Archives for April 2010

This is a guest post by Evan, author of the Blog My Journey to Millions.

Mike recently wrote an interesting post about using a Single Premium Immediate Annuity to protect the inheritance you intend to leave behind. He suggested creating two separate buckets for your assets:

1. A Single Premium Immediate Annuity (SPIA) for your income needs, and
2. A portfolio of other investments, intended to be left for your heirs.

Just so I don’t confuse myself I will call them Insurance Bucket (used to buy the SPIA) and Investment bucket (Investments).

But what if we turn what Mike suggested on its head? Can we use the investment bucket to provide income and the insurance product(s) for inheritance?

Note: The following strategy will only work in a small percentage of cases. We need an older person, who has a really good amount of money and is healthy.

SPIA-LI Arbitrage

In this planning technique we play two life insurance companies against one another. One will be betting on the fact that you die and the other is betting on the fact that you’ll live a long life.  Let’s use an imaginary man named Bob:

• Bob is a really healthy 70 year old male (DOB: 1/20/1940)
• Bob is living off his investments, but he doesn’t “need” all of them. (That is, he can get by with a withdrawal rate well within the “safe” range.)

In Mike’s plan, we would let the investment bucket be the inheritance and use the SPIA bucket to provide income.  I am flipping that around. We’ll leave enough in the investment bucket to live off of. Then we’ll purchase two competing insurance products with the SPIA Bucket (which, as an example, we’ll assume to be $350,000):

• $350,000 will buy $2,379/month in income from a 150 year old, AAA Rated Insurance Company;
• We’ll then use $2,000 of that monthly payout to pay the premiums on a Guaranteed Universal Life Insurance Product which provides a little over  $800,000 in Death Benefit!

Why did I use $2,000 instead of $2,300? To cover income tax on the SPIA’s payments.

Why does this strategy work?

An arbitrage is created because life insurance companies go through medical underwriting on a life insurance contract, but not on an annuity product. On annuity products they just use life expectancy tables based on your age.  So in my example:

• Life Insurance Company A (knowing about your good health) is betting that you will live for a long time and that they will get to collect your premiums, and
• Life Insurance Company B (unaware of your good health) is betting that you will die exactly in keeping with typical life expectancy tables, at which point they can stop paying your monthly annuity payment.

But, Evan you stacked the deck!

Of course I did. I said above this is only going to be used in a small amount of cases. If you have a struggling retiree who weighs 285 pounds and has 42 years of smoking behind him…no dice.

Benefits of Creating a SPIA-Life Insurance Arbitrage

We took $350,000 and turned it into $800,000 for heirs – this is the biggest benefit.

Another side benefit that can be looked into (if the numbers were bigger) is that the Life Insurance can be owned by a Trust and then not included in your estate when calculating your estate taxes.

Drawbacks of this Technique

The most obvious downside is that this strategy only works in a small number of cases. The second negative is that once you put this into place, it is very hard to get out of.

Evan is an attorney, admitted to practice in the State of New York and works as a Director of Financial Planning overseeing the firm’s high net worth gift and estate planning. His blog covers topics ranging from Estate Planning, to his personal financial situation, to libertarian views and hatred for big government.

If you’re at the point where your portfolio is large enough that your annual spending can be satisfied using a withdrawal rate that’s likely to be sustainable, you don’t need to annuitize any of your portfolio.

But should you do it anyway?

What about buying a single premium immediate fixed annuity large enough to completely fund your living expenses? That would allow you to treat the remainder of your portfolio as an “accumulation portfolio” rather than a “distribution portfolio.” The benefits being that:

• If you wanted to, you could invest it aggressively, because its time horizon is now that of your heirs, and
• You will have eliminated the return-damaging effects caused by DCA’ing out of a volatile investment.

When you don’t need to annuitize, the question of whether or not to do it anyway is basically a “break even point” calculation. If you end up living long enough, the return provided by an annuity will make it a great investment, even if you didn’t need it as a risk management tool.

A Silly Example to Make a Point

If you knew with 100% certainty that you were going to live to be 150, an annuity would be a super idea, regardless of whether or not you needed to buy one. The guaranteed payout provided by the annuity would be far higher than the payout that could be safely provided by drawing down a portfolio of stocks, bonds, and cash over that time frame.

The end result: Annuitizing would dramatically increase the amount that you leave to your heirs. (In fact, it could even be wise to annuitize your entire portfolio. The portion of the annuity’s payout that you don’t need to fund living expenses could be used to start building a new “inheritance portfolio.”)

Annuities and Inheritances in Real Life

Of course, in real life you don’t know how long you’re going to live. So–as with much of investing, and retirement planning in particular–it’s somewhat of a guessing game. My analysis would look something like this:

1. What inflation-adjusted payout can you get from a single premium immediate fixed annuity?
2. If you used that payout as the withdrawal rate for a portfolio, when would you expect the portfolio to run out?
3. Do you expect to live longer than that?

If so, an annuity makes sense even if you don’t need one. And the more certain you are, or the longer past that date you expect to live, the more sense it makes to annuitize.