If you work with older, high net worth clients, you have most likely uncovered the need for life insurance, either to provide estate liquidity or for the purpose of increasing a family legacy. Whatever the reason, a life insurance policy is a major purchase for older clients, often requiring the payment of large premiums for the remainder of their lives. While you wouldn’t recommend such a purchase for any clients who don’t have the income or the assets to comfortably cover the premium payments, you could greatly enhance the financial position of those who do with the use of a Single Premium Immediate Annuity (SPIA) as a funding source.
Leveraging an SPIA into Life Insurance
The strategy of using an SPIA to purchase a life insurance policy is often referred to as an “annuity arbitrage.” Although it doesn’t involve anywhere near the level of risk associated with stock arbitrage, it is referred to as such because the two transactions occur simultaneously, similar to a hedged investment strategy. The SPIA is purchased from one insurance carrier that assumes the risk that the person will live beyond his life expectancy, while a life insurance policy is purchased from another carrier that assumes the risk of the person dying too soon. In fact, all of the risk is transferred to both of the carriers, which is why it is important to work with highly rated carriers.
How It Works
A 70 year-old male client needs to purchase a $500,000 life insurance policy to cover estate settlement costs. The premium on a whole life policy is $18,200 to be paid for the life of the policy. The client has $2.5 million in assets, $500,000 of which is parked in a money market account and certificates of deposits. He uses $200,000 from his money market account to purchase an SPIA that will generate $20,000 a year to cover the premium payments and taxes on the SPIA income. Payments from the SPIA will begin 30 days from its purchase, so he transfers another $19,200 from his money market account to make the first premium payment on the life insurance policy. After transferring his life insurance policy into an irrevocable life insurance trust (ILIT), he uses the income from the SPIA to pay the premium.
How the Client Benefits
Here’s how the client has substantially enhanced his financial position. His CDs and money market account are yielding just under 2%, generating about $10,000 a year in interest income which he reinvests. To cover his premium using these assets he would have had to tap into $9,000 of principal each year, which would have depleted his principal by as much as $180,000 over 20 years.
By taking $190,000 from his funds to purchase the SPIA, he is able to generate an income equivalent to a 10% return and leveraging it to buy $500,000 of tax-free death benefits. Because the income from the SPIA consists of both interest and a return of principal, he pays about as much in taxes as he owed on the income from his money market account and CDs.
Finally, the life insurance policy will provide a full return of capital at his death when the ILIT distributes the death benefit proceeds free of income and estate taxes. The annuity arbitrage is a strategy best employed for high net worth clients, 70 and over, in relatively good health. Even clients with health issues, if they can qualify for a rated policy, can take advantage of the strategy, though it might require a larger SPIA or smaller life insurance purchase. If they have a strong desire to maximize their estate, increase estate liquidity or increase the family or charitable legacy, the strategy can be the most efficient use of their assets.