Annuities Fixed Index Annuities Retirement Income Planning

Looking for a Pension with a Flexible Start Date?

If you want peace of mind when you retire, you need to have a plan that will generate sustainable income streams that will cover a large portion of your fixed and discretionary expenses. Income tax planning is critical since your income needs to be calculated net of income tax to determine the amount that will be available for spending.

A sustainable income stream is simply a regular series of payments that, once it begins, will continue for the rest of your life. An ideal sustainable income stream is one that’s calculated using life expectancy and has a flexible start date. The longer you wait to turn on your income, the greater the periodic payment.

Social Security is a great example of a sustainable income stream that meets these criteria. Although you can begin collecting as early as age 62, you can also delay your start date to as late as age 70. The longer you wait, the greater your monthly payment. Assuming a full retirement age of 67, your benefit will be 80% greater if you delay your start date from 62 to age 70, excluding cost of living adjustments.

While Social Security is an important cornerstone of most retirement income plans, it generally needs to be supplemented by other sources of sustainable income. Even if you qualify for the maximum monthly benefit of $2,663 assuming you reach full retirement age in 2015, your annual benefits of approximately $32,000 may be reduced to as little as $21,000 after income tax, depending on your other income and income tax bracket.

Fortunately, there’s another source of sustainable income beside Social Security that’s calculated using life expectancy and also features a flexible start date. It’s offered by life insurance companies and is called a fixed index annuity (FIA) with an income rider.

Unlike the start date of Social Security which is limited to a window of eight years (age 62 to 70), a FIA income rider start date is open-ended. Generally speaking, the only requirement is that you must be at least age 50 when you begin receiving income. Assuming you meet this condition, you can start your lifetime income stream at any age you choose.

Similar to Social Security, the longer you defer your start date, the greater your lifetime income payments will be. Other factors that will influence your income payment are the age at which you purchase your FIA, your original investment amount, additional investments if permitted, premium bonus when applicable, and non-income withdrawals. The calculation of your payment amount is defined by the income rider provision of your FIA’s contract.

Since the calculation of your payment amount is contractually defined, you can determine the amount of initial and ongoing investments required to provide you with a target amount of income beginning at one or more specified ages of your choice before you purchase a FIA. Furthermore, if you need different amounts of income beginning at different ages, you may want to consider investing in two or more FIAs with income riders.

In addition to meeting the criteria of an ideal sustainable income stream, i.e., one that’s calculated using life expectancy and has a flexible start date, a FIA with an income rider offers another benefit that can be important where there are potential beneficiaries. Unlike other types of fixed income annuities, i.e., immediate and deferred income annuities, a FIA has an accumulation, or cash, value.

The accumulation value increases by purchases and premium bonuses and decreases by income and non-income withdrawals and income rider and surrender charges. Any accumulation value remaining at the death of the contract owner(s) will be paid as a death benefit to the beneficiaries.

As stated at the beginning of this post, income tax planning is a critical part of the retirement income planning process since your income needs to be calculated net of income tax to determine the amount that will be available for spending. All income payments from FIAs with income riders are taxable as ordinary income. This is true whether they’re held in traditional IRAs and other types of retirement plans or as nonqualified, i.e., nonretirement, investments.

If you’re looking for a pension with a flexible start date to increase the amount of your fixed and discretionary expenses that are covered by sustainable income throughout your retirement, one or more FIAs with an income rider may meet your needs.

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.

Annuities Deferred Income Annuities

You Don’t Have to Wait Until 85 to Receive Your Annuity Payments

Longevity insurance was recently blessed again by the IRS with its finalization of a regulation allowing the inclusion of an advanced-age lifetime-income option in retirement plans such as 401(k) plans and IRAs.

As discussed in my July 25 MarketWatch article, 6 Ways a New Tax Law Benefits a Sustainable Retirement, “longevity insurance” isn’t an actual product that you can purchase from a life insurance carrier. It’s instead a term that refers to a deferred lifetime fixed income annuity with an advanced age start date, typically 80 to 85.

In a nutshell, IRS’ final regulation allows you to invest up to the lesser of $125,000 or 25% of your retirement plan balance in “qualifying longevity annuity contracts” (QLACs) provided that lifetime distributions begin at a specified date no later than age 85. Although the regulation leaves the door open for other types of fixed-income annuities in the future, QLAC investment vehicles are currently limited to lifetime deferred income annuities, or DIAs.

Suppose you’re concerned about the possibility of outliving your assets and you’re considering investing a portion of your retirement plan in a QLAC. Do you have to wait until age 85 to begin receiving your lifetime annuity payments? Absolutely not. So long as distributions begin no later than the first day of the month following the attainment of age 85, you will be in compliance with the regulation.

Although the regulation doesn’t define the earliest starting date of QLAC payments, based on previous legislation, it would seem to be April 2 of the year following the year that you turn 70-1/2. Why April 2? Per my MarketWatch article, regulations in effect before the new rule allow for inclusion of fixed income annuities without limit provided that the periodic annuity payments (a) begin by April 1 of the year following the year that the owner turns 70-1/2 and (b) are structured so that they will be completely distributed over the life expectancies of the owner and the owner’s beneficiary in compliance with IRS’ required minimum distribution, or RMD, rules.

Let’s suppose that you’re doing retirement income planning when you’re 60 and you’re planning on retiring at 67. In addition to your IRA which has a value of $600,000, you have a sizeable nonretirement portfolio that will not only enable you to defer your Social Security start date to age 70, there’s a high likelihood that you won’t need to withdraw from your IRA until 75.

Despite the fact that you don’t foresee needing income from your IRA until 75, IRS requires you to begin taking minimum annual distributions from your IRA beginning by April 1 of the year following the year that you turn 70-1/2. This is true, however, IRS now also allows you to circumvent the RMD rules by investing a portion of your retirement plan assets in a QLAC. Relying on these rules, you decide to invest $125,000 of your IRA in a QLAC with an income start date of 75. This enables you to longevitize, or extend the financial life of, your retirement using the six ways described in my MarketWatch article.

As you can see, there’s a lot of flexibility when it comes to selecting the start date of your lifetime income distributions from a QLAC. There’s approximately a 13- to 14-year window depending upon your birth date which falls between April 2 of the year following the year that you turn 70-1/2 and age 85. The key is that you must define your income start date at the time of applying for your QLAC. This is a requirement of all deferred income annuities, not just QLAC’s.

Finally, a QLAC may, but is not required to, offer an option to begin payments before the contract’s annuity starting date. While the amount of your periodic distributions will be greater the longer you defer your start date, you don’t have to wait until age 85 to begin receiving lifetime income.

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.

Annuities Fixed Index Annuities Retirement Income Planning

How Flexible are Flexible Premium Deferred Annuities?

When planning for retirement, you need to generate sustainable income that will meet your projected inflation-adjusted financial needs during various stages. This often requires multiple income-generating sources that ideally start, and potentially stop, to match your projected needs at different stages of retirement.

A diversified portfolio of fixed income investments that’s part of your overall portfolio generally needs to be designed to provide the desired after-tax income amounts and timing of same. The planning is complicated, should begin well in advance of retirement, and needs to be monitored and updated on a regular basis.

One popular investment that’s designed for the fixed income portion of a retirement income plan is a fixed index annuity (“FIA”) with an income rider. When you invest in a FIA, you’re purchasing a deferred annuity. As defined in the Glossary, a deferred annuity is an annuity that doesn’t mature or begin making payments until some future date.

Deferred Annuity Types

There are two types of deferred annuities, both of which are suitable for inclusion in a retirement income plan: (a) single premium deferred annuity (“SPDA”) and (b) flexible premium deferred annuity (“FPDA”). The basic difference between the two is the allowable investment frequency. A SPDA is a one-time investment whereas a FPDA provides for multiple investments in the same annuity.

The key to understanding FPDA’s, including how they will fit into a particular retirement income plan, is that flexibility is in the eye of the beholder, or, in this case, the insurance carrier that issues a particular product. While a FPDA by definition allows for multiple premiums, the number of years the additional premiums may be added and/or the premium amounts are often limited by the terms of an annuity contract. This can be problematic where ongoing investments of specific amounts are required to achieve a targeted level of retirement income.

Types of Flexibility Restrictions

While many FPDA’s provide for indefinite additional investments, several have a limited defined window of opportunity. To give you an idea of the possibilities, let’s take a look at the FIA offerings available through the life insurance agency with which I’m associated.

Of the 52 FIA’s currently offered by 14 carriers, all of which are highly rated, 25 are SPDA’s and 27, or 52%, are FPDA’s. 16 of the 27, or 59%, of the FPDA’s have no restrictions regarding the number of years additional premiums may be added or the amounts of same.

That leaves 11 FPDA’s with restrictions, seven of which limit the number of years that additional premiums may be added and four limit the additional premium amount. The seven FPDA’s that limit the number of years uses either one or three years as the limitation. The four that limit the premium amount are all offered by the same carrier which limits additional premiums to $25,000 per year.

Retirement income planning requires flexibility. The ability to make unlimited additional investments after the first contract year without restriction as to dollar amount is an important consideration in many cases when evaluating FIA’s with income riders. In summary, the type of fixed income annuity and product that you’re evaluating needs to dovetail with your projected financial needs to increase your opportunity for success.

Annuities Fixed Index Annuities

Fixed Index Annuity Income Rider Charge – Is It Worth It? – Part 2 of 2

Part 1 of this post explained the benefits of attaching an income rider to a fixed index annuity (“FIA”). It also discussed the charge for this rider, including how it’s calculated. Now we come to the crux of the matter – is a FIA income rider charge worth it?

Before answering this question, I want to make it clear that the charge doesn’t reduce the lifetime income, or lifetime retirement paycheck (“LRP”) amount that you will receive. It’s deducted from the accumulation value of your FIA, or value of your FIA before any applicable surrender charges. As explained in Part 1, the income account value is used to calculate the amount of your LRP and is separate and apart from the accumulation value of your annuity contract.

Not to state the obvious, however, when you purchase something for yourself, you generally do so only if you plan on using it or benefiting from it in some way. This applies to a FIA income rider. The reason that people purchase a FIA with an income rider is to obtain the security that no matter what happens with the rest of their investment portfolio, subject to individual life insurance company claims-paying abilities, they will receive guaranteed lifetime income beginning at a flexible income start date, with the amount of income increasing the longer the start date is deferred.

Furthermore, per Part 1, one of the five benefits offered by an income rider is the ability to calculate the LRP amount that you will receive beginning on a specified future date on the date of purchase. When you invest in a FIA and tack on an optional income rider, your retirement income planner should be able to show you (a) the amount of annual income that you will receive beginning on different dates with specified initial and additional purchase amounts and (b) the amount of your projected retirement income need that will be met by your FIA income.

Assuming your goal is to receive a specific amount of income each year beginning at a specified future date, you won’t withdraw funds from the accumulation value of your FIA before or after your income start date. If you do so, the income account value will decrease by the amount of your withdrawals, decreasing your LRP amount.

Assuming you won’t be withdrawing funds from the accumulation value of your FIA and you will only be using your FIA to generate lifetime income, the accumulation value will be of secondary importance to you during your lifetime. If there’s a chance that you may take withdrawals from your accumulation value, you shouldn’t be purchasing an FIA with an income rider.

With an income rider, once you start receiving income from your contract, you will continue to do so for the rest of your life even if the accumulation value has been reduced to $0 as a result of income withdrawals and income rider charges. Assuming that you use your income rider as intended, receiving lifetime income without taking any withdrawals from the accumulation value of your contract, the primary benefit of your contract’s accumulation value is as a potential death benefit to your beneficiaries. Keeping in mind that income distributions reduce accumulation value, the latter may be minimal or potentially depleted in the event that there have been ongoing income distributions for many years.

Assuming (a) you value the five benefits of a FIA income rider presented in Part 1, (b) you understand that the income rider charge won’t affect the amount of your lifetime income, (c) you recognize that the accumulation value is of secondary importance, and (d) the income rider charge is competitive with other FIA income rider charges assessed by similarly-rated life insurance carriers that will pay a similar amount of income, you will probably conclude that the income rider charge is a small price to pay to obtain the unique combination of benefits offered by a FIA income rider.

Annuities Fixed Index Annuities

Fixed Index Annuity Income Rider Charge – Is It Worth It? – Part 1 of 2

Although fixed index annuities (“FIA’s”) offer a number of attractive features, not the least of which is protection from stock market downturns, I recommend them as a sustainable lifetime income strategy for a portion of my retirement income planning clients’ investment portfolios when appropriate. In order to obtain this popular benefit, it’s generally, although not always, necessary to apply for an optional income rider when you apply for a FIA.

When you add an income rider, you turbocharge your FIA. A FIA income rider offers the following five benefits that, when taken as a whole, cannot be duplicated by any other investment:

  1. Guaranteed, subject to individual life insurance company claims-paying abilities, lifetime income or lifetime retirement paycheck (“LRP”)
  2. Flexible LRP start date
  3. Potential for increased LRP amount
  4. Ability to calculate an LRP amount that you will receive beginning on a specified future date on the date of purchase
  5. Ability to adjust initial and ongoing investment amount to match one’s income needs

A charge is deducted from the accumulation value of a FIA on a monthly, quarterly, or annual basis in exchange for the foregoing five features when they are provided by an optional income rider. It’s generally calculated as a percentage of the income account value, however, the charge is sometimes calculated as a percentage of the accumulation value. A typical charge ranges between 0.75% and 0.95% of the income account value.

The income account value is used to calculate the amount of your LRP and is separate and apart from the accumulation value of your annuity contract. The starting point for the calculation is your initial and ongoing investments plus any premium bonuses offered by the life insurance company. A simple or compound growth factor is applied to the income account value for a specified number of contract years or until income withdrawals begin, whichever occurs first.

As an example, let’s say that you invest $100,000 in a FIA with an income rider that uses 6% annual compound growth for the first 12 years of the contract to calculate the income account value in exchange for an income rider charge of 0.95% of the income account value that’s deducted from the accumulation value. At the end of year 1, your income value is $106,000 ($100,000 x 1.06). An income rider charge of $1,007 ($106,000 x 0.95) will be deducted from your accumulation value. At the end of year 2, your income value is $112,360 ($106,000 x 1.06). An income rider charge of $1,067 ($112,360 x 0.95) will be deducted from your accumulation value.

The income account value will continue to increase by the 6% compound growth factor for 12 years in this example, assuming income withdrawals aren’t taken in the first 12 years. Consequently, the income rider charge will also increase for the first 12 years of the contract before it levels off and begins decreasing when income withdrawals begin.

Is the income rider charge worth it? Find out in Part 2 next week.

Annuities Deferred Income Annuities Fixed Index Annuities Retirement Income Planning

Sustainable Lifetime Income When You Need It – Part 1 of 2

There have been many articles and blog posts over the last several years about the ability to delay your Social Security retirement benefit start date in order to increase your monthly benefit. I wrote about this in my March 4, 2013 post, Increase Your Longevity Risk with Social Security. Per the post, with a choice of start dates ranging between 62 through 70, you can increase your benefits 7% – 8% each year that your start date is deferred, excluding cost-of-living adjustments (“COLA’s”).

Sources of sustainable lifetime income are few and far between these days with the widespread elimination of monthly pension benefits. The ability to receive a stream of sustainable lifetime income throughout retirement while also choosing your income start date is a rare planning opportunity, the value of which shouldn’t be underestimated.

While the opportunity to receive sustainable lifetime income with a flexible start date is limited, Social Security isn’t the only game in town. If the security of sustainable lifetime income appeals to you and you want to create one or more income streams, fixed income annuities offered by life insurance companies, preferably ones that are highly rated, will also meet your need.

There are three types of fixed income annuities, all of which are contractually guaranteed by the life insurance company from which they are purchased. The three types are single premium immediate annuities (“SPIA’s”), deferred income annuities (“DIA’s”), and fixed index annuities (“FIA’s”) with income riders.

There are several important differences between the three types of fixed income annuities that have been discussed in several Retirement Income Visions™ posts. One of the differences that are relevant to this post is the income start date. SPIA’s and DIA’s have contractually defined income start dates, while the start date of FIA’s with income riders is flexible.

SPIA’s are the most restrictive with a start date that begins one month after the contract is issued, assuming a monthly payment mode is chosen. When you purchase DIA’s, you choose the income start date at the time of application. It is contractually defined with the provision that it cannot begin earlier than 13 months after your contract is issued.

Please read Part 2 of this post next week to learn about the income start date flexibility available with FIA’s with income riders that are designed to provide you with sustainable retirement income when you need it.

Annuities Deferred Income Annuities Fixed Index Annuities Retirement Income Planning

Is Your Investment Advisor Afraid of Losing AUM?

When it comes to retirement income planning, one of my philosophies is a bird in the hand is worth two in the bush. As defined in Urban Dictionary, this expression means that it is better to have an advantage or opportunity that is certain than having one that is worth more but is not so certain.

One of the ways that I use this approach is to look for opportunities to convert what amounts to a sliver of a client’s portfolio into a deferred sustainable income stream beginning in a targeted year during my client’s planned retirement. The income stream, while it’s often for life, is sometimes for a specified period of time to close a projected retirement income gap (See Mind the Gap).

The opportunities to which I’m referring are sizeable abnormal increases in the stock market that inevitably are followed by market corrections, or downturns. Rather than celebrating what often proves to be temporary good fortune, when appropriate, I will recommend to my clients who need sustainable retirement income that they consider transferring a small portion of their investment portfolio into one or more new or existing fixed income annuities. These include fixed index annuities (“FIA’s”) with income riders, deferred income annuities (“DIA’s”), and single premium immediate annuities (“SPIA’s”).

This is a natural timely conversation that invariably makes sense to the clients to whom I recommend this approach since it is in their best interest. Furthermore, it’s an easy conversation for me to initiate since I specialize in retirement income planning, am a Retirement Income Certified Professional® (RICP®), CPA, CFP® professional, and a licensed insurance agent in addition to my firm being regulated as a Registered Investment Advisor (“RIA”). There’s no conflict of interest when I make the above recommendation to a client since, unlike most investment advisors, my income isn’t tied to a single compensation model.

The compensation model to which I’m referring is assets under management, or “AUM.” While many firms charge financial planning fees, the lion’s share of compensation earned by most traditional investment management firms is derived from AUM. As the name implies, the fee is typically calculated as a declining percentage of the value of a client’s investment portfolio. The greater the value of a portfolio, the smaller the percentage is that is applied to calculate the investment management fee. This is one of several compensation models offered by my firm.

Firms that are tied to an “AUM” compensation model generally don’t offer retirement income planning solutions that require insurance licensing and ongoing specialized insurance and annuity training. Most “AUM” driven firms are reluctant to refer clients to advisors like myself who offer a total retirement income planning approach since, in addition to the obvious revenue loss, this would be tantamount to an admission that they’re unable to provide a total retirement income planning solution.

An “AUM” model, while it’s appropriate for assisting clients with their retirement planning, i.e., asset accumulation, needs, isn’t designed for addressing lifetime sustainable income and other retirement income planning solutions. For clients seeking sustainable retirement income, it’s like trying to fit a square peg in a round hole.


Immediate Annuities – Where’s the Planning?

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.

Annuities Fixed Index Annuities Social Security

Delayed Gratification is the Key to Maximizing Income with Fixed Index Annuities

When you’re planning for retirement, income is the name of the game. The more sustainable income that you can generate, the less you need to worry about things like sequence of returns and major stock market downturns – before and during retirement.

The idea is to build a base, or floor, of predictable income that will cover your day-to-day expenses. For most people doing retirement income planning, Social Security is the core element of an income floor. Although pre-retirees today can plan to receive a full Social Security benefit beginning somewhere between age 66 and 67 depending upon their year of birth, the benefit that they, and potentially their spouse, will receive will increase by 8% per year for each year that they defer their start date up until age 70. This equates to as much as a 24% – 32% greater benefit depending upon your year of birth and how long you defer your start date.

Assuming that your goal is to build a solid base of sustainable income with the ability to increase your lifetime income amount similar to Social Security, one of the best ways to do this is to invest in a flexible fixed index annuity (“FIA”) with an income rider. The reason that you want to use a flexible, vs. a single, premium FIA is to provide you with the ability to add to your investment should you choose to do so. In addition, you need to purchase an income rider, which is optional with most FIA’s, in order to receive guaranteed (subject to the claims-paying ability of individual insurance companies) income.

Like Social Security, the longer you wait to begin receiving your income, the greater it will be. Unlike Social Security benefits which are increased by cost of living adjustments (“COLA’s”), the lifetime income from the majority of FIA’s available today will remain unchanged once it’s started.

To demonstrate the benefit of deferring the start date of FIA income withdrawals, let’s use one of the contracts purchased by my wife and me two years ago when we were 55 and 48, respectively. I will use my wife’s age as a point of reference for the remainder of this post since income withdrawal amounts are always calculated using the younger spouse’s age.

Per our annuity contract, my wife and I are eligible to begin income withdrawals at least 12 months after our contract was issued provided that both of us are at least age 50. It generally doesn’t make sense to take withdrawals from a FIA income rider before age 60 since the formula used to calculate the withdrawal amount is less favorable and the withdrawals will be subject to a 10% IRS premature distribution penalty and potentially a state penalty. Assuming that we plan on retiring after my wife is 60, there would be no need to begin income withdrawals before this age.

I have prepared a spreadsheet with various starting ages in increments of five years beginning at 55 through 75. The spreadsheet shows the projected percentage increase in our annual income withdrawal amount that we will realize by deferring our income start age compared to ages that are 5, 10, 15, 20, and 25 years younger, depending upon the starting age chosen.

Using an example that’s comparable to the Social Security starting age decision, suppose that we decide to defer our income start age from 65 to 70. This would result in a 31.2% annual increase in lifetime income. We will receive 120.3% more income if we begin our income withdrawals at age 70 instead of at 60. The percentage increases are significant in many cases depending upon the chosen withdrawal starting age compared to another potential starting age.

Similar to the Social Security starting age decision, there are numerous factors that need to be considered when determining the optimal age to begin income withdrawals from a FIA with an income rider, a discussion of which is beyond the scope of this post. Like Social Security, when possible and it makes sense, delayed gratification is the key to maximizing lifetime income.

Social Security

Insure Your Longevity Risk with Social Security

When planning for retirement, you need to plan for all of your retirement years. Sounds obvious, however, too often there’s a focus on living it up in the early years without fully considering the potential for longevity and financial risks associated with the later years. As stated in previous posts, the consequences of the financial decisions that you make before you retire can have a profound effect on your ability to meet your financial needs throughout your later retirement years.

How do you plan for all of your retirement years if you don’t know how long you’re going to live? The answer is longevity insurance, otherwise known as a lifetime income annuity. This type of investment will pay you a specified amount of income beginning at a specified date at specified intervals, e.g., monthly or quarterly, with potential annual payment increases for the duration of your life.

If you’re married, the payments can continue to be paid to your spouse upon your death at the same or a reduced amount, depending upon the contractual terms of the particular annuity. Unlike equity-based investments, the payments will be made regardless of market performance.

One of the best longevity insurance planning tools that most of us have at our disposal is Social Security. With its lifetime income payments, not to mention flexible starting date, i.e., age 62 through 70, and associated 7% – 8% increase in benefits each year that the starting date is deferred, excluding cost-of-living adjustments (“COLA’s”), we can use it to insure our, and, if married, our spouse’s, longevity risk.

The amount of retirement income that we choose to insure with Social Security is a personal decision. It’s dependent upon several factors, including, but not limited to, projected investment assets and liabilities, other projected sources of income and expenses and projected timing and duration of same, as well as income tax laws and projected income tax rates.

Delayed claiming of Social Security benefits, in addition to providing increased annual lifetime benefits, results in greater longevity insurance since there will be more guaranteed income available in the latter years of retirement when it may be needed the most. The ability to delay one’s Social Security benefit start date needs to be determined within the context of an overall retirement income planning analysis that includes an analysis of various potential retirement dates.

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.

Annuities Fixed Index Annuities Retirement Income Planning

Retirement Income Planner Key to Success When Investing in Fixed Index Annuities

Last week’s post presented a list of 12 questions you should ask yourself when considering the purchase of fixed index annuities (“FIA’s”). As evidenced by the questions, themselves, as well as the number of questions, this is a very technical area that requires specialized expertise.

So where do you find answers to the various questions? Assuming that investment in one or more FIA’s makes sense in your financial situation, where should you go to purchase these long-term investments? The remainder of this post will assume that you’re considering FIA’s in the context of a retirement income plan.

Unlike investing in the stock market, where you can utilize the services of an investment manager or be a do-it-yourselfer, you must purchase fixed index annuities from a licensed life insurance agent who has the requisite training to sell annuities. Life insurance agents can sell different types of insurance products, including life, disability, and long-term care insurance, as well as annuities. Life insurance companies, life insurance agents, types of products, and the specific products that can be sold, are regulated by an insurance body in each state.

Not every life insurance agent sells annuities. Some only sell variable annuities. Furthermore, there are several different types of fixed annuities, including single premium deferred annuities (“SPDA’s”), single premium immediate annuities (“SPIA’s), deferred income annuities (“DIA’s), and FIA’s. FIA’s are a unique type of fixed annuity that requires specialized expertise and training, and, as such, aren’t offered by every life insurance agent who sells fixed annuities.

Since a FIA is a unique long-term investment with several moving parts in the base product as well as the income rider that change on a regular basis in response to market conditions, it’s important to work with an independent life insurance agent who has access to at least two dozen FIA’s offered by at least six different highly-rated life insurance companies, and sells them on a regular basis.

Going beyond locating a life insurance agent who (a) sells annuities, (b) sells fixed annuities, (c) sells FIA’s, and (d) is an independent agent with access to several different FIA’s offered by several different highly-rated life insurance companies, there are other considerations to keep in mind before purchasing a FIA. First and foremost, you need to recognize and understand the fact that retirement income planning is a specialized discipline, it’s complicated, there are many risks that need to be considered, and mistakes can be costly.

Given the fact that the purchase of a FIA with an income rider for retirement income planning purposes is typically a lifetime investment that often requires a large upfront financial commitment and potentially ongoing periodic investments, it’s especially important that you work with the right individual. Specifically, the person you choose should be a professional retirement income planner. What exactly is a retirement income planner? Sounds like the subject of another post.

Annuities Deferred Income Annuities Fixed Index Annuities

FIAs With Income Riders vs. DIAs: Which is Right for You? – Part 4 of 5

If you haven’t read the first three parts of this series yet, you may want to do so since it will provide you with the background for this post. The first three parts listed and compared 12 features offered by fixed index annuities (“FIAs”) with an income rider with deferred income annuities (“DIAs”). It organized the 12 features into three categories: (a) offered by DIAs, (b) applicable to DIAs, and (c) applicable to DIAs on a limited basis.

DIAs are a unique investment in and of themselves. As such, they offer features that are unavailable in other investments, including FIAs with income riders. This week’s post discusses the retirement income planning benefits that are applicable to DIAs that aren’t present in FIAs with income riders.

Simply stated, a DIA is (a) the income rider portion of a FIA, (b) minus the income start date flexibility, (c) plus potential annual income inflation adjustments, (d) plus potential term vs. lifetime income opportunity.

Income Rider Portion of a FIA

As discussed in Part 2, DIAs, unlike FIAs, don’t have a traditional investment value associated with them. As such, a DIA is a simpler investment to understand than a FIA since it’s all about a future income stream.

Unlike the payments from FIA income riders that represent income withdrawals, DIA payments are annuity payments. This is an important distinction when it comes to income taxation. When held in a qualified plan such as a traditional IRA, 100% of FIA income rider and DIA payments are taxable as ordinary income.

With nonqualified, or nonretirement plans, income withdrawals from nonretirement FIAs are subject to “last-in first-out,” or “LIFO,” taxation. 100% of all withdrawals up to your income amount are taxable as ordinary income with any subsequent withdrawals received tax-free. Since DIA payments are annuity payments, they benefit from more favorable taxation when held in nonqualified plans. Each payment is subject to an “exclusion ratio” that excludes from taxation the portion of the payment that’s deemed to be a return of principal.

Minus the Income Start Date Flexibility

One of the best features of a FIA with an income rider from a retirement income planner’s perspective is the ability to begin income withdrawals at virtually any future date so long as it’s generally at least one year from the date of purchase and you’ve reached a specified age, typically 50. Most DIAs have a specified income start date and, therefore, don’t offer this flexibility. This downside can be negated to a certain extent by purchasing multiple DIA’s with different start dates.

Plus Potential Annual Income Inflation Adjustments

While it may change in the future, FIA income withdrawals, once they begin, are generally fixed amounts that don’t adjust for inflation. Although it isn’t automatic, the income payout from a DIA, on the other hand, can be structured to increase by a specified annual inflation factor, generally ranging between 3% and 6%.

Plus Potential Term vs. Lifetime Income Opportunity

One of the benefits of income annuities in general, including FIAs with income riders, is lifetime income. This also applies to DIA’s, however, you can also structure a DIA for a specified term. The term can be a certain number of years, however, it can be fine-tuned to a specified number of months.

With a known payment beginning at a specified future date for a specified number of months, you know exactly the total amount of income that will be received over the term of the DIA at the time of purchase. This offers three distinct retirement income planning benefits:

  1. Ability to precisely calculate an internal rate of return
  2. Ability to structure income to dovetail with the amount, frequency, and duration of other projected income sources to meet projected expenses
  3. Ongoing income payment to beneficiaries in the event of death prior to the end of the term

So which is right for you – FIAs with income riders or DIAs? Mark your calendar to read next week’s post to find out.