Editor’s Note: This series is based on Duff’s consumer-friendly book, “Retirement Breakthrough, the Safe, Secure Way to a Guaranteed Income You Can’t Outlive.” In this issue he describes the magnificent benefits of lifetime incomes.
Books, magazines and the Internet are stocked with information about incomes that you can’t outlive. I’m not referring to Social Security here. But, I am thinking of something similar — let’s call it a private security plan. Most books and articles give just enough of the story to get you interested. We need to be more thorough when describing what happens to money spent over 40 or 50 years in retirement.
This article (and the next two or three) is different. I will explain the true tax, asset protection and financial consequences when capital is liquidated into our income. I’ll help you master this subject.
In “Retirement Breakthrough,” I encourage readers to picture their lump sum capital turned into streams of income they can’t outlive. Their payments are on time, every time, and follow them anywhere in the world. They come automatically to a checking account — which pays bills and assures a worry-free lifestyle. There are no more late charges or past due notices. There is more time for dinners out, cruises, golf, tennis, bridge and the grandkids. An income for life is the Holy Grail of financial planning. It can’t get any better.
There’s more. Lifetime incomes can have a special tax advantage that needs to be explained. In case of a foreclosure or unforeseen financial trauma, there may be creditor protection, too. They form the core foundation of a financial plan. And by definition, their most important characteristic is they pay for life. They ease the fear of living too long and having the money run out.
This amounts to a change (breakthrough) in how we think about money. It takes a mental switch to measure capital in terms of what it can possibly pay in income. Clients and prospects assuredly are ready. Their unopened brokerage statements give testimony. Ask someone age 65 this question: “Would you rather inherit $500,000 in securities, or a $3,500 guaranteed monthly income that could last until age 105?" People are alert. Many will take the income. It may be all there is. Running out of money is their worst nightmare.
It’s one thing to leap from accumulation to liquidation thinking. It’s another — in a difficult financial environment — to accurately describe money that provides a steady income stream in retirement. You may have to explain nominal and true interest rates, present and future values, the rule of 72, and available options that are safe and secure. Know also that many people are frightened and confused when they hear about “amortizing,” which is the process of systematically spending one’s money over a lifetime. Consumers are ready for practical solutions to their retirement needs. They want information to come from trusted advisers who are passionate about their messages.
The basic math of liquidating CDs, treasuries, bonds and other securities over time
Today, interest rates are extremely low — say a 3.5 percent, 20-year treasury yield curve; .25 percent on passbook savings and 1.5 percent on a 10-year bank CD. When you consider surrender charges on CDs (interest for one year) and market adjustments for treasuries, it’s easy to get confused and depressed when it comes to accumulating money.
So when you liquidate money, do things get any better?
Example: At age 65, assume a $100,000 10-year treasury CD pays you 3.5 percent interest, about $285 monthly or $3,500 at the end of each one-year period. Instead, try amortizing this capital gradually (on an annual basis) over 20 years, as you maintain a 3.5 percent return on your money. Each payment will be part principal and part interest.
The result: You will receive 20 year-end payments of $7,036 – a total of $140,720. It’s not that simple, however. You’ll have to ladder CDs, bonds and 10-year treasuries and manage some variable cash flow. You’ll also pay taxes on a LIFO – last-in, first-out (interest first) basis. Finally, nothing here is guaranteed. Even 10-year treasuries fluctuate with interest rates and market risk, and they don’t match well with a 20-year liquidation plan.
The tax situation will look like this: An average of $5,000 ($100,000 ÷ 20) annually will be tax-free. But in the first year, when $3,500 of interest is added (and $7,036 received), only $3,536 is tax-free. At the 20th year, about $6,700 of the payment is tax-free. In summary, the annual payment is $7,036, but the taxable portion starts at $3,500. If the taxable portion were levelized, you’d receive $7,036 with $5,000 tax-free every year.
The bottom line: A personal asset liquidation plan which spends treasuries, CDs, mutual funds or other traditional assets doesn’t save on tax. It is daunting to say the least. There is risk that the plan can’t be managed. There is no lifetime contingency in the bargain. There is no levelized tax treatment. There is no spendthrift clause or state specific creditor or lawsuit protection when these conventional assets are liquidated to pay a regular income. Technically, debt repayment plans just don’t offer much extra for one’s retirement income picture. In fact, things could actually seem worse when spending the assets begins.
Note: Most mutual funds do offer withdrawal programs where (a) a level percentage or (b) a specific amount is paid as long as the money lasts. These convenient payout programs reduce the management risk, but they do introduce investment risk. Taxation is still interest first. And, there is always a concern that the money could run out far too soon.
Cash value life insurance that liquidates capital
You’ll find a number of books that offer creative income solutions using cash value life insurance. Be aware: Most are based on estimated/projected interest rates. And, the assumptions may not be realistic.
Example: At age 45, company XYZ offers a $1 million life policy with a $20,000 set annual premium paid for 20 years — a projected outlay of $400,000. It is not a modified endowment contract. At age 66, when cash values are $500,000, you’ll take tax-free withdrawals of $40,000 annually for 10 years until the $400,000 premium cost basis is distributed. Then, you will borrow from the contract as long as the money lasts. The problem is that everything is probably based on returns that might not be attainable in a challenging financial environment.
The problems: Projections could fall short. And eventually, it may be difficult to navigate all the withdrawals and policy loans. In my experience, some advisers illustrate returns that look good on paper, but are difficult to achieve.
This program doesn’t promise a lifetime income either. At some point, the money may run out. When that happens — and the policy’s premium cost basis is spent — policy loans and all unpaid loan interest will be taxed if the policy lapses and collapses in a heap. The death benefit ceases as well.
Observation: I like the idea of maximum premiums into a high cash value, lower death benefit policy — with tax-free distributions to the policyowner. This really wins if tax rates increase in the future. It’s just that the plan design should identify guarantees as its foundation. Then, it’s okay to show projections; it’s not the other way around.
Consider the following example (options 1 and 2) taken from an e-mail I recently received. The insurer wasn’t identified, but the plan emphasized guarantees first and projections next. It was based on assured premiums, death benefits and interest crediting rates.
Option 1 – “A male age 45 at 2nd best preferred rates can buy a $500,000 policy for a guaranteed 20-pay premium of $7,885 per year. This client can stop paying and keep the death benefit or cash out the contract in year 20 for a guaranteed cash surrender value of $229,295. This equates to a guaranteed RR of 3.44 percent on the surrender value before taxes. If he keeps the contract inforce, the guaranteed net IRR on the death benefit in year 40 is 3.8 percent.”
Option 2 – “The same 45 year old male can begin taking a guaranteed $11,000 year of income starting in year 21 for 20 years via withdrawals only and still have a $128,517 guaranteed death benefit leftover. The guaranteed net IRR in year 40 would be 3.16 percent. Essentially, the client withdrew (after a 35 percent tax bracket) a net $40,000 more than his cost basis while maintaining a significant guaranteed death benefit.”
Observations – Option 1
This e-mail seems to make a lot of sense. A guaranteed 3.44 percent tax-free IRR really beats 1.50 percent or so in a taxable certificate of deposit (as does a 3.78 percent tax-free IRR on the 40th year death benefit). But, IRRs on death benefits, cash values and payouts after the 40th year aren’t disclosed. And, after a 20-year withdrawal plan, the policy could collapse just at the wrong time.
Observations – Option 2
In this illustration, 20 years of withdrawals are promised — a total of $157,700 (20 x $7,885 paid-in) and $220,000 (20 x $11,000) taken from the contract. Thus, $62,300 ($220,000 less $157,700) in excess of the premium cost basis will be taxed in the later years of the withdrawal plan. Loans (after basis) may work better, but there is no information about these. The policy information should include what happens after the 40th year. In addition, there should be a carefully crafted warning that a policy lapse could cause unwanted taxable income. I’d suggest a specific example in plain English.
The classic definition of annuity
A personal note: Up to now, I’ve referred to incomes you can’t outlive, income streams in retirement, and/or a private security plan. You might even do better. You could use phrases and terms like, “guaranteed lifetime income,” “a lifelong spending spree,” “optimal income plans,” “personal pension plans,” “comfortable earnings plans,” or “a steady return of your money.” Focus on income planning as consumption driven and not investment oriented.
I haven’t used the term that describes all this thinking — annuity — mentioned in Websters as a “periodic income usually over one’s lifetime.” This definition is the classic or traditional explanation of what an annuity is and always has been.
Clients and prospects have biases. Everyone has heard about Harry who seemingly lost money in an annuity. To some, the word is synonymous with bad news, misfortune and poor investments. The term annuity can wait until you get further into a client discussion with your prospects. When people understand that capital is only worth the cash flow it pays, you’ll be on the same page with your prospects. It will be easier to identify products that match someone’s expectances. The key to your business becomes income annuities. Accumulation annuities, cash value life insurance and long term care sales will take care of themselves.
In the next two articles, I’ll focus on payments from income annuities. This will be fun. We will measure annuity incomes and cash flows with and without life contingencies. I’ll use simple backhanded mathematics or poor man’s actuarial science. This is number crunching anyone can understand.