Tag: annuitization

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Annuities Deferred Income Annuities Longevity Insurance Qualified Longevity Annuity Contract (QLAC)

QLACs are Here

Since the Treasury and IRS finalized a regulation in the beginning of July blessing the use of qualified longevity annuity contracts, or “QLAC’s,” a lot of people have been wondering when and where they can buy one. Per the last paragraph of my September 15th “Don’t Expect to See QLAC’s Soon” post, speculation was that product launch may begin in the fourth quarter of this year.

The mystery is now behind us. The first QLAC to hit the market was recently released by AIG through American General Life Insurance Co with its American Pathway deferred income annuity. AIG enjoys overall high ratings from independent ratings agencies, including A+, or strong, ratings from Standard & Poor’s and Fitch Ratings, A, or excellent, from A.M. Best Company, and A2, or good, from Moody’s Investors Service.

What’s Different about QLACs?

Subject to their current investment limitation of the lesser of $125,000 or 25% of one’s retirement plan balance, QLACs offer two distinct advantages over other investment vehicles for meeting part of a retiree’s income needs as follows:

  1. A portion of retirement assets exposed to stock market declines can be exchanged for a predictable sustainable lifetime income stream beginning at a specific date up to age 85.
  2. Can defer income taxation of a portion of retirement plan balances for up to 15 years with its exemption from the required minimum distribution, or “RMD,” rules, that otherwise require taking minimum distributions from retirement plans beginning by April 1st of the year following the year that you turn 70-1/2.

Predictable Sustainable Lifetime Income Stream

QLACs are a special type of deferred income annuity, or “DIA.” A DIA is an annuity from which annuitization begins at least 12 months after the date of purchase in exchange for a lump sum or series of periodic payments. The annuitization can be for a term certain or lifetime, depending upon the terms of the annuity contract.

Fixed income annuities, including lifetime DIAs, have previously been allowed to be included in retirement plans provided that payments (a) begin by April 1st of the year following the year that the owner turns 70-1/2 and (b) are structured so that they will be completed distributed over the life expectancies of the owner and the owner’s beneficiary.

QLACs extend the potential income start date of retirement plan assets allocated to them to age 85. In addition to predictable sustainable lifetime income, this enables individuals who have other sources of income to increase the amount of annual income that they will eventually receive from QLAC investments compared to non-QLAC DIAs held in retirement asset accounts.

Circumvent RMD Rules for a Portion of Retirement Plan Assets

Other than converting retirement plan assets to Roth IRAs which often triggers income tax liability at the time of conversion, there has been no other game in town for avoiding the RMD rules prior to QLAC’s. QLAC’s offer an opportunity to defer taxation on up to the lesser of $125,000 or 25% of one’s retirement plan balance at the time of investment.

Depending upon the timing of the QLAC investment and the income start date, the reduction in RMDs and potential income tax savings can be significant. Suppose that you’re 50 and your traditional IRA, which is your only retirement plan, has a value of $600,000. Let’s further assume that you invest $125,000 of your IRA in a QLAC with an income start date of 80.

Had you not invested $125,000 in a QLAC, assuming a 4% rate of return, this portion of your IRA would grow to $273,890 when you turn 70. The first year RMD for this value would be just under $10,000. The income tax savings from not withdrawing this amount of income from your IRA and potential greater amounts for the next ten years could be significant.

QLAC Market

With the release of AIG’s QLAC, the cat is out of the bag. Other insurance carriers are either in the process, or will soon be, requesting regulatory approval for their QLAC offerings. Per my September 15th post, it was, and still is, my personal opinion that widespread availability will not occur until well into 2015. Once this happens and consumers understand and appreciate the two distinct advantages that QLACs offer over other investment vehicles for meeting part of a retiree’s income needs, I believe that demand for this unique product will increase significantly.

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Annuities Deferred Income Annuities

A Hidden Treasure: Annuitization Options on Older Annuity Contracts

From time to time my life insurance agency refers potential clients to me who need to make a decision with an existing life insurance or annuity contract and are no longer in touch with the agent who sold them the contract. This happened recently with an older retired couple who received a letter from their life insurance company informing them that their annuity contract was maturing in a couple of months.

By way of background, all annuity contracts have a maturity date. In the case of a deferred fixed income annuity, the maturity date is the last date on which you can begin receiving payments from your annuity. Older contracts tend to have a maturity date that’s a fixed number of years from the date the contract was issued. Newer contracts usually define the maturity date based on the annuitant’s age, e.g., age 90.

The Smiths (not their real name) purchased a deferred fixed income annuity in 1984 from a large, well-known life insurance company that matured 30 years from the issue date in 2014. They received a letter from the company in January informing them that their annuity was maturing in March and they needed to choose one of three options:

  • Cash out the annuity and take a lump sum equal to the current value
  • Select an annuitization option and receive periodic annuity payments
  • Invest in another annuity

After preparing a detailed analysis for the Smiths, I determined that annuitization using a 10-year certain monthly payout was the best alternative in their situation for a number of reasons. My analysis included preparation and review of various period certain and installment refund payout option illustrations for their existing annuity contract as well as a potential replacement contract with other highly-rated life insurance carriers and preparation of income tax and cash flow projections.

To make a long story short, it turned out that the payout from the Smith’s existing annuity contract would provide them with monthly income that was 22% greater than the best alternative from any potential replacement contract. The reason for this is that the interest rate assumptions that were used for calculating annuitization payout amounts with their existing contract were much higher than those used in new annuity contracts. 6-month CD rates were approximately 9% in 1984 when the Smith’s contract was issued vs. less than 1% today.

Whether you have an annuity contract that’s maturing in the near future or you’re considering doing a tax-free exchange to replace your existing contract, don’t overlook annuitization options on your existing contract. If it’s an older contract, the payout amounts may be significantly greater than those on new contracts.

There are other issues to keep in mind when deciding whether to replace an existing annuity contract which are beyond the scope of this post. These include, but aren’t limited to, potential surrender charges and the overall purpose of an annuity, including particular types of annuities, as part of your investment/retirement income portfolio.

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Annuities

Immediate Annuities – Where’s the Planning?

Retirement Income Center

As a retirement income planner, in addition to the Retirement Income Visions™ blog posts and MarketWatch RetireMentors articles that I write, I read a lot of retirement planning and retirement income planning (If you’ve been reading my articles, you know there’s a distinct difference between the two disciplines) articles written by other writers.

While I’m happy to see that immediate annuities are often recommended as a potential retirement income planning strategy, I get concerned when they’re touted as the only income solution, especially in today’s low-interest-rate environment.

I have discovered after questioning writers about their recommendation that knowledge about other types of income annuities is lacking in many cases.

An immediate annuity is a fixed income annuity for which annuitization begins one month after date of purchase with a single premium. For those of you who aren’t familiar with, or need to brush up on your understanding of, annuities, please refer to the following five terms that are defined in the Glossary of Terms: annuity, annuitization, fixed annuity, fixed income annuity, and immediate annuity.

From a planning perspective, assuming there isn’t an existing retirement income plan in place that includes deferred fixed income annuities, it’s my belief that the recommendation of an immediate annuity as the only income solution in many cases demonstrates a lack of planning and understanding about other types of annuity income strategies, including how they can interact to optimize an individual or family’s sustainable income.

By definition, annuitization, or the structured payout, of an immediate annuity begins one month after date of purchase of the annuity contract. Assuming that a recommendation is made today to purchase an immediate annuity with a lifetime payout, the lack of income deferral opportunity, combined with today’s low interest rate environment, is generally going to result in a relatively small monthly payment. While the payment is guaranteed by each individual life insurance carrier, subject to each carrier’s claims paying ability, and is subject to favorable income tax treatment, it nonetheless will generally be modest at best.

Assuming that you have at least five years until retirement, you have the ability to implement retirement income planning strategies that include fixed income annuities with deferred payments as part of your plan. This includes deferred income annuities (“DIA’s”) and fixed index annuities (“FIA’s) with guaranteed lifetime withdrawal benefits (“GLWB’s”), generally offered as income riders. Please refer to these terms in the Glossary of Terms if you’re not familiar with them. In addition, you may want to read the five-part series, FIA’s With Income Riders vs. DIA’s: Which is Right for You?

The deferred payment nature of DIA’s and FIA’s with income riders provides insurance carriers with the opportunity to invest your premium for an extended period of time as defined by each annuity contract. How does this benefit you? For starters, there will be no taxation of your investment between the date of your purchase and the date that you begin your withdrawals, otherwise known as tax deferral. More importantly, the deferral period provides you with the ability to receive a larger monthly income stream than a stand-alone immediate annuity solution. Furthermore, the timing of the commencement and amount of your payments can be customized to meet your financial needs.

An immediate annuity, when presented as the only income strategy, is generally not appropriate as a retirement income planning solution in many cases in my opinion. A holistic retirement income plan that includes deferred fixed income annuities is often a preferable alternative.

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Annuities Fixed Index Annuities

With a Fixed Index Annuity, You Can Have Your Cake and Eat It Too

Beginning with the August 1, 2011 post, Do You Want to Limit Your Potential Gains? through the November 5, 2012 post, Invest in DIA to Fund LTCI Premiums When Retired – Part 4 of 4, there were a total of 58 posts about fixed index annuities (“FIA’s”). Not to state the obvious, however, that’s a lot of information about one subject!

The impetus for the volume of material on FIA’s was, and continues to be, the fact that a FIA with an income rider is a unique and underutilized strategy that can provide a meaningful lifetime income floor for many retirement income plans while protecting against downside risk. As evidence of this fact, fixed index annuity sales have been increasing at a rapid pace the last two years while sales of variable annuities have been on the decline. Furthermore, their use as a retirement income planning tool is affirmed by the fact that the majority of sales have included an optional income rider.

What’s so special about a FIA? In one word – flexibility. A FIA is the only fixed annuity where you can receive a stream of income and also enjoy an investment value — that comes with downside protection. The other two types of fixed annuities, i.e., single premium immediate annuities (“SPIA’s”) and deferred income annuities (“DIA’s”) fulfill the income role (immediate in the case of SPIA’s and deferred with DIA’s), however, neither one of these two vehicles has an investment value. In addition, the lifetime income stream from a DIA often isn’t as competitive as lifetime payments from a FIA income rider with the same deferral period.

Another example of the flexibility associated with FIA’s is the income start date. Unlike a DIA where there’s a contractual fixed start date, the commencement of lifetime income from a FIA is totally flexible. It can typically be turned on at any time beginning one year after the contract date. Furthermore, while the lifetime income amount generally increases the longer you defer the start date, there’s no requirement to ever begin taking income withdrawals.

While SPIA’s and lifetime DIA’s (there are also period certain, or fixed term, DIA’s), are both designed to protect against the risk of longevity, the fact of the matter is that premature death can reduce their value, in some cases significantly. Some DIA’s can be purchased with a death benefit to protect against the possibility of death prior to their deferred annuitization date, however, the added insurance protection often increases the required investment amount, all else being equal.

When FIA’s are purchased with an optional income rider, it’s usually done in conjunction with some type of retirement income planning. As such, the emphasis is on deferred lifetime income, with the investment, or accumulation, value playing a secondary role. The fact of the matter is that the investment value is the anchor that provides the following four important benefits in addition to the sustainable lifetime income from the income rider:

  • Principal protection
  • Minimum guarantees
  • Upside interest potential
  • Death benefit

Assuming that no withdrawals are taken from the accumulation value in addition to income rider distributions, the accumulation value will only decrease by the income rider charge prior to turning on the income stream. Given this fact, unlike SPIA’s and lifetime DIA’s, FIA’s will have a death benefit available from day 1 that continues for much of the life of the FIA.

Once income begins, the accumulation value, i.e., death benefit, will decrease by the amount of income withdrawals in addition to the income rider charge. An optional death benefit rider can be added to the contract at the time of purchase to provide a guaranteed death benefit that will be paid even if there’s no accumulation value.

A fixed index annuity with an income rider is truly a unique retirement income planning tool. Unlike other types of fixed annuities where income begins immediately, i.e., SPIA’s, or at a contractually fixed date in the future, i.e., DIA’s, a FIA income start date is totally flexible. In addition, unlike SPIA’s and DIA’s which are only about lifetime income, FIA’s include an investment value. Furthermore, the investment value has built-in downside protection. Who said you can’t have your cake and eat it too?

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Annuities Deferred Income Annuities Social Security

Social Security – A Lifetime Deferred Income Annuity

Do you have an investment that will pay you guaranteed lifetime income totaling $870,000 to $1.87 million? This is the projected range of income that my wife and I expect to receive from Social Security during our lifetime based solely on my earnings record depending upon when I choose to start my benefits and how long both of us live. Granted that my earnings have exceeded the taxable Social Security wage base for most of my working years, however, this isn’t unusual.

Our projected benefits assume that (a) my current earnings level continues until I begin receiving Social Security, (b) either my wife or I live until at least my age 90, (c) my wife potentially lives until age 95, and (d) Social Security cost-of-living adjustments (“COLA’s”) are 2% each year which is less than the average increase of 2.6% over the last ten years. If all of these assumptions are realized, our actual benefits will likely be greater than the projected amounts since the projections don’t include COLA’s between now and retirement.

In order to truly appreciate the value of Social Security retirement benefits, it’s important to understand that it isn’t simply an entitlement program. Social Security is instead an investment; in particular, it’s a deferred income annuity (“DIA”) payable for life.

Let’s review a couple of definitions in order to put things in perspective. Per Retirement Income Visions™
Glossary, a Deferred Income Annuity is an annuity for which annuitization begins at least 13 months after the date of purchase in exchange for a lump sum or series of periodic payments. Per the Glossary, Annuitization is the irrevocable structured payout of income with a specified payment beginning at a specified date, paid at specified intervals over a stated period of months or years or for the duration of the annuitant’s and potentially his/her spouse’s and/or other individuals’ lifetime(s) depending upon the payout option selected.

Relating these two definitions to Social Security, in exchange for a series of payments, i.e., Social Security taxes paid by you and your employer, over your working years, you will receive an irrevocable structured payout of income with a specified payment beginning at a specified date paid for the duration of your, and potentially your spouse’s, lifetime, depending upon the payout option selected.

The primary difference between Social Security and a commercial DIA is the organization from which the investment is purchased and payments are guaranteed. In the case of Social Security, it is the federal government while DIA’s are purchased from, and payments guaranteed by, individual life insurance companies.

A second difference is the methodology used to calculate one’s lifetime benefit. Simply stated, Social Security benefits are calculated using a series of formulas based on one’s historical earnings relative to the taxable Social Security wage base in effect during each year of employment. Lifetime DIA payouts, on the other hand, are actuarially calculated using the amount and timing of lump sum and/or series of periodic payments, life expectancy factors, as well as current and projected interest rates.

A third potential difference between Social Security and a commercial DIA is the calculation of the payment amount after the initial year. Although a specified payment beginning at a specified date is calculated by the Social Security Administration based on various assumptions, the payment is the amount payable during the first year of benefits. Subsequent years’ payments can increase depending upon annual COLA’s. DIA payouts can increase as well if contractually provided. In some cases it’s also based on COLA’s, however, most of the time it’s determined by a predefined inflation factor.

Approximately 96% of working-age Americans are covered by the Social Security system. Social Security provides 90% of retirement income for one in three retirees and more than 50% for two in three retirees. Given these facts, Social Security is the most prevalent type of investment in the United States. Furthermore, it is, by far, the most popular DIA available in the marketplace.

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Annuities Deferred Income Annuities Fixed Index Annuities

Invest in DIA to Fund LTCI Premiums When Retired – Part 4 of 4

The first three posts in this series discussed five differences between fixed index annuities (“FIA’s”) with income riders and deferred income annuities (“DIA’s”) that will influence which retirement income planning strategy is preferable for funding long-term care insurance (“LTCI”) premiums in a given situation. If you haven’t done so already, I would recommend that you read each of these posts.

This week’s post presents a sample case to illustrate the use of a FIA with an income rider vs. a DIA to fund LTCI premiums during retirement.

Assumptions

As with all financial illustrations, assumptions are key. A change in any single assumption will affect the results. The following is a list of assumptions used in the sample case:

  1. 55-year old, single individual
  2. Planned retirement start age of 68
  3. Life expectancy to age 90
  4. Current annual LTCI premium of $4,000 payable for life
  5. Need to plan for infrequent, although potentially double-digit percentage increases in LTCI premium at unknown points in time
  6. Given assumptions #4 and #5, plan for annual pre-tax income withdrawals of approximately $6,000 beginning at retirement age
  7. Solve for single lump sum investment at age 55 that will provide needed income
  8. Investment will come from a nonqualified, i.e., nonretirement, investment account
  9. One investment option is a fixed index annuity (“FIA”) with an income rider with lifetime income withdrawals beginning at age 68.
  10. Second investment option is a deferred income annuity (“DIA”) with no death benefit and lifetime income payout beginning at age 68.
  11. FIA premium bonus of 10%
  12. FIA annual return of 3%
  13. FIA income rider charge of 0.95% of income rider value otherwise known as the guaranteed minimum withdrawal benefit (“GMWB”)
  14. No withdrawals are taken from the FIA other than the income withdrawals.
  15. All investments are purchased from highly-rated life insurance companies known for providing innovative and competitive retirement income planning solutions.

Investment Amount

The first thing that needs to be solved for is the amount of investment that must be made at the individual’s age 55 in order to produce lifetime annual income of approximately $6,000 beginning at age 68. The goal is to minimize the amount of funds needed for the investment while choosing a strategy from a highly-rated insurance company that’s known for providing innovative and competitive retirement income planning solutions.

It turns out that an investment of $50,000 to $65,000 is needed to produce lifetime annual income of approximately $6,000 beginning at age 68. Given the fact that my goal as a retirement income planner is to use the smallest amount of investment for a fixed income annuity to produce a targeted income stream in order to preserve the remainder of a client’s investment portfolio for my client’s other financial goals, the amount of the investment needed is $50,000.

Results

There are three items we will examine to compare the results between investing $50,000 in a FIA with an income rider vs. a DIA to fund LTCI premiums during retirement. They are as follows:

  • Annual gross income
  • Annual taxable income
  • Value/death benefit

Annual Gross Income

Per the Exhibit, the annual payout, or gross income, from the FIA is $5,764, or $236 less than the annual gross income of $6,000 from the DIA. This equates to a total of $5,428 for the 23 years of payouts from age 68 through age 90.

Annual Taxable Income

If the investment was made in a retirement account like a traditional IRA and assuming there have been no nondeductible contributions made to the IRA, 100% of the income would be taxable. This would be the case for both the FIA or DIA.

As stated in assumption #8, the investment will come from a nonqualified, i.e., nonretirement, investment account. Per Part 2 of this series, this makes a difference when it comes to taxation of the withdrawals. Per the Exhibit, 100% of the annual FIA income of $5,764 is fully taxable vs. $3,066 of the DIA income. This is because the DIA, unlike the FIA, is being annuitized and approximately 50% of each income payment is nontaxable as a return of principal. Over the course of 23 years of payouts, this results in $62,054 of additional taxable income for the FIA vs. the DIA.

The amount of income tax liability resulting from the additional taxable income from the FIA will be dependent upon several factors that will vary each year, including (a) types, and amounts, of other income, (b) amount of Social Security income, (c) potential losses, (d) adjusted gross income, (e) itemized deductions, (f) marginal tax bracket, and (g) applicable state income tax law.

Value/Death Benefit

While the present value of the future income stream of a DIA represents an asset, you generally won’t receive an annual statement from the life insurance company showing you the value of your investment. In addition, while some DIA’s will pay a death benefit in the event that the annuitant dies prior to receiving income, per assumption #10, this isn’t the case in this situation. Consequently, the DIA column of the “Value/Death Benefit” section of the Exhibit is $0 for each year of the analysis.

On the other hand, there’s a projected value for the FIA from age 55 through age 79. This value is also the amount that would be paid to the FIA’s beneficiaries in the event of death. There’s a projected increase in value each year during the accumulation stage between age 55 and 67 equal to the net difference between the assumed annual return of 3% and the income rider charge of 0.95% of the income rider value.

Per the Exhibit, the projected value/death benefit increases from $56,278 at age 55 to $68,510 at age 67. Although the assumed premium bonus of 10% is on the high side these days, this is reasonable given the fact that FIA values never decrease as a result of negative performance of underlying indexes, the assumed rate of return of 3% is reasonable in today’s low index cap rate environment, and the assumed income rider charge of 0.95% of the income rider value is on the upper end of what’s prevalent in the industry. The projected value/death benefit decreases each year from age 68 to age 79 until it reaches $0 beginning at age 80 as a result of the annual income withdrawals of $5,764.

Conclusion

As discussed in Parts 1 – 3 of this series, there are five important differences between FIA’s with income riders and DIA’s that will influence which retirement income planning strategy is preferable for funding LTCI premiums during retirement in a given situation. Two of the differences, income start date flexibility and income increase provision, haven’t been addressed in this post.

In addition to the five differences, the amount of the investment required to produce a targeted lifetime annual income amount to pay LTCI premiums, including potential increases, will differ depending upon the particular FIA or DIA strategy used. In the illustrated case, which isn’t uncommon today, an investment of $50,000 resulted in an almost identical lifetime income payout whether a FIA with an income rider or a DIA is used.

As illustrated, the taxable income associated with a DIA in a nonqualified environment is much less compared to a FIA. As previously discussed, the amount of tax savings resulting from the reduced taxable income will depend upon an analysis of several factors and will vary each year. Ignoring the potential income tax savings resulting from the tax-favored DIA payouts, the FIA with income rider would be the preferred investment choice for many individuals in this case given the presence, duration, and projected amount of, the investment value/death benefit.

The FIA edge is reinforced by the fact that, unlike most traditional DIA’s, the income start date and associated annual lifetime income payout amount for FIA’s is flexible. This would be an important consideration in the event that the year of retirement changes. Furthermore, this is quite possible given the fact that the individual is 13 years away from her projected retirement year.

As emphasized throughout this series, the purchase of LTCI needs to be a lifetime commitment. Planning for the potential purchase of a LTCI policy should be included as part of the retirement income planning process to determine the sources of income that will be used to pay for LTCI throughout retirement. Whether it’s a FIA with an income rider, a DIA, or some other planning strategy that’s used for this purpose will depend on the particular situation.

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Annuities Deferred Income Annuities Fixed Index Annuities Longevity Insurance

Invest in DIA to Fund LTCI Premiums When Retired – Part 2 of 4

Last week’s post discussed the use of a deferred income annuity (“DIA”), commonly referred to as longevity insurance, to fund long-term care insurance (“LTCI”) premiums during retirement. Similar to a fixed index annuity (“FIA”) with an income rider, in exchange for an initial investment, or premium, you’re entitled to receive a lifetime income beginning at least a year from the date of purchase.

As noted in last week’s post, there are five important differences between FIA’s with income riders and DIA’s that will influence which retirement income planning strategy is preferable for funding LTCI premiums in a given situation. These differences are as follows:

  1. Income start date flexibility
  2. Income increase provision
  3. Income tax consequences
  4. Investment value
  5. Death benefit

The first three distinctions are explained below. Part three will discuss the fourth and fifth differences. Part four will present a sample case to illustrate the use of a DIA vs. a FIA with an income rider to fund LTCI premiums during retirement.

Income Start Date Flexibility

FIA’s with income riders are known for their flexibility when it comes to their income start date. Income can typically be withdrawn beginning one year from the initial issue date with no time limit after that. The lifetime income payout will generally increase the longer you wait to begin your withdrawals as a result of potential increases in the income base and withdrawal percentages.

Unlike FIA’s, DIA’s generally aren’t flexible when it comes to the income start date. With most DIA’s, you’re tied to a specified payout at a specified start date at the time of investment.

Income Increase Provision

Although DIA’s generally have a fixed income start date, an annual inflation factor can be applied to the income payout to result in increasing annual payments. A greater premium, or investment, is required for this feature.

While the annual lifetime income payout will generally increase the longer you wait to begin your withdrawals with a FIA, the income amount generally won’t change once you turn on your income. In other words, there’s inflation protection built into FIA income riders only up until the time that you begin taking income withdrawals.

Income Tax Consequences

If retirement plans such as 401(k)’s or traditional IRA’s are the source of premium payments, then 100% of withdrawals from DIA’s and FIA’s will generally be taxable as ordinary income. Consequently, it doesn’t matter if the source of funds for LTCI premium payments is a FIA with an income rider or a DIA since taxation will be identical.

Whenever possible, nonretirement funds should be used to pay LTCI premiums. Here’s where DIA’s have the edge, especially during the early years. DIA payouts are considered to be an annuitization of the investment. Part of each payment through one’s life expectancy is deemed to be principal and interest. Any payments received thereafter are fully taxable.

Since only the interest portion is taxable and a large part of each payment is often classified as principal over the course of one’s life expectancy, DIA distributions receive tax-favored treatment.

When you take income withdrawals from FIA’s, on the other hand, you aren’t annuitizing your investment. Instead, “last-in first-out,” or “LIFO,” taxation is applied to your withdrawals. This means that 100% of your initial withdrawals will be taxed until all interest is recovered with subsequent withdrawals received tax-free as a return of principal.

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Annuities Deferred Income Annuities Fixed Index Annuities

FIAs With Income Riders vs. DIAs: Which is Right for You? – Part 3 of 5

Retirement Income Center - Puzzle

I hope that you’re enjoying this series so far comparing two innovative retirement income planning tools – fixed index annuities (“FIAs”) with income riders and deferred income annuities (“DIAs”). Of the 12 features offered by FIAs with income riders that are listed in Part 1, we’ve looked at three features that are also offered by DIAs, and five that aren’t applicable to DIAs.

This post will discuss the remaining four features that are applicable to DIAs on a limited basis. They are as follows:

  1. Known future income amount at time of initial and ongoing investments
  2. Flexible income start date
  3. Greater income amount the longer you defer your income start date
  4. Death benefit

Known Future Income Amount at Time of Initial and Ongoing Investments

One of the really cool things about fixed income annuities from a retirement income planning perspective is the ability to structure a guaranteed (subject to the claims paying ability of individual life insurance companies) income stream to match one’s income needs. In the case of both FIA’s with income riders and DIA’s, the amount of the future income stream is known at the time of initial and ongoing investments.

When you purchase a DIA, a known amount of income, with or without an annual inflation factor, will be paid to you as an annuity beginning at a specified future date for either a specified number of months or for life, either single or joint as applicable. With traditional DIA’s, you make a one-time investment; however, there are a handful of products that offer you the ability to make ongoing investments.

Unlike traditional DIA’s where you generally make a single investment and you receive a specified amount of income beginning at a specified date, FIA’s with income riders have more variations. For one thing, assuming you’re working with a flexible– vs. a single-premium FIA, you have the ability to make ongoing investments in a single FIA. In addition, the income start date, which will be discussed in the next section, is flexible. While the future income amount is known at the time of initial and ongoing investments, both of these variables combine to offer a much broader range of possibilities than a traditional DIA when it comes to the income withdrawal amount.

Flexible Income Start Date

All FIAs with income riders have a flexible income start date with the ability to begin income withdrawals either in the year of purchase or one year from the date of purchase assuming you’ve reached a specified age, generally 50. There’s no requirement with FIA income riders to commit to the income start date at the time of purchase, and, furthermore, you don’t have to ever start taking income withdrawals if you choose not to do so.

Per the previous section, traditional DIAs begin their income payouts at a specified future date. There are some nontraditional DIAs that provide for a flexible income start date similar to FIAs with income riders.

Greater Income Amount the Longer You Defer Your Income Start Date

With all fixed income annuities where the income isn’t payable during the first year, i.e., single premium immediate annuities, or “SPIAs,” the longer you defer your income start date, the greater the amount of income you will receive. This is true whether the income payment is for a fixed term, as it is with some DIAs, or if it’s for life.

FIAs with income riders, with their built-in flexible income start date, include this feature. In order to obtain this benefit with a traditional DIA, you need to choose a later income start date at the time of purchase.

Death Benefit

Income withdrawal is an optional rider with FIAs. The base product has an accumulation value that’s increased by initial and ongoing investments, premium bonuses, and interest credits and is decreased by withdrawals and surrender and income rider charges. To the extent that there’s accumulation value remaining upon the death of the owner(s), it’s paid to the contract’s beneficiaries as a death benefit.

Traditional DIAs may or may not include a death benefit prior to annuitization. Once annuitization occurs, there’s generally no death benefit payable. If you opt for a traditional DIA that includes a death benefit before annuitization, the amount of the benefit will generally be equal to your investment amount; however, the tradeoff will be a reduced income amount than would otherwise be payable by a similar product that doesn’t include a death benefit.

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Annuities Fixed Index Annuities

Fixed Index Annuity Income Rider Similarities to Social Security – Part 1 of 4

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As evidenced by the number of blog posts regarding fixed index annuity (“FIA”) income riders beginning with the December 12, 2011 post, Add an Income Rider to Your Fixed Index Annuity to Create a Retirement Paycheck, there are a lot of things to consider before adding this powerful optional benefit to a FIA.

It isn’t easy to determine which fixed index annuity income rider will produce the optimal amount of lifetime income in a given situation. This task is best left to an experienced retirement income planner who not only works routinely with this and other retirement income planning vehicles, but more importantly, understands you, your retirement income planning needs, and your overall financial situation.

As a potential purchaser of a FIA with an income rider, the easiest way to begin to understand a fixed index annuity income rider is to compare and contrast this retirement income planning strategy with Social Security retirement benefits. There are eight characteristics shared by FIA income riders and Social Security as follows:

  1. Lifetime income
  2. Entry fee
  3. Flexible income start date
  4. Increased annual lifetime income
  5. Inflation and longevity risk protection
  6. Income ceiling
  7. Portfolio risk reduction
  8. Income taxation

This post will discuss the first two, with three through five addressed in Part 2, six and seven covered in Part 3, and income taxation reserved for Part 4.

Lifetime Income

Both Social Security and FIA income riders are designed to provide their intended recipients with lifetime income. By their nature, the investment return and overall investment value of both income vehicles is open-ended and cannot be determined until the death of the recipient, and in many cases, a spouse, if married.

The income in both cases is generally considered to be guaranteed, however, the nature of the guarantee is different in each case. Although the resources backing the Social Security system are projected to be sufficient to sustain current benefit formula payments for approximately the next 20 to 30 years, there is a strong possibility that the projected increasing ratio of number of retirees to employees will necessitate a reduction in benefit levels at some point. Although the security of annuitization and income rider payments enjoy a superb historical track record, the income rider lifetime guarantee is subject to the claims-paying ability of individual life insurance companies.

Entry Fee

In order to obtain the lifetime income benefit associated with FIA income riders and Social Security, there’s an entry fee. The amount of the fee in both cases is calculated as a percentage of a predefined base and is generally, although not always in the case of Social Security, automatically deducted from the applicable funding source.

For employees, the Social Security entry fee is currently 4.2% of Social Security earnings up to a maximum of $110,100 in 2012. The calculated amount is automatically deducted from an employee’s gross salary. In addition, employers are required to pay a rate of 6.2% on the same earnings level. For self-employed individuals, the rate is 10.4% of net self-employment earnings and is typically paid, together with medicare tax and projected income tax liability, via estimated tax payments.

The entry fee for a FIA income rider is deducted from the FIA’s accumulation value. It’s calculated as either a percentage of the accumulation value or income account value, with the latter being the most prevalent. Of the 171 FIA’s offering guaranteed minimum withdrawal benefits (“GMWB’s”), or income riders, on the market today, 121, or approximately 70%, use the income account value as the basis for charging the income rider charge. 90 of the 121, or approximately 75%, charge up to 0.75% of income account value, with 52 of the 90, or 58%, falling between 0.50% and 0.75%.

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Annuities Fixed Index Annuities Income Tax Planning

Annuitization Tax Treatment of Nonretirement Distributions

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Per last week’s post, there are four things that you don’t receive when you purchase an income rider with a fixed index annuity that are associated with fixed income annuities. The first three, i.e., annuitization, immediate payments, and ability to receive payments over a fixed period, were discussed in last week’s post. The fourth thing – annuitization tax treatment of nonretirement distributions – is the subject of this week’s post.

Before we discuss tax treatment of distributions, I want to talk briefly about taxation of annuities during the accumulation stage before any distributions are made. Similar to IRA’s and other qualified retirement plans, unless they’re immediately annuitized, all annuities, including fixed income annuities, enjoy tax-deferred growth. That is, until distributions are taken, there’s no taxation. This is true whether the annuity is held within a nonretirement account, a traditional IRA or other qualified plan, or a Roth IRA.

Once payments begin, they’re subject to taxation. Income tax treatment is dependent upon the type of account or plan in which the annuity is held. The remainder of this post will discuss income tax treatment of payments as it pertains specifically to fixed index annuity income riders.

At the two extremes when it comes to taxation are traditional IRA’s and Roth IRA’s. If held within a traditional IRA or other qualified plan, all distributions, other than those deemed to come from nondeductible contributions, are taxable as ordinary income. For fixed index annuities held within a Roth IRA, and assuming that the investment has been held for at least until the greater of five years or age 59-1/2, none of the distributions are taxable.

Taxation of distributions from annuities held within nonretirement accounts, on the other hand, uses a hybrid approach. Furthermore, the tax treatment is different depending upon whether you’re annuitizing an annuity vs. receiving payments from a fixed index annuity income rider.

When you annuitize a nonretirement fixed income annuity, part of each payment is considered to be a return of principal and part is deemed to be earnings. The principal portion is nontaxable and the earnings are taxable as ordinary income. Once the total amount of the investment in the contract is recovered, all future payments are fully taxable.

Per the “Annuitization” section of last week’s post, income rider payments are deemed to be withdrawals vs. annuitization of a fixed index annuity contract. This is an important distinction when it comes to income tax treatment of nonretirement distributions. As withdrawals, last-in first-out, or “LIFO,” tax treatment applies for investments made after August 13, 1982. This means that the first money that comes out is taxable as ordinary income similar to distributions from contributory IRA’s. Once all of the earnings have been received, all future payments are considered to be a return of investment, and, as such, are nontaxable.

In summary, the fourth and final thing that you don’t receive when you purchase an income rider with a fixed index annuity is annuitization tax treatment of nonretirement distributions. This is initially less favorable compared to annuitization since distributions are fully taxable until all earnings have been received. After this occurs, future distributions are nontaxable vs. taxable as ordinary income once the investment in the contract has been recovered when you annuitize an annuity.

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Annuities Fixed Index Annuities

Your Fixed Index Annuity Income Rider – What You Don’t Receive – Part 2 of 2

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Per Part 1 of this two-part series, before we talk about what you receive when you purchase an income rider with a fixed index annuity, it’s important to understand what you don’t receive. As stated last week, this needs to be placed in the context of fixed income annuities. If you haven’t done so already, I recommend that you read last week’s post before continuing with this one.

There are four things that you don’t receive when you purchase an income rider with a fixed index annuity that are associated with fixed income annuities:

  1. Annuitization
  2. Immediate payments
  3. Ability to receive payments over a fixed period
  4. Annuitization tax treatment of nonretirement distributions

The first three things will be addressed in the remainder of this post, with a discussion of annuitization tax treatment of nonretirement distributions deferred to next week.

Annuitization

As explained last week, one of the unique features that’s associated with a fixed income annuity is the right to annuitize, or receive an income stream for a specified length of time from your investment. While you retain the right to annuitize the accumulation value of a fixed index annuity, the determination of income rider payment amounts is a separate calculation, independent of the accumulation value. Although they reduce the accumulation value of the contract, income rider payments are deemed to be withdrawals vs. annuitization of the contract. This is an important distinction when it comes to income tax treatment as you will learn about next week.

Immediate Payments

With a fixed index annuity income rider, you have flexibility as to when you begin receiving your income so long as you don’t need the income right away. Unlike fixed income annuities, however, where the payments that you receive can be either immediate or deferred, with fixed index annuities, the earliest income starting date generally doesn’t begin until twelve months after the contract’s issue date.

Ability to Receive Payments Over a Fixed Period

Another important difference between a fixed income annuity and the receipt of income payments using an income rider that’s attached to a fixed index annuity is the payment duration. Per Part 1, when you annuitize a fixed income annuity, the payments are made (a) over a stated period of months or years, or (b) for the duration of the insured’s and potentially his/her spouse’s and/or other individuals’ lifetime(s) depending upon the payout option selected. With a fixed index annuity, payments are for life. This is the case even if there’s no accumulation value remaining in the fixed index annuity.

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Annuities Fixed Index Annuities

Your Fixed Index Annuity Income Rider – What You Don’t Receive – Part 1 of 2

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As stated in last week’s post, while a fixed index annuity has several unique conservative and desirable investment features, assuming your goal is to create a lifetime retirement paycheck, you need to apply for an optional income rider when your retirement income planner submits your application. As pointed out last week, income riders are currently available with less than 40% of all fixed index annuities.

What exactly do you receive when you purchase an income rider with your fixed index annuity? How does it work? How can it be used as part of a retirement income planning strategy to create a lifetime retirement paycheck?

Before we talk about what you receive when you purchase an income rider with a fixed index annuity, it’s important to understand what you don’t receive. The remainder of this post will begin a two-part discussion devoted to this topic.

In order to understand what you don’t receive when you purchase an income rider with your fixed index annuity, we need to place it in the context of fixed income annuities. A fixed income annuity is the broad class of annuities under which fixed index annuities fall.

One of the unique features that’s associated with a fixed income annuity is the right to annuitize your investment. Per the Glossary, annuitization is defined as the irrevocable structured payout of an annuity with a specified payment beginning at a specified date, paid at specified intervals over a stated period of months or years or for the duration of the annuitant’s and potentially his/her spouse’s and/or other individuals’ lifetime(s) depending upon the payout option selected. That’s a roundabout way of saying that you’re entitled to receive an income stream for a specified length of time.

In addition, when you purchase a fixed income annuity, the timing of commencement of payments can be different, depending upon whether you purchase an immediate or deferred fixed income annuity. With an immediate annuity, payments begin one month after date of purchase. Deferred annuities generally won’t begin making payments for at least 12 months from date of purchase.

Finally, with fixed income annuities, when the income stream as defined by the terms of the annuity contract ends, so does the annuity contract. Unless there’s a refund feature, there’s no accumulation value that’s payable to the annuitant(s) or to his/her beneficiaries.

Now that you have a basic understanding of fixed income annuities, I will continue the discussion regarding what you don’t receive when you purchase an income rider with a fixed index annuity next week when I share with you the unique characteristics of fixed index annuity income riders compared to fixed income annuities in Part 2.

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Annuities Fixed Index Annuities Retirement Income Planning

No Pension? Create Your Own

Retirement Income Center

Last week’s post, A Retirement Paycheck is Essential, emphasized that it’s imperative for each and every one of us to have a retirement income plan. The cornerstone of a retirement income plan is a retirement paycheck. Specifically, we need to know that when we stop working, we will receive a predetermined monthly payment for the rest of our life, and, if married, our spouse’s life. Furthermore, this monthly payment needs to be in addition to whatever Social Security benefits we may receive.

Given the fact that the majority of us won’t receive a pension from an employer’s defined benefit plan that our parents’ generation took for granted (see the November 21, 2011 post, Where Have All the Pensions Gone?), it’s incumbent upon us to create our own retirement paycheck. This isn’t an task and generally requires the assistance of an experienced retirement income planner.

As pointed out in the Where Have All the Pensions Gone? Post, the nature of many investment vehicles don’t lend themselves to plan for a predictable known future lifetime or joint lifetime stream of income. This is true, for example, whether you’re talking about a savings account, CD, bond, stock, mutual fund, or exchange traded fund.

Fortunately, there exists a long-standing, reliable, conservative investment solution that’s specifically designed to provide us with a predetermined monthly payment for the rest of our life. The payment will be made without interruption, no matter how the stock market is performing. This investment solution is commonly known as a fixed income annuity and is offered exclusively by life insurance companies.

Unlike a traditional defined benefit pension plan that pays a defined stream of income that generally doesn’t change beginning at retirement age and ending at death, a fixed income annuity strategy can be quite flexible. There are several types of fixed income annuities that can be used to customize a retirement income plan that dovetails with one’s retirement income needs. This entails both timing and amount of payment, including adjustment for inflation.

There are two broad classes of fixed income annuities that are distinguished by the timing of the commencement of the initial income payment: (a) single premium immediate and (b) deferred. A feature shared by both types of annuities is “annuitization,” or the conversion of an annuity to an irrevocable structured payment plan with a specified payout by a life insurance company to an individual(s) or “annuitant(s)” over a specified period of time through different lifetime and term certain options offered by the insurance company.

Single premium immediate annuities, or “SPIAs,” make periodic payments, typically monthly, for a specified number of months or for an individual’s lifetime or joint lifetimes as applicable. The payments generally begin one month after purchase of a SPIA, hence the name “immediate.”

The second broad class of fixed income annuities, deferred income annuities, or “DIAs,” although they play an important role in a retirement income plan, aren’t as prevalent in the marketplace as SPIAs. Like SPIAs, DIAs pay periodic income for a specified period of time or over one’s lifetime or joint lifetimes as applicable. Unlike SPIAs, the start date of the payments for DIAs is deferred for at least 13 months from the date of investment.

SPIAs and DIAs can be used alone or in combination to create a retirement paycheck. In addition, a rider, or endorsement, can be added to a fixed index annuity to generate a retirement paycheck. This retirement income planning strategy, which is striking a chord with more and more people the last few years, will be introduced in next week’s post.

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Annuities Deferred Income Annuities Retirement Income Planning

Mirror Your Retirement Income Needs With Period Certain Annuities

Retirement Income Center

One of the most difficult financial planning challenges for any financial planner when planning for any goal, retirement or otherwise, is screening, performing due diligence on, and selecting, financial products that have the greatest potential for helping a client attain his/her goals while being suited to the client’s investment temperament. This is especially true when it comes to retirement income planning given the fact that the planner’s mission is to (1) find a way to use assets to create predictable, inflation-protected, and whenever possible, tax-efficient, income streams that, (2) when combined with other sources of income (Social Security, pensions, etc.), are designed to match a client’s projected and unknown (e.g., potential uninsured long-term care expense) retirement income needs for an unknown period of time (i.e., the remainder of one or more lives), (3) while also retaining a portion of those assets to pay for lump-sum expenses (e.g., car purchases, home improvements, weddings, etc.), and (4) to also accomplish the client’s estate planning (e.g., leave money to children and/or to charitable organizations) and other objectives. Suffice it to say, this isn’t an easy task, to say the least!

Two weeks ago, Annuitization Payment Option: The Financial Decision You Will Live With for the Rest of Your Life introduced a financial strategy, annuitization, for generating guaranteed (subject to individual insurers’ claims-paying ability) and tax-favored (when used in nonretirement accounts) income, often for life. It discussed the four types of annuitization payment options available with annuity contracts:  life annuity, life annuity with guaranteed payment, joint and survivor annuity, and period certain. Last week’s blog post, Lifetime Annuity Payout – Watch Out! explained that, while a life annuity payment option offers the security of lifetime payments, there are several downsides associated with this choice. As pointed out, one of the most notable is that it won’t provide for different and distinct income streams to match your retirement income needs.

The fourth type of annuitization payment option, period certain, or term certain, as it is often referred, offers perhaps the greatest potential of any type of investment strategy to provide guaranteed (subject to the individual insurers’ claims-paying ability) income to mirror retirement income needs over defined periods of time. Under this option, a life insurance company is obligated to make periodic payments to an annuitant for a specified number of months or years. The payments, which can be inflation-adjusted, can begin today, through either annuitization of an existing annuity contract or purchase of a single premium immediate annuity (“SPIA”), or at some future date at least 13 months from today, via purchase of one or more deferred income annuity (“DIA”) contracts.

Whether the period certain annuity begins today or sometime in the future, it will always be a specified payment for a specified period of time, e.g., $2,500 a month for ten years. Unlike any other type of annuitization payment option, you will always know the total payout, e.g., $300,000 in the previous example ($2,500 x 12 months x 10 years) that you will receive from a period certain annuity before you purchase it. This, in turn, provides you with the ability to precisely calculate an internal rate of return on your investment and, furthermore, compare it to other fixed-rate return investments. The internal rate of return is often provided by life insurance companies in their pre-sale illustrations.

Because of their flexibility to begin and end at any time, combined with the ability to increase payments by an inflation factor, period certain annuities can be structured to dovetail with the amount, frequency, and duration of other income sources to enable better and more predictable matching of total income to one’s retirement lifestyle needs than with most other types of investments. As an added benefit, in the case of nonretirement assets, a portion of each payment is nontaxable since it’s considered to be a return of principle.

Finally, unlike the life annuity payment option whereby payments terminate upon the annuitant’s death, payments from period certain annuities are made dead or alive. If an annuitant dies during the payout term, the life insurance company will continue to make the same payments that were being made to the annuitant to the annuitant’s beneficiary until the end of the specified term.

If your objective is to find a financial product that will provide you with predictable, inflation-protected, tax-efficient (in the case of nonretirement assets) income streams that, when combined with other sources of income, will have a high likelihood of matching your retirement income needs, you would be hard-pressed not to include one or more period certain annuities as part of your solution.

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Annuities Deferred Income Annuities Retirement Income Planning

Lifetime Annuity Payout – Watch Out!

Retirement Income Center

Using Fixed Income Annuities to Build Your Income Portfolio Ladder introduced two types of fixed income annuities: single premium immediate annuities, or “SPIAs,” and deferred income annuities, or “DIAs.” As stated in that blog post, while the use of SPIAs is widespread, DIAs are currently offered by only a handful of life insurance companies.

SPIAs and DIAs come in two flavors insofar as the length of time that life insurance companies are on the hook for making payments to you: life annuities and period certain annuities. While SPIAs have traditionally been favored over DIAs, life annuity payment modes have generally been chosen over period certain annuities. This is understandable since most people don’t want to run out of money, with married couples preferring income to last for the remainder of both individuals’ lifetimes.

A life, or joint life, payout, can be a great choice in certain situations, however, if your goal is to create a retirement income plan that provides for different and distinct income streams to match your expense needs associated with different stages of your retirement years, it probably won’t be the best solution. Also, a lifetime payout, due to the open-ended nature of the number of payments, is the most expensive annuitization choice. Finally, unless you purchase an appropriate amount of life insurance in conjunction with the commencement of lifetime annuitization of a fixed annuity, you could potentially lose your entire investment after receiving just one annuity payment.

Let’s take a look at the last situation first since it is potentially the most devastating. Suppose that you are 65 and the value of your fixed income annuity is $250,000 when you decide to annuitize it, choosing a life annuity payment option resulting in a $1,400 per month payment to you for the rest of your life. This seems like a good deal to you since you will be receiving $16,800 a year, or 6.7% of the current value of your investment each year for the rest of your life. After receiving your first electronic deposit (whatever happened to checks?) for $1,400, you die in a car accident. Guess what? Game over. Life insurance company passes go and retains $248,600 ($250,000 – $1,400). Your beneficiaries receive nothing.

The previous example, while it’s certainly possible, is not your typical scenario. What’s more likely to occur is that you will live for a longer period of time, say ten, twenty, or even thirty years, receiving $1,400 each and every month. While it may not end up being such a great deal if you live to 75 since you will receive a total of $168,000, or $82,000 less than the value of your investment of $250,000 when you began receiving payments, if you live twenty or thirty years, you will receive payments totaling $336,000 or $504,000, respectively.

While you may receive payments under a life payout option for an extended period of time that may meet your needs when you retire, this generally won’t be the case after five or ten years due to inflation. Assuming 3% inflation, your $1,400 per month payment will be worth $1,045 in ten years, $775 in twenty years, and $580 in thirty years. Unless your retirement income plan includes another source of income kicking in ten years into your retirement, e.g., a deferred income annuity, or DIA, you may be forced to adjust your lifestyle and/or sell your house in order to cover your expenses.

Finally, when deciding between different payment options, always keep in mind that a lifetime payout is always going to be the most expensive way to go. When you choose this option, and assuming that you are 65 when you begin receiving payments, keep in mind that the life insurance company is potentially liable for making payments for 30, 40, or more years. Due to the open-ended nature of the number of payments combined with increasing life expectancies, the monthly payment that you will receive by choosing a life, or joint life payout, will usually be much less than if you choose a term certain, e.g., twenty years, payout.