The best income planning tool
By Jason Konopik
Income planning has been the talk of the town in the insurance industry for the last decade. This is due to the more than 75 million baby boomers transitioning over the next 15 years from income accumulators to income harvesters. Combine that with the 60 million people already looking to harvest wealth and you have nearly $3.5 trillion in total wealth - and it is easy to generate a lot of excitement about this wealth distribution opportunity. However, the income solutions currently being promoted to clients don’t offer a lot of excitement.
The life insurance industry offers more tools and suitable solutions for these clients than any other industry. So why haven’t more insurance producers been focusing on this opportunity? It all comes down to education and, unfortunately, we have only been educated on some of the tools available.
Indexed universal life (IUL) is one of the most stable accumulation and income generation tools available. Traditionally, the words “life insurance” conjure visions of mutual insurance companies peddling participating whole life with very limited upside potential, or other companies pushing variable universal life (VUL) with no downside protection. Indexed life, however, provides significantly greater upside potential than traditional fixed life insurance does. Additionally, indexed life exposes the client to far less risk than a VUL product. Finally, IUL still offers all the tax benefits and flexibility of cash-value life insurance, but on a much more efficient model.
Major risks and simple solutions
The four major risks facing clients who wish to develop a “harvesting” plan include growth, safety, flexibility and taxes.
No. 1: Growth
Even though senior clients interested in generating income may have a shorter accumulation period, they still desire an attractive return. The key to reaching this goal involves setting the right expectations for the definition of attractive. When setting expectations, several factors need to be taken into account, but the biggest factor is the incremental return over inflation, even as a client takes distributions.
No. 2: Safety
This is perhaps the most significant risk facing an income-oriented client. Safety can be defined many different ways, but generally, clients want a vehicle that offers returns regardless of the economic environment. As Will Rogers once said, “It’s not the return on your money - it’s the return of your money.”
No. 3: Flexibility
I see many bumper stickers that read “‘Blank’ Happens”—you can fill in the blank. Whether it is Murphy’s Law or just impossible to predict all needs while developing a strategy, a plan is only as good as its ability to adapt. The absence of flexibility forces a client to live his or her life by a rigid plan. As advisors, our job involves developing a plan that evolves with your clients’ lives so they can live freely without worry.
No. 4: Taxes
Throughout the past 100 years the U.S. marginal tax rate ranged from below 10 percent to more than 90 percent. Today, the marginal tax rate hovers around 35 percent. Almost every economic expert agrees that tax rates will most likely be higher - perhaps significantly - one decade from now. Think about millions of boomers reaching retirement age and qualifying for government benefits and programs. Where is all the money going to come from to support those programs? The answer? Taxes. However, years ago many financial professionals advised clients that their average tax rates will go down in the future, specifically during retirement. Now that assumption gets turned upside down as experts start to assume that tax rates will most likely be higher - even if clients are in a lower tax bracket. This ultimately leads to client uncertainly. It is relatively impossible to take an instrument for which taxes are paid on accumulation - or harvesting or both - and be able to project the impact taxes will have on the ultimate return.
Harvesting with the right tools
These four risk factors all determine whether a harvesting plan ends up meeting a client’s expectation or falls dramatically short. The simplest answer involves finding a tool that offers the best answer for each risk. That leads to a fairly simple scoring sheet, which enables us to show clients their options along with the positives and negatives of each choice.
The tools traditionally used in income planning (highlighted below) offer both benefits and drawbacks.
Tax-qualified account
As the primary tool for growing wealth to be consumed in the future, a tax-qualified account certainly meets the first objective of potential growth. However, even with diversification, this tool can never meet the best definition of safety without significantly reducing its growth potential. Plus, due to the tax-favored nature of qualified plans, flexibility is significantly reduced. Then, the limitations on contributions and withdrawals make adaptation difficult for clients - not to mention that every cent coming out of the qualified plan will be subject to taxes at the current tax rate. When it comes to qualified plans, the only one that makes sense when you take into consideration higher future tax rates is probably the Roth IRA. But, the low contribution rates make them less attractive to those looking to harvest in the immediate future.
Nonqualified account
The growth and safety risks of this tool mirror qualified accounts. The biggest differences involve flexibility and taxes. As one of the most flexible tools for income, distributions can be increased or decreased as needed - as long as the returns warrant the change. But, many experts agree that you should limit the income you take out of your accounts to no more than 4 percent annually. The most significant drawback under a nonqualified plan involves being taxed on the gains each year; you receive no tax-deferred growth as you would under a qualified account, and definitely no tax-free income. Of all the options discussed to this point, the nonqualified account is the least tax-efficient tool.
Single-premium immediate annuity (SPIA)
Perhaps the only tool available designed exclusively for generating income, a SPIA clearly addresses safety in providing clients the assurance of an income down to the penny. Unfortunately, in today’s economic environment, the inherent growth in this tool is unlikely to beat inflation. For example, while a client might receive $2,000 a month for life, the amount of goods they can purchase down the road decreases as inflation erodes purchasing power. In addition, this tool is relatively inflexible (although some designs have somewhat increased flexibility). For example, if your client needed emergency funds, you just can’t get them out of a SPIA; those funds would need to come from other sources. Additionally, if death occurs early in the payout stream - depending on how the payment duration was structured - there may be limited, if any, benefits paid. Finally, from a taxation perspective, there is limited tax benefit to this tool as taxes are paid in proportion to the benefits being paid out.
Annuitizing a deferred annuity
Deferred annuities have been used as a retirement accumulation tool for decades. Deferred annuities accumulate wealth on a tax-deferred basis until those funds are needed, at which time the policy is annuitized. While this concept looks great on paper, the statistics on how few of these funds actually have been annuitized in retirement can be mind boggling. The suspected reason for this has to do with the same shortcomings of purchasing a SPIA: The limited flexibility and growth potential, coupled with the taxation of all contract earnings while the annuitization benefit that generates income leads to a less than attractive means of providing income. In addition, I strongly suspect that annuitization interest rates on deferred annuities are typically lower than equivalent rates on newly purchased single-premium immediate annuities.
Withdrawing funds from a deferred annuity
Recently designed to overcome the inflexible nature of annuitization, a deferred annuity can offer lifetime withdrawal features to provide sustained income. While these riders look attractive, they often generate more questions than answers, such as:
- How will the lifetime withdrawal income be taxed?
- How will the actual product perform? Will the account value ever come close to the benefit value?
- What limitations exist in taking income?
- How much do these riders cost and is it really worth it in the end?
- What happens if I need emergency funds, and how will that impact future lifetime income?
At the end of the day, these riders can help clients sleep better at night, but in reality, accomplish nothing more than providing a simple guarantee on a future income benefit. Another way of putting it is that you can guarantee a future SPIA-like income with today’s dollars.
Indexed universal life
IUL is the only product that addresses all four harvesting concerns. First, it offers very good growth potential with no downside exposure. The high cap rates (as high as 15 percent), the lower internal expenses of newer IULs, and the valuable loan provisions enable these products to offer a realistic chance at significantly beating inflation and keeping pace with the overall market. Second, the minimum guarantees associated with any IUL product provide the safety needed for income-oriented clients. Third, the flexibility of IUL allows clients to stop and start income at any time and provides significant additional benefits through the death benefit. Finally, and probably most importantly, the tax-free nature of cash-value life insurance provides a safe haven from paying future taxes on any income taken when the policy is structured properly.
If you’ve ever heard the old adage, “There are only two certainties in life: death and taxes,” I believe the expression should be updated to, “There are two certainties protected with life insurance: death and taxes.” First, only cash-value life insurance addresses the biggest impact on harvesting future income - taxes. Not only do all values accumulate tax-deferred but, when structured properly, only life insurance provides a tax-favored income stream. Second, every single person on this planet is going to die, the only uncertainty is when that death is going to occur. At least with cash-value life insurance, you can protect against premature death with a tax-free death benefit, which most likely will be greater than the amount of premium you placed in the contract - no other product can make that claim. If the death occurs later in life, you just enjoyed a tax-free income throughout retirement - again, only available through life insurance. In my humble opinion, the IUL is the best income planning tool today.