Refinancing for a 32% Increase in Income
My wife and I just completed a couple big “refinancing” retirement moves last month. One may ask, “Why would someone do any refinancing in our current higher interest rate environment?” If you are refinancing a mortgage or some other debt you owe, you would not. But if you are “refinancing” a Delayed Income Annuity (DIA), the higher the interest rates, the better.
A year ago I posted a commentary (click here to read this post) that concluded that changing out our current Fixed-Index Annuities (FIAs) for new ones would not increase our lifetime income if we were to start receiving the income on the same dates (i.e., at the same ages) as our previous FIAs.
NOTE: You can click here to read my blog post from July 2020 where I provided a detailed explanation as to why I decided that purchasing the two annuities (one each for my wife and myself) was the right thing for us to do. Also, I discuss why I decided on the FIA (same product as the Equity-Index Annuity) product with the attached “Income Rider.”
I do not know what happened, but over the last 12 months the insurance companies have increased their payout rates significantly. When I wrote my last post in September 2023, the Federal Reserve had finished increasing the federal funds interest rate. I assumed, since all the interest rate increases had occurred, that whatever payout rates the insurance companies were offering at that time, would be the best we would see. But that was not the case.
The only reason I even became aware of the increased payouts was, when we received our most recent FIAs’ annual statements in Mid-June (which was our 4th contract year anniversary date), I decided to check the market again, just out of curiosity. Am I glad I did. I will summarize the impact that “refinancing” our FIAs made for us.
To keep the numbers simple, I will show all figures for our previous and our new FIAs based on a $100K single upfront premium. And remember DIA payouts are a function of three variables; the premium paid, how long the deferral period is before you “activate” the income stream, and the age of the younger spouse (for joint income payouts) at the time of income activation.
With our previous FIAs, we were planning to activate the income stream when my wife turned 72, the age of Required Minimum Distributions (RMDs) at that time. This represented a 12-year deferral period from the purchase date.
With our previous FIAs, after 12 years, the joint lifetime annual payout was contracted to be $10,890 (assuming a $100K initial premium). Our new FIAs’ contracted lifetime annual payouts will be $14,393. This is a 32% payout increase…. after only an 8-year holding period. This higher payout is even after paying a 10% “early surrender charge” to our old FIA company to receive the funds to purchase the new FIAs. In our case, the income increase was so much that it was starting to impact our future tax liability as the original FIAs were purchased with “Traditional IRA” funds. After some analysis, I decided to cancel my old FIA that I had purchased using Traditional IRA funds and purchase the new FIA using tax-free “Roth IRA” funds.
Another change since we purchased our old annuities in 2020 is the age at which RMDs must begin has increased to 75 (for anyone born in 1960 and later), so we can now hold my wife’s FIA three years longer before activating the income stream. For most DIAs, after ten years, the annual increase in the income stream drops off significantly. So, for my wife, contract year 10 will be when she is age 74. So, it makes sense to start her income stream at that time rather than her RMD age of 75.
If she had waited until age 74 (a 14-year deferral period) with our previous FIAs to start the income stream, the annual income would have been $12,360 (again, based on a $100K initial premium). If we decide to start my wife’s income stream for her new FIA at age 74 (a 10-year deferral period), the lifetime annual income will be $17,254. This is 40% higher than the old FIA starting the income stream on the exact same date.
Four years ago, if we had had a choice to purchase either the contract terms of our old or new FIAs (i.e., without having to pay a surrender charge) and held them for 10 years, the income difference, starting at age 70, for our new FIAs would have been over 70% higher ($16,321 vs. $9500). This is the difference that purchasing the FIAs at today’s higher interest rates (about 5.25%) makes versus the very low rates of the summer of 2020 (about 0.5%).
Refinancing our FIAs allowed us to make a change that I wish I had done when we first purchased in 2020. My wife’s FIA is three times larger than mine. So, after receiving the funds from her old FIA, I split them up and purchased two smaller contracts of the new FIA with a 60%/40% ratio. The two contracts are exactly the same with the same start date, but now we have more flexibility. For example, if we decide we need a little more income in, say, six years, when my wife is age 70, we can activate the income for the smaller FIA contract. Alternately, in the future, we may decide we do not need the income from both FIAs and cash out one of them.
Our new FIAs also added a couple of extra features at no cost. Anytime, after we start the lifetime income stream, if one of us enters a Long-Term Care (LTC) facility, our annuity payouts increase by 50% for up to five years. This is not a replacement for LTC insurance, but it is certainly better than nothing. Additionally, after the first contract anniversary date, if we change our minds for any reason, we can cancel the annuity contracts and get 100% of the initial premium paid returned at no cost. This “Return of Premium” feature is very rare in the annuity business. I believe this feature is only offered in the current environment because interest rates are slated to go down in the near future. If this happens, there is very little market risk for the insurance company if someone surrenders a policy early. So they probably added the “Return of Premium” feature as a selling point.
If you are currently in your late 50s or early 60s, you are in the “sweet spot” (age-wise) for purchasing one of these FIA products. Why? Because, for most FIAs, to get the highest payout from the “Income Rider,” it is best to hold the funds for 10 years before activating the income stream. Ten years from age 56-62 would put you at a typical retirement age.
Finally, if you are considering an income annuity, the Federal Reserve is getting ready to start lowering the Fed funds interest rate. I would be very surprised if they lower the rate back to where it was four years ago, but, due to the high level of federal government debt, the rates will have to go lower and likely stay there for the foreseeable future. That means that today’s income annuity payout rates are very likely the highest they will be for many years. If an income annuity fits into your retirement planning, now would be the time to purchase. However, purchasing an income annuity, whether an immediate annuity or a DIA, is a big decision that should not be done without evaluating your entire retirement plan, preferably with an experienced financial advisor.
One last consideration is most income annuities are not adjusted to annual inflation. As the last three years have shown, inflation is a risk that one must evaluate before purchasing one of these products. However, the inflation risk of fixed annuity payments must also be weighed against the other risk that the income annuity is intended to address. That risk is Longevity risk…. the risk of outliving your assets. Even though the income payments are fixed for life, can you do a better job of self-insuring against this longevity risk than an insurance company can? This is not a trick question. The answer is NO! Let me explain why.
Today, at age 60, if you purchased the FIA product that we just purchased with a $100K premium, after ten years (at age 70), you would start receiving annual payments of $16,320 for as long as both you and your spouse live. There is no reduction in the annual payment after the death of the first spouse.
Assuming a payout period of 20 years (i.e., until you reach age 90), to be able to fund this same $16,320 annual payment yourself, you would need to have increased that $100K at age 60 to $272K at age 70 (this assumes a 2% interest rate on the remaining funds during the 20-year drawdown period). This increase, over a 10-year period, would require that you obtain an average annual return of 10.5% per year.
Do you (or a professional money manager) think you could get a 10.5% return per year for 10 years to be able to make these income payments for the following 20 years? Can you guarantee it? The insurance company is “guaranteeing” these annual payouts. Do you want to take the risk that your funds will be exhausted before the 20-year period is completed? And what if one of you just happened to live to age 95? Could you cover that extra 5 years? The insurance company can and will do it without a sweat. How is this possible?
The insurance company has the advantage of being able to use the ”Law of large numbers.” They do not care how long you personally will live because they know, statistically, that some policy holders will die early and others will die later. So, they can afford to “guarantee” the higher payouts to everyone. This is the same advantage that insurance companies have when selling you homeowners insurance, or car insurance, or any insurance.
When deciding if purchasing an income annuity is right for you, these are some of the Pros and Cons that one must consider.
And one last very important note that I have mentioned in a previous blog post, but it is worth repeating again. If longevity risk is a big concern, you should first look to your social security benefit. Social security has the highest payout of any income annuity available today as it is based on life expectancies from decades ago. Plus, it has a small adjustment for inflation every year. Before purchasing any commercial annuity, you should maximize your social security benefit payment by delaying its start date as late as possible. And remember social security benefits are not impacted by changes in interest rates. Only then decide if a commercial annuity makes sense for your situation.
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