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Arbitraging a SPIA and a Life Insurance Policy to Create an Inheritance

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.

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Comments

  1. Thanks for the guest post, Evan. 🙂

    What I find interesting about this strategy is that it’s a bet on how long you’ll live.

    For example, if you end up living only a few years after implementation, you’d have been better off skipping the SPIA completely and just paying the Life premiums out of a typical retirement portfolio.

    Alternatively, if you live a very long life, it’s likely that the $350k would have turned into more than $800k via other investments. (For example, if the investor lives another 20 years, to age 90, the return is only 4.2%, which could be beaten with just a 20-year T-Bond.)

    This strategy is essentially a bet that you’ll live somewhere in the middle.

  2. It’s an interesting twist- but I think I would feel better if I had living expenses without risks and kept the inheritance as a variable investment because my children can earn their own income when they are adults… I don’t want to risk running out of $ at 90.

    -Rick

  3. “This strategy is essentially a bet that you’ll live somewhere in the middle.”

    But don’t most people live to somewhere in the middle?

  4. And Thanks for letting me write this!

  5. “But don’t most people live to somewhere in the middle?”

    Right. I’m not saying that makes it a bad strategy. I just think it’s worth noting.

    In my experience at least, most investors don’t make explicit guesses as to their life expectancy when they’re planning their retirement. (That’s understandable, given the unpleasant nature of giving yourself a predicted expiration date.) But it’s unfortunate, I think, because which retirement investment strategy ends up being best for you depends largely upon how long you end up living. Better to use some guess than no guess.

  6. Rick,

    Thanks for commenting. I don’t think this type of arbitrage is for everyone, but I think you may be confused.

    ” but I think I would feel better if I had living expenses without risks and kept the inheritance as a variable investment ”

    Does that mean when you get a little older you are going to put everything into a SPIA? As not to run out of money?

  7. If you take the $350,000 out of the mix you’d better be sure you don’t need it. The insurance salesman is a pretty happy recipient in this scenario, having sold not one but two products. If the person is indeed that healthy, there’s a reasonable chance he’ll live to be 90 and a slight chance he’ll live to be 100. $350,000 invested at 4.22% for 20 years equals $800,000 and $350,000 invested at 2.79% for 30 years equals $800,000 (ignoring tax issues for simplicity… consider it an after-tax rate or the person possibly has tax-deferred or tax-free investment accounts). Plus, you keep the dollars for your life if you need it. Lastly, for most people, a goal of “leaving my kids a big inheritance” is a far distant second to “providing for myself and my spouse for our remaining lifetime.”

    Buy insurance when you need it (ie, if your premature death and cessation of earned income would cause financial hardship to your family), not to fund a “would be nice to have” goal at the expense of a “have to have” goal.

  8. Just because an insurance salesman is getting paid, doesn’t mean you should immediately dismiss this strategy.

    “If the person is indeed that healthy, there’s a reasonable chance he’ll live to be 90 and a slight chance he’ll live to be 100. ”
    – Reasonable? Slight? Arbitrary words don’t work in my office, I produce excel spreadsheets that tell the client where the cross over would be (and there is one like I showed above) and they make the decision.

    “ignoring tax issues for simplicity… consider it an after-tax rate or the person possibly has tax-deferred or tax-free investment accounts.”
    When I am working with these kinds of numbers I can’t just ignore tax rates. Which canquickly become 45 – 55% if that money is then included in your taxable estate (45% 2009 rates – 0 this year (maybe) and 55% next year over $1mil in assets). This stategy combined with gifting and an ILIT can remove a lot from a person’s taxable estate.

    “Buy insurance when you need it (ie, if your premature death and cessation of earned income would cause financial hardship to your family), not to fund a “would be nice to have” goal at the expense of a “have to have” goal.”
    – While that may be he norm in your practice, and to be honest, in most people’s lives. Then this strategy would not be for them, but it could be discussed and shot down, no?

  9. You’d be pretty hard-pressed to find someone who doesn’t earn their living selling insurance to support this.

    By the way, there’s no arbitrage involved. Actuaries are a lot of things but stupid isn’t one of them. They know good and well that annuity buyers are typically healthy and have long life expectancies and they price annuities accordingly.

  10. “By the way, there’s no arbitrage involved.”
    There is an arbitrage and I explained it above (and I even think I proved it with numbers).

    “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. ”

    Most SPIAs do not involve a health test, so you might be on the way to live to a 100 but they are lumping you together with every other 33 year old (in my example).

    I would never call an actuary stupid! They are some of the smartest people out there (maybe some are anti-social, but not stupid lol).

    I am enjoying the discussion though!

  11. |Hey,

    I had never thought of these options. I’d always adhered to the theory of decreasing responsibility which suggests that once all of the debts are paid off and kids are gone, than there’s really a minimal if any need for insurance.
    Thanks for showing me another option, I’ll look into it a bit more.

    Cheers,
    Guy

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