Life insurance/annuity arbitrage has been a popular subject in recent years. The ability to obtain different underwriting from different insurance companies has allowed clients to "pay less" for their life insurance using a single premium immediate annuity (SPIA) to fund life insurance premiums. When this strategy works, it provides significant benefits.
One can derive even greater benefits from this technique by placing the insurance/SPIA arbitrage inside a charitable remainder annuity trust. Let's analyze this strategy in the context of a case study.
John and his wife, Julie, are 75 and 65 years old, respectively. They are very involved with their local community and are both charitably inclined. John is a retired executive from a large, publicly traded company. A significant portion of his wealth is tied up in low-basis (practically zero) stock of his former employer.
The stock yields a low dividend, but John doesn't want to sell because of the potential capital gains tax. John and Julie only have been married for five years. John also has grown children from his first marriage whom he wants to take care of with his estate assets. John wants to take care of Julie as well but believes that she only needs a steady stream of income because she has significant assets of her own.
John is considering making a single premium payment to purchase a guaranteed universal life policy. John is suffering from moderate hypertension and well-controlled diabetes with possible "build issues" (insurance underwriting slang for overweight). He may qualify for a table 4/table D rating offer from a life insurer.
Because of John's health issues, the case is submitted to a life insurance company with a Table 4 to Standard table shave program (underwriting discounts that some carriers offer for certain cases), which qualifies John for standard insurance rates. One million dollars in guaranteed UL coverage will cost $48,972 per year if John pays premiums over his lifetime. The life insurer also requires an up-front single premium of $566,700 for the $1 million in guaranteed UL coverage.
A client of John's age who is in normal health would have a life expectancy of about 10 years, according to tables published by the Social Security Administration. An internal rate of return (IRR) calculation tells us that for $566,700 today to be worth $1 million 10 years from now, the money will have to earn an annual rate of return of 5.84%.
Enhanced solution
First, John and Julie establish a charitable remainder annuity trust (CRAT) with an annual payout rate of 5%. They will contribute the $3 million of stock to the CRAT, which will then sell the stock. This means the CRAT will "owe" John and Julie $150,000 per year as long as either of them is alive.
The contribution produces a charitable income tax deduction of $1,249,860, which John and Julie can use for up to six years. We will now transact the life insurance/SPIA arbitrage inside of the CRAT using only John's life.
Because of his health conditions, John may qualify for an immediate annuity that factors in a shorter than expected life expectancy. "Medically underwritten" or "age-rated" IAs can decrease John's up-front cost for the $1 million death benefit, thereby increasing his expected IRR.
Contracts like these are underwritten like life insurance, only in reverse. The shorter the client's life expectancy, the cheaper is the annuity. Most insurers add years to the actual age of the potential annuitant to reflect the client's impaired health. Other insurers calculate credits based on medical conditions that reduce the required premium by certain percentages. These programs have limitations, such as a maximum age and a maximum number of credits that can be earned (and a maximum number of years offset that can be used).
The cost to John of the $1 million of life insurance coverage is $4,081 per month. Using a standard immediate annuity, he can purchase a lifetime income in this amount for a single premium of $450,025. The annuity income can pay the monthly premium for the life insurance contract.
With a life expectancy of 10 years, our client's IRR increases to 8.31% from 5.84%. The increase leaves about $2,550,000 in the CRAT to produce the $150,000 of annual income for the distribution required. If the annuity company adds years onto our client's current age, the IRR can be enhanced even more and the amount remaining to produce the CRAT income is increased.
Chart 1 shows the costs of the immediate annuity at each age and the IRR at 10 years. The table also shows the IRR at the adjusted life expectancy based on the companies underwriting.
Chart 2 reflects the differences in costs between the single life premium and the annuity premium.
If John predeceases Julie, the SPIA payments stop, but there is now an additional $1,000,000 in the CRAT to sustain Julie's CRAT income stream. All of this has taken place outside of John's or Julie's taxable estate; when Julie dies, there will be a significant charitable gift.
Furthermore, we have avoided up to $600,000 in capital gains (considering a combined state and federal tax rate of 20%) on the sale of $3,000,000 of assets. And we have saved $480,000 in income taxes (considering a 40% combined state and federal income tax rate) through the deferred gift to charity.
Clearly this strategy does not fit many circumstances. However, when it does, it can be quite powerful.
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