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Most people are aware that they must have funds available during their retirement years and that the retirement period could be much longer than originally anticipated. However, planning for retirement still is generally inadequate.

Although the level of Social Security benefits is at the whim of Congress, most post-retirement planning does include income from Social Security. But company pension plans, including 401(k) plans, are the primary retirement income for a sizable portion of the population.

Even so, there is still a need to supplement those retirement programs with others, particularly plans that individuals fund directly. This raises the question: What is being done with the other savings dollars?

One of the least recognized sources of retirement income is the insurance contract, but in reality it may be one of the best sources, for many reasons. In fact, much work is taking place today to inform customers of insurance options.

Within the life insurance industry, the topic of income planning usually comes up in the context of an annuity. One need only look at the relative sales of life insurance versus variable annuities within financial distribution channels, such as stock brokers, to see how this tendency plays out. The contract loads and cost of insurance charges, not to mention underwriting requirements, have been the death knell to sales of life insurance policies for income planning purposes.

However, the reality is that the use of annuities for retirement income purposes is not always the optimal solution. Let?s explore this situation.

First, if an individual dies before retirement, the funds accumulated within an annuity may not be adequate to fund the retirement needs of a surviving spouse, and that is the case before any taxes on the investment gain. Contrast this with a life insurance policy, even a heavily funded policy such as would be used for income purposes, which provides a tax-free stepped-up death benefit.

Next, let?s explore the income situation. If the annuity and life product are comparably priced, particularly in terms of compensation, and assuming the same types of funds are available in the 2 offerings, we can expect the annuity?s account value to exceed that of the life insurance policy. That should not come as a surprise, because the life insurance contract will have mortality charges that come out of the account value while the annuity contract would not. This is true even if the annuity does have some sort of risk account, since it is extremely likely to be less than that of the life policy. However, a significant though by no means sole advantage of the life insurance product lies in the tax treatment of the policy. That is, the costs of providing death benefit coverage are offset by the ability to make tax-free withdrawals/loans from a non-Modified Endowment Contract (non-MEC) life insurance contract.

As I have stated in previous articles for National Underwriter, the life product needs to be a non-MEC. When it is such, then the initial income needs are met by taking withdrawals from the contract. Such withdrawals are considered as reductions in basis and are not taxable to the policyholder. Further income needs are taken as policy loans, which are not considered distributions and therefore aren?t considered taxable distributions of gain.

Thus, while the annuity?s account value is greater, as noted, the after-tax distribution of the life product can be considerably greater. This explains the retirement income advantage of the life contract.

Also, in case of death of the retiree, the annuity may well generate taxable income if there is gain in the contract. But the life contract, just as with the pre-retirement situation, will generate a stepped-up income tax-free death benefit.

Is the life contract always the better contract? Not necessarily. The table on this page shows some guidelines to use when assessing whether to consider a life offering.

Here are some additional observations.

First, many individuals are seeking guaranteed payments because of the volatility they have experienced with equities in their qualified retirement accounts and individual stock portfolios. In fact, annuity sales have been as active as they have been in recent years due in large part to the availability of guaranteed minimum payment levels in those contracts. But variable life products can provide guaranteed withdrawal benefits, too. Furthermore, the variable life products can be designed to retain the favorable life insurance treatment of such distributions. Thus, choosing a life contract does not have to result in the loss of the minimum benefit features.

Second, insurance contracts are now available that assure the contracts will always remain in force, even if investment returns fall. This avoids unfavorable tax treatment upon lapse.

Finally, to optimize the appeal of insurance contracts, insurers increasingly are developing more sophisticated software to help reps and clients manage the policy appropriately during retirement years. This is an invaluable aid to those involved in the income planning process.

, FSA, MAAA, CLU, is president of Actuarial Strategies Inc., Bloomfield, Conn. E-mail him at caryl@actstrat.com.


Reproduced from National Underwriter Life & Health/Financial Services Edition, September 3, 2004. Copyright 2004 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.