If you are in the life insurance business and you serve clients age 65 and older, annuity income maximization is a strategy that must be in your repertoire of capabilities. If you are not familiar with how this strategy works, and you are not looking for this opportunity as you evaluate a client situation, you could completely miss a great opportunity to help a client and build your business. You have to know what to look for.

First, let’s begin with some definitions. Annuity income maximization is the simultaneous purchase of a fixed life insurance product from one carrier and a single premium immediate annuity from a different carrier when the insured and annuitant is the same person. This strategy is also known as annuity arbitrage. I personally do not like to use the term “arbitrage” with the client because it sounds complicated and possibly risky. The strategy is neither complicated nor risky, so I much prefer a more user-friendly name for this idea.

A single premium immediate annuity (SPIA) is a contract with an insurance company whereby the client makes a one-time payment up front and the company provides a guaranteed payment stream for life.

Companies typically offer several variations on this theme, including life-only and period certain options. In the life-only arrangement, when the client (called the annuitant) dies, the payments stop. With a period certain contract, the company promises to make payments for the longer of either the annuitant’s life or the period certain (ten years, for example).

The payments for a life-only annuity will be higher than for a period certain contract. In the annuity income maximization strategy (which I also refer to as the AIM strategy), we almost always use the life-only option. Why? Because we use the annuity payments to pay life insurance premiums. We want the highest possible income during the client’s life. When the client dies the life insurance benefit is paid, so we have no need for ongoing annuity payments for premiums.

There are many benefits of annuity income maximization, including the ability to increase personal income, increase inheritance, increase family income, create estate liquidity, and increase charitable giving. There are many different ways to use annuity income maximization to help deliver these client benefits, and we are going to look at some of the most powerful ones today.

Now, let’s look at a basic strategy to see how it works:

1. First, the client allocates a lump sum of capital. I will use $100,000 as an example.

2. The client uses a portion of capital used to pay the first life insurance premium; $2,400 on a $100,000 policy.

3. The client invests the balance of $97,600 capital invested in a SPIA.

4 The SPIA pays 8.92% of the deposit at the end of each year. This provides $8,706 of cash flow to client annually.

5. The client pays the income tax on the SPIA earnings, but 83.6% of the distribution is treated as return of principal for income tax purposes, so taxable income is only $1,428 and the tax is $571.

6. The SPIA will provide the means to pay the future life insurance premiums.

7. After taxes and premiums, the client will have a balance of $5,735 to spend. Compare this to the after-tax yield of a CD or municipal bond, which may have produced something like $3,000. This is nearly a doubling of net spendable income for the first 14 years.

8. Finally, the insurance death benefit replaces the money the client invested in the SPIA.

You can see from the detailed cash flow report the distribution from the SPIA, the amount excluded for tax purposes, and the taxable SPIA income. [visual] We begin with the gross SPIA distribution and subtract the income tax and the insurance premium to get the net spendable income.

This graph compares the net spendable income from the AIM strategy to the hypothetical net income from an alternative investment yielding 3% after tax. [visual] You can see the client has a huge advantage during the first 14 years. When the client’s cost basis in the SPIA is fully recovered, all future SPIA payments are taxed at ordinary income rates. As a result, in this example the client’s spendable income will drop down to a level very similar to what it might have been with the conventional investment. Later we are going to talk about ways to design the arrangement so that there is not such a precipitous drop.

Now, what does an ideal client look like? Generally, you are looking for clients who are 65 to 85 in fair or better health. You need to get them in underwriting to find out what kinds of rates may be available and just run the numbers to see if the results are attractive relative to the client’s current investments. It helps if the clients are in higher tax brackets because AIM produces a tax-favored income. Clients should own liquid, high basis, and low-yielding assets. They need to be liquid because they have to be sold to invest in the strategy. It helps to have a high basis, like CDs or bonds, because you want minimal income tax consequences when clients sell assets to allocate to the AIM strategy. Low-yielding assets work better because it is the yield you are trying to improve upon. You are also looking for clients who have other sources of liquidity. Another way of saying this is, don’t use all the clients’ liquid assets for this strategy because the strategy is not liquid.

This strategy works well for clients who want higher personal spendable income and who appreciate stable, reliable income. But it can also be attractive to clients who do not need any more personal income but want to increase the benefits they give to their family. It can be configured to either leave more inheritance or more current cash flow to family members. Or it could be designed to generate more benefits to charity. And to emphasize what I said before, it comes with guarantees that will be attractive to many. Generally, it could be attractive to anybody who would appreciate the financial benefits that a more efficient economic engine could provide.

By economic engine, I mean a financial strategy that produces an attractive set of financial benefits. The economic engine we are creating here is the combination of the life insurance and the annuity. This economic engine produces a set of cash flow and return of principal benefits that is comparable in some ways to a corporate bond. It is like a synthetic fixed income instrument. The income is provided by the SPIA and the return of principal is provided by the life insurance. Good target assets include CDs, money market funds, municipal bonds, government bonds, and corporate bonds or bond funds, and don’t forget existing deferred annuities.

In the interest of clarity, let me mention a few basics about the taxation of the SPIA income. A portion of each payment initially is treated as tax-free return of principal and the balance is taxed as ordinary income. The amount of each payment is calculated by multiplying an “exclusion ratio”-for example, 75%-by the amount of the payment. The exclusion ratio is calculated by the insurance company and is the value of the single premium divided by the expected cumulative payments over the client’s life expectancy. Therefore, if the client lives past life expectancy, 100% of the future payments would be taxed as ordinary income.

The AIM strategy could be compared in several ways to a corporate bond. A conventional corporate bond has a maturity of a fixed number of years. AIM has a maturity based on the life of the insured. Corporate bonds are generally taxed at ordinary income rates. AIM enjoys the tax-favored treatment of the exclusion ratio. Now, just in case you have forgotten how this works, let me remind you, because this is one of the primary reasons why AIM is so powerful. From the time the annuity is placed up to the life expectancy of the client, each annuity payment is treated for tax purposes as though a portion of the payment is return of principal (which is not taxed) and the other portion is ordinary income. The exclusion ratio, expressed as a percent, when multiplied by the payment gives you the amount that is treated as tax-free return of principal. After the client has recovered his or her cost basis, the payments are taxed as ordinary income. A female annuitant, age 73, will typically have an exclusion ratio in the 80% range. Obviously, if the income tax is applied to only 20% of the income, you have a very tax-favored income stream indeed. A corporate bond generally provides a tax-free return of principal at the end of the term. AIM provides an income tax-free death benefit when the insured dies. Corporate bonds are guaranteed by the issuer and may have secondary guarantees. AIM is guaranteed by insurance companies issuing the annuity and the life insurance. Due to the heavily regulated nature of the life insurance industry, there is reason to believe that the guarantees offered by the life insurance companies are more reliable than many corporations and even municipalities.

As I mentioned earlier, the AIM strategy is also known as “annuity arbitrage.” I would like to comment on this because understanding the nature of arbitrage is fundamental to understanding how and why the strategy works. What is arbitrage? Arbitrage is the simultaneous buying and selling of an asset with the intent to make a profit by exploiting differences in price due to inefficiencies in the market. “Underwriting arbitrage” might be a better term than annuity arbitrage. Essentially, we are facilitating the simultaneous buying and selling of mortality risk. The life insurance carrier takes the “long” position on the mortality risk. The life carrier wins if the client lives a long time. The annuity provider takes the “short” position on the mortality risk. The annuity carrier wins if the client dies prematurely because the obligation to make the annuity payments will stop. We are looking for differences in opinions between underwriters and between rates of different companies. Now let me ask you a question: Do underwriters ever make mistakes?

Have you ever gone out for informals and received a result like this? Decline, decline, decline, decline, Table D, Standard? [visual] It might not happen that often, but it does happen. The AIM strategy works best when we can uncover anomalies like this. However, you don’t necessarily need to find an underwriting discrepancy for it to work. You just need to run the numbers and see.

Now, let’s look at some sample strategies. In these examples, we are going to use some common assumptions. We are going to look at a female, age 73, preferred nonsmoker. We are going to use universal life products with no-lapse guarantees to age 100 and with a minimum premium to fund to age 100. For comparison purposes, I assumed a pretax yield on existing assets of 5%. I chose this because it is in the range with a triple-A rated corporate bond. Another alternative would be to compare to municipal bonds with a tax-free yield of 3.25%. The result would be very similar. I also assumed a combined federal and state income tax rate of 40% and an estate tax rate of 45%. Finally, I assumed that the clients had no remaining lifetime exemption. This will probably not be the case with most of your clients, so you have to give thought to how to handle this appropriately. For some clients with larger estates, you might simply say that you are assuming that the lifetime exemption is being used against other assets.

Now that we have covered the basics, let’s take a look at several different strategies involving the AIM strategy. These strategies will become more complex as we go, but at the core we always have the simple idea of the life SPIA combo creating an economic engine. First, we are going to look at how to increase spendable income and maintain the inheritance. We are going to look at a case in which we maximize inheritance with deferred annuities. We are going to look at IRA maximization. We will examine making a large gift to a family trust. Finally, we will look at private financing–in other words, making a loan to a grantor trust.

In Example 1 our client, Sally, wants to maintain her income and preserve the value of the inheritance she leaves. Sally is going to move $1 million from her bond fund into the AIM strategy. She establishes an ILIT and makes an initial $13,200 gift to pay the premium on a $550,000 life insurance policy. The reason she is not buying more insurance is that we determined that this is the amount of inheritance the family may have otherwise received after estate tax, so she wants to replace only that much. Buying a smaller policy means she will have more net income to spend, which is her primary objective. So she invests the $986,800 balance in a SPIA, which will pay her $88,041 annually. After taxes and premiums, her income will be $69,048, more than double what it had previously been.

The table illustrates that Sally’s income is more than double for the first 14 years when she is enjoying the benefit of the tax-free recovery of basis. [visual] But even after she has recovered her basis, her income is still higher than what it was before. Finally, her heirs receive the death benefit of $550,000, which is about the same amount they would have received without the AIM strategy.

Example 2 may be attractive to many seniors who have invested in deferred annuities for retirement income but now feel that they really will not need this money to live on. Instead they would rather see the money pass to the family. The problem with this is that deferred annuities, somewhat like IRAs, may be subject to double taxation. The AIM strategy may be an attractive alternative. In this case Sally has a $1 million deferred annuity she no longer thinks she needs for retirement. She want as much as possible to pass to her family when she dies. In this case we want to solve for the maximum death benefit we can buy with the income generated by the SPIA. So in this case, she makes an initial gift of $71,825 to the ILIT and invests the balance of $928,175 in the SPIA. We are able to buy $2,992,699 of coverage. This will provide the family initially more than five times as much as it might have received after estate and income taxes from the deferred annuity. Note that after the exclusion ratio expires, Sally will have negative cash flow of about $22,000 per year. If she thought this might be a problem, we could have reduced the face amount slightly and adjusted the premium schedule in the future so that a premium reduced by $22,000 per year would have worked.

Example 3 is the IRA maximizer. This is very similar to the strategy we just talked about except the asset is in a qualified plan. Again, the client’s goals are to move the maximum amount to the family and consume none of the money herself. In this case the custodian of the IRA will invest the IRA funds in a SPIA. Then each year the IRA will distribute all the SPIA income to the client. This will be fully taxable when the client receives it. Unfortunately, we do not get the benefit of the recovery of cost basis because technically, in the case of deductible contributions to a qualified plan, there is no tax basis to recover. Nonetheless, there is still plenty of cash flow to produce attractive results. In this case the client makes a gift of $50,801 to the ILIT, which is the net after-tax IRA distribution. This buys $2,116,708 in coverage and represents an improvement of about a factor of five. An alternative you might naturally consider is to have the client use all of the gross IRA distribution to give to the ILIT to pay the premium. The client would pay the income tax out of other assets. This can make good economic sense if the client can afford it. It buys about 40% more insurance and it prevents the size of the client’s estate from growing as fast, which helps to manage any future estate tax liability on the client’s other property. In this example we could buy about $3.5 million of face. If the client kept the IRA, reinvested that after-tax minimum distributions, and left everything to the family after income and estate tax, the net to the family would have been less than $400,000. This is about an eightfold increase. Be sure to add the IRA maximizer to your list.

Example 4 involves a large gift to a family trust. In the United States, taxpayers may give up to $1 million to family without transfer tax. If the client gave $1 million to an estate planning trust, and if the trust executed the AIM strategy, the trust could buy a $3.2 million policy on Sally using the SPIA income to pay the premiums. If you are ever considering a single premium policy, compare it to the AIM strategy. You might find that the overall benefits compare very favorably to an MEC greater, and you would also end up with a policy with more favorable tax benefits than an MEC.

Example 5 is a strategy in which the client lends funds to a trust instead of making a gift. Why would someone do this? Generally, this would be more attractive when an outright gift would produce a gift tax liability. Structured properly, a loan is not a gift and should not result in adverse gift taxes. So how would this work? First, the client makes the loan to an irrevocable life insurance trust. We are assuming a 2% interest-only loan with a balloon repayment of principal at the end of a nine-year period. In the United States, we can use the federal midterm rate as the interest rate on the loan as long as the term of the loan is nine years or less. This rate changes monthly, but when the client executes the loan, we can lock in that rate for the entire nine-year term. The ILIT trustee will pay the first life insurance premium of $63,533 and use the balance of $936,467 to purchase the SPIA. Each year the trustee will use the $83,533 SPIA income to pay the next life insurance premium, pay the interest to the client, and pay the tax on the SPIA income. When the client dies, the trustee will use $1,000,000 of the death benefit to repay the loan principal to the estate, and the balance of $1,647,208 would be distributed to the ILIT beneficiaries according to its terms. The note is in the client’s estate and subject to estate tax. After estate taxes this will add another $550,000 to the benefit, bringing the total benefit to heirs up to $2,197,208. There are some other factors you have to think about. For example, in the United States, if the ILIT is a grantor trust, the grantor will report and pay the tax on the SPIA income. The annual 2% interest should more than cover the client’s income tax liability until the exclusion ratio expires but not if the client outlives her life expectancy, so it would be important to disclose this. It may be advisable to make a seed gift to the ILIT at the outset unless the loan can be structured as a split-dollar arrangement, which might eliminate the need for the seed gift. Also, if the client lives more than nine years, the note would need to be renewed at the prevailing interest rate, which would likely have changed.

So far we have talked about several very powerful ways to use the AIM strategy to generate client benefits, but there are actually many more. Here are some others:

1. How about augmenting the strategy with a life settlement? Let’s say you have an existing policy and are evaluating ways to increase benefits. You could, of course, 1035 the cash value into a new policy. You could sell the policy and dump the proceeds into a new policy. But how about selling the policy and using the proceeds to purchase an SPIA as part of an AIM strategy? Check it out. It may be the most attractive alternative.

2. How about using excess cash flow for making family gifts? The client may not need more income but might like the idea of having more for the family.

3. Or for that matter, what about increasing charitable giving? Not all clients have family they want to give to, but some might like to increase their philanthropy.

4. What if you are talking to an affluent client in his or her 40s or 50s? This client is not a good prospect for AIM strategy but the parents may be! Your 50-something client could put up the money and purchase the SPIA and life insurance on a parent.

5. What about a private foundation? Absolutely! Foundations need safe, secure investments that generate high cash flow.

6. How about an existing family limited partnership the client sets up for estate planning purposes?

7. How about an estate planning trust, sometimes known as a bypass trust, that was funded at the death of the first spouse and is now holding assets for the surviving spouse and the children?

8. Finally-and this is more sophisticated-you could use the AIM strategy as an investment inside a grantor charitable lead annuity trust. A contribution to a GCLAT generates a very large charitable income tax deduction. The SPIA generates the cash flow needed to make the charitable payments. The family gets what is left after a period of years. Our firm has been involved with a couple of these, and it is very attractive for a client who has a very large current income, wants income tax deductions, and is very charitably minded.

9. For a charitably minded client, you could also consider substituting a charitable gift annuity for the SPIA. These instruments usually pay less than a commercial SPIA, but it may be more important to a client to include charity as part of the transaction.

10. Another charitable variation is to assist the charity issuing the gift annuity to reinsure their income obligation to the donor by purchasing a commercial annuity in an amount sufficient to make the payments.

Now, what are the disadvantages and risks? Actually, there aren’t many, but a couple of key things come to mind. Naturally, as your compliance officer has reminded you, the benefits are limited to the claims-paying ability of the carriers. The main disadvantage is the illiquidity of the strategy. The clients can’t really get their money back out. Oh, there may be some liquidity in the life insurance cash values. But if you are using thinly funded contracts, as you probably will most of the time, the amount of liquidity is negligible. Therefore, make sure the clients have sufficient liquidity from other sources.

Let me share some things we have learned over the years about how to make the numbers work better. Believe me, if you do this very much, you will find yourself pushing the envelope to find a way to enhance income and death benefits.

As you develop the idea for a prospect or client, you will always be working on improving the results. You will always be asking, is this good enough? Can we do better? Here are some things to consider:

1. Reduce the premium after the exclusion ratio expires. This would lower your potential death benefit but help the cash flow.

2. Use an indexed product if you can find one with the guarantees you need.

3. Fund the insurance to a younger age. You don’t have to go to 100. Maybe 95 would work. This would give you either more cash flow or more death benefit, depending on what you are trying to improve.

4. Fund the guarantees to a younger age. Again, lowering the premium will help optimize other benefits.

5. Lower the death benefit. You don’t necessarily have to replace the full amount of the SPIA deposit.

6. Start with a lower DB and add a ROP rider or option B or some other way to increase the DB in the future. This may lower your commission, but it may be the thing you have to do to make the strategy work.

7. Straddle age changes. Purchase the annuity at age 83 and save age with the insurance to age 82 if it makes sense.

8. Finally, blend in term. Again, if you have to improve the results, this is one way to do it.

I also want to point out what may be obvious: Make sure you always secure the life insurance before you commit any funds to the SPIA. You certainly would not want to run the risk of buying an SPIA without knowing you have acquired life insurance at favorable rates.

As I stated earlier, when we design the SPIA, we normally use a life-only product. No period certain or refunds. We are using the life insurance to provide the return of capital, so to speak. We also coordinate the SPIA payments with the insurance premium notices. Typically, we use an annual payment at the end of each year. This makes things easy. But you don’t have to do it this way. You could have monthly SPIA payments and monthly premiums. That’s a lot of work, and I prefer to make it easy on whomever is going to have to monitor the arrangement.

Some other things to consider are using two SPIAs if the client wants cash flow. Set up one SPIA on an annual payment schedule and use those funds for the life insurance premium. Set up the other SPIA to produce monthly cash flow to the client for spending. Also, as I mentioned before, think about reducing the life premium in the future to coincide with the tax increase when the client’s cost basis is fully recovered. If the client lives past life expectancy and the tax liability increases even though the cash flow remains the same, you may have an unhappy client.

So wrapping up, remember that you are looking for people who:

1. Want more personal income

2. Want to increase family income

3. Want to increase the inheritance they leave their family

4. Want to add to their estate liquidity

5. Want to increase their charitable giving either during life or at their death

Or they want some combination of all of the above.

Remember, you are looking for people who are 70 or older, in reasonable health, and in higher income tax brackets. You are looking for people who own liquid, high basis, low-yielding investments and who have an estate tax liability. And finally, you are looking for people who have other sources of liquidity.

I wish you all the best as you help your clients achieve their goals and make the most of their assets.

This is a published version of a focus session presented by David w. Holaday at the 2011 MDRT annual meeting in Atlanta. Holaday, ChFC, is director of planning for Family Office Services, Inc., Carmel, Ind.