Tag: present value

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Annuities Deferred Income Annuities Fixed Index Annuities

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

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

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

Assumptions

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

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

Investment Amount

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

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

Results

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

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

Annual Gross Income

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

Annual Taxable Income

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

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

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

Value/Death Benefit

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

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

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

Conclusion

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

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

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

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

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

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Annuities Deferred Income Annuities Fixed Index Annuities

Invest in DIA to Fund LTCI Premiums When Retired – Part 3 of 4

Last week’s post discussed the first three of five differences between fixed index annuities (“FIA’s”) with income riders and deferred income annuities (“DIA’s”) that will influence which retirement income planning strategy is preferable for funding long-term care insurance (“LTCI”) premiums in a given situation. Once again, the differences are as follows:

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

This post will discuss the fourth and fifth differences. Part four will present a sample case to illustrate the use of a DIA vs. a FIA with an income rider to fund LTCI premiums during retirement.

Investment Value

Although guaranteed lifetime income is the primary purpose when using a FIA with income rider or DIA strategy for funding LTCI premiums during retirement, the presence of an investment value may be important for many people.

With traditional DIA’s, you purchase from a life insurance company the promise to pay a periodic income stream for either a term certain or lifetime, with or without inflation, beginning at a defined future date at least 13 months from the date of purchase. Although the present value of your future income stream represents an asset, you generally won’t receive an annual statement from the life insurance company showing you the value of your investment.

A FIA, on the other hand, has an “accumulation value” in addition to the right to receive income withdrawals when you purchase an optional income rider. The accumulation value is increased by initial and ongoing investments, premium bonuses if applicable, and periodic interest crediting. It’s reduced by income and other withdrawals, income rider charges, and surrender charges.

Death Benefit

There may or may not be a death benefit with both FIA’s with income riders and DIA’s. In the case of DIA’s, it’s a contractual issue vs. a function of the accumulation value in the case of a FIA.

Some DIA’s will pay a death benefit in the event that the annuitant dies prior to receiving income. If this is the case, the income payment will often be less than what it would be if there’s no death benefit.

With FIA’s, the death benefit will be equal to the greater of the minimum guaranteed value or the accumulation value. As previously stated, the accumulation value is a moving target that increases and decreases as a result of various transactions. Depending upon the amount of cumulative income and other withdrawals as well as income rider and surrender charges, there may eventually be no minimum guaranteed value or accumulation value remaining.

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Annuities Fixed Index Annuities

Why Isn’t the Value of Your Income Stream Shown on Your Fixed Index Annuity Statement?

Last week’s post made the point that, in addition to the accumulation value of a fixed index annuity (“FIA”), there’s a value that can be calculated and attached to the future income stream from an income rider. Furthermore, unlike the accumulation value of your FIA that will change over time, unless you make additional investments or take non-income withdrawals, the amount of your lifetime income withdrawals are predetermined and are contractually guaranteed.

So if the amounts of lifetime income withdrawals are known at the time of purchase of your FIA, why don’t life insurance companies show the present value of the withdrawals on annual statements? The reason it’s not done is because there are several unknowns throughout the life of the contract that can affect the amount and duration of the income payout. There are two types of unknowns:  amount and duration variables.

Amount Variables

There are two variables that can increase or decrease the lifetime retirement payments (“LRP”) from an FIA:

  1. Additional investments
  2. Non-income withdrawals

Additional investments will increase LRP’s while non-income withdrawals will decrease LRP’s. In addition, the timing of additional investments and non-income withdrawals relative to the issue date will directly affect the LRP amount.

Additional Investments

Generally speaking, the sooner that additional funds are added to an existing FIA contract, the larger the income payout. This can happen in two different ways as follows:

  1. The sooner additional investments are made, the more time there is for the funds to increase the income account value and the ultimate LRP.
  2. To the extent that the FIA offers a premium bonus and the premium bonus provision applies to additional investments, this will also increase the income account value and LRP.

Non-Income Withdrawals

Timing of non-income withdrawals will also affect the LRP amount. This can happen in three different ways as follows:

  1. The sooner that the withdrawals occur, there will be a reduced income account value growing for a longer period of time.
  2. The sooner withdrawals occur, the greater the surrender charge which will increase the withdrawal amount and decrease the income account value and LRP.
  3. To the extent that a premium bonus has been paid, non-income withdrawals will result in a recapture of part, or all, of the premium bonus if they occur during a stated period of time, generally the first ten years of the contract, which will in turn reduce the income account value and LRP.

Duration Variables

Let’s assume that your FIA will never have any additional investment or non-income withdrawal transactions. In this case, the LRP’s will be the amounts beginning at different ages per the illustration that was prepared for you when you purchased your FIA. Why doesn’t your FIA statement show the present value of your LRP in this situation?

The answer is unknown duration. While the LRP amount is known, its duration isn’t. FIA income withdrawal amounts are paid for life and no one knows when you’re going to die. If you’re married, payments are made for the duration of the lives of both spouses and no one knows when the surviving spouse will die.

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Annuities Deferred Income Annuities Fixed Index Annuities

FIAs With Income Riders vs. DIAs: Which is Right for You? – Part 2 of 5

Retirement Income Center - Puzzle

As stated in Part 1 of this post, while fixed index annuities (“FIAs”) with income riders can be used to provide guaranteed (subject to the claims paying ability of individual life insurance companies) lifetime income beginning at a future date, they aren’t the only fixed income annuity game in town. Of the 12 features offered by FIA’s with an income rider that are listed in Part 1, three are offered by deferred income annuities (“DIAs”), four are applicable on a limited basis, and the remaining five aren’t applicable. The last group is the subject of this post.

The following is a list of the five features offered by FIAs that aren’t applicable to DIAs:

  1. Potential doubling of income amount to cover nursing home expense
  2. Investment value in addition to future income stream
  3. Protection from loss of principal
  4. Potential for increase in investment value
  5. Potential matching of percentage of investment amounts by financial institution

Potential Doubling of Income Amount to Cover Nursing Home Expense

The first feature, potential doubling of income amount to cover nursing home expense, isn’t a standard feature of FIAs with income riders. Of the 184 FIAs that currently offer guaranteed minimum withdrawal benefits (“GMWBs”), or income riders, 53, or less than one-third, include some type of long-term care benefit. When present, the amount of the benefit compared to the standard income amount, as well as qualification for this benefit, varies.

Investment Value in Addition to Future Income Stream

While DIAs and FIAs with income riders both offer the ideal retirement income feature of guaranteed (subject to the claims paying ability of individual life insurance companies) tax-deferred lifetime income, only FIAs also have a traditional investment value associated with them. Psychologically, this is comforting to investors who are uneasy with exchanging a lump sum of money “only” for an income stream who don’t understand the concept that the present value of the future income stream is an investment just like a brokerage account or any other investment asset.

Protection From Loss of Principal

Protection from loss of principal as well as features #4 and #5 are driven by feature #3, i.e., investment value in addition to a future income stream. The investment, or accumulation, value of FIAs, as it’s better known, will never decrease as a result of investment performance. It will either increase or remain unchanged on an annual or biennial basis, depending upon particular stock indexing strategies chosen. In the event of negative performance of a particular strategy, it will remain unchanged.

Potential for Increase of Investment Value

The investment, or accumulation, value of a FIA can increase to the extent that it’s allocated to one or more of the following three investment choices:

  1. Fixed account
  2. Traditional indexing method when the performance of the chosen index is positive
  3. Inverse performance trigger when the performance of the associated index is negative

The last choice, inverse performance trigger, isn’t a standard FIA indexing crediting option. Of the 253 FIAs on the market today, there are only 12 products available from two life insurance companies that offer this innovative strategy.

Potential Matching of Percentage of Investment Amount by Investment Institution

As previously stated, unlike DIAs that don’t have a traditional investment value associated with them, FIAs offer this feature. In addition, of the 253 FIAs available today, 130, or approximately one-half, have a percentage matching, or premium bonus, as it’s more commonly known, feature. A premium bonus is a fixed percentage of the investment in a FIA that’s added by some life insurance companies to the FIAs accumulation value during the first contract year and, sometimes, subsequent contract years, for a specified number of years.

As discussed in previous posts, the availability of this feature, as well as the bonus percentage amount when offered, shouldn’t be relied upon in and of itself to determine the suitability of a particular FIA in a given situation.

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Social Security

Your Social Security Retirement Asset – Part 3 of 3

Retirement Income Center

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.