Insured Annuities for Wise Bloggers

by Nora Dunn on 17 September 2007 16 comments
Photo: taylorkoa22

Have Your Cake And Eat It Too With Insured Annuities

Today's seniors are often concerned with covering their living expenses while still preserving their hard-earned capital for their beneficiaries. They are also typically more conservative investors, not willing to bet their life savings on higher risk/reward investments.

Yet they don't have enough money to kick off an income that will provide for their expenses without encroaching on the capital itself.

Or, they have loads of money, but are paying tax year over year on the interest income, and are sick of seeing a chunk of their cash going to the taxman.

In either of these cases, utilizing a concept called the Insured Annuity would be perfect.

 

The Insured Annuity is a concept that involves the use of two different insurance products; an Annuity to provide tax-preferred lifetime income, and Life Insurance to guarantee the capital.

The best way to demonstrate this concept is with numbers.

 

Primary Market: Single seniors aged 65+, with heirs

  • Desire for the highest possible guaranteed revenue stream
  • Wants to leave something for their heirs
  • Looking to minimize taxes
  • Desires safety against volatile markets

 

Example: Female, aged 77, 2 children and 3 grandchildren

  • $500,000 in assets, invested in secure investments yielding 4% interest/year
  • Wants to leave the full $500,000 to her heirs
  • For illustration purposes, assume she is in a 25% tax bracket

Given her current situation, her annual income from the $500,000 is $20,000, fully taxable. After tax, she receives $15,000.

 

Insured Annuity Option:

  • Purchase a $500,000 Life Annuity with a 10 year guarantee option. (This means she gives up the $500,000 to the insurance company, who in turn uses it to provide her with a steady lifetime guaranteed income. If she dies in the first 10 years, the insurance company will guarantee the 10 years of payments to her estate).
  • Annual income from the annuity: $48,031
  • Taxable portion: $9,569
  • After-tax income from the annuity: $45,639 (The taxable portion is so small, because the insurance company is paying out part capital, part interest as the annual income). 

Is this too good to be true? Right now, yes. She has given up the full $500,000, and currently has nothing to give to her heirs. To get around this, she purchases a $500,000 Life Insurance policy.

 

Cost of a Term-100 $500,000 Life Insurance policy: $25,575

 

After-tax annuity income: $45,639

Subtract life insurance premiums: ($25,575)

 

Final after-tax income with the insured annuity concept: $20,064.

 

Bottom line: She just paid less tax to the tax-man, increased her after-tax income by over $5,000/year, and guaranteed her full principal to her beneficiaries!

 

Additional benefits:

  • With her original situation, she was at the mercy of the prevailing interest rates determining her income. Right now it is around 4%, but it fluctuates, which makes it hard to plan.
  • Since the $500,000 is paid to beneficiaries as a life insurance payment, the lengthy probate process is circumvented, and the distribution of insurance proceeds is private (read: not subject to contesting in the will).
  • What if in our example, she doesn't need the income from the $500,000? She could use the annuity income to purchase an even bigger insurance policy for her heirs or charity: approx $900,000.
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Guest's picture
Linda

For years I have been confused about annuities, although my broker keeps pushing them. Your explanation was the FIRST ONE to make sense to me. Mind you, that doesn't mean I'll be getting an annuity, but thank you for the clear and concise explanation of how they work.

Guest's picture

Thanks for the annuities information, I hadn't geiven them much thought before.

Guest's picture

Hi Nora - what a great post on the Insured Annuity Strategy. For those that don't know - this is a very commonly used strategy for those who would like to reduce taxes and increase cashflow - so in other words, pretty much everyone.

There is one catch though - in that you have to be in good health in order to get an insurance premium low enough that the strategy will make sense. If you are of "average" health for people your age - then the quotes generated by insurance policy illustration software is the going rate. If you qualify as healthier than average then the strategy will really start to look like a no brainer. Unfortunately, if you are below average health then the strategy may become untenable as the insurance premiums are too high...

I suppose the other flipside is that you DO give up the use of the $500,000 (in this case) which may tie your hands if you need to make an "extraordinary" one time purchase (i.e. for an emergency). If that is something you are worried about, then you could always do a half and half strategy - i.e. do the insured annuity strategy for $400,000 and keep $100,000 on hand just in case. (Okay, I realize that's not technically half and half... :) )

For those who would like serious peace of mind - this is definitely a strategy worth investigating.

Nora Dunn's picture

Actually, you don't necessarily need to be in terrific health to get a good deal with an insured annuity. See - with this concept, you're playing both sides of the insurance fence.

If you are in poor health, you indeed may have higher life insurance premiums (because the insurance company figures you're a higher risk of dying sooner than later and they want to get enough money in premiums out of you to justify giving you the policy).

BUT - You're also getting an annuity, and since you are in poor health, the insurance company will give you a higher income since they figure you have a reduced life span.

So as long as you are in good enough health to qualify for life insurance at all, the numbers generally work themselves out.

 And a great observation on having a little additional cash on hand.....it's always prudent to have an emergency reserve. The example I used in the article is fairly narrow in scope, not taking into account what the entire financial situation looks like.

@Linda: You're welcome! I love it when people get it! Not that I specifically recommend any of these products for everybody (you are right in that you need to make the best decision for yourself) - I just want people to understand them.

Guest's picture

Another good point but do you find that the spread always works in favour of the insurance company for both the annuity and the life insurance? By that they are charging more for the premium than necessary for profit and margin of safety and they are underpaying on the annuity for the same reasons - I think that when health is less than average the insurance premiums go up faster than the annuity payments do they not?

In the end I suppose you have to actually get the quotes on both before seeing if the strategy is viable for any one person's situation.

Guest's picture
Guest

Under the scenario you painted my choices are $15,000 a year income and $500,000 in the bank or $20,000 a year income and $0 in the bank.

No brainer, I'll take the half mill thank you. Why? Because your scenario is highly flawed.

Your analysis falls short in two key areas. First, the interest rate you qoute as a return for the non-annuity scenario is ridiculously low. The fact is the spread between what you can earn safely on your money and what the annuity is paying isn't nearly as wide as you state it is. When you recaculate using accurate return rates what you suggest makes no sense.

Also what you fail to mention of extreme importance to your analysis is that you put yourself in a position where you have no emergency fund. That is about as poor an idea as anyone could possibly suggest as financial advice. The whole reason we save and invest is to have an available supply of funds to draw on not just live on but to deal with unforeseen expenses and emergencies. Under your scenario if an extraordinary cost arises there isn't anyway to deal with it other than borrowing money. Bad, bad, bad.

Your example does NOT reflect real world conditions. But it is a great suggestion if you happen to sell either of or both of these vehicles. Commissions are a wonderful thing.

Myscha Theriault's picture

I believe you were just trying to illustrate the concept with simple numbers, not tell people to ignore a savings plan . . .

I had heard about the annuity strategy before, but under a completely different scenario.

Nora Dunn's picture

Thanks Myscha for your understanding that this is just a concept, separate from what a full financial plan should look like. In fact, I also mentioned something to this effect in my last comment here.

re: Interest Rates - ING 's Orange Savings Account (a liquid guaranteed investment which many seniors gravitate towards) is currently paying out 4.3% interest. If this is off base and there are other liquid guaranteed investments that yield higher returns, then please do share them with us all! I'd love to see what "accurate" looks like. I'm game for making the most money that I can!

"But it is a great suggestion if you happen to sell either of or both of these vehicles. Commissions are a wonderful thing."

I hope this isn't an implication that I might be trying to gain business through Wise Bread. I couldn't make commissions or get business through Wise Bread if I wanted to! Belive it or not, I actually just write to educate and provide thought-provoking articles.

It's such a shame that we are constantly shrouded in suspicion of being "pitched" to in some way, or fearful that a hidden agenda is always prevalent. It says something scary about our society in general. 

Guest's picture
Jon

With $500k, getting over 5% shouldn't be too tough. Even good old Bank of America has a 5.55% money market savings account if you have at least $50k (check out their MyExpression accounts). Just using that will give after-tax income of $20,812.50, which out-does the annuity idea.

More importantly, ALL of the income being taxed at the 25% rate implies that she is earning approximately $30k to $50k aside from this income (since otherwise the effective tax rate would be less than 25%). If that's the case, and she expects to continue to receive that income, she can probably increase her risk in the investment and earn a higher return (maybe put 30% in stocks?).

If that's not the case (i.e. she will lose that other income), then we need to look at the effect that has on her taxes. $500k @ 5.55% investment income, using 2007 tax tables, will give her $23978.75 after taxes (effective tax rate of 13.6% instead of 25%), which is quite a bit better. That's also ignoring the standard deduction and any other deductions or credits she might have, which should push it to $24500 or more.

Myscha Theriault's picture

I'm with you on that. It's one of the reasons I believe so strongly in what Wise Bread is trying to do. I've always been an educator at heart.

With things the way they are these days, I feel that financial education is more important than ever. Gaining independence from the rat race early has enable us to focus completely on projects and ideas that we value greatly. Can you imagine the power of what our world could be like if everyone was in such a place?

Keep those financial strategies coming, Nora!!!!!

Guest's picture
Guest

"re: Interest Rates - ING 's Orange Savings Account (a liquid guaranteed investment which many seniors gravitate towards) is currently paying out 4.3% interest. If this is off base and there are other liquid guaranteed investments that yield higher returns, then please do share them with us all! I'd love to see what "accurate" looks like. I'm game for making the most money that I can!"

I can list over 10 different accounts from various brokers, banks, credit card companies and other financial institutions that all pay over 5%.

Every single one of them liquid. Every single one of them FDIC insured.

Thing I don't get is how anyone, I mean anyone, can't find them. I just received in the mail today an offer for a money market account from a credit card company yielding better than 5%. You can't search the web for such accounts and not find them. I'm currently yielding 6% on a savings account (though the rate on this one is set to readjust at the end of September).

Yeah, some have limitations like high minimum balances but put into the context of the scenario presented it is a non-issue.

I'm sorry, but if you can't find a wealth of offers yielding better than 5% something is terribly wrong.

Guest's picture
Ermos Erotocritou

Despite what some skeptics are posting, your concept is rock solid.

Putting 30% in stocks as Jon states is not an option in most cases. Someone who is 65 years old today is not that far removed from the last depression which means that he/she would rather stick their money under a mattress (or stick needles in their eyes) than experience the risk of losing a dime in the markets.

As far as your return estimate, I still say it's bang on. First of all, money market funds are not guaranteed as one skeptic claimed. A vast majority of Americans/Canadians get zilch on their bank accounts much less the 4+ you were stating or the 5% or 6% that is avaialable at some obscure financial institution run by Guido out of his basement.

Lest we forget that as the Fed drops interest rates like Britney Spears drops babies, returns on short term savings will continue to deminish.

Keep up the great work Nora. I enjoy all your articles.

Guest's picture
Ermos Erotocritou

Despite what some skeptics are posting, your concept is rock solid.

Putting 30% in stocks as Jon states is not an option in most cases. Someone who is 65 years old today is not that far removed from the last depression which means that he/she would rather stick their money under a mattress (or stick needles in their eyes) than experience the risk of losing a dime in the markets.

As far as your return estimate, I still say it's bang on. First of all, money market funds are not guaranteed as one skeptic claimed. A vast majority of Americans/Canadians get zilch on their bank accounts much less the 4+ you were stating or the 5% or 6% that is avaialable at some obscure financial institution run by Guido out of his basement.

Lest we forget that as the Fed drops interest rates like Britney Spears drops babies, returns on short term savings will continue to deminish.

Keep up the great work Nora. I enjoy all your articles.

Guest's picture
shirley brooke

you buy a term 100 $500,000 life ins for $25,575. so you spend $26k then when you die your family get4 $500k as an annuity , right? Yuo buy a fixed annuity, ladder bonds and buy stks or mutual funds. Wouldn't this be diversified enough even if you are 65 and retired to get you thru the next 20-30 years? And still be somewhat safe and secure?

Nora Dunn's picture
Nora Dunn

@Shirley - Your strategy could very well be the best strategy for some people. However it is not guaranteed. You buy the life insurance to guarantee the principal, but it does cost a pretty penny ($26k/year). By taking the principal ($500k) and investing it in ladder bonds, stocks, and mutual funds, you do a few things:

1) Your returns won't be guaranteed, nor steady, and will fluctuate with both the stock markets and interest rates. This can be harrowing and very stressful for some seniors.

2) Your fixed income investments (eg: the bonds) will generate interest income, which is fully taxable, and may further decrease your after-tax income.

The best thing to do is consult with your financial planner who can help you determine the best investment strategy for you.

Thanks for the comment!

Guest's picture

Every retiree has his own savings that they need to turn into a source of income. And annuity is designed exactly to do so. That’s why there will always be a logical appeal to annuity. But choosing an annuity product is not always an easy task as it comes with a lot of variety. Your calculations are very helpful to get a clear scenario of Insured annuity.