Breaking the Income Annuity Liquidity Myth

Why clients need not fear tying up their money

Here are some case study facts:
Husband and wife, ages 65 and 64, respectively 
Non-qualified assets available = $250,000
Income need = $10,000 annually 
Option No. 1: Annuitize a portion using a joint lifetime option, and invest the rest at 4 percent
Option No. 2: Invest in 25-year corporate bonds with a coupon rate of 4 percent

Option #1

In the case of Option No.1, the joint lifetime income annuity with a deposit of $156,796 provides the $10,000 annual income payment need with a 63.7 percent tax exclusion ratio. The exclusion ratio means that only 36.3 percent of each income payment is taxable, while 68.7 percent of the payment represents a pro-rata return of the principal basis. In effect, this may provide a higher net income stream based on the client’s tax situation.

Note that once the taxable portion of the income payments received exceeds the original premium basis, the income payments may become fully taxable. After funding the income annuity, they could invest the remaining $93,204 for growth without needing to produce income. In this case, we assume the purchase of corporate bonds with a 4 percent coupon rate. Splitting the assets in this way provides a significant amount of liquidity without having any effect on the income stream that the income annuity provides.

If the client survives longer than 25 years, the accumulation of the growth portion continues to grow without consuming any additional investment resources to generate the target income. This allows the growth assets to potentially grow beyond the original investment of $250,000. This option also gives the client an opportunity to invest the growth portion in something that may generate a more than 4 percent rate of return without fear that volatility will create undue risk. This will also allow for discretionary income beyond the target income to help keep pace with inflation.

Option #2

In the case of Option No. 2, the client holds the entire $250,000 hostage to income needs. Though the client could technically liquidate the proposed bond prior to maturity, it may cause a potential discount sale, all while affecting future income on a pro-rational basis. This could risk a loss of principal and reduce future income. Finally, since the client is depending on 100 percent earnings for their income, taxes may diminish their income. Assuming a 25 percent tax bracket, the bonds portfolio would have to achieve a 5 percent or greater coupon rate to match the net income of the option shown in Option No.1.

As an aside, funding an additional $3,000 into the income annuity would provide a joint lifetime income with a 20-year period certain while providing the same
$10,000 annual income. With one specific carrier, the contract offers a living commuted-value rider that allows liquidity from a portion of the undistributed premium based on a discount formula stated in the contract. Though this option would be discounted from the portion withdrawn, it does provide an option for unseen events.

This can be referred to as “annuitize part and invest the rest,” and it may be help retain liquidity while eliminating their fear of outliving assets.

Curtis V. Cloke is a financial advisor and agent for Two Rivers Insurance in Burlington, IA


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