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.


Retirement Income Visions Celebrates 4-Year Anniversary!

Thanks to my clients, subscribers, and other readers, Retirement Income Visions™ is celebrating its four-year anniversary. Retirement Income Visions™ published a weekly post each Monday morning beginning four years ago through and including the March 11, 2013 post.

Beginning with the March 25, 2013 post, Retirement Income Visions™ changed to a biweekly publication schedule. This was in response to my acceptance of another retirement income planning writing gig as a Wall Street Journal MarketWatch RetireMentors contributor. I continue to do all my writing on Saturday mornings, enabling me to fulfill my primary goal of providing outstanding, timely service to my clients.

Even with its reduced publication schedule, Retirement Income Visions™ continues to boast a fair number of followers. It has had over 72,000 pageviews in its four years of publication, including over 4,000 in the last 30 days.

In addition to becoming a RetireMentors contributor, I further distinguished myself as a retirement income planning expert when I became one of the first recipients of the Retirement Income Certified Professional® (RICP®) designation from The American College on July 1st. The RICP® educational curricula is the most complete and comprehensive program available to professional financial advisors looking to help their clients create sustainable retirement income.

This past year, Retirement Income Visions™ deviated from its themed approach whereby it historically featured a long stretch of weekly posts focusing on a single retirement income planning strategy. After completing a lengthy series of weekly posts about fixed index and deferred income annuities from August 20, 2012 through November 5, 2012, I began mixing it up with a variety of educational topics.

The November 12, 2012 post, The Smooth COLA, straightened out some misconceptions about Social Security retirement benefit cost of living adjustments. The November 19, 2012 post, Black Friday – Think Roth IRA Conversion, proved to be a very timely post for those who did Roth IRA conversions at that time since they have benefited from a 23% increase in stock prices as of Friday, combined with a significant tax increase that went into effect on January 1st for higher income taxpayers.

The November 26, 2012 through December 17, 2012 posts featured two two-part miniseries about two important Social Security topics, Social Security as a deferred income annuity and considerations when choosing a Social Security starting age.

The January 7, 2013 post, The 2013 Tax Law Schizophrenic Definition of Income – Part 1, was timely, as it was quoted extensively and linked in Robert Powell’s MarketWatch January 11, 2013 Now is the Time for Tax-Efficient Investments article. The January 7th post and the January 14th, 21st, and February 4th posts, which included Part 2 of the January 7th post and a two-part miniseries, New Tax Law – Don’t Let the Tax Tail Wag the Dog, provided readers with a comprehensive understanding of the new tax laws that went into effect on January 1st.

The next four posts, beginning with the February 11, 2013 post, The Almost Irrevocable Retirement Income Planning Decision, through the March 4, 2013 post, Insure Your Longevity Risk with Social Security, featured a series of four timely Social Security topics.

Retirement Income Visions™ really began mixing it up, beginning with the March 11, 2013 post, Consider the Future Purchase Option When Buying Long-Term Care Insurance, through the July 29, 2013 post, Immediate Annuities – Where’s the Planning? The eleven posts in this stretch presented a number of different topics, including long-term care insurance, retirement income planning considerations and strategies, fixed index and immediate annuities, Medicare, longevity insurance, budgeting, and personal financial management systems.

As I’ve traditionally done in previous “anniversary” posts, I would like to conclude this post by thanking all of my readers for taking the time to read Retirement Income Visions™. Once again, a special thanks to my clients and non-clients, alike, who continue to give me tremendous and much-appreciated feedback and inspiration. Last, but not least, a big thank you to Nira, my incredible wife, for her enduring support of my blog and MarketWatch RetireMentors writing and other professional activities.

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.

Social Security

The Almost Irrevocable Retirement Income Planning Decision

I don’t know about you, however, I appreciate and enjoy flexibility in my life. When I hear the word “irrevocable,” other than in the phrase “irrevocable life insurance trust,” which I know from many years of experience is a wonderful estate planning tool in the right situation, I get a little squeamish. As Duke Frederick says to Celia in Scene 3 of Act 1 of Shakespeare’s As You Like It, “Firm and irrevocable is my doom.”

As pointed out in the December 17, 2012 post, Approaching 62? – Stop Before You Leap – Part 2 of 2, with two exceptions, the choice of your Social Security start date is an irrevocable decision. This wasn’t always the case. Although it wasn’t well-publicized and wasn’t used very often, the “do-over,” or “pay-to-play” strategy as I liked to refer to it, enabled individuals who claimed Social Security at age 62 to repay 100% of their benefits received to date without interest and receive a higher benefit going forward based on their current age. Ironically, Social Security Administration ended the ability to use this strategy on December 10, 2010, four days after the third of a three-part series on this topic was published by Retirement Income Visions™ (see Pay-to-Play Social Security – Part 3 of 3).

Once you start receiving your Social Security retirement benefits, why would you want to stop receiving them? As pointed out in last week’s post, benefit amounts will increase by 7% – 8% each year that the start date is deferred between age 62 and 70, excluding cost-of-living adjustments (“COLA’s”). You may have started your benefits at age 62 or some other age before your full retirement age (“FRA”) since you thought this made sense at the time and later realized this wasn’t the right choice in your situation. Another possibility is that you learned about a strategy to suspend and restart your benefits at a later date in order to receive a larger monthly payment.

Stopping Social Security Before Your Full Retirement Age

Unlike the now defunct “do-over” strategy where you could repay 100% of your benefits received to date without interest at any time after you began receiving them, there’s a limited exception that enables you to employ a scaled-down version of this strategy. If you claimed benefits before your FRA and you’re within 12 months of when your benefits started, you can withdraw your application and stop your benefits by repaying 100% of what you received so far.

Stopping Social Security After Your Full Retirement Age

Between FRA and age 70, Social Security Administration allows you to suspend retirement benefit payments. This can be done either when you’re approaching your FRA and haven’t started receiving benefits yet or after you have reached FRA and are already receiving benefits. There are different reasons why you would want to do this that’s beyond the scope of this post.

While there are two exceptions when it comes to the irrevocability of the Social Security start date that may or may not be beneficial in a particular situation, these are limited exceptions. As emphasized in the last post, the age at which you begin receiving Social Security retirement benefits may possibly be the most significant factor in your ability to sustain financial security throughout retirement. As Billy Joel says in his song, Get it Right the First Time, “Get it right the first time, that’s the main thing. I can’t afford to let it pass. Get it right the next time, that’s not the same thing.”

Social Security

Approaching 62? – Stop Before You Leap – Part 2 of 2

Last week’s post began a discussion regarding the far-reaching and long-term consequences of the Social Security claiming decision. It concluded by stating that the choice of a Social Security starting age will differ depending upon each person’s unique circumstances.

Why is the choice of a Social Security start date so important? There are several reasons, all of which can be divided into two categories:  (a) Those dictated by Social Security rules and regulations and (b) Other fianncial reasons.

Reasons Dictated by Social Security Rules and Regulations

Social Security rules and regulations affecting the choice of a start date include the following:

  • Benefit amounts will increase by 7% – 8% each year that the start date is deferred between age 62 and 70, excluding cost-of-living adjustments (“COLA’s”).
  • Social Security COLA amounts will be greater for those who defer their start date.
  • If married, it will affect the amount of one’s spousal Social Security benefit.
  • If married, it will affect the amount of one’s survivor’s Social Security benefit.
  • With two exceptions, it’s an irrevocable decision.

Other Financial Reasons

Other financial reasons why the choice of a Social Security start date is so important include the following:

  • It can affect the choice of one’s retirement age as well as that of one’s spouse if married.
  • It may impact sustainability of retirement income and assets for 30 to 40 years.
  • It will influence the amount and timing of withdrawals from retirement and nonretirement investment assets.
  • It can affect the amount of Social Security benefits that are taxable each year.
  • It will directly affect one’s overall income tax liability and tax planning.

As you can see, there are many things riding on the choice of one’s Social Security starting age, most of which won’t become apparent until several years, or even decades, after the claiming age decision has been made. The age at which you begin receiving Social Security retirement benefits may possibly be the most significant factor in your ability to sustain financial security throughout retirement. Given the importance of this decision, sit down with your retirement income planner before going to the “Boldly Go Online to Retire – It’s So Easy!” section of the Social Security Administration website and clicking the “Apply for Retirement” link.

Deferred Income Annuities Social Security

Social Security – The Ultimate Deferred Income Annuity

Last week’s post made the point that Social Security isn’t simply an entitlement program and is instead a deferred income annuity (“DIA”) payable for life. As discussed, 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’s the federal government while DIA’s are purchased from, and payments guaranteed by, individual life insurance companies.

It turns out that in today’s low-interest rate environment, Social Security is inarguably the ultimate DIA. To illustrate this, I will use my current Social Security benefits statement that includes the following information about my projected monthly retirement benefit beginning at various ages:

Age 62                                                        $1,870
Age 66 and 2 months (full retirement)    $2,559
Age 70                                                        $3,385

In addition to projected monthly retirement benefits, my statement also shows that through 2011, I have paid Social Security taxes totaling approximately $149,000 and my employers (including myself and my two corporations for the last 23 years) have paid approximately $94,000, for a total of approximately $243,000.These taxes have been paid over the last 40 years beginning with part-time employment when I was in high school, with the vast majority paid over the last 25 years.

In addition to my Social Security retirement benefit, my wife is entitled to receive a monthly benefit equal to one-half of my full retirement benefit, or $1,280 (50% x $2,559) if she starts receiving benefits at her full retirement age. This is referred to as a spousal benefit and is independent of any benefit to which she may be entitled based on her earnings record. Assuming my wife has no significant earnings and further assuming that I predecease her, she will receive her spousal benefit for the rest of my life at which time she will receive my higher monthly benefit for the remainder of her life.

Ignoring my wife’s spousal benefit in order to minimize complications, let’s demonstrate the value of my Social Security retirement benefit by calculating the single premium required today at my age 57 to purchase a DIA that will pay my projected monthly retirement benefit beginning at various ages with a 2% annual increase for the remainder of my wife and my lives. Per the November 12, 2012 The Smooth COLA post, Social Security cost-of-living adjustments (“COLA’s”) have averaged 2.6% over the last ten years; therefore, an assumed 2% annual increase is probably conservative.

The following is the range of DIA single premiums required to pay various joint lifetime income amounts assuming an annual 2% increase beginning at various ages using illustrations from three highly-rated life insurance carriers:

While it’s obvious that the above single premium amounts are significantly greater than the total Social Security taxes of $243,000 paid through 2011 by my employers and myself, it’s important to keep in mind the following facts when doing a cost/benefit analysis of Social Security compared to commercial DIA’s:

  • In order to receive the projected Social Security monthly income beginning at various ages, it’s assumed that my current earnings will continue until my full retirement age.
  • In order to receive the projected Social Security monthly income beginning at various ages, Social Security taxes paid by my employers and myself are projected to total $314,000 – $381,000 or greater depending upon my annual earnings, actual taxable Social Security wage bases, and when I retire.
  • Although my Social Security tax payments haven’t been segregated and invested in an account in my name and they have been used to fund Social Security benefits for other individuals, my employers and I have been paying into the Social Security Trust Fund for 40 years.
  • My projected Social Security monthly income beginning at various ages doesn’t include COLA’s between now and my Social Security starting age.
  • The DIA assumed annual increase of 2% may be greater or less than the actual Social Security COLA’s for the remainder of my wife and my lifetime.
  • Although it isn’t likely, it’s possible that my projected Social Security benefit amounts may change if Social Security law changes.
  • As previously stated, my projected Social Security benefits and the single premium DIA calculation both exclude my wife’s Social Security spousal benefits.
  • While it’s possible that less than 50% of my Social Security benefits will be taxable, under current law, it’s likely that 50% – 85% of my benefits will be taxable, depending upon the amount of my other income.
  • Depending upon when I would start receiving payments from a DIA, approximately 40% – 60% of my payments would be taxable as a result of favorable tax treatment associated with nonqualified annuity payments.
  • The required DIA single premium amounts are on the high side since they were calculated assuming that I’m a California resident when I receive my payments and, as such, take into consideration California’s nonqualified annuity premium tax of 2.35% which isn’t applicable in most states.

As you can see, a number of factors must be considered when comparing Social Security as a DIA to purchasing a commercial DIA. Despite these various factors, in today’s low-interest rate environment, it’s clear that Social Security is the ultimate DIA.

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.

Social Security

The Smooth COLA

Remember the old Dr Pepper commercials promoting the fact that this famous soft drink, which was created in the 1880s and was first nationally marketed in the United States in 1904, was “so misunderstood.” I’m a firm believer that this saying also applies to a non-soft drink COLA brought to you by the Social Security Administration.

Every year since 1975, the Social Security Administration calculates a cost-of-living adjustment, or COLA. The 1975 – 1982 COLAs were effective with benefits payable for June in each of those years. Since 1982, COLAs have been effective with benefits payable for December.

The COLA has always been based on an annual increase in the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). Since 1983, COLAs have been calculated using increases in the CPI-W from the third quarter of the prior year to the corresponding quarter of the current year in which the COLA became effective. The 2012 COLA of 1.7% was announced in October and will apply to benefits payable beginning in December.

Per the Social Security Cost-of-Living Adjustments table below, there were sizeable annual increases the first eight years from 1975 to 1982. The increases ranged from a low of 5.9% in 1977 to a high of 14.3% in 1980, averaging 8.7% during this period. The COLA decreased to 3.5% in 1983 and further declined to 1.3% in 1986 before climbing to over 4% for four straight years beginning in 1987. There have been only two years since 1982 when the COLA exceeded 5% (1990 – 5.4% and 2008 – 5.8%). There were also two consecutive years recently in 2009 and 2010 that saw no increases.

Since its roaring start the first eight years, average COLA increases have declined dramatically and have remained consistent over extended periods of time. They have averaged 2.6%, 2.5%, and 2.9% for the last 10-, 20-, and 30-year periods, respectively. As a result of their initial jump start, COLA’s have averaged 4.1% over their 38 years of existence.

Although average annual increases have remained below 3% for extended periods of time over the last 30 years, Social Security recipients have kept up with inflation as measured by the CPI-W. Someone still alive today who started receiving benefits in 1975 has seen a 354% increase in benefits, with 108% of the increase attributable to COLA’s during the first 10 years. For the individual who began receiving benefits in 1982, her benefits have increased by 134% over the last 30 years. Benefits have doubled over the last 25 years as a result of COLA’s.

With only two COLA’s exceeding 4% in the last 20 years (4.1% in 2005 and 5.8% in 2008), the pace of the total increase in Social Security benefits has declined significantly. If you began receiving benefits 20 years ago in 1992, you have seen an increase of 63%. If your start year was 2002, your benefits have increased by 29%. Finally, the total increase over the last five years has been only 11%.

Despite the fact that Social Security recipients have enjoyed sizeable cumulative increases in their benefits over the past 20+ years, another reason why COLAs are often misunderstood is due to their accounting treatment. Social Security benefits are reduced by the Medicare Part B premium that helps pay for doctors’ services and outpatient care. The monthly premium for most individuals in 2012 is $99.90. Although Medicare premium increases cannot be greater than the COLA, Social Security benefit increases are diluted to the extent of any increase in Medicare premium.

Enjoy your COLA’s!


Annuities Fixed Index Annuities

Fixed Index Annuity Income Rider Similarities to Social Security – Part 3 of 4

I hope that you’re enjoying this series about fixed index annuity income rider similarities to Social Security. I personally find it easier to understand a new concept when there’s something familiar I can compare it to.

Parts 1 and 2 discussed the first five of eight characteristics shared by fixed index annuity (“FIA”) income riders and Social Security. This post addresses characteristics six and seven as follows:

6. Income ceiling
7. Portfolio risk reduction

Income Ceiling

Characteristic #4, increased annual lifetime income, which was discussed in Part 2, is a very important benefit shared by FIA income riders and Social Security alike. By deferring the income start date, Social Security recipients and FIA income rider holders will receive larger annual lifetime income amounts than if they elect to receive income sooner.

Deferring the start date of Social Security retirement benefits from 66, assuming 66 is full retirement age, to 70 translates to a 32% increase in monthly benefits. Waiting to receive lifetime retirement payments (“LRP’s”) from FIA income riders can also result in a significant increase in payments.

There’s a limit in the ability to realize additional income by deferring the start date of both Social Security benefits and LRP’s from FIA income riders. In the case of Social Security, other than potential annual cost of living adjustment (“COLA”) increases, payments max out at age 70. Once you achieve this milestone, there’s no benefit to delaying the start date further.

Although it’s not a set age and it varies by product and situation, there’s also an income ceiling when it comes to FIA income riders. Unlike Social Security where benefits max out at age 70, this may not occur until age 90+ with various FIA income riders. The FIA income rider ceiling for each situation is different and is dependent on three factors: (1) age at which a particular FIA is purchased (2) number of years in the accumulation, or roll-up, period, and (3) age at which withdrawal percentage no longer increases.

Although the vast majority of individuals elect to begin receiving Social Security by their full retirement age, with longer life expectancies and the associated possibility of living to 90 and beyond, it makes sense in many situations to wait until age 70 to begin receiving benefits.

On the other hand, given the fact that FIA income rider LRP’s may not max out until age 90+, while it’s prudent to defer the income start date for several years, it generally doesn’t make sense to wait until the year in which the income ceiling is reached. Unlike Social Security, however, where income is the only benefit, if income hasn’t been started at the time of death, a FIA owner’s beneficiaries will receive the contract’s accumulation value which may be substantial.

Portfolio Risk Reduction

Since they both provide predictable lifetime income, Social Security and FIA income riders, in addition to all of their other benefits, reduce portfolio risk. In both cases, the present value of the future income stream comprises an important, if not dominating, piece of the fixed income component of one’s investment allocation model.

When viewed this way, Social Security reduces overall portfolio risk, and, in turn, reduces the dollar amount of traditional fixed income assets, e.g., CD’s, bonds, etc. that would otherwise need to be included in a portfolio if Social Security wasn’t available. To the extent that significant income will also be received from a FIA income rider, this further reduces a portfolio’s dependence on traditional fixed income instruments.

Social Security

Your Social Security Retirement Asset – Part 3 of 3

Part 1 of this post made the point that Social Security is a retirement asset, specifically, an annuity. Part 2 took this concept one step further and stated that, similar to a commercial annuity contract that has been annuitized, the value of the future payment stream can be calculated and included on every qualified Social Security recipientTM‘s personal financial statements. The question is, who is a qualified Social Security recipientTM?

There are two types of qualified Social Security recipientsTM when it comes to Social Security retirement benefits: (1) current recipients and (2) future recipients who are vested in their benefits.

Current Recipients

Although as stated in Part 2, the valuation of Social Security benefits as an asset isn’t straightforward, it’s easiest to do for current recipients. These individuals are currently receiving a defined monthly payment. What isn’t known and must be determined is (1) the number of payments that will be received going forward, i.e., life expectancy, (2) projected Social Security cost of living adjustments (“COLA’s”), and (3) an assumed interest rate. In the case of a married couple where one spouse currently receives or will receive 50% of the other spouse’s benefit, the 50% spouse’s life expectancy must also be determined.

Future Recipients Vested in Their Benefits

For those of you who participate, or who have participated, in defined benefit pension plans, you’re familiar with the concept of vesting. Simply stated, vesting as it pertains to pension plans, is the non-forfeitable right to receive a defined benefit based on one’s salary and the number of years of service performed by an employee. How do you vest, or qualify, for Social Security retirement benefits? Assuming that you were born after 1928, you need 40 quarters, or 10 years of work and associated payment of Social Security taxes.

Once you hit the 10-year mark, you become vested in Social Security. At this point, although it isn’t likely to be your actual starting benefit, an estimated retirement benefit can be calculated based on your earnings to date. Each year, the Social Security Administration mails statements to all American workers age 25 or older who aren’t yet receiving Social Security benefits approximately three months before their birthday. Each statement includes an estimated retirement benefit for three different retirement ages: (1) age 62, (2) full retirement age, or “FRA,” which varies from age 65 to 67 depending upon when you were born, and (3) age 70.

In addition to the age at which you start receiving benefits, your actual benefit payment will be based on the 35 years in which you earned the most. The closer you are to age 62, the more likely the benefit on your Social Security statement will approximate your actual starting benefit. Whether you’re 30 or 60 years old, assuming you’ve worked for 10 years and paid Social Security taxes, a defined benefit is determinable and readily available.

While your actual benefit is likely to be much greater than what is shown on your statement if you’re 30 years old assuming that you will continue to work for several years, in my opinion, this is the figure that should be used to calculate the current value of your Social Security benefits for inclusion as an asset on your personal financial statement. Future salary increases, although likely, should be ignored for purposes of this calculation. A basic principle that is used in the preparation of any financial statement, whether it be for business or personal purposes, is conservatism. Since there’s a possibility, although not likely, that even if you’re 30 years old, your current estimated Social Security benefit will be your actual starting benefit, this amount should be used since it’s known and non-forfeitable pending future potential changes to the Social Security system, itself.

The calculation of the value of Social Security benefits for a future recipient vested in his/her benefit is more complicated than for a current recipient. In addition to the three variables listed above for current recipients that must be determined to calculate the value of Social Security benefits, future recipients must also project their retirement age. This is used for to calculate two values: (1) the projected value of retirement benefits at retirement age and (2) the current value of #1.

Whether you’re a current or future recipient vested in your benefit, the calculation of the current value of your Social Security retirement benefits is referred to as determining its “present value.” Present value, as defined by Wikipedia, is the value on a given date of a future payment or series of future payments, discounted to reflect the time value of money and other factors such as investment risk. While the calculation of present value of Social Security benefits is complicated, it can and should be done for every qualified Social Security recipientTM with the resulting value included as an asset on the individual’s personal financial statements.

Social Security

Pay-to-Play Social Security – Part 3 of 3

If you haven’t done so already, I would highly recommend that you read parts 1 and 2 of this series before diving into Part 3. Part 1 introduced a strategy called the “do-over,” or, as I like to refer to it, “pay-to-play” Social Security. In a nutshell, the use of this strategy enables Social Security recipients who are less than 70 to increase the amount of their retirement benefit in exchange for repayment of all benefits received to date. Part 2 used a hypothetical example of an individual who had been collecting Social Security since age 62, paid back 100% of his benefits totaling approximately $190,000, and was projected to recoup his payback in 12 – 13 years via projected benefits of approximately 47% greater than what he was previously receiving.

The success of this technique is dependent upon surviving the “break-even” period. Suppose the individual, let’s call him Sam, in our hypothetical example is single, is in good health, and decides to implement this strategy, writing a check to Social Security Administration for $190,000. After receiving one increased monthly payment of $3,282, or $1,048 greater than his former monthly payment of $2,234, Sam suffers a major heart attack and dies. Guess what? Assuming that Sam invested his additional monthly benefit of $1,048, Sam’s beneficiaries will receive $189,000 (190,000 – $1,000) less than what they would have received had Sam done nothing. Furthermore, once again assuming that Sam invests his additional monthly benefit of $1,048 each and every month, Sam needs to survive for 12 – 13 years in order for Sam and his beneficiaries to benefit from Sam’s implementation of the “pay-to-play” strategy.

Knowing that premature death is a risk, some individuals go ahead and implement the strategy thinking that it’s a bargain compared with what it would cost to buy an immediate life income annuity with annual cost-of-living increases from an insurance company. For those of you who aren’t familiar with the concept of an “immediate life income annuity,” allow me to explain. In exchange for a lump sum investment, or premium, an insurance company will make a monthly payment to you for the remainder of your life, with all payments ending upon death. An optional cost-of-living increase provides that the payments will increase each year by a specified percentage, typically 1% to 6%. Since the benefit will increase each year, the premium will be greater than what would otherwise be required without this option.

Let’s see how much of a bargain the use of the “pay-to-play” strategy is compared to purchasing a commercial annuity using our example. In order to duplicate the proposed increased monthly Social Security benefit of $1,048 plus an assumed cost-of-living adjustment of 2% beginning in 2012 per Exhibit 1 of Part 2 of this blog post, I ran annuity illustrations with three highly-rated life insurance companies, solving for the required premium, using the following eight parameters:

  1. Sex – Male
  2. Age – 70
  3. State of residence – California
  4. Type of annuity – single-premium life income annuity
  5. Payment amount – $1,048
  6. Payment frequency – monthly
  7. Annual increase – 2%
  8. Contract type – non-qualified

The state of residence is important because some states, including California where I live, assess a premium tax on annuity investments which, in turn, increases the amount of premium that would otherwise be payable in those states which don’t assess the tax. Using the foregoing assumptions, the amount of premium required ranged between approximately $189,000 and $192,000 for the three companies. This is identical to the payback amount of approximately $190,000 per Exhibit 1 of Part 2. As stated in Part 2, the analysis needs to be extended to include income tax savings attributable to the payback, which, in our example was approximately $24,000, reducing the after-tax cost of the payback to $166,000 ($190,000 – $24,000).

In the hypothetical example, at first blush, the payback of approximately $190,000 isn’t a bargain when compared to the purchase of a commercial annuity providing comparable increased benefits, i.e, $1,048 a month plus 2% annual increases. It isn’t until the income tax savings of approximately $24,000 is considered that it becomes apparent that the after-tax cost of $166,000 is less than the annuity premium, making the “pay-to-play ” strategy vs. purchase of a commercial annuity a potentially better way to go in this example.

“Potentially” is the operative word because, in addition to the possibility of premature death, three, or four additional factors, depending upon marital status, need to be analyzed and considered when evaluating this strategy:

  1. Whereas the annuity annual increase of 2% is locked in and will be paid each year by the insurance company, the annual Social Security benefit increase of 2% in Exhibit 2 of Part 2 is an assumed increase. Actual increases may be equal to, greater, or less than 2%, and can even be 0% as they have been the last two years.
  2. Under current law, up to 85% of Social Security benefits are taxable at federal income tax rates as high as 35% which are scheduled to increase to 39% on January 1st. Depending upon one’s tax situation, the after-tax increase of $1,048 a month may be only two-thirds of this amount, or approximately $700.
  3. Non-qualified annuity contracts are subject to an exclusion ratio. Basically this means that the portion of each payment that represents a return of principal is nontaxable. In the case of the three annuity illustrations, approximately 80%, or approximately $800, of each payment is nontaxable. The remaining 20%, or approximately $200 is taxable at one’s applicable marginal tax rate
  4. For married individuals where one spouse is receiving a “spousal benefit,” additional analysis is required.

As you can see, I wasn’t kidding when I stated in the beginning of Part 2 that some serious number crunching is necessary in order to determine if the use of the “do-over,” or “pay-to-play” strategy makes sense in your situation. Besides the fact that this strategy isn’t well publicized, it’s no wonder that very few individuals actually implement it. The future use of this strategy may become a moot point since, as stated in Part 1, it may be discontinued by Social Security Administration in the near future.

Social Security

Pay-to-Play Social Security – Part 2 of 3

Part 1 of this post introduced the Social Security “do-over” or, as I like to refer to it, “pay-to-play” Social Security strategy. Basically, this strategy provides individuals who elected to begin receiving their Social Security retirement benefits before age 70 with the ability to increase their future monthly benefit. In order to receive this ongoing increase, which, in some cases may be substantial, you’re required to pay back 100% of the Social Security benefits that you’ve received from the date you began collecting your benefits. As stated in Part 1, you’re entitled to claim a tax credit or tax deduction for the amount of tax liability attributable to your benefits, whichever results in the most tax savings.

In order to determine if the use of this strategy makes sense, some serious number crunching is necessary. Even though I’m not old enough to collect Social Security yet, I used benefit information from my Social Security Statement to prepare a hypothetical example in Exhibit 1. Per my Statement, here are the projected monthly benefits that I’m entitled to receive at various ages:

  1. Age 62 = $1,805
  2. Age 65 = $2,475
  3. Age 70 = $3,282

Let’s fast forward and assume that I turned 62 in 2002 and, at that time, made an election to begin receiving my monthly benefit of $1,805, or $21,660 per year. Applying Social Security Administration’s annual cost-of-living adjustments, or COLA’s shown in column 3 of Exhibit 1, my annual benefit would have increased each year by 1.4% (in 2003) to as much as 5.8% (in 2009), with my 2009 annual benefit being $26,804. This represents an increase of $5,144, or 23.7% of the benefit of $21,660 that I was receiving seven years prior in 2002.

Here we are in 2010. Since there was no COLA in 2009, my 2010 annual Social Security benefit will be the same as what it was in 2009, or $26,804 if I do nothing. Using the “do-over” or “pay-to-play” Social Security strategy, and assuming that my spouse isn’t receiving a spousal benefit (See Do Your Homework Before Flipping the Social Security Switch – Part 4 of 5), per Exhibit 1, in exchange for writing a check to Social Security Administration for the amount of my cumulative benefits of $189,956, I will receive a monthly benefit of $3,282 vs. $2,234 ($26,804 divided by 12). On an annual basis, I will receive $39,384, or $12,580, or 46.9% more, than the benefit of $26,804 that I would receive if I don’t employ this strategy.

While there is no COLA for 2010 or 2011, Exhibit 1 assumes annual COLA’s of 2% each year beginning in 2012. Once these COLA’s kick in, the annual “do-over” increased benefits, i.e., the difference between the amount of the “do-over” benefit and my current projected benefit, is projected to escalate each year. Per Exhibit 1, the annual “do-over” increased benefit is projected to increase from $12,580 in 2010 to $13,617 in 2015 to $15,034 in 2020, etc.

Exhibit 1 assumes that I will reinvest my increased annual benefit that I receive beginning at age 70. It further assumes that my after-tax reinvestment rate will be the same as the rate that I would have earned had I chosen to invest the Social Security repayment amount of $189,956. Ignoring potential income tax savings that I would receive from the tax credit or deduction attributable to the income tax that I paid from 2002 through 2009 on my total Social Security benefits of $189,956, per Exhibit 1, it would take until sometime when I’m 83, or almost 13 years, for my cumulative “do-over” increased benefits to exceed my Social Security payback amount.

Although up to 85% of one’s Social Security benefits can be taxable at federal tax rates as high as 35% which may increase to 39.6% beginning in 2011, let’s assume that 50% of my benefits between 2002 and 2009 have been taxable at a rate of 25%. The income tax attributable to my cumulative benefits of $189,956 is $23,745 (50% x $189,956 x 25%). Since I would be receiving income tax savings of this amount when I write my check to Social Security Administration, my out-of-pocket cost would be $166,211 ($189,956 – $23,745). Per Exhibit 1, “break-even” would occur when I turn 82 since my cumulative “do-over” increased benefits of $165,658 at age 81 would be slightly less than my after-tax “do-over” payback of $166,211.

Per Exhibit 1, the longer I live, whether it’s until 82 if I’ve previously paid income taxes on my Social Security benefits or sometime into my 83rd year if I haven’t, the “pay-to-play” Social Security strategy becomes more and more attractive. Although I’ve done a fair amount of number crunching, there’s one more step remaining in my analysis to determine whether the strategy makes sense for me. Stay tuned for Part 3 next week.