Income planning basics, Pt. 2: Understanding the flexibility cushion and paycheck planning
By Scott Wheeler
Income planning has grown up, and is now coming into vogue as a valid and real concern for consumers. As a result, the insurance industry has responded with new products, typically in the form of what are generically known as benefit riders. To be sure, these riders aren't free, but they can provide tremendous value for those clients that have done a relatively good job of saving for retirement.
Benefit riders first appeared in the 90s, and from that time, they have evolved, steadily offering more flexibility and value. The first was referred to as the guaranteed minimum death benefit (GMDB). This rider first appeared on variable annuities in the early to mid-90s and guaranteed the policyholder a minimum death benefit, regardless of how the underlying investments performed. Of course, this rider had a charge.
Some years later, the industry developed the next generation rider called the guaranteed minimum income benefit (GMIB). This rider essentially guaranteed a minimum amount of income to the policyholder through an annuitization option, regardless of how the underlying investments performed. And like its predecessor involved a rider charge.
Finally, over the last several years, these riders have evolved again and are now what we know as a guaranteed withdrawal benefit (GWB). This newest iteration has been a boon to the industry, as it has really resonated with advisors and clients due to its deliverability of income along with flexibility through its "withdrawal chassis," which we will look at shortly.
The "flexibility cushion" and continuum
When sitting down with a client there are many factors that need to be considered before an income strategy can be developed. One of the most basic and important factors to consider is how much extra (if any) in retirement savings a client has over and above what they need. The more "cushion" the client has -- which is defined as the amount of savings compared to what is needed to pay the bills every month -- the more the client will be able to enjoy the following flexibility enhancing options during retirement (as they are taking income):
- Allowing money to grow throughout retirement
- Easy access to money for emergencies
- Availability of money upon death
- Inflation protection
When we create our income maps (our form of income planning), we start by estimating or ball parking the flexibility cushion we have to work with -- the percentage of the estimated monthly expenses that will be covered by the monthly income generated from the client's assets (we use a 5 percent est. figure to start).
Here's a continuum you can use as a rule of thumb:
There are many factors to consider when strategizing for income, and the last thing we (or you) want to do is waste time looking at options your clients can't afford. Just to clarify, let's assume a client has $1,500 of estimated monthly retirement expenses and retirement assets of $550,000. At a 5 percent payout, the $550,000 of retirement assets would generate $27,500 per year, or $2,291 per month, which equates to 153 percent of estimated expenses. And, according to our rule of thumb above, in that case we would start with a SPIA with a return of premium (ROP).
The best way to tackle this discussion -- and more importantly, give you something you can use in the field with your clients -- is to go through some hypothetical examples. The numbers and examples we are going to show are for educational purposes only and do not represent particular products. Instead, they are reasonable results one would expect from a general product class (i.e., SPIA's with L/10 payout or income benefit riders).
For all examples, we will assume we are working with a 65-year-old client with estimated monthly expenses during retirement of $1,800 after tax. However, for each example, we will lower the retirement assets available and see how that impacts available options.
In this example, our 65-year-old client has $750,000 of available retirement assets, which, at 5 percent payout percentage, is over 200 percent above estimated expenses. In other words, they have ample cushion. We will consider including a fixed indexed annuity (FIA) with an income benefit rider (IBR) as a component within the overall income strategy.
As part of this developing strategy, assume $420,000 is put to work within an FIA with an IBR that will generate a guaranteed income of approximately $2,500 per month. Now, you should know that this is less income compared to the other options on the continuum above (which we will cover in a moment). But with ample cushion (additional $330,000), our client's attention can turn toward other potential issues -- death benefit, account growth, inflation protection and ease of access for emergencies.
So, let's see what this extra cushion buys. In addition to the $2,000 dollars per month guaranteed, the client also has a death benefit of $200,000 day one, $140,000 after five years, $82,000 after 10 years, and $25,000 after 15 years (assuming no growth in the account). If the FIA experiences just 3 percent average growth through interest credits, the death benefit amounts will be even higher -- $200,000 day one, roughly $167,000 after five years, $128,000 after 10 years, and $85,000 after 15 years.
In addition, with some FIAs, the income itself can be indexed; based on the indexes chosen, the monthly income could grow over time. This could act as a COLA-type adjustment to their monthly income (at just 3 percent inflation over 20 years, a dollar today is worth just 60 cents in 20 years!). And of course, as long as there are funds within the account value, the client can access that money for emergencies (withdrawals will reduce the guaranteed income available).
In this example, our 65-year-old client has $470,000 of available retirement assets, which puts us about 150 percent (at 5 percent payout percentage) over estimated expenses. So, this is a situation where the cushion is not as high (middle of the continuum above). This will inevitably direct the discussion toward squeezing out more income, inevitably reducing flexibility.
In this case, let's look at $310,000 going into a SPIA with a lifetime payout and a return of premium rider (return of any residual of premium paid over income received). The first thing you will notice is that for 25 percent less payment, this option generates almost the same monthly income as the first option -- $2,200 per month compared to $2,500 from above.
In addition to the $2,200 monthly income amount, the client has a death benefit of $200,000 day one, $125,000 after five years, $50,000 after 10 years, and nothing past 13 years. In addition, there is no option for keeping the money growing, battling inflation and limited options if a financial emergency arises (just $170,000).
Finally, our 65-year-old client has only managed to save $340,000 of retirement assets, which puts us about 100 percent (at 5 percent payout percentage) over estimated expenses. So, this is a situation where the cushion is low. This will focus the entire exercise toward one thing: maximum income. Future flexibility is not an option in these kinds of situations, so the $280,000 will go into a SPIA with a lifetime payout option. The first thing you will notice is an uptick in income compared to our prior two examples, with far less premium paid -- $2,252 per month. We can't go any further, since each client needs to have some liquid funds available; in this case, just $65,000 is left for emergencies.
Unfortunately, the client has no death benefit and very limited options if a financial emergency arises. But like we addressed before, without enough income to live on every month, other benefits hardly seem important.
Taking it down to a "paycheck" for clients
When you are discussing IBRs and looking to include them as part of an income strategy, make sure you know how they are treated for taxes. Income generated from IBRs are based on the withdrawal rules - requiring it be treated as interest first (gains first) followed by recovery of basis (after basis the rest is taxable). This is commonly known as LIFO.
Let's assume that the FIA with an IBR example above (ample cushion) is a nonqualified annuity. Any premium bonus or interest credited to the FIA will be deemed to come out first in the form of monthly income payments, followed by principal.
Be aware that in the real world, where index-based interest credits within an FIA are sporadic from year to year, the paycheck available can fluctuate dramatically (Note: there will likely be sporadic index gains throughout the income payout, creating unpredictable paychecks, which we will discuss in part three of this series).
Just to play devil's advocate, if the FIA didn't have a premium bonus and didn't receive any index-based interest credits, all monthly income payments would then be return of basis. On the other hand, if the FIA had a premium bonus and, say, 3 percent annual interest credits, the monthly income payments for the first several years would be 100 percent taxable followed by basis.
However, when considering an annuitization option like we did above (life with return of premium or life only), income payments will be taxed under Section 72 of the Internal Revenue Code. This is known as the exclusion ratio -- in essence, every income payment represents a partial return of principal (or basis), along with some earnings. Our "medium cushion" income payment was $1,250 per month, or $15,000 per year. Roughly 60 percent, or $9,000, would be excluded from tax. At an assumed 25 percent tax bracket, the income paycheck amount would approximately $1,125 per month.
In the last example, which we labeled as "little cushion," we showed a lifetime payment of $1,352, which is $16,224 per year. Roughly 62 percent, or $10,059, would be excluded from tax. At an assumed 25 percent tax bracket, the income paycheck amount would approximately $1,224 per month.
Don't forget, it's not enough to show your clients what they will have in guaranteed income every month. You need to go further and show them what they will have to spend. For most of your clients, they have been living off of paychecks their entire lives. By taking the time to show them what they will have to spend, you'll be talking their language. Besides, it appears taxes aren't going away anytime soon.
*For further information, or to contact this author, please leave a comment and your e-mail address in the forum below.