income using investment assets? Fortunately, there’s a long-standing, highly-regulated solution that’s been successfully used for this purpose by several generations of retirees.

Fixed income annuities, with their unique mortality credits, leverage assets to provide for an optimal level of income that’s guaranteed to be paid by the issuing life insurance carrier for a defined period of time, typically life. Premiums paid by those who die earlier than expected enable the insurance company to guarantee and make larger income payments to all annuitants. This hedges longevity risk and creates a highly competitive, if not unbeatable, return. 

Asset Leveraging Example

To illustrate the leveraging power of a fixed income annuity, especially a nonqualified fixed income annuity, let’s assume that Sam, a 65-year-old male, is deciding whether to invest $200,000 in a single-premium immediate annuity (SPIA) with a 10-year certain payout or a managed investment account. Sam also needs to decide if he should make the investment using funds from his traditional 401(k) plan or from nonqualified money.   

Other assumptions include the following:

  • Sam can purchase a SPIA from a highly-rated life insurance carrier that will pay him monthly income of $1,108.18, or annual income of $13,298.16 for the rest of his life beginning one month after date of purchase.
  • An exclusion ratio of 72.2% would apply to the SPIA if purchased with nonqualified funds.
  • Sam will withdraw $1,108.18 per month from a managed investment account.
  • If Sam’s investment is made using 401(k) plan funds, the annual distribution of $13,298.16 is projected to exceed Sam’s annual required minimum distribution (RMD) amounts beginning at age 70-1/2.
  • Sam will use 100% of his after-tax distributions to pay for various expenses.
  • The ordinary income tax rate that would be applied to 401(k) plan and taxable nonqualified SPIA income is 30%.
  • An income tax rate of 25% would be applied to nonqualified managed investment account distributions.
  • The net rate of return after management fees on the managed investment account is 4%.

Traditional 401(k) (See Exhibit 1)

Let’s assume that the proposed investment is being made using traditional 401(k) plan funds. Sam’s annual distributions would be $13,298.16, with after-tax distributions of $9,308.71 whether he invests in a SPIA or a managed investment account.

Sam’s annual distributions of $13,298.16 from his managed investment account would equal 6.65% of the original value of the account of $200,000. Sam’s first-year distributions would exceed the projected earnings of $7,468.07 by $5,830.09, reducing the value of Sam’s 401(k) to $194,169.91 at the end of year 1. Sam’s 401(k) is projected to be depleted at Sam’s age 87 at which time his projected cumulative after-tax distributions would be $205,023.63.

Sam’s projected cumulative after-tax distributions from his SPIA would equal those from his managed investment account when the latter is depleted. Sam would continue to receive his monthly distributions of $1,108.18 from his SPIA for the rest of his life.

While Sam’s SPIA hedges against longevity risk, the managed investment account in this example would be a better alternative if Sam dies between age 75 and 85. Sam’s SPIA distributions will continue to be paid to his beneficiaries if he dies between age 65 and 74 due to the 10-year certain provision.

Sam’s SPIA distributions will no longer be paid if he dies after age 74. Sam’s beneficiaries would receive the remaining value of his traditional 401(k) which is projected to be approximately $130,000 at Sam’s age 74 and decrease to approximately $14,000 at Sam’s age 85.

Although he would receive slightly less monthly income, Sam could insure against the risk of dying between 75 and 85 by purchasing a SPIA with a 20- vs. 10-year certain period. Sam’s monthly income with a 20-year certain SPIA would be approximately $100 less than with a 10-year certain SPIA.

Nonqualified Account (See Exhibit 2)

As previously discussed, asset placement is the first step in leveraging assets for optimal retirement income. Let’s suppose that the funds for Sam’s investment are held in a nonretirement, or nonqualified, investment account. In this case, Sam’s SPIA would enjoy favorable income tax treatment compared to his managed investment account due to the availability of an “exclusion ratio” with a nonqualified SPIA.

The ratio of 72.2% in this example represents the nontaxable portion of each income payment. This is considered to be a return of Sam’s original investment based on his life expectancy when he invested in the SPIA at age 65 and the 10-year certain payout.

This results in a reduction of the effective income tax rate on Sam’s distributions from 30% to 8.34%. This would reduce his annual income tax liability from $3,989.45 if the SPIA is held in a traditional 401(k) to $1,109.07 if purchased using nonqualified funds.

Sam’s SPIA cumulative after-tax distributions are projected to be $280,349.15, or $60,680.98 greater than those from his managed investment account of $219,668.17 at age 87 when the latter is projected to be depleted. The managed investment account in this example would be a better choice if Sam dies between 75 and 82. During these years, the remaining projected balance of Sam’s managed investment account reduced by the projected additional after-tax cumulative distributions from the SPIA vs. the managed investment account would be positive.

Asset Placement and Income Sustainability – A Winning Combination

A retirement plan isn’t complete unless it includes strategies for converting investment assets into an optimal amount of annual after-tax income that will match your expenses during different phases of retirement.  Leveraging investment assets through asset placement and sustainable income strategies using fixed income annuities will generally increase your ability to achieve this goal. Choice of specific strategies will be dependent upon preparation of a detailed financial analysis, as well as assumptions used in the analysis.

Categories
Annuities Fixed Index Annuities

Retain Your Gains with Fixed Index Annuities

Retain Your Gains
Chain Reaction In Business Concept, Businessman Intervening Dominos Continuous Toppling and Protecting Assets

Some nerves were recently rattled when the Dow Jones Industrial Average (DJIA) declined 2,052 points, or 7.6%, in six trading sessions, going from a high of 26,952 on October 3rd to a low of 24,900 on October 11th. The loss increased to 2,830 points, or 10.5%, when the DJIA hit a low of 24,122 yesterday before it closed at 24,443.

Given its 9.5-year ascent of 317%, or 33% per year, from its low of 6,470 on March 6, 2009 to its recent high, many people are wondering more and more if this is the beginning of a long-overdue major correction.

What most people don’t realize is that when the stock market experiences a sizable decline, their investments need to work a lot harder just to get back to where they were before the downturn. As an example, suppose you invested $500,000 in a DJIA portfolio on December 31, 2007. The DJIA finished down 34% in 2008, resulting in your portfolio being worth $330,000 on December 31, 2008. In order to recover its loss of $170,000, your portfolio would need to increase 52%.

Fixed index annuities, or FIAs, are insulated from stock market declines. Unlike investments in stocks, bonds, mutual funds, index funds, and exchange traded funds that fluctuate in value, the value of FIAs either increase or remain unchanged.

Value Increases When Stock Market Increases

The performance of a FIA is tied to the performance of stock market indices associated with one or more indexing strategies chosen by you. Interest is credited annually to your contract value based on performance of each selected indexing strategy during the previous contract year.

Interest will be credited to your FIA account, or accumulation value, whenever the performance of a chosen indexing strategy has been positive during the previous contract year. The amount of interest that’s credited is generally subject to a cap rate, or preset maximum amount.

Value is Unchanged When Stock Market Declines

Whenever the value of an indexing strategy is either unchanged or has declined from the previous contract year, your FIA will be credited with no interest at the end of the contract year. The value is simply unchanged from what it was a year ago.

To illustrate, suppose that instead of investing $500,000 in a DJIA portfolio on December 31, 2007, you invested $500,000 in XYZ fixed index annuity. Let’s assume that you allocated 100% of your investment to the DJIA indexing strategy which declined 34% in 2008.

No interest would be credited to your FIA contract value in 2008. Furthermore, you wouldn’t be penalized by the negative performance of your strategy. Unlike a direct investment in a DJIA portfolio which would have been worth $330,000 on December 31, 2008, the value of your FIA would have been $500,000.

Gains are Retained

Unlike other types of investments, FIAs are unaffected by stock market declines. While annual gains from increases in indexing strategies are limited by cap rates, they’re locked in.

The ability to shelter gains from subsequent losses isn’t available with most other types of investments. This benefit can be especially important for older retired individuals who don’t have a long time horizon to recover from sizable stock market losses. Never underestimate peace of mind.

Categories
Annuities Deferred Income Annuities Retirement Income Planning

Protect Against Elder Fraud with Fixed Income Annuities

Closeup portrait senior man grandfather holding piggy bank looking suspicious trying to protect his savings from being stolen isolated on gray wall background. Financial fraud concept "n

If you’ve been reading Retirement Income Visions™ and my RetireMentors MarketWatch column, you know that I’ve written extensively about the use of fixed income annuities as a retirement income planning strategy.

Fixed income annuities are a natural fit as part of a retirement income plan. They provide a predictable sustainable income stream that can be customized to meet current and projected financial needs.

An important, although unpublicized, benefit of fixed income annuities is protection against elder fraud. Earlier this year, the FBI brought charges against 250 subjects who collectively victimized more than one million mostly elderly Americans. The criminals who were charged caused losses exceeding $600 million.

Two of the three types of fixed income annuities – single premium immediate annuities (SPIAs) and deferred income annuities (DIAs) – offer the greatest protection against elder fraud. Fixed index annuities (FIAs) with income riders aren’t as effective for this purpose due to their accumulation value.

SPIA and DIA Basics

When you purchase a SPIA or DIA from a life insurance company, you receive a contract that includes confirmation of your initial, and, in the case of a SPIA, only premium. The contract also includes your income start date and payment frequency, amount, and duration.

Income payments from SPIAs generally begin one month after purchase and continue for life. The income start date for DIAs is at least 12 months after the purchase date, with term certain or lifetime payments, depending upon the terms of the contract. For both SPIAs and DIAs, there are various lifetime payment options available to provide for either an extension of income payments or payment of a lump sum to named beneficiaries in the event of premature death.

No Investment Account to Raid

With SPIAs and DIAs, there’s no investment account that can be raided by a fraudster. Premiums are held in the life insurance company’s general account. Aside from confirmations of premiums and associated income amounts, there are no investment statements.

Although the present value of the future income stream of SPIAs and DIAs can be calculated, it’s generally excluded from a personal net worth statement.

Secure but Illiquid

SPIAs and DIAs are a promise by a life insurance company to make periodic income payments to an annuitant, who is usually the contract owner, for a specified length of time in exchange for receipt of one or more premiums. Since the life insurance industry is heavily regulated, payments are secure subject to each company’s claims paying ability.

Other than periodic income, which is generally paid monthly, annuitants are unable to request withdrawals from SPIAs and DIAs. As such, their investment is illiquid. This is a highly attractive feature when it comes to elder fraud protection.

Payment Amounts Minimize Risk of Elder Fraud

Since income from SPIAs and DIAs is generally paid monthly over one’s lifetime, individual payments are typically small relative to premiums and are further reduced by income tax withholding. Consequently, the risk of elder fraud is minimized.

Assuming that payments are deposited into a checking account, frequent comparison of transactions and reconciliation of checking account balances to online transactions and statements, respectively, will reduce the possibility of theft.

Electronic Payments Enhance Protection

The option to have fixed income annuity payments electronically deposited into one’s checking account should be chosen whenever possible. Paper checks present opportunities for fraud from the moment they’re mailed by an insurance company until they’re deposited in one’s checking account.

Electronic payments have a high degree of security. Timing is predictable since fixed income annuity payments are made on a specified day of each month, quarter, or year in accordance with the contract terms.

Peace of Mind

Assuming that there’s no fraudulent activity related to premium payments, SPIAs and DIAs are well-suited for providing ongoing protection against elder fraud. Absence of an investment account, payment security, illiquidity, relatively small payment amounts, and electronic payments provide this safety.

These same features are also inherent in Social Security. SPIA and DIA owners who understand this generally have peace of mind from their initial purchase until receipt of the final income payment.

Categories
Annuities Deferred Income Annuities Income Tax Planning Long-Term Care Longevity Insurance Retirement Income Planning

The Perfect Storm for a Tax Credit Longevity Annuity Plan

The Perfect Storm
The United States Capitol Building

With momentum building for tax reform, concerns about the long-term sustainability of Social Security, widespread lack of long-term care protection planning, and the failure of 401(k) plans to replace private pension plans that were once a cornerstone of our parents’ and grandparents’ retirement income, we have the perfect storm for Congress to introduce, and the President to sign, Tax Credit Longevity Annuity Plan legislation.

Similar to a qualifying longevity annuity contract, or QLAC, which was enacted in 2014, a Tax Credit Longevity Annuity Plan, or TCLAP, (my creation) would use one or more deferred income annuities, or DIAs, offered by life insurance companies as its chassis.

Deferred Income Annuity Advantages

DIAs offer three advantages over traditional savings vehicles which make them attractive as the foundation of a comprehensive retirement income planning strategy:

While payment options include a fixed term or lifetime, most people opt for the latter. When you purchase a DIA, you choose a deferred income start date. Once payments begin, they continue for the life of the annuitant and a joint annuitant if applicable assuming a lifetime payment option is chosen.

  • Locked-in savings plan

A DIA is irrevocable. Unlike traditional retirement savings plans from which funds can be withdrawn before retirement resulting in premature depletion, you enter into a contractual relationship with a life insurance company when you purchase a DIA. The contract provides that you will receive a defined monthly income beginning on a specified future date in exchange for a specified premium. Unless there’s a return of premium provision included in your contract, your premium is nonrefundable.

Subject to the claims-paying ability of individual life insurance companies, funds allocated to DIAs are protected against stock market declines. Individuals who purchase DIAs will receive a contractually-fixed amount of lifetime income beginning on a certain date even if there’s a major stock market correction.

12 Proposed Provisions

A Tax Credit Longevity Annuity Plan, or TCLAP, if enacted, would expand upon, and overcome, various shortcomings associated with QLACs. Periodic income payments would be similar to comparable non-TCLAP DIAs. There would be 12 proposed provisions as follows:

1.  Nonqualified Investment

Most people associate retirement planning with investing in qualified retirement plans such as 401(k)s and IRAs. To the extent that you make deductible contributions to these types of plans, 100% of your distributions will eventually be taxable. This wouldn’t be so bad if you invested the tax savings from your deductible contributions and used them for retirement, however, most people don’t do this.

Unlike a QLAC which can only be used inside retirement plans, the source of TCLAP investments would be nonqualified funds. Although income payments would still be taxable, a sizable portion would be exempt from taxation. This is due to the fact that an “exclusion ratio” is applied to nonqualified DIA distributions.

An exclusion ratio reduces the amount of taxable DIA distributions by the portion of each distribution that’s deemed to be a return of investment. The ratio is equal to your investment in the contract divided by your expected return based on your actuarial life expectancy at the age that you begin receiving distributions.

Approximately 25% to 65% of each income payment can be excluded from taxation depending upon your age when you begin receiving your distributions. The percentage that’s initially used will continue until you reach your actuarial life expectancy and your cumulative payments equal your total investment in your contract. 100% of future payments are taxable once this occurs.

2.  Additional Premiums

While several DIAs allow for subsequent investments in future years, there are several that limit investment to a single premium. Given the fact that the purpose of a TCLAP would be to meet sustainable income needs not fulfilled by other sources such as Social Security, a single premium would generally be insufficient.

Given this reality, a TCLAP carrier would accept initial and subsequent premiums up to a specified period, e.g., two years, prior to the income start date.

3.  Investment Tax Credit for Initial and Subsequent Investments

One of the most compelling ways to incentivize behavior is with tax credits. A tax credit, unlike a tax deduction which is dependent upon one’s marginal tax bracket for determining the amount of tax savings, is a direct offset to tax liability. Most tax credits today, with the exception of residential energy and credits for all-electric and plug-in hybrid vehicles, the latter of which can be as much as $7,500, are subject to income limitations.

Assuming that the purpose of tax reform is to benefit the middle class, the long-term sustainability of Social Security is questionable, and Congress wants to encourage and promote self-funded private pension plans, an investment tax credit equal to a percentage of initial and subsequent investments makes sense. The percentage would be modest to compensate for the fact that a sizable portion of income distributions will be nontaxable.

In order to encourage individuals to direct a high level of their savings into TCLAPs beginning at an early age to produce a significant amount of sustainable income to pay for their retirement expenses, I would recommend that Congress support a tax credit equal to 8% of initial and subsequent investments for individuals who aren’t qualified retirement plan participants and 4% for those who are. This would go a long way toward subsidizing investment in TCLAPs that wouldn’t otherwise be made in most cases.

4.  Annual and Lifetime Investment Limitation

Given the fact that a sizable investment in a fixed income annuity such as a DIA is required in order to receive a meaningful amount of income, there should be a reasonably high limit on the amount of allowable initial and subsequent investments in TCLAPs.

I would propose a limit of $100,000 in the initial contribution year and $50,000 in subsequent years with a lifetime limit of $750,000 per household. This would result in a maximum investment tax credit of $8,000 (8% x $100,000) or $4,000 (4% x $100,000) in the initial year and $4,000 (8% x $50,000) or $2,000 (4% x $50,000) in subsequent years depending upon participation in a qualified retirement plan.

5.  Minimum Investment Amounts

As stated in the previous section, a sizable investment in a DIA is required in order to receive a meaningful amount of income. The amount of income in each situation is different depending upon each individual’s retirement income planning needs, the percentage of total income that’s targeted from sustainable income sources, and the amount that will be provided by other sources, e.g., Social Security.

Having said this, minimum investment amounts need to be established that will help meet one’s planning needs as well as make it profitable for life insurance companies to underwrite TCLAPs. I would suggest a required minimum investment of $50,000 in the initial contribution year and $10,000 in subsequent years in which an individual decides to add funds to his/her TCLAP. These amounts would be applied to all of a household’s TCLAPs if more than one is owned.

6.  No Income Restriction

Unlike many tax credits, including the retirement savings contributions credit that’s subject to a maximum income limitation, this wouldn’t be the case for TCLAPs. Everyone, regardless of income level, needs to save for retirement. To the extent that there’s a vehicle for doing so that provides sustainable lifetime income protection from stock market corrections, we shouldn’t be limited by income from making that investment.

7.  Maximum Income Start Age

Since a TCLAP would be a double tax-favored plan with its built-in exclusion ratio and legislated-investment tax credit, a maximum income start age would need to be included in order for taxation on the nonexcluded portion of income payments to begin at a reasonable time from an IRS perspective.

Given the fact that most nonqualified DIAs provide for a maximum income start age of 85 to 95, I would recommend a maximum income start age of 75 for a TCLAP. Although most people would opt for a starting age approximating the traditional retirement age of 65, this would encourage purchase of multiple contracts with different starting ages to meet changing income needs in retirement.

8.  Minimum Income Start Age

To encourage individuals to defer their income start date for a reasonably long time to increase their periodic income payments and to discourage investment for the sole purpose of obtaining the tax credit, a minimum income start age would need to be legislated. I would recommend that the later of age 60 or 10 years from the initial purchase date be used for this purpose.

9.  Flexible Income Start Date

Flexibility is important since TCLAPS would be used for retirement planning. This includes the income start date since it’s a known fact that people often retire earlier than planned for various reasons. Likewise, there are situations where individuals either elect or are forced to extend their working years.

Recognizing this, subject to IRS’ maximum and minimum income start ages (see #7 and #8), accelerated and deferred income start dates could be provided for as follows:

  • Earliest income start date: 1 year after the last premium payment
  • Latest income start date: 5 years after the original income start date

10.  Larger Return of Premium Than DIA Contracts

When you purchase a traditional DIA or QLAC, you can include a return of premium provision in your contract in exchange for a small reduction in your periodic income amount. This provides for an income tax-free death benefit payable to one or more beneficiaries equal to the amount of investment in the contract in the event that the annuitant(s) die before income payments begin.

Once again, to encourage individuals to take advantage of TCLAPs, I would recommend that the return of premium be increased from the traditional 100% of investment amount to 125% of all investments made at least five years before the death of the annuitant or surviving annuitant in the case of joint annuitants. The purpose of the five-year rule would be to remove the incentive of individuals in declining health who wouldn’t normally purchase a DIA from obtaining a guaranteed 25% return on investment in a short period of time for their beneficiaries.

11.  Ability to Use Funds for Long-Term Care Protection Prior to Income Start Date

In the event that one or both annuitants, as applicable, meets one of the two traditional long-term care insurance benefit triggers, funds could be withdrawn from a TCLAP tax-free to pay for long-term care expenses. The two benefit triggers are:

  • Inability to perform two out of six of the activities of daily living (ADLs): bathing, continence, dressing, eating, toileting, and transferring
  • Cognitive impairment

A TCLAP owner would be able to take advantage of this provision after being a TCLAP owner for a specified period, say ten years. At that time, upon submitting periodic proof of meeting one of the two benefit triggers from a physician, a TCLAP owner would be paid a tax-free cash benefit of up to $5,000 per month to be used for long-term care expenses with a lifetime limit of 125% of the cumulative TCLAP investment amount.

Long-term care payments would be in lieu of receiving lifetime income beginning at the contractual income start date. If the annuitant dies before receiving 125% of the cumulative investment amount, the remainder would be paid to the individual’s beneficiaries as a tax-free death benefit.

12.  Required In-Force Income Illustrations and Income Benefit Statements

Before you invest in a DIA, your life insurance agent will prepare an illustration showing the amount of periodic income that you will receive beginning on a specified date assuming that you make your investment today. When permitted, the illustration can also include planned future additional premiums.

Given the fact that a TCLAP carrier would be required to accept additional premiums (See #2) and it’s important to know the amount of additional periodic lifetime income that you will receive, insurance companies would be required to provide in-force income illustrations upon request.

Confirmation and annual statements would also be required to show original and revised periodic income payment amounts resulting from additional contributions beginning at the contractual income start date.

Timely Idea

The proposed “Tax Cuts and Jobs Act” introduced by House Republicans on November 2nd includes no incentives for saving for retirement. While it generally retains the current rules for 401(k) and other retirement plans, it would repeal the rules allowable Roth IRA conversions and recharacterization of Roth IRA contributions as traditional IRA contributions.

A Tax Credit Longevity Annuity Plan, or TCLAP, would be a timely addition, and potential cornerstone, to any tax legislation. It could, and should, be passed as stand-alone legislation in the event that Congress is unable to agree on a comprehensive tax plan.

A TCLAP would have widespread appeal given its potential to create private pension plans similar to what our parents and grandparents enjoyed while also providing for long-term care benefits should this need arise. Throw in concerns about the long-term sustainability of Social Security and you’ve got the perfect storm for a TCLAP.

 

Categories
Annuities Deferred Income Annuities Retirement Income Planning

Are You Using This Tax-Favored Sustainable Income Strategy?

Sustainable Income

Do you own any investments that offer all of the following five benefits?:

  • Guaranteed lifetime income payment beginning at a future date chosen by you
  • Return of your investment if you die before income start date
  • Income payments can be insured for a specified number of years or until original investment has been returned
  • Nontaxable until income start date
  • 25% to 65% of each income payment excluded from taxation

There’s only one type of investment that offers all five advantages – a nonqualified, or nonretirement, deferred income annuity, or DIA. The first four benefits, which are individually and collectively very attractive as part of a retirement income planning strategy, are also provided by qualified, or retirement plan, DIAs. Unlike nonqualified DIAs, however, qualified DIA income distributions, including those from qualified longevity annuity contracts, or QLACs, are fully taxable.

Deferred Income Annuities vs. Single Premium Immediate Annuities

Benefit #5, exclusion of a portion of each income payment from taxation, is provided by nonqualified single premium immediate annuities (SPIAs) as well as DIAs. SPIAs can be an appropriate retirement income planning solution if you’re about to retire or are already retired and have an immediate need for sustainable lifetime income. With a SPIA, income distributions begin one month after purchase assuming a monthly periodic payment and no later than one year after purchase if you opt for annual payments.

Although they aren’t as prevalent in the marketplace, DIAs are a more appropriate retirement income planning strategy than SPIAs in most situations due to their deferred income start date. Whether you’re 40 years old and won’t be retiring for 25 years or you’re 65 and want to defer your income start date for five or more years, one or more DIAs can meet your need. Deferral of your income start date increases the amount of your periodic income payment since the insurance company will be making payments to you for a shorter period of time.

Exclusion of Portion of Each Income Payment from Taxation

DIAs and SPIAs offer a unique income tax advantage when they’re purchased as a nonqualified asset vs. inside a retirement plan. A portion of each income payment, generally in the range of 25% to 65%, is excluded from taxation.

How does this work? When you receive income payments from an annuity, in addition to earnings, you’re receiving a return of your premium, or investment. Any time that you receive a return of a nonqualified investment, this is considered to be your cost, or basis, and is nontaxable.

The amount of your income payment that’s nontaxable is determined using an “exclusion ratio.” This is calculated by dividing the investment in the annuity contract by the total expected lifetime payments in the case of a lifetime DIA. The latter is an actuarial calculation based on the life expectancy of you and a joint annuitant if applicable.

As an example, let’s say that you invest $100,000 in a lifetime DIA and your expected lifetime payments are $150,000. 66.7 percent ($100,000 divided by $150,000) of each payment will be tax-free until you receive $100,000. Once your payments total $100,000, 100% of each of your additional payments will be fully taxable.

Taxable Amount Determined by Purchase and Income Starting Ages

How is the taxable portion of each nonqualified DIA or SPIA payment determined? The younger you are when you purchase your DIA or SPIA and the longer you defer your income starting age in the case of a DIA, the greater the taxable percentage of each payment. Although, as stated earlier, you will increase the amount of each of your income payments with a DIA the longer you defer your income start date, you will also increase the taxable percentage.

The best way to illustrate this is with an example. Using actual payouts from a highly-rated life insurance company’s current lifetime deferred income annuity offering, the following is a table showing the taxable percentage of each monthly income payment assuming the following eight parameters:

  1. Male and female joint annuitants.
  2. Male is three years older than female.
  3. Male purchase age varies in increments of five years from 45 to 60.
  4. Female purchase age varies in increments of five years from 42 to 57.
  5. Male income starting age varies in increments of five years from 65 to 75.
  6. 100% of income continues upon death of first annuitant.
  7. Return of premium in the event of the death of both individuals prior to the income payout starting date whereby beneficiaries will receive 100% of the original investment.
  8. 10-year certain payout in the event that both individuals die after payments begin and before 10 years of payments have been distributed. The annuitants’ beneficiaries would continue to receive payments for the remainder of the 10 years.
Nonqualified Lifetime Deferred Income Annuity
TAXABLE INCOME PERCENTAGE
Male and Female Annuitants With Return of Premium and 10-Year Certain
               
  Purchase Age   Male Income Starting Age  
  Male Female   65 70 75  
  45 42   65.7% 69.6% 73.7%  
  50 47   58.4% 63.1% 68.1%  
  55 52   49.4% 55.3% 61.3%  
  60 57   38.3% 45.4% 53.0%  
               

Per the table, the taxable portion of each payment ranges from 38.3% to 73.7% (26.3% to 61.7% is nontaxable) depending upon purchase and income starting ages. Assuming an investment of $100,000, the monthly lifetime income payments range from $510 assuming a male purchase age of 60 and male income starting age of 65 to $1,707 assuming a male purchase age of 45 and male income starting age of 75. The annual lifetime and taxable payment amounts would be as follows for these two extremes:

Male purchase age of 60 and male income starting age of 65:

Total annual payments:                         $6,117
Total taxable annual payments:           $2,343 (38.3% x $6,117)

Male purchase age of 45 and male income starting age of 75:

Total annual payments:                         $20,487
Total taxable annual payments:           $15,099 (73.7% x $20,487)

Unique Tax-Favored Sustainable Income Strategy

If you have a sustainable income need and it isn’t immediate, one or more nonqualified deferred income annuities, or DIAs, can provide a unique tax-favored solution. While this post addresses lifetime DIAs, you can also purchase term, or period certain, DIAs that provide income streams for a specified number of months or years. This is a more sophisticated strategy that can be used to meet projected changing retirement income needs in different stages of retirement.

Finally, an inflation factor can be applied to DIA and SPIA income payments that will increase the amount of each payment each year. This will, however, reduce the initial payment amount accordingly.

Categories
Annuities Deferred Income Annuities Qualified Longevity Annuity Contract (QLAC) Retirement Income Planning

Replace Unpredictable RMDs with Secure Lifetime Income

I don’t know about you, however, whenever I’ve been required to do anything, I’ve never looked forward to it. This includes childhood chores like making my bed and mowing the lawn, taking prerequisite courses in college, and satisfying professional continuing education requirements.

It’s not enough that I’ve fulfilled, and continue to fulfill, numerous personal and professional demands. When I turn 70-1/2, I will be subject to yet another obligation that will be enforced for the rest of my life – Congress’ required minimum distribution rules.

Required Minimum Distribution Basics

Assuming that you have one or more retirement plans,  you need to take required minimum distributions (RMDs) from your plans each year beginning no later than April 1st of the year following the year that you turn age 70-1/2. Retirement plans include all employer sponsored plans, including traditional and Roth 401(k) plans, profit-sharing plans, 403(b) plans and 457(b) plans. Traditional IRAs, SEP-IRAs, and SIMPLE IRAs, as well as inherited traditional and Roth IRA accounts, are also subject to the rules.

RMD amounts change each year. They may increase or decrease depending upon two variables:  (a) the value of your retirement plan accounts on December 31st of the prior year, and (b) a life expectancy factor obtained from tables in IRS Publication 590-B. If you fail to withdraw your RMD by the applicable deadline, which is December 31st after the initial year, the amount that hasn’t been withdrawn is subject to an excise tax of 50%.

RMD Example

The main problem with RMDs is lack of predictability of projected annual withdrawal amounts compared to projected retirement income needs. RMDs are dependent upon retirement plan account values which, in addition to contributions, are dependent upon return.

Ignoring future contributions and potential withdrawals before age 70-1/2, let’s assume that you’re 50 years old, single, plan to retire at 67 when you will begin receiving Social Security benefits, and the value of your traditional IRA is $300,000. What will be the amount of your annual RMDs beginning at age 70-1/2? The answer to this question is that it depends upon the underlying investments in your IRA and annual rate of return.

Let’s assume that your traditional IRA appreciates 4% each year for the rest of your life. Per Exhibit 1, the value is projected to increase from $300,000 at age 50 to $684,000 at age 70. RMD’s are projected to increase from $26,000 beginning at age 71, to $35,000 at age 80, and to $44,000 at age 90 at which time they’re projected to level off and begin decreasing.

RMD Alternative

Since you’re planning for retirement and a long lifetime is a possibility, you want to receive a predictable and sustainable lifetime income stream to supplement Social Security while reducing investment risk. You discuss your goals and concerns with your retirement income planner. She recommends that you transfer your traditional IRA into a deferred income annuity (DIA) with a highly-rated life insurance company.

Assuming that you implement your advisor’s recommendation, you will receive monthly lifetime income of $4,059 beginning at age 70-1/2. There are additional guarantees built into your contract, including a return of premium, or investment, in the event that you die before age 70-1/2 and a 10-year certain payout if you die after your payments begin and before age 80-1/2.

Per Exhibit 2, you will receive income distributions totaling just under $49,000 a year from your DIA for the rest of your life beginning at age 70-1/2 in October, 2037. This amount is projected to initially exceed your annual RMD’s by $23,000, declining to an advantage of $13,000 at age 80 and $5,000 at age 89.

Fixed Income Annuities Exempt from RMDs

Fixed income annuities are exempt from RMDs since they have no cash value that can be used in a RMD calculation and the annuity payments are the same each year. Although they’re exempt from RMDs, payments from fixed income annuities held inside retirement plans must begin no later than age 70-1/2.

The income start date of qualified longevity annuity contracts (QLACs), a special kind of DIA designed for non-Roth retirement plan accounts, can be deferred to age 85. QLACs have a maximum allowable investment of 25% of the value of retirement accounts subject to a cap of $125,000.

RMDs vs. Fixed Income Annuity Payments

RMDs may not meet one’s needs since they’re calculated amounts based on fluctuating account values subject to underlying investment values and changing life expectancy factors. Annual calculations must be made and calculated amounts withdrawn by stipulated deadlines to avoid a 50% excise tax.

Fixed income annuity payments, on the other hand, are contractually fixed amounts that can be predetermined years before their start date to cover projected expenses beginning at age 70-1/2. Unlike RMDs, fixed income annuities aren’t subject to investment risk.

Fixed income annuity payments will often be greater than RMDs in early years. Annual differences will be dependent upon retirement plan annual investment returns. While investment accounts can be depleted, fixed income annuity payments will be paid for the remainder of one’s life. Best of all – they’re not required!

Categories
Annuities Deferred Income Annuities Retirement Income Planning

Is Cognitive Impairment Part of Your Retirement Income Plan?

The basic purpose of a retirement income plan is to develop tax-efficient strategies that are designed to provide predictable income streams to meet an individual’s or family’s financial needs during different stages of retirement.

A comprehensive plan should also include provisions for addressing potential life-changing experiences. One such event that’s generally associated with the latter stage of retirement is cognitive impairment.

As pointed out in the Center for Retirement Research of Boston College’s (CRR) January article, Cognitive Aging and the Capacity to Manage Money, most people who experience normal cognitive aging can manage their money in their 70s and 80s. This includes bill paying and evaluating an investment’s potential return relative to risk. Per the article, there are two situations that are problematic:  (1) financial novices and (2) individuals with cognitive impairment.

Financial Novices

While those with financial knowledge are generally able to manage their money in their later years, it’s much more challenging for individuals who haven’t acquired the requisite knowledge and experience needed to perform this task. These financial novices, who are often women, tend to be surviving spouses or individuals whose spouse has become incapacitated.

People who take on this role will either need informal help from a family member or formal assistance depending upon their depth of financial knowledge. The good news, according to the CRR study, is that most financial novices who aren’t cognitively challenged “will eventually gain enough knowledge to handle most financial matters without help.”

Individuals with Cognitive Impairment

Individuals in their 70s and 80s can often develop mild cognitive impairment (MCI) and ultimately severe dementia which is common in one’s 80s and 90s. According to a recent study cited in the CRR article, 95 percent of participants without any cognitive impairment were capable of managing their finances. This dropped to 82 percent of adults with MCI and 20 percent of adults with dementia.

Interestingly, individuals with cognitive impairment are often unaware that they’re not in control of their faculties, including their ability to manage their finances. Per the CRR article, “several studies have shown that people with MCI to full-blown dementia continue to feel confident about handling financial matters.” Given the fact that many of these individuals rely on a caregiver, this subjects them to the risk of financial abuse by the caregiver.

Simplify Investment Management

Although it can be challenging, surviving spouses and spouses of incapacitated individuals who don’t have the knowledge and experience of managing finances can eventually acquire the requisite information and skills to do so. It’s a much different story, however, for those with MCI and dementia.

Financial tools that are often used for retirement income planning include immediate and deferred fixed income annuities.  Both can fulfill the basic purpose of a retirement income plan as stated at the beginning of this article:  develop tax-efficient strategies that are designed to provide predictable income streams to meet an individual’s or family’s financial needs during different stages of retirement.

Immediate and deferred fixed income annuities can also eliminate the financial management challenges associated with cognitive impairment. Unlike a diversified investment portfolio that requires ongoing management, there are generally no significant financial decisions that need to be made with a fixed income annuity during one’s lifetime once an income start date is selected.

The income start date will vary depending upon the type of fixed income annuity as follows:

  • Immediate annuity: Generally one month after date of purchase
  • Deferred income annuity: Contractually set at the time of purchase with some contracts offering flexible start dates within a specified range before and after the contractual start date
  • Fixed index annuity with income rider: Totally flexible with most contracts requiring a one-year waiting period after the contract date

Develop an Extended Care Plan

Extended care should be a focal point of a retirement income plan. Strategies will vary with each household, depending upon medical history, marital status, potential extended family involvement, and financial knowledge and experience.

As discussed in my October 10, 2016 MarketWatch RetireMentors article, Make Sure You Have a Long-Term Care Plan in Place Before It’s Too Late, an extended, or long-term care, plan addresses various physical and mental changes that occur as we age. It includes specific steps that will be performed by family members and other individuals to manage the various changes when they occur. An extended care plan doesn’t necessarily have to include long-term care insurance.

Plan for Cognitive Impairment

Given the possibility and increasing occurrence of MCI and dementia, it’s important that informal and formal planning for these cognitive impairments begins long before they are likely to occur. As a general rule, the earlier that planning is done, the more options will be available to implement solutions to manage cognitive challenges when they materialize.

Categories
Annuities Deferred Income Annuities Retirement Income Planning

Income-Proof Your Aggressive Portfolio

With the Dow Jones Industrial Average (DJIA) crossing the elusive 20,000 barrier last Wednesday for the first time, a lot of people are excited about investing in the stock market. Never mind the fact that the DJIA has tripled in price from its low of 6,470 on March 6, 2009, increasing at a mind-boggling average annual rate of return of 40% for the last eight years.

If you have an aggressive portfolio and are within 15 years of retiring, you need to protect it from a sizable decline. When the Dow lost 52% in 17 months between October 1, 2007 and March 6, 2009, no one saw it coming. A lot of people who were planning on retiring in 2008 and 2009 were forced to postpone retirement.

Given the stock market’s unsustainable climb in the last eight years and the associated possibility of a significant market correction, it makes sense to insure your investment strategy. Assuming a portfolio of at least $500,000, one of the best ways that you can do this is by allocating 20% to 25% to one or more deferred fixed income annuities.

Aggressive Portfolio With No Income Protection Plan

Let’s assume that you’re 58, single, are planning to retire in 10 years, and you have an aggressive portfolio with a value of $1 million. Let’s take a look at two scenarios:

  1. Your portfolio declines 50% over the next 17 months.
  2. Your portfolio increases 10% over the next two years and then declines 50% over the next 17 months.

In scenario #1, the value of your portfolio has decreased from $1 million to $500,000 at the end of 17 months. In scenario #2, the value of your portfolio has increased from $1 million to $1,210,000 before decreasing to $605,000 17 months later.

You would probably agree that whether the value of your portfolio is 50% or 60% of its initial value, this doesn’t bode well for your retirement planning. It will take a long time for you to recover your loss. You’re also getting closer to your planned retirement date. Furthermore, your portfolio isn’t designed to provide you with any predictable retirement income.

Aggressive Portfolio With Income Protection Plan

Let’s suppose instead that you decide to insure your $1 million portfolio from a potential market decline by transferring 20%, or $200,000, into a deferred income annuity offered by a highly-rated life insurance company that will pay you lifetime income beginning when you retire in 10 years.  The life insurance company will also pay (a) a death benefit of $200,000 to your beneficiaries if you die before your income start date or (b) up to 10 years of payments to you and your beneficiaries if you die within the first 10 years after your income start date.

In scenario #1, the value of your remaining portfolio of $800,000 has decreased to $400,000 at the end of 17 months. In scenario #2, the value of your portfolio has increased from $800,000 to $968,000 before decreasing to $484,000.

By transferring $200,000 into a deferred income annuity, you have reduced your portfolio loss by $100,000 or $79,000, depending upon the scenario as follows:

  1. Scenario #1: Investment portfolio of $400,000 + deferred income annuity of $200,000 = $600,000 vs. $500,000 with no income protection plan
  2. Scenario #2: Investment portfolio of $484,000 + deferred income annuity of $200,000 = $684,000 vs. $605,000 with no income protection plan

In addition to reducing your portfolio loss, by transferring $200,000 into a deferred income annuity, you will receive annual income of approximately $20,000 for the rest of your life beginning at age 68 no matter what the stock market does. If the investment source is nonqualified funds, approximately 50%, or $10,000, of your annual income will be nontaxable.

Insure Your Portfolio

I believe that the 20,000 Dow is more than just a milestone given the breakneck pace at which it was achieved assuming that your reference point is March 6, 2009. It is instead a wake-up call for anyone with an aggressive portfolio who is within 15 years of retiring who doesn’t currently own any fixed income annuities. If this describes your situation, now is the time to income-proof your portfolio before the next major downturn when you’re that much closer to your planned retirement date.