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Annuity arbitrage is a sophisticated financial planning technique that can be used to transfer wealth out of an estate tax-free and create income for life for a surviving spouse or other beneficiary. Annuity arbitrage is remarkably simple to implement: An investor purchases an annuity and uses the income from that to purchase a life insurance policy. The life insurance significantly leverages an investor’s assets because the death benefit purchased is considerably larger than the cost of the annuity.
The optimal structure for annuity arbitrage is created by using the most straightforward forms of annuity and life insurance contracts. The goal is to own the type of annuity that pays out the highest possible lifetime income and couple it with the least expensive form of life insurance.
A single premium immediate annuity (SPIA) and term life insurance are the perfect products to use in annuity arbitrage.
Term is the least expensive form of life insurance. Premiums paid go toward the pure cost of insurance. There are no additional features to increase the expense or decrease the death benefit (relative to the premium paid). Term insurance does not accumulate cash value that an investor can withdraw over time, nor does it offer any of the flexibility that comes with various forms of permanent insurance. Most importantly, the premium never changes over the life of the contract. Therefore, term life insurance is ideal for matching to the fixed income stream provided by an SPIA.
A single premium immediate annuity is likewise a pure form of annuity. It begins paying a lifetime of income immediately after it is purchased with one lump sum payment. There is no deferred growth and no accumulation period, and like term insurance, there are no additional costs.
Why Call These Purchases Arbitrage?
Arbitrage is a term Wall Street uses to explain the simultaneous purchase and sale of the same (or substantially equivalent) asset on different exchanges to take advantages of pricing mismatches. Annuity arbitrage takes advantage of a different type of mismatch.
According to a report by Ernst & Young and the Life Insurance Marketing Research Association, buying an annuity to finance the purchase of an insurance policy creates arbitrage “because of the differences in the insurance industry between mortality assumptions for annuities and for life insurance.”
In other words, insurance companies assume one life expectancy when underwriting life insurance and a completely different one when underwriting an annuity. This means a $500,000 annuity doesn’t have the same value to the insurance company as an insurance policy with a $500,000 death benefit. The annuity will pay out much more than the cost of the life insurance policy.
For example, a 70-year-old male in good health purchasing a $500,000 SPIA would earn approximately $2,850 a month for life. Yet that amount would be more than enough to buy this same man approximately $4 million of 10-year term life insurance.
The arbitrage results in the insurance company taking in $500,000 and then paying out more than $34,000 annually until the annuitant dies. It will collect $34,000 in term life insurance premiums for 10 years.
If this person dies within 10 years, the insurance company will cease paying the $34,000 on the annuity. It will also stop collecting the $34,000 in insurance premiums. But it will pay his heirs a nearly $4 million death benefit.
Using Annuity Arbitrage to Augment Retirement Income
This mismatch makes annuity arbitrage very useful for retirement planning purposes. It can provide lifetime income for an annuitant and his or her spouse. When the insured spouse passes away, his or her survivor will have a tax-free windfall from the insurance policy’s death benefit. This would be the case if the couple bought an SPIA with a joint and survivor rider attached.
While the annuity would continue to pay the surviving spouse regardless of which one died first, that is not the case with the life insurance. Life insurance is generally written on the life of just one person, although joint life policies are available. Without a joint life policy, if the non-insured spouse passes away first, the purpose of the arbitrage is defeated.
Annuity Arbitrage as Part of a Comprehensive Estate Plan
Annuity arbitrage can be very useful for people with large, taxable estates. The strategy makes it possible to transfer wealth out of an estate without incurring any tax. This estate planning technique uses an Irrevocable Life Insurance Trust (ILIT) to own and be the beneficiary of the life insurance policy.
The income from the annuity finances the premium payments, which are made from the ILIT. Any annuity income in excess of the insurance premiums can be kept by the annuitant or gifted to the trust. When the annuitant dies, the death benefit is paid to the trust and then distributed to the trust’s beneficiaries. The transfers are tax-free because they are life insurance proceeds.
Issues to Consider
Investors contemplating annuity arbitrage should examine the composition of their current portfolio before engaging in this strategy. Funds used to purchase the annuity have to come from somewhere, so investors should understand how the strategy will affect their income and liquidity.
The funds used to buy the annuity should come from a low-yielding asset whose income won’t be missed because the cash flow generated by the annuity will be consumed by insurance premiums. Investors need to factor this in.
An existing deferred annuity still in the accumulation stage would make an excellent candidate for these funds. Investors in this situation might consider making a 1035 exchange into a new SPIA. This would avoid any taxes on the sale of some other asset such as stocks or bonds and it won’t decrease the portfolio’s overall cash flow. This would also be the case if an existing insurance policy were to be transferred via a 1035 exchange in the annuity.
Investors must also take their overall liquidity needs into account. Funds used to purchase the annuity will be tied up (virtually) forever. Assets intended to finance specific high-priority consumption goals should not be used for this purpose unless the investor can replace them and still confidently accomplish those goals.
The investor’s current tax situation should also be taken into consideration when structuring this strategy. Investors in the highest income and estate tax brackets will enjoy the most benefit from annuity arbitrage. But the strategy can still help investors create a legacy for their heirs even if their total estate wouldn’t be taxable.
Investors should also calculate how annuity payments might affect their total income, especially if they are collecting Social Security benefits. This is because a portion of the annuity payments will be taxable, which could make a portion of their Social Security income taxable. Fortunately, low interest rates translate into higher exclusion ratios — the proportion of an annuity payment not subject to income tax.
As with most sophisticated financial planning techniques, the goal here isn’t necessarily to maximize annuity income or life insurance death benefit. Instead, consider annuity arbitrage as another tool to help investors optimize the totality of their financial resources.
10 Cited Research Articles
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