Retirement Income Tools: Lifetime Income Annuities and Reverse Mortgages Explained

That’s all well and good – but you need to be able to keep food on your table and a roof over your head now, and not at some theoretical point in the future (that may never arrive, since growth stock companies occasionally do go bust!)

If you are relying on your investment portfolio to generate income to live on, though… and an income that’s going to be reliable, no matter what the stock market does. The consequences of a bear market early in a retirement, when you have no choice but to pull your living expenses out of a stock-heavy portfolio even when prices are low – can create a devastating chain reaction from which your portfolio many never recover.

I’m not speaking so much to those with tens of millions of dollars to your name. I’m sure you’ll muddle through somehow – and tax mitigation is a big part of your strategy, anyway, in many cases. You may not want to maximize income.

But for the lower-to upper-middle classes, who’ve had to try to save money for retirement through the bear markets of the 1970s, 2000 and 2008, and are now faced with the lowest interest rate, lowest-dividend environment in living memory, you’re going to need every break you can get.

So what tools are out there to maximize income?

The Lifetime Income Annuity

The lifetime income annuity is the pure income play. You give a chunk of your nest egg – or the whole thing, in some cases – to an insurance company. In return, you get a contract saying the insurance company will pay you X amount per month or per year for as long as you live. You can also elect to spread the payments out over the lifetime of yourself and one other person. Normally, it’s the spouse (though I’ve seen grandparents set up a lifetime annuity to give a small check to a beloved grandchild or grandchildren every year at Christmas time for as long as that child lives, long after grandma is gone. Which is neat to be able to do!)

The income is partially taxable – you pay income tax on the fraction of the income attributable to the growth of whatever you put in – and you spread that tax out over your expected natural life.

Advantages

The big advantages to the lifetime income annuity are the guarantees – you are guaranteed not to run out of income for as long as you live (as long as the insurer remains solvent, that is!). There’s nothing else that will provide you that guarantee and put it in writing.

The other advantage, from an income point of view, is the concept of mortality credits. These credits enable older annuity buyers to get a much higher payout on a given lump sum than interest rates would allow.

Here’s how it works:
Imagine four elderly women in a knitting club. They make a pact: They’ll each put $100 in a cookie jar, and vow to get together in one year and enjoy the money. This they do, except that one of the ladies dies. Each of the three ladies now gets $133.33. That money didn’t make a penny of interest, but all the survivors got a 33 percent return on capital! For not doing anything except being alive!

Lifetime income annuities work the same way: Those who die ahead of actuaries’ expectations subsidize the incomes of those who survive.

Typically, these annuities will often come with a return of principal guarantee – if you die before you receive back an amount equal to what you paid in, your heirs will receive the difference in an annuity death benefit. You can also buy an inflation benefit, though it will reduce your starting income level substantially.

Disadvantages

Lifetime income annuities always seem to be going on sale – next year. All things being equal, the payout on LIAs increases with age – since, on average, your premium contribution plus interest gets paid back to you over a shorter period of time. So if you commit to a large lifetime income annuity, you’re committing yourself to a lower payout for life.

This is particularly disadvantageous in todays’ low interest rate environment. Yes, you get paid a payout rate, not strictly an interest rate. Every payment back to you contains a partial return of principal (non-taxable.) But with interest rates so low, you are locking yourself into a very modest return – one that could improve markedly if you hold on for a year.

Lastly, assets in a lifetime income annuity don’t get passed on to your heirs. Once you commit to a lifetime income annuity, it’s pretty much lost to your family, except via any return of premium at death guarantees.

Reverse Mortgages

This is pretty much the real estate equivalent of the lifetime income annuity. Except that instead of sending an insurance company cash, you transfer to them the title to your home. You go on living in the house, and they send you income. How much? That’s a function of how long you are expected to live and the value of your equity in the home.

These are similar to LIAs, in that you do have a guarantee of lifetime income. The insurance company gets its money after you pass on, when they sell the house. Normally, you need to be at least age 62 to qualify.

More on these in an upcoming post. Before you commit to one of these, though, look carefully at the precise terms of the contract. If you have to live in a nursing home temporarily, can the reverse mortgage company come in and seize your home while you’re not living in it? The AARP and the Department of Housing and Urban Development have both put out useful consumer guides.

Both the LIA and the reverse mortgage are powerful options for increasing or maximizing income – without taking on market volatility. For some people they are just the ticket. But there are significant downsides and caveats to each of these products as well.

Tips: Read the fine print on these contracts before you sign. Both lifetime income annuities and reverse mortgage programs are commitments, and are very difficult or impossible to unravel later if you change your mind.

Be careful about changing any plan in which income is guaranteed for a plan in which your income is not guaranteed.

Consider the needs of your heirs and dependents, too, after your death. If they are entirely dependent on your wealth and your ability to earn, then you’ll want to look at some alternatives.

One technique: Just buy a lifetime income annuity big enough to cover your basic expenses. That way, you can reap the benefits of long term investment, avoid committing your entire portfolio to a low-interest rate environment and less-than historically-average payouts, and you can sleep well at night knowing that no matter what the market does, you still have the basics covered.

Remember that these products are sold, not given away. The salesman almost always gets paid if you buy and doesn’t get paid if you don’t. A good fee only planner can go over the advantages and disadvantages for each plan in your case, without any conflict of interest.

Tax Diversification

Congress has a mountainous struggle ahead with debt. We’re already borrowing 40 cents for every dollar of federal outlays. Structural and demographic issues hardwired into the Social Security program since the baby boomers were born are about to make themselves felt – overwhelming payroll tax receipts. And Medicare is in even worse shape. Meanwhile, Congress stripped 500 million from Medicare over the next 8 years to fund ObamaCare, which we now know will cost about $800 billion more than advertised over the next ten years.

One way or another, taxes are going to go up.

What we don’t know is how. Will Congress raise taxes on Social Security income, as the Clinton Administration did in 1993? Will they raise the retirement age to 70 and beyond to balance Social Security cash flows? Will they get out of the Medicaid business and leave it in the hands of the states? Will they move to nationalize 401(k) and other pension assets, or tax their growth? Will they make Roth IRA income taxable?  Take away the homeowners mortgage interest tax deduction? Raise income tax rates or lower exemptions? Tax life insurance cash value accumulation and/or death benefits? Raise the estate tax or slash the current exemption of $5 million?

We don’t know.

You’ve heard of investment risk and inflation risk. In the bond world, you have default risk. Well, all investors in America must also deal with the presence of legislative risk: The possibility that Congress will pass laws that substantially change the present or future value of your assets, and present changes to the set of assumptions that guide your investment and savings decisions.

Tax Diversification

That’s why it’s important to spread your legislative risk among many different types of assets: Tax deferred retirement accounts, pensions, home equity, savings in taxable accounts, municipal bonds, dividend paying stocks, cash value life insurance – all have an important role to play in building a tax-diversified retirement portfolio.

We believe it’s important to divide assets among at least three “buckets,” the taxable bucket, the tax-deferred bucket, and the tax-free bucket

Taxable Assets

These are assets that don’t present an income tax bill after the year in which you receive them – at least, under the current set of laws. Instead, Congress levies capital gain taxes on any profits you make – though they may charge income tax of some kind on dividend income these sources generate.

The main benefit here is the favorable rate accorded to long-term capital gains – that is, profits on assets you held more than a year.

You can also mitigate your tax liability through techniques such as tax loss harvesting – that is, selling some losers to generate capital losses, to offset your gains (and up to $3,000 of income in any given year).

Examples of assets in the taxable bucket include most things you hold outside of retirement accounts, including rental real estate, your own home (you do get a $250,000 or $500,000 capital gains exemption on your personal residence, depending on whether or not you are married, though Congress can modify this at any time as well). CDs, bank accounts, money market accounts, bonds, mutual funds, stocks, and investment property, including collectibles, tends to fall in this category unless you put it in a retirement fund.

Tax-Deferred Assets

Tax deferred assets include things like deferred annuities, 401(k)s, SEP IRAs, SIMPLE IRAs, 403(b)s, and traditional IRAs. These assets are most vulnerable to an increase in income tax rates in future years. Congress could also begin charging for transactions within them, to some extent, though they would have some difficult questions to explain to the public about why they were changing the rules after investors had committed these funds.

Tax Free Assets

Tax free assets include assets you already paid taxes on, which current law allows to grow tax free, and generate tax free income to you. This works for you very well if you front-loaded your income taxes when rates were comparatively low – as they likely were during the Bush Tax Cut era. Congress is quite likely to repeal the Bush cuts at some point – perhaps after the economy has recovered somewhat and the Democrats retake control of the House.

Examples of assets currently inhabiting this bucket include Roth IRAs, designated accounts in 401(k)s, and cash value life insurance (funded under modified endowment contract limits).

By dividing your assets among each of these tax buckets, you can go a long way towards avoiding a severe shock to your retirement income or plans to pass on assets to the next generation.

Part of our process is looking beyond your assets and asset classes to help ensure you are diversified against acts of Congress as well as acts of God and acts of neurotic stock market players and bond players.

An Introduction to Long Term Care Insurance and Planning Considerations

According to the National Clearinghouse for Long-Term Care, a federal depository of long term care information and statistics, the average cost of a stay in a nursing home in Oregon was $246 per day. That’s more than $89,000 per year – enough to totally swallow most pensions.

More than that, an extended stay in a long term care facility can force families to liquidate assets prematurely in order to pay long term care costs. It is not uncommon for the costs of chronic or custodial long term care to totally evaporate a family’s entire legacy.

Even if you or a loved one doesn’t need a skilled care facility, the costs of an adult day care facility – fairly low on the continuum of care – still averages $79 per day, statewide, as of 2010.

Assisted living facilities cost an average of $3,120 per month in Oregon.

Want in home care? That’s going to run you an average of $22 per hour, in Oregon, at today’s prices.

But bear in mind that long term care insurance you buy today will hopefully not pay a benefit for many years in the future.

Don’t Count on Medicare

Medicare doesn’t cover long term care, in any significant way. Medicare only covers about three months of care, and only for acute conditions as a result of a qualifying hospitalization. Medicare provides no coverage for long-term chronic conditions that do not require acute care.

Medicaid is a Last Resort

Many people are under the impression that the government must provide for their long term care needs. Under current law, that’s true: The State of Oregon does provide some limited long term care, under Medicaid auspices. But with some exemptions, Medicaid only provides benefits for those who have impoverished themselves first. Except for a small exemption for home equity, a small allowance for spouses still in the community and not requiring Medicaid benefits, and a few other items, you must pretty much spend yourself down to your last couple of thousand dollars in the world to qualify for Medicaid.

Specifically, you can keep up to $2,022 if you are single, and $21,912 if you are married. Couples with assets above $21,912 may be required to split their assets and spend down before becoming eligible for Medicaid assistance. You can also keep a home (though not a home with more than $500,000 in equity), a burial fund of $1,500, a modest family car, and some household goods and personal effects.

That’s about it.

Even if you have some home equity, the government will come seize your home after you’re gone, or your spouse is gone, to recoup as much of the costs of long term care as they can, courtesy of the Medicaid Estate Recovery Program.

Don’t try to circumvent the rules by giving away your assets. Under the terms of the Deficit Reduction Act of 2006, Medicaid officials have a “lookback” period of up to 5 years. Any gifts you made during this time are still counted against you for the purpose of Medicaid eligibility.

Receiving a pension? You’re in trouble, unless the pension is very small: If you receive too much money from any source per month, you could find yourself disqualified for Medicaid. Long term care is the beast that eats income – and then washes it down with an asset chaser.

Long term care insurance, then is an important part of retirement planning. Indeed, it’s vital for the middle class. Only the very wealthiest among us can afford to write a check for the tremendous costs of long term care. For the middle class to affluent and even well into the millionaire zone, you will need to plan carefully.

What Long Term Care Insurance Covers

Typically, long term care insurance provides a maximum daily benefit to offset nursing home or assisted living facilities. For example, a typical plan I see might be a $225 maximum daily benefit. That’s a benefit of up to $82,150 per year. If you have a 10 year cap, that’s a maximum benefit of $821,500.

You can elect plans that don’t cover in-home care (which cost a little less) to plans that cover a substantial portion of in-home care. This can be an important consideration because it gives the insured individual and his family choices. You may be able to stay at home with loved ones much longer with a little assistance during the day – possibly allowing family members to work – than you could without some assistance.

Usually, benefits kick in when you lose the ability to accomplish at least two of the usual activities of daily living: Bathing, dressing, eating, transferring, continence and toileting. Alternatively, benefits are payable if you need close assistance and supervision due to a severe cognitive impairment such as Alzheimer’s Disease or dementia.

In the weeks ahead, we’ll be taking a closer look at the various aspects of long term care insurance and planning, and the roles it can take in your life.

Do I Need Long Term Care Insurance?

In my view, it makes sense for most people to buy at least some coverage. It seems to be a good deal in the long run. You can tell because of the overwhelming trend of insurance companies that sell LTC policies – or which used to sell it – to either cease issuing new policies, or raise rates substantially. This tells me that the overall trend has been to underprice these policies significantly. And it’s no wonder – the risk is nearly impossible for actuaries and underwriters to predict.

I usually recommend buying an amount you can easily afford—and to start doing it young. It’s ok to have multiple policies. Indeed, in some ways, it’s advantageous. I do not recommend buying an amount you have to strain to afford, because a lapsed policy does you no good.

If you have a home, or assets to protect from Medicaid recovery agents, you should definitely give serious thought to buying a total benefit equal to your assets, at least. More on long term care partnership programs in a future column.

Use solid, highly-rated insurers with good track records, and keep things at a level you can afford.