Consider Cash Flow Planning With Laddering And Annuities
Lets compare the classic retirement income cash flow planning technique–laddering of bank certificates of deposit (CDs)–with a modified strategy using annuities.
First, heres the classic method: The client buys CDs with maturities that are split among several future years (say, five). The client lives off the income from these CDs, being sure to reinvest the CD principal as each certificate comes due.
Why has this been considered to be a valuable income strategy? Because it reduces risk by carefully matching maturity of investments to projected needs.
The retiree benefits from being farther out on the yield curve. Even now in times of low interest rates, the interest yield curve is about 1.3% higher at five years than one, and 2.0% higher at 10 years.
The strategy spreads out the purchase dates for the CDs, reducing the risks of buying at an inopportune time.
Are there problems today with using this approach? Yes. These include: the interest rates now are very low; the strategy doesnt utilize principal; and the strategy doesnt have growth potential.
Lets look at a modified approach:
Project income needs forward, say five years. (The investments could be CDs, bonds, fixed annuities or any other sensible fixed-income investment.)
Each year, seek to marshal one more years assets to cover one more year. The first year, the money would be invested to mature in year six, in this example. The retiree can choose the timing and source of funds each year, giving some flexibility. High tax basis assets for the new years funding will be most tax-efficient.
This modified approach offers opportunities to invest in equities or anything else, in hopes of achieving better returns long term, while taking on more risk. Note, however, that one would always have a five-year leeway before having to liquidate equities. The next five years are set!
Thinking in terms of asset allocation strategies, this method would start with a fairly even mix of equities and fixed income but automatically and gradually shift over to almost all fixed income by about age 85.
If the client takes this approach with deferred annuities (fixed and variable), then for tax efficiencies, the client would want to have the money in several annuities. But, the producer should be sure the client does not run afoul of government rules requiring the lumping together of annuities bought in one year from one carrier. In short, the modified approach is clumsy with deferred annuities.
Also, this plan implies a do-it-yourself uninsured annuitization. How can the important benefits of a lifetime income guarantee be worked in? Would this strategy fit into a variable annuity gracefully?
Heres the challenge for VA carriers: Current VA designs dont work gracefully. They allow changing the investment mix on annuitized VAs but not what subaccount the money is drawn from for particular payments. True, numerous income-averaging techniques are available, but all potentially create income discontinuities. Meaningful long-period fixed buckets are rarely available in immediate VAs. Thus, the economic benefits of the strategy cant be realized.
What can VA carriers do to improve this?
Offer the ability to designate the VA subaccount from which current payments are withdrawn. The math is easy! The computer administration would be novel.
Offer long-term fixed income subaccounts with restrictions on withdrawals.
Allow limited flexibility in choosing the income amount, using fixed-income withdrawal planning instead of the conventional calculation of income based on overall account values.
Heres how the VA carrier might explain the choices available in a particular year: “You presently have annual income of $15,000 scheduled in each of 2004, 2005, 2006 and 2007. For 2008, you can transfer funds to provide for one additional year of predetermined income. The amounts transferred will have a crediting rate of 4.50% until paid out in income in 2008. You cannot transfer the money from this fund before 2008.
“Given that the stock market is down, you can choose between $14,000 and $15,000 income. The $14,000 is based on current values in your annuity and is the amount of income that can be sustained into the future if your subaccounts were to earn 5% a year. If you choose $15,000, your future income capacity is reduced.”
(Note: The VA would limit the ability to continue level payments during a down market, to control mortality anti-selection and to prevent premature exhaustion of funds.)
Such a plan would enable the client to achieve all the benefits of annuitization, tax efficiencies, planning and administration efficiencies, and substantial smoothing of income payments.
G. Thomas Mitchell is an independent consulting actuary and president of Aurora Consulting Inc., St. Louis, Missouri. He can be reached at Mitchell.firstname.lastname@example.org.
Reproduced from National Underwriter Life & Health/Financial Services Edition, August 11, 2003. Copyright 2003 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.