Charlie Gipple, CFP, CLU, ChFC

With the hundreds of billions of dollars that are currently sitting in annuities that have guaranteed lifetime withdrawal benefits that are also IRA money, I think it’s important that I point something out that many financial professionals are unaware of. It has to do with Roth IRA conversions. It also has to do with required minimum distributions.

Let’s use an example and say that “John” rolled over $100,000 of IRA money into an annuity 10 years ago. That annuity has a GLWB benefit base that has grown to $200,000 because of the guaranteed roll ups. However, John’s annuity contract value is only $120,000. If he were to trigger the GLWB this year, he could get around $15,000 per year, just as an example. Wouldn’t it be a great concept if he could convert that IRA to a Roth IRA prior to taking that income that would later come in tax free? Before we answer that question, we should also ask the question, ”What value is it that he is taxed on when he converts the entire IRA to a Roth IRA?”

Let’s use an extreme—and slightly ridiculous—example. Extreme examples help demonstrate the point. Let’s say the benefit base has grown to $1 million. And if John were to trigger the income after that 10th year, he would get $70,000 per year, even though his contract value was only $120,000. Wouldn’t it be a fabulous idea if he can convert that entire traditional IRA into a Roth IRA and only be taxed on his $120,000 contract value, and then get $70k per year tax-free? Of course, that would be a great idea. So great that the IRS has already addressed this with a rule back in 2006 that many people are unaware of. However, as Roth IRA conversions become more prominent, I believe many folks will become more aware of this. Since you are reading this article, you will certainly be aware of the “IRS Entire Interest Rule.”

What is the answer?
So, let’s get back to the question. What value is it that determines the amount that is taxable to John in the year that he makes the Roth IRA conversion? It is neither the contract value, nor the benefit base. It is the “fair market value” of the annuity. The fair market value equals the accumulation value plus the net present value of future additional benefits (GLWB income) on that annuity. The IRS has not given carriers much guidance on the actual calculation of the net present value other than that the carrier should abide by the “reasonableness standard.” That fair market value is then put into a letter that the carrier will send your clients every year. It is usually called a “Fair Market Value Letter.” Very original, I know.

If the Roth IRA scenario sounds kind of far out and that Charlie is just doing mental gymnastics for no reason, I promise you that you will come across it eventually. Either by the Roth IRA scenario I mentioned previously or the other two scenarios below:

1. Required Minimum Distributions: That “fair market value” which is usually larger than the contract value is also what determines the required minimum distributions on a policy that has a GLWB! Not the contract value and not the benefit base. (Note: there are a couple of exceptions to the use of the “fair market value” rule. One such example is, if the present value of the additional benefit does not exceed the contract value by 20 percent or more, then it can be disregarded.)
2. “What the heck is this letter I received?” Eventually a client will call you up and say, “I got a fair market value statement in the mail and what does that mean?” They might be very happy because that fair market value statement will show a number larger than their current accumulation value.

The scenario in bullet point #2 is likely what you will run into the most; your clients will get these letters. At the end of last year, a client of mine called in because he got a fair market value letter stating he had a fair market value of almost $230,000. He was ecstatic because the year before he put $185,000 of IRA money into his indexed annuity. He was surprised because the stock market had been horrible, and he didn’t know how he received so much growth. I explained to him that the $230k value didn’t apply to him yet because: 1. He will not be converting it anytime soon; and, 2. He is 10 years away from his first required minimum distribution. I also told him that the present value of the GLWB benefits must have been around $45,000 ($230k minus $185k).

The last thing I mentioned to him was that the $230,000 number is nothing to get excited about, just as we should not jump for joy when the county sends us a large “assessment value” on our house. The fair market value on an annuity and the assessment value on a house are very similar and for similar purposes. Taxes.

My title is tongue in cheek of course but there is truth to it. There are a lot of acronyms and terminology that can make one’s head spin. So, I wanted to write a quick article discussing the meaning of some of these things, differentiate between a few areas of the long term care business, and also explain correct terminology.

I believe that the long term care opportunity for you, the financial professional, is too large to ignore. So, if you are not really familiar with the long term care space, this article may shed a little light on the topic.

Stand Alone LTCI
Although the stand-alone long term care insurance marketplace has gone through some significant “de-risking,” these policies are still superior to what they were when first offered as they are loaded with various features that did not exist previously. For instance, when first offered in the late 70s by the handful of carriers that offered it, LTCI only covered expenses associated with nursing home/skilled nursing facilities. This is in contrast to the policies today that also offer coverage for in-home care, adult day care, and assisted living facilities.

The old label of “nursing home insurance” is no longer appropriate. As a matter of fact, based on many studies as well as my experience at long term care carriers, anywhere from 50 to 75 percent of first time long term care claims are for in-home care versus nursing home and assisted living facilities. These numbers are important because they demonstrate the flaw in the notion that long term care insurance is “nursing home insurance.” It is important to discuss with clients that LTCI is insurance that can actually allow you to stay out of the nursing home and allow you to have more options than if you were otherwise on Medicaid.

To discuss some features of these products, some traditional LTCI policies today have return of premium options that address the “use it or lose it” concern that many consumers have had about LTCI. One can choose among a handful of benefit periods and also a handful of inflation options. One can also choose a shared care feature that allows you to use your spouse’s benefit pool if yours depletes. The list of features goes on…

What about the huge premium increases that have happened over the last couple of decades? I believe that, with updated interest and lapse assumptions on new offers, the prices will be more stable than they have been in decades. No longer are carriers estimating overly optimistic long term interest rates along with six percent lapse assumptions! (Note: For carriers, an aggressive lapse assumption can be dangerous and overly rosy because that means they are assuming they will not have to pay claims on those policies that lapse. Consumers have held on to their long term care policies and carriers have reflected this in their new lapse assumptions.)

Combination/Hybrid Products
Combination products are an alternative to the traditional LTCI we just discussed. Because many people discuss “combination products,” “acceleration products,” and “linked benefit products” as if these terms are synonymous, I would like to spend some time differentiating the terminology as these terms are not synonymous.

Combination/hybrid products are the broad category of products that can be on a life insurance chassis or an annuity chassis. Thus, a combination/hybrid product is an annuity or life insurance policy that has some form of long term care benefit, usually in the form of a rider. These products can be life insurance with accelerated death benefit riders, annuities with long term care riders, or they can be true linked benefit products that we will discuss in a bit.

With what has happened in the stand-alone LTCI marketplace, today around 90 percent (Milliman 2021 Long Term Care Insurance Survey) of the long term care marketplace is combination products versus stand-alone LTCI. Clearly the flexibility of these combo products is very appealing to financial professionals and consumers. Combo products will only continue to grow in popularity.

Below are two subcategories that make up the larger combo products/hybrid products category:

• Acceleration of Death Benefit Products. (Note: the AOB is technically a rider added on to the base policy.)
• Linked Benefit Products

Accelerated Death Benefit Type Products
This is a subcategory of the broader combination product/hybrid world. These are usually life insurance-based products where the death benefit (and no more than the death benefit) can be accelerated for the purposes of a long term care event or a chronic illness.

When I present this product/rider I like to point out that the life insurance of the old days typically had one “trigger” in order to access the death benefit—death. However, today’s products many times have a chronic illness rider or long term care rider that allows for the acceleration of the death benefit. These AOB riders are the mechanism that allows the insured to get enjoyment out of the product during their lifetimes rather than having to die. Again, the two prominent rider types offered within this category are chronic illness riders and long term care riders. Again, AOB riders will generally allow for just the death benefit to be paid out for long term care, nothing more. What if you want more of a long term care pool? That is where linked benefits might come in.

Linked Benefit Products
Linked benefit products are the second subcategory of the broader combination product/hybrid world. What separates a linked benefit product from just a normal life policy with the death benefit being available for acceleration? It is the COB rider (continuation of benefits) or EOB rider (extension of benefits). With just an AOB rider (acceleration of the death benefit) that we previously discussed, the maximum amount that is accessible is the death benefit, period! However, when you add a COB/EOB to a product that also has an AOB, you get access to multiples of the death benefit when it comes to long term care. A lot of acronyms, so allow me to give you an example.

Example: John bought a linked benefit life insurance policy for a single premium of $100,000. The death benefit on this life policy is $200,000. Should he need long term care, the acceleration of benefits rider allows him to access all of this death benefit. What if he continues to need care even after his death benefit is depleted? Well, fortunately, because this is a linked benefit product, he has a COB/EOB rider that allows for an additional two times (example) his death benefit, or an additional $400,000 in the long term care pool. That COB/AOB that piggybacks on the base product and the AOB is what makes a linked benefit product a linked benefit product. Once his AOB is depleted, the COB/EOB can kick in. What if he died before depleting all of his death benefit? The remaining death benefit will go to a beneficiary.

(Note: One of my favorite products is actually a linked benefit annuity product that triples the clients premium for purposes of long term care, with relatively minimal underwriting. The client gets access to their annuity accumulation value if they need long term care, plus they have a COB/EOB that is an additional two times their accumulation value!)

Carriers have better pricing horsepower for annuities than they have had in over a decade. By “pricing horsepower” what I am referring to is interest rates. We all know that the 10-year Treasury Bond yield has increased substantially over the last couple of years. However, a better benchmark to pay attention to for what carriers largely invest in is corporate bonds. Carriers like the additional yield that corporate bonds provide over Treasury Bonds, while maintaining “investment grade” quality. Hence, my favorite benchmark, the Moodys Baa Corporate Bond yield.

Chart 1 shows the interest rates–minus the carriers’ spread–can be viewed as the call option budget for indexed annuities, which ultimately determines the caps and participation rates. Clearly, at the time of this writing with the rate being 5.59 percent, the carriers are able to purchase caps and participation rates that are very high, at least relative to recent history.

For many agents, these rising rates and the rising rates’ impact on annuities is new territory. Because of this, I have recently had conversations with agents about the disconnect between the caps/par-rates on new policies versus renewal caps/par-rates on existing policies.

For example: I recently saw a renewal statement on a client’s policy where the renewal participation rate was 185 percent. Although that seems very high, what was the participation rate on new policies for new clients that want to purchase that same annuity today? Almost 300 percent! Naturally, this disconnect has generated questions from the agents. Let’s discuss a couple.

First, is the carrier trying to “rip off” our clients that are in the old policies?

No. Allow me to explain.

Annuity caps are based on “new money rates” that the carrier is able to invest their dollars in at the time the annuity was issued. And to simplify, the cap on the annuity will remain somewhat tied to those original rates, although there will be some ebbing and flowing as interest rates adjust and also as call option costs ebb and flow. With existing annuities, you see relatively low deviation among the caps/par-rates at issue versus caps/par-rates on renewal. The important thing to note with annuity/new money pricing is, when prevailing interest rates increase, annuity caps on new issues are very quick to respond—like what we have seen over the last year. The downside here is, as interest rates have increased and new issues are looking great, the renewal rates on seemingly identical older policies are not keeping up! Why is this? Because, remember, new money pricing “kind of” anchors the annuity pricing to the original bond rate from when the policy was originally purchased X years ago.

Annuity/New Money Pricing is in contrast to “Portfolio Pricing” that carriers often use with life insurance. With portfolio pricing, the blended rate of the insurance carriers general account (or large “tranches” within the general account) is what determines the cap/par rates on IUL, whether those IULs are new IULs or renewal IULs. Over time, that multi-billion-dollar chunk of investments will slowly go up and down with prevailing interest rates. The overall interest rate of the general account is very slow to respond because the carrier’s general accounts are so large. Those general accounts always have bonds that come to maturity and are being replaced, but only a relatively small chunk at a time.

Furthermore, with the life insurance general account pricing, the carriers are generally able to keep new issue caps/par-rates in lockstep with the renewal cap rates on existing policies, at least for the same generation of product. (Note, it is a common practice for carriers to launch new generations of products where the carriers can more easily disconnect the renewal-caps/par-rates from the new-issue cap/par-rates, but that is a conversation for another day.)

The positive side to “Portfolio Pricing” that most life carriers use is when interest rates are rapidly decreasing. When this happens, there is a significant lag in the amount of time it takes for that giant portfolio to get watered down by the lower rates. For instance, for the longest time we saw IUL caps on new IUL policies hold “relatively” stable while the annuity caps on new issues plummeted because of dropping interest rates. Now the inverse is happening with annuities. Rates are spiking up and new-issue annuity caps are as well. But agents are left wondering why the annuity renewal caps are not increasing as well. It all has to do with the “New Money” pricing that annuities use. So, the answer is , the carriers are generally not playing games by purposely keeping renewal caps low relative to new issues.

Now, with what I just said about annuities, many agents are wondering if it would make sense to “surrender” old annuities to get the better pricing. The answer is, it depends on the scenario. Also, it depends on the carrier. Many carriers have rules such as, “As long as the net loss (after premium bonus is taken into consideration) is less than two percent or three percent, then we will allow you to use our annuity to replace the old annuity.” Of course, that is me paraphrasing.

Also remember, this interest rate environment that we are in is exactly why “Market Value Adjustments” on annuities were created—to insulate the carrier from the bond losses they would have if your clients cashed out their annuities after interest rates have increased. It is no coincidence that the MVA formula in most policies is a similar formula as the formula for bond pricing. With bonds that the carriers are buying, as interest rates increase the value of their bonds decreases. With an annuity, as interest rates rise, the client’s surrender value decreases, all else being equal. The MVA is the mechanism the companies use for passing through bond losses or gains to the clients, at least if the clients are going to cash out their annuity prematurely.

We have all read about the failed Silicon Valley Bank that had to liquidate treasury bonds at a severe loss, which accelerated their demise. This loss in their treasury bond portfolio was because of one thing—rising interest rates that diluted the bonds’ values. If the bank had a way to pass on those losses to consumers, it may have helped. Alas, that is not how bank products work. With annuity contracts however, insurance companies have the luxury of having “MVAs” that provide some insulation against interest rate risk (the risk of rising rates).

So, if you are considering surrendering a client’s annuity to go into a new one, understand that there is a lot to take into consideration such as:

• Market Value Adjustments
• Carriers’ rules on “replacements”
• Losing a “benefit base” that may be very high on the old policy
• Losing an enhanced death benefit
• Fees on the new policy versus fees on the old policy
• Comparing new guaranteed income levels to that of the old policy
• Premium Bonuses on new policies to offset surrender charges on the old

On the last point about Premium Bonuses: There are great premium bonus products out there that may help put the client in a better position than what the client currently owns. These premium bonuses can often offset surrender charges and MVAs. But, there are also premium bonus products that may be inferior to the existing product the client currently owns. Premium bonuses are rarely given because the carrier just wants to be nice. That pricing is always made up elsewhere in the product.

This article is intended for financial professionals that have the wise business practice in helping consumers plan for Social Security, and also for consumers.

For folks that may not be interested in number crunching or those that are not real familiar with financial calculators and cash flow analysis, this article may shed light on if delaying Social Security benefits is worth it. For the layperson, it may sound good when one hears, “If you delay Social Security Retirement Benefits from age 67 until age 70, you will get 24 percent more in income by waiting those extra three years.” Well, is that a good deal or a bad deal taking into consideration “Time Value of Money?” Let’s discuss.

Time Value of Huh?
The concept of “Time Value of Money” is that $100 today is generally better than $100 received in the future, which is a large reason why around 50 percent of folks take Social Security early.

Taking it further, what would you prefer to have—$100 today or $103 one year into the future? That is a more difficult calculation because it depends on what prevailing interest rates are in the economy and if you could turn that $100 today into more than $103 one year from now by investing your $100 today. My personal choice would be to have $100 today because I know that I can invest that into something that would give me a guaranteed rate of almost six percent (Guaranteed Rate Annuity). That means that I could turn my $100 into $106 in a year. (Note: I am not taking into consideration taxes in my example.)

With Social Security analysis, we need to view what we are foregoing today—also known as “opportunity cost”—in order to get X in the future as this: What you are foregoing today is the “investment” in order to get X as the payoff in the future. The lost opportunity—or “opportunity cost”—is an economic term that much of the financial world revolves around.

In other words, if I were to invest $100 today and get $103 back one year from now, then that means the internal rate of return on my money was three percent. That means that if you are given a choice between $100 today and $103 in a year, but can only get three percent on your money, then the $100 today is exactly equivalent to $103 one year from now. Again, simplified because we are not considering taxes on the growth. The decision between $100 and $103 is a toss-up if you can only get three percent.

Another decision that is a toss-up is, if you were offered $100 today versus $106.09 two years from now. Why is that a toss-up? Because if you could invest $100 today at a rate of three percent per year, you would have exactly $106.09 two-years from now after compounding. So again, $100 today is equivalent to $106.09 two-years from now, at least if you could only get three percent on your money. Three percent is the “discount rate” that makes $106.09 two-years from now equivalent to $100 today. It is no coincidence that if you punched into a financial calculator that you are investing $100 and getting back $106.09 two years from now, that the internal rate of return will come back at three percent. Well, again, if I can get a six percent internal rate of return on my money, instead of three percent, then I will choose to take the $100 today. That $100 today can grow to $112.36 two years from now at a six percent rate.

That is how “time value of money” works.

Case Study:
Now let’s get to Social Security. With Social Security analysis, we will use the same logic as above except we are not trading one small payment today for one small payment in the future. We are trading a series of dollar amounts over a number of years for a larger series of dollar amounts in the future. So, the math is more complicated but it is utilizing the same logic.

Let’s take Rob, who has a Social Security “full retirement age” of 67. Rob’s full SS benefit—also known as his primary insurance amount—is $20,000 per year. He has a choice: Does he take his Social Security benefit today at age 67, or delay?

By my 67-year-old delaying filing until age 70, he is giving up total income of more than $60,000 over the next three years. I say “more than” because technically that $20,000 that he would receive today—at full retirement age—is generally increased with inflation. So this year Rob may be giving up $20,000, but next year he may be leaving $20,700 on the table by not filing—assuming a hypothetical 3.5 percent inflation rate.

But what is his tradeoff? The positive tradeoff in waiting until age 70 is that after three years his Social Security payments would amount to $24,800 per year—not including inflation adjustments—instead of the original $20,000 per year. This is because he would have received eight percent per year in “delayed retirement credits” that the Social Security Administration gives us for delaying, which amounts to an additional $4,800 in yearly benefits. Again, it would actually be more than $24,800 because it would technically be inflation adjusted. We will reflect on inflation in a bit.

So, we understand that he would get roughly $4,800 more in Social Security payments, but for how long? And most importantly, is that a good deal? Our 65-year old male has a life expectancy (per the Social Security Tables) of approximately 15 years. Therefore, we can plan on our “approximately” $4,800 in additional Social Security payments going for 15 years.

As we analyze the question of “is it worth it?” think of the scenario as the following analogy: Rob would be paying into an “annuity” for three years to the tune of $20,000 per year plus inflation. That is the “opportunity cost” of delaying. We will assume a 3.5 percent inflation rate because that is the historic long-term average. That “annuity” will start providing lifetime payouts in the fourth year of the additional $4,800 per year that is adjusted for inflation every year. That last point is important. Rob is not “just” getting an additional payout of $4,800 per year. We are getting an additional inflation adjusted $4,800 per year!

In (Table 1) I laid out the cash flow of our scenario. The parenthesis represents the lost opportunity of $20k per year for three years, which adjusts for inflation each year. Then, at age-70, the benefit that our retiree gets starts rolling in. As mentioned, the $4,800 is adjusted each year for inflation as well. With inflation of 3.5 percent, our $4,800 today will “inflate” to $5,321 three years from now, and so on.

Our ultimate question is this: In our “annuity” analogy, what would the rate of return be on this annuity where we paid in over $60k in return for the additional income? What “internal rate of return” does delaying Social Security provide, at least based on our 67-year-old male, this lifespan assumption, and this inflation assumption? 5.66 percent. Not a bad rate, especially if Rob is receiving his Social Security tax-free. If Rob was in a 22 percent tax bracket, then that is a “taxable equivalent” rate of return of 7.26 percent. Can Rob get that kind of return elsewhere? If he can, then maybe taking Social Security at “full retirement age” is the best option.

\Table 1 is merely some quick IRR analysis of Rob’s decision using certain assumptions. Technically, there are other variables and factors that he should look at as well before making his decision, but we will discuss a few of those in a bit.

Rob Lives Longer than “Life Expectancy”
One such “variable” is, what if he lives shorter or he lives longer?

Let’s assume he lives an additional five years beyond life expectancy. (Table 2) is our new cash flow table that shows our internal rate of return as being 8.10 percent! That is a taxable equivalent of 10.38 percent, assuming his 22 percent tax bracket. If Rob has good genetics, he may want to consider delaying!

Other Factors:

1. Different Inflation Assumptions: If you think inflation is going to be higher than my 3.5 percent, then the internal rates of return will increase relative to my examples above and vice versa.
2. Taxes: If your Social Security is being taxed, as almost 50 percent of recipients’ are, then my “taxable equivalent yield” goes out the window. However, many times, delaying Social Security to age 70 helps the tax situation because you are generally “spending down” your pre-tax dollars in those “bridge years” from age 67 to age 70. This can lead to less reliance on pre-tax dollars at age 70+ that can otherwise add to your Social Security taxation. Said differently and to exaggerate, if you spun down all of your pre-tax dollars from age 67 to age 70, then you would not be taking any of those pre-tax dollars in the years you are taking your Social Security. This means possibly less taxes on your Social Security because your provisional income would be relatively less! Furthermore, by spending pre-tax dollars in your bridge years you are reducing what you will ultimately have to take in required distributions at age 73.
3. It’s not just about Rob: Stats say that one of a couple that is in their mid-60s will live until age 92. So, if Rob has the higher SS payment between he and his wife, she will ultimately inherit his benefit. And if she lives until 92, for example, then my IRR number is even larger. The internal rate of return on Rob delaying until age 70—and assuming that his wife lives until age 92—is 8.94 percent, or a taxable equivalent IRR of 11.46 percent.
4. Annuity Payments: Let’s say Rob has an annuity where he can start taking lifetime income. Many annuities “reward” you if you delay, like Social Security. So, if at age 67 Rob is deciding among delaying his SS into the future and activating annuity benefits right now or taking SS now and delaying activating his annuity payouts into the future, that could be some interesting analysis. For example, if the IRR on delaying an annuity payout is greater than the IRR on delaying the Social Security payout, he may want to consider taking Social Security now.

Retirement Income Software is Invaluable!
This article reflects just a few variables and components of hundreds. Therefore, each consumer should work with a financial professional that has the planning software that will project how much each filing scenario will give them over their lifetime, on an after-tax basis and after inflation basis. Then and only then will a consumer feel confident that they made the right choice. It’s better than flying by the seat of our pants. If you are a financial professional and want to learn more about software (or Social Security in general), feel free to contact me.
If done correctly and in a manner that reflects “time value of money,” you will see that the difference between filing correctly and filing incorrectly can be a difference of tens or even hundreds of thousands of dollars.