Hybrid Annuities: Cracking the Retirement Income Code

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When securing income for someone retiring in the future, most professional advisors and agents believe that the only way to solve the guaranteed lifetime income issue is to sell a deferred annuity in combination with some form of income rider (GLWB/GLIB). Most do not know that a deferred income annuity (DIA) may be able to secure the same income for a lot less of the client’s portfolio, while providing better tax efficiency than traditional annuity approaches.

A deferred income annuity is basically a single premium deferred annuity with an income annuity component. Just like the single premium immediate annuity, the income payments are known and fully defined at the time of purchase. In this case, however, the income payments can be delayed from as little as 13 months up to 50 years into the future. In the end, there are four reasons why the DIA may require a smaller investment to provide a comparable or larger payout than other product solutions:

1. Elimination of “Fee Drag”

All income annuities typically have an initial, one-time policy fee that usually is several hundred dollars. After the initial fee, however, there are no ongoing annual fees charged by the contract. What this means for your clients is what they see is what they get, the benefits are known and there is no fee drag.

For example, with some variable annuities, clients may be able to get a high annual return on investment. Let’s say six percent. However, there will be an annual mortality and expense charge, a GLWB/GLIB rider charge, as well as an annual fund allocation fee. This may knock the total net return down to two percent, and taxes, using ordinary income rates for years the annuity has gains, will lower the net returns even farther. Even when this is explained clearly and explicitly to clients up front, they still may not fully comprehend why their returns look better on paper than in reality. With the DIA, you can avoid this entire issue from the start, because the parameters are the net of all fees.

2. “Tax Exclusion Ratio”

Taxes, like the fee drag, reduce the net return clients get out of their investments. However, “income annuities” provide the special tax treatment based on the “exclusion ratio.” Under this provision, part of the income is counted as a return of principal (cost basis) and is not subject to tax. This provision reduces the annual tax burden and can protect a client’s Social Security benefits from additional taxation, while providing higher cash flows.

Basically, for period certain contracts, the exclusion ratio is calculated by dividing the original investment by its expected returns. For life-contingent contracts, it applies to life-expectancy tables. For example, if a client purchased a period certain annuity for $100,000 with an expected return of $150,000, the exclusion ratio would be $100,000/$150,000. In this case, the ratio comes to 66 percent, which means if the annuity holder was receiving a $1,000 monthly payment, $660 of that would be considered a return of principal and exempt from taxation. Lower taxes mean more net income generated from the same amount of principal. However, once the full amount of the original investment is returned, payouts will then be subject to ordinary tax. In this situation, the IRS allows the order of taxes on the gains to be changed from LIFO (Last In/First Out) to what we call FIBO® (First In/Blend Out).

3. Mortality Credits

The life-contingent income annuity offers mortality credits, which means your clients are paid more for living longer. This is one of the key components that make DIAs so valuable. At every payout, annuity holders will receive money that is part return of principal, part interest, and part mortality credits. This takes longevity risk off of the table. Make sure clients understand the benefit of mortality credits. Only insurance companies can provide these extra returns because they are on both sides of the risk, using both annuities and life insurance.

4. Built in Inflation or COLA Adjustments

Income annuities are the only guaranteed retirement income solution where you can guarantee the income now or in the future and guarantee a specified inflation adjustment, such as 1 to 6.5 percent in any selected increment needed or desired. The guaranteed income benefit with inflation protection is subject to the provisions of each annuity product offering, and it will shrink the front-end income payout, while increasing the income payout as the client gets older. Also, there are other investments that are inflation sensitive but may not offer guaranteed income, so be sure your clients understand there are alternatives as well.

Cracking the Retirement Income Code

Modern DIA contracts allow flexibility for changes after initial purchase, such as changes to the income start date and liquidity features, such as living commuted value riders and the possibility to add additional premiums. Because these products do not have an annual “fee drag” and provide special tax treatment (FIBO®), the discounted value needed to fund the net income is often times 20 to 30 percent less than a traditional deferred annuity with income rider. It could be a (GLWB/GLIB) or other traditional systematic withdrawal plan solution. Using some creative and well-designed strategies, while taking advantage of all these benefits, can create very efficient ways for us to show our clients how to buy income and invest the difference.


Curtis Cloke, CLTC, LUTCF, award-winning financial professional, speaker, and author, is an early pioneer and advocate for deferred income annuities (DIA). His contribution toward the discovery, development, and delivery of the power of the DIA has been widely acknowledged and embraced as part of the retirement income puzzle by the financial industry. Curtis is the founder and developer of Thrive Income Distribution System launched in 2009, which helps advisors and clients create more income utilizing less of the client’s portfolio. To learn more, visit www.thriveincome.com or www.incomeannuitytoolbox.com.

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