Providing You with more guaranteed income with less capital
Immediate annuities that pay a guaranteed monthly income over a predetermined time period are in the family of annuities known as the â€œPeriod Certain Immediate Annuities.â€ These annuities liquidate principal and interest over the â€œcertain period.â€ At the end of the period, the contract is terminated with no value. These plans are generally available in 5-25 yr guarantee periods. These annuities generally provide large payouts since the principal is systematically liquidated and interest is paid over the period certain. Investors are generally unable to duplicate this guaranteed liquidation model on their own since they are unable to guarantee liquidation rates. For example, long term 15 year bonds rated AA guarantee similar interest as a 15 yr. AA rated insurance company annuity. Liquidating small pieces of a 15 yr bond to guarantee monthly payments is impossible since the value of the bond will fluctuate over the 15 year period and commissions need to be paid on the liquidated bonds. The period certain annuity guarantees the liquidation rate each month and shifts the liquidation risk to the insurance company which hedges its risk. In effect the period certain immediate annuity is a high quality bond with a guaranteed put on the monthly liquidation price.
If death should occur before the period certain term ends, the income guarantee continues to be paid to the named beneficiary until the end of the period certain. Some companies allow a lump sum payment at death and or during life. This is called the right of commutation and the few companies that offer this commutation benefit have different methods of calculating the commuted value. The commuted value, when available, is not usually very attractive except in cases where immediate cash is necessary. This is because there can be a big discounting that occurs, particularly if interest rates have increased since issue of the plan. The benefit can help though when there is no other source of capital. While we can and do search for companies that provide this benefit when it is requested, we always like to break down the cost of the provision since the companies that provide the benefit are not always the most competitive. Our feeling is that the period certain annuity is suitable for generating high guaranteed cash flow for income investors that want safety and persistence with a large guaranteed payout to fill in an income gap in their life.
Period Certain Annuities Favor Long Term Payouts
Since insurance companies are generally long term investors, the period certain annuities generally provide more value to investors when implemented with longer guarantee periods since long term rates are generally higher than short. While the monthly payout on a shorter maturity period certain annuity is larger than those of longer term plans, the interest rate provided on the shorter maturity plan itself is generally lower. Our experience with these annuities is that they are very attractive at the 15 year or higher guarantee payment level.
Uses of the Period Certain annuity
The most common use of the period certain annuity is to fill the gap of income until a specific date or occurrences.Â For example, a retiree at age 55 may elect a 10 or 15 year period certain annuity to fill in the gap in income until social security starts. Under this scenario, the period certain annuity can be designed to stop payments the day that social security starts. Over the 40 years we have been in this market we have implemented these plans for all kinds of income gaps including deferred retirement dates, forecasted inheritance etc.
Many young investors that need income (50â€™s to mid 60â€™s) are looking for certainty of monthly income. For these younger investors, an immediate lifetime annuity that guarantees income for life may not be very attractive because the high life expectancy means less principal is in the payment bringing the total payment down. The period certain annuity, when the period selected is less than the life expectancy, brings in a larger cash flow than the life annuity. As the time goes by, the life annuity becomes more attractive with decreasing life expectancy as the period certain period winds down. Using a period certain annuity to bridge to the life annuity is a strategy that makes good sense for middle age investors that are looking for guaranteed income since they can assure safe and persistently high guaranteed income
For those individuals that need to provide a guaranteed income for assisted living and other health and or old age arrangements, and when the life expectancy is greatly reduced, the period certain provides the simplicity and persistency of high guaranteed income to handle the plan. We have recommended these plans to families seeking to fund expenses for loved ones where life expectancy is short since the guaranteed payments can be continued to the beneficiaries, returning the principal when early loss of life occurs. This type of arrangement may warrant a commutation of benefits plan at death and we always present a company with this option for this type of need.
Increasingly, we have noticed more investors are looking to enjoy their money early in life when their health is good. These investors feel that the money is needed as early as possible in the retirement period. These investors as well as those that feel their life expectancy is limited opt for the period certain annuity because of the higher cash flow payment and the certainty of the persistent guaranteed income. These investors perceive that as they get older, they will not need as much money for the activities that they enjoy now like traveling, golf and other activities that require mobility. They therefore opt for maximizing guaranteed income for the period certain when they feel they will enjoy the income the most.
Taxation of Benefits
When the period certain annuity is purchased with IRA or other qualified plan money, the entire payment is taxable. When the investment is made with dollars that have already been taxed (Non Qualified), a portion of the payment is considered interest and another portion principal. The shorter the period certain the more the payment is considered principal and not subject to income tax. The taxable portion of the payment is predetermined and level over the life of the annuity. The insurance company at time of investment discloses the taxable vs. non taxable portion of the annuity in the form of an exclusion allowance or ratio. This exclusion ratio simply states the percent of the payment that is excluded from income taxation. This amount represents the level principal withdrawal amount in each payment.
Tax Benefits and leverage
For Ira or qualified plan investors, since the full payment is taxable there are no special tax benefits. The Non Qualified annuity however does provide more spendable or net cash flow since the amount excludable for income is a large part of the payment. This benefit is more pronounced with higher tax bracket investors particularly with shorter period certain payout periods. This larger spendable income brings the equivalent return of the plan much higher than similar risk investments. This higher relative income allows the investor to tie up less capital to provide the guaranteed income and thereby allows more of the estate to grow to replace the principal being liquidated.
Annuity Provides risk free leverage
All immediate annuities provide significant capital leverage benefits since they use the guaranteed rate of liquidation of principal to create high guaranteed cash flow. This leverage is more pronounced on a period certain annuity. For a Non-qualified investor (annuity purchased with money that has already been taxed) in a period certain annuity we demonstrate this leverage. Assume that a 15 year AA corporate bond yields 4%. In the 20% tax bracket the yield on the bond is 3.2%. To guarantee $1,000 per month of spendable income would take $375,000 in capital with the AA 15 yr. bond. At the end of the 15 year period, the bond would be worth $375,000. A 15 yr. period certain annuity generates $1,000 after taxes guaranteed for 15 years from a AA insurance company for this same investor when an investment of $144,804 is invested. The difference in the capital requirement is $230,196. A 15 yr deferred annuity from a AA insurance company guarantees 4.5% compounded interest. If the $230,196 is invested in a deferred annuity yielding 4.5%, in 15 years this difference in capital would be guaranteed to be $445,494. Investing the freed up capita more than replenishes the immediate annuity capital that is depleted guaranteed. Since the bond and the insurance company are both rated AA, the credit risk is the same. However, the leverage provided by the higher guaranteed payout from a guaranteed rate of liquidation, frees up the capital for other uses. Perhaps the investor would want to be a bit more aggressive than the AA deferred annuity.
If we assume that the investment will be made from an IRA or other qualified pension plan where all of the income is taxable, then in a 20% tax bracket, the pretax income requirement is $1,250 to generate $1,000 of spendable income.Â A bond rated AA for 15 years yielding 4% would take $375,000 to generate the after tax income of $1,000. The 15 yr period certain annuity for $1,250 nets $1,000 after taxes in the 20% tax bracket. A 15 yr. annuity paying $1,250 requires an investment of $172,386 thereby freeing up $202,613 in capital Â to produce the same spendable income as the AA bond. At the end of 15 years, the $202,613 would grow to $392,114 if invested in a deferred annuity rated AA guaranteeing 4.5% for 15 years, more than replacing the capital liquidated by the immediate annuity guaranteed.. Once again, the risk is the same since both the bond and insurance company have AA ratings. The leverage of the annuity comes from the guaranteed liquidation rate.Â An investor could attempt to liquidate a bond to create the same cash flow as the annuity. However, bond prices will fluctuate until maturity and commissions would have to be paid so that investors could not duplicate the guaranteed liquidation rate given by the annuity. The insurance company assumes the risk of the liquidation losses.
Selecting an insurance company(s)
There are a small number of insurance companies that offer immediate annuities and even fewer that are consistently competitive in the market. Rates from companies vary weekly depending on insurance company investment opportunities and current reserve levels. Companies therefore literally come in and out of the market weekly. Company strength or credit ratings are important as well. In looking at ratings, we feel it is important to look at all of the rating agencies, not just one. A.M. Best, Standard and Poors (S&P), Moodys and Fitch are the major rating agencies that analyze the credit quality of insurance companies. We prefer to look at all of the agencies as they may have done their analysis at different times and may have opinions we should be concerned about. The problem with using the multiple rating agencies is they all use a different rating scheme. For example, A+ is the second highest rating for A.M. Best. However, an A+ rating from S&P is the fifth highest rating. For this reason, insurance insiders use the Comdex score. The Comdex score is not a rating but a score which normalizes the different rating agency ratings and expresses them numerically. A Comdex score of 90 for example means that the company has a stronger financial profile than 90% of all companies rated. We feel that the Comdex score pays attention to all ratings, normalizes those ratings and expresses the score in a form that has meaning. While we quote companies with low scores we prefer companies 90 or better.
Very few companies provide significantly different rates for larger annuity investments. For this reason, it may be desirable to purchase multiple policies from different companies. Since most annuitants have their monthly payment deposited to their checking account, purchasing multiple annuities is only extra work for the agent. If it costs you little to diversify companies, it certainly makes sense to do so. Moreover, each state has an insurance guarantee association that backs up your annuity benefit should a company become insolvent. All state guarantee associations have limits on the amount of benefit they provide to each annuitant from one company. Purchasing multiple companies to stay in the limit for a state may make sense if it does not cost much in reduced overall payment. Additional information on the state guarantee association can be obtained for each state at http://www.nolhga.com/factsandfigures/main.cfm/location/stateinfo . Additional information on the Comdex score can be obtained at the following two links on the internet. http://www.ebixlife.com/vitalsigns/comdexconfus.aspx , http://www.lifelinkcorp.com/vitalsigns/comdex_ps.asp?nb=29&sb=11.