Vol 10 No 5		June 2008

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An Annuity-Rescue Strategy

"The question is whether the deferred annuity, exchanged for an immediate annuity, will produce enough after tax income to fund a life insurance policy whose proceeds are income tax-free? The large-ball answer is there is a significant probability that this strategy works, but close attention to the details is absolutely necessary to properly serve Alex and Leon."

The question is whether the deferred annuity, exchanged for an immediate annuity, will produce enough after tax income to fund a life insurance policy whose proceeds are income tax-free? The large-ball answer is there is a significant probability that this strategy works, but close attention to the details is absolutely necessary to properly serve Alex and Leon.

Alex, an East Coast real estate broker, contacted me 18 months ago. An insurance agent had proposed that his father, Leon 84, convert a deferred fixed annuity to an immediate annuity and use the income to purchase a life insurance policy. This is often called an annuity-rescue strategy. Preliminary underwriting had already taken place and it appeared that Leon would qualify for a sub-standard life insurance policy. The agent apparently hadn't heard that there are sub-standard immediate annuities because he was recommending an off-the-shelf standard annuity. He did no specific calculations as to the merits of annuity-rescue, relying on the theory that it works. Using a standard rated immediate annuity without underwriting would have foiled this attempt.

Leon, a widower, had a deferred annuity with a balance of $855,000 and a cost basis of $403,000. Leon had no need for the income from this annuity asset. He considered it part of his sons' inheritance. Upon Leon's death the annuity would have an after-tax value of some $741,000. The question is whether the deferred annuity, exchanged for an immediate annuity, will produce enough after tax income to fund a life insurance policy whose proceeds are income tax-free? The large-ball answer is there is a significant probability that this strategy works, but close attention to the details is absolutely necessary to properly serve Alex and Leon.

An analysis can't be done until underwriting is completed. In this case Leon qualified for sub-standard Table 4 life insurance and the equivalent sub-standard rating for the annuity. As soon as that information was in I performed calculations that included, at the attorney's assistance, a 10-year certain payout. Calculations had to apply taxes to each of the scenarios with the caveat that a change in tax rates could change the outcome. The following table shows the net value of: 1) retaining the deferred annuity; 2) 10-year certain immediate annuity with life insurance; and 3) life-only immediate annuity with life insurance.

Comparison of Three Options

The 10-year certain immediate annuity payout is the best option for three years, then life-only immediate annuity is the better option to age 96. Beyond 96 retaining the deferred annuity is the better choice. Leon has about a five year live expectancy as a Table 4 insured, so retaining the annuity has a very low probability of success.

These calculations convinced Alex and Leon to begin implementation of this annuity-rescue strategy using life-only payments. But this isn't the time to sit back and take implementation for granted. There are some complex issues yet to deal with.

One of the delivery requirements for life insurance is written confirmation that the proposed insured's health hasn't changed. Therefore the life insurance must be put into force before exchanging the deferred annuity. If done the other way, it is possible for the deferred annuity principal to be given up before having the certainty of the life insurance policy.

With the life insurance in place the 1035 exchange is put into play. This will generally take two to six weeks for the exchange to actually occur and another week or two before the first annual annuity payment is made to cover the life insurance premiums, so a loan occurs each year for a month or two. (In this case the loan was coming from Alex).

Let's say the life insurance policy date is June 1 and Leon dies August 25 (the year doesn't matter). The premium would have been paid as of June 1 for 12 months. Some policies pay unearned premiums as part of the death benefits. This one doesn't. If Leon dies after payment of the life insurance premium, but before the immediate annuity payment, his family will not receive that year's annuity payment. This caused a recalculation that determined if this timing sequence were to occur, the annuity rescue plan is a good choice to age 92, not 96. That is, death during the wrong two months is less valuable then death during the other 10 months. Either way the probabilities strongly favor annuity-rescue.

Advisors need to pay close attention to this kind of complexity and communicate it to the client to avoid possible claims against them for not fully disclosing possible negative circumstances.