Baby boomers are hunkering down for retirement. They are putting computer to spreadsheet, as it were, and running asset and cash flow projections, with frequent stops in Monte Carlo. And — after they factor in commonly suggested assumptions about longevity, investment returns, portfolio withdrawal rates, income taxes and health-care costs — even the well-to-do are becominE. anxious.

This is because they're finding that one component of their retirement picture is conspicuously absent: a substantial and dependable stream of income that they can't outlive — period. So, many of these clients are turning to annuities to generate an income stream. They are also turning to cash value life insurance to help them maximize other expected sources of cash flow for their golden years.

Estate planners need to be aware of the implications to their practices of this migration to products and strategies for owning products that lessen clients' interest or need to think about planning for probate, trusts and “all that stuff.”

Fortunately, estate planners have an important role in what might otherwise seem to be a totally product-oriented aspect of a client's planning. True, many products allow clients to avoid probate. But it's also true that the highways are littered with cases in which people didn't coordinate the ownership and beneficiary designations of their products with the rest of their estate plans. And although more wealthy clients are considering and buying annuities, they are hardly doing so with all of their funds. There still is a great deal of planning to be done in terms of, for example, how to identify which assets to deploy for lifetime income or for the other investment benefits that life insurance and deferred annuities can offer. It is also important to determine which assets to retain for eventual gifting, discount planning and so forth. My point is that there is plenty of planning involved with these products. It's just a little different area of planning than most advisors have been focusing on.

By the way, I am not arguing for or against any particular vehicle to meet a client's retirement income objectives. In many instances, after we develop an understanding of the client's financial and personal goals, we recommend a blend of approaches be used. But I emphatically urge planners to learn more about this area. After all, it's easier to ride a horse in the direction it's already going.


To illustrate the real-world application of the kinds of issues and decisions that clients are facing and need a planner's help for, consider a typical executive and his wife. Call them Harry and Happy Featherstone. They're 60- and 59-years-old now, but Harry plans to retire at 65 — and not a day later. The Featherstones' children are grown and out of the house. Harry has the usual constellation of company benefits and retirement income sources, including a defined benefit pension plan. He'll also have Social Security, which he plans on starting to collect when he's 66. Harry has a sizeable 401(k) and a diversified portfolio of mutual funds. He has a universal life (UL) insurance policy that he's been funding at a fairly minimal premium just to support the death benefit well beyond his life expectancy. Based on advice he's heard at seminars offered by his company, Harry will roll the 401(k) into an individual retirement account (IRA) at retirement and try to delay distributions until he's 701/2-years-old. Both Harry and Happy have been going to seminars held by financial planners, and they've had several conversations with those planners. The conversations have been illuminating but also confusing.

For starters, there are a number of issues involving life insurance. Harry isn't sure that he will he need life insurance after he retires. After all, he will have the pension, Social Security, the 401(k)/IRA rollover and the investment portfolio. But most executives like Harry find that, on an objective basis, they will need some insurance coverage after they retire. When they run the numbers, they see that if they die a little too prematurely, their survivor's income from the pension and Social Security would take a real hit. This will also potentially disturb the game plan to defer IRA distributions until they are required.

Many of those same executives are actually (and pleasantly) surprised to learn about the tax advantages of cash value life insurance. They are intrigued by how those tax advantages can be used to accumulate cash value on a tax-deferred basis, then withdraw/borrow that value on a tax-free basis for several years, all while retaining (a gradually declining) death benefit. Once executives are more aware of the impact of their death on the surviving spouse's cash flow and more familiar with what cash value life insurance can bring to the table, they may conclude that they need the coverage anyway, so perhaps they should increase their premiums to generate retirement income and provide an enduring death benefit for their spouse.

Whether Harry can use his UL policy as a combination retirement vehicle and insurance policy depends on the product. If it's a traditional, current-assumption UL policy, Harry generally can increase the premium at any time without evidence of insurability. His agent can show him how to revise the premium pattern and reshape the policy to deploy it for protection, as well as accumulation. However, if Harry's policy is a no-lapse UL (NLUL), it might neither build cash value efficiently nor distribute it (via loans) efficiently.

If the notion of using a cash value policy for these dual purposes appeals to Harry, but he either has an NLUL or a current assumption UL that is not efficient for these purposes, he might speak with his agent about exchanging his current policy for a new one that is designed for more efficient cash value accumulation and distribution of income.

While not directly related to generating retirement income, life insurance has been used for years for “pension maximization,” a concept that is getting a new look from executives for a number of reasons. With Happy's permission, Harry can elect a higher pension (for example, a single life annuity) than he would otherwise elect, and still provide a survivor benefit for Happy by way of life insurance.

Happy should take an active role in this decision because if Harry dies shortly after retirement, she will bear the brunt of an inartful decision-making process. Happy will want to ensure that Harry has enough insurance to enable her to generate the desired survivor benefit. A common approach is for the Featherstones to work with their agent to determine how much life insurance Harry should have at retirement to allow Happy to purchase a single premium immediate annuity (SPIA) for a guaranteed lifetime income equal to the forgone pension survivor benefit. But there are still risks for Happy, such as divorce, Harry's failure to pay the premiums and insufficiency of the insurance proceeds to replicate the survivor benefit. At the very least, Happy should own the policy as a first step towards protecting herself.

What often happens when executives like Harry take a hard look at the numbers (at the same time that their spouse is taking a hard look at them) is that they conclude that, on a risk-adjusted basis, the after-tax difference in the benefits makes pension maximization a push on the numbers. But the insurance can protect Happy's survivor benefit against the long-term credit risk of Harry's employer and other vicissitudes of life. So, already inclined to purchase or carry life insurance for other planning reasons, these executives often will select the usual joint-and-survivor pension benefit, but purchase or carry the insurance as well!

Beyond life insurance, other insurance products come into play for retirement. Planners are talking to Harry and Happy about ideas for investment and diversification. Some suggest the Featherstones stay the course with, and add to, their mutual fund portfolio. But other planners suggest they put some money into deferred variable annuities, for tax deferral, investment flexibility and an eventual source of guaranteed income. Still others are suggesting that Harry and Happy consider immediate annuities, albeit not until retirement, as a way to supplement the pension and Social Security with additional income they can't outlive.

Harry and Happy have a balanced portfolio of stock and tax-exempt bond funds. They are comfortable that, at least based on history, their portfolio should generate a rising level of income, as long as the total return on the portfolio exceeds the rate at which they withdraw (spend down) the funds. From a planning standpoint, the Featherstones will have full liquidity and a step-up in basis for the survivor.

But they also know that they have no guarantees as to the income they'll be able to take from that portfolio. Besides, the taxable portion of the portfolio will generate taxable interest, dividends and gains on the entire portfolio, not just on the portion they access for income. So, all things considered, they would like to know more about deferred variable annuities (as well as other types of deferred annuities, such as equity-indexed annuities, which are beyond the scope of this article).

It won't take long for Harry and Happy to realize that discussions about variable annuities are likely to generate more heat than light, depending upon who is holding the torch. Proponents of this product point to its tax deferral, downside protection on the death benefit, options for steady retirement income, asset protection and probate avoidance, and so forth. But others will warn about high fees, potential surrender charges and a host of unfavorable income and transfer tax implications.

Most estate planners are somewhat familiar with variable deferred annuities. But what they may not be familiar with are the relatively new features that are catching clients' attention, features that can address concerns about market volatility, living too long and having to balance investing too conservatively with not investing aggressively enough. The guaranteed minimum income benefit, for example, assures the owner of a minimum value or payout on annuitization; it also assures that the owner will get his money back at an annual withdrawal rate regardless of market performance; and it assures the owner that the accumulated value will not be less than the initial investments less withdrawals. Each of these benefits generally has a separate cost attached, as well as a constellation of terms and conditions. But together they enable clients to invest somewhat more aggressively than they otherwise would.

The Featherstones will have to understand the essential tax implications of the variable annuity, especially vis-a-vis their current portfolio. The annuity's cash value grows tax-deferred. The couple can shift money from one fund to another inside the annuity, without incurring tax on any gain. The ability to reallocate assets without gain may be important to the Featherstones, because it frees them from letting tax considerations get the better of their investment common sense.

The tax consequences of taking money out of a deferred annuity depend on how it's done. If the Featherstones annuitize, each payment is comprised of a tax-free return of basis and an ordinary income portion, determined by an exclusion ratio, until their investment in the contract is exhausted. If they take the cash out in a series of withdrawals and not as an annuity, then amounts withdrawn are taxable as ordinary income to the extent of gain in the policy. The key point is that when the cash is withdrawn from the deferred variable annuity, it is ordinary income, not capital gain. However, unlike the current portfolio that generates taxable income on that portion not invested in tax-exempts, the balance of the annuity not distributed continues to grow tax-deferred.

The financial and tax implications of the deferred annuity at death are sublimely technical. From Harry and Happy's perspective, those implications are more akin to their 401(k)/IRA than their mutual funds. The salient points are that the annuity will be included in the owner's estate but will qualify for the marital deduction and provide the surviving spouse beneficiary with special flexibility to maintain the deferral. There will be no step-up in basis for the survivor, who still will take out cash as ordinary income. There is an income tax deduction for any estate tax attributable to inclusion of the annuity in the owner's estate.

Should the deferred variable annuity find a place in Harry and Happy's financial plan? Once well-informed about the product's working parts, contractual flexibility and limitations, as well as the income and transfer tax implications, they may well conclude that the product is a worthy part of their overall retirement investment program, even if it is counterintuitive from a conventional estate-planning standpoint. On the other hand, they might conclude that in light of the deferred annuity's cost structure, contractual limitations and tax implications, a well-managed portfolio of mutual funds is a more effective vehicle for long-term investment and tax planning.

My point, and my concern, is that folks like Harry and Happy are being denied the opportunity to make informed decisions about these products. Too many advisors are making sweeping generalizations, pro and con, about a product's suitability in particular circumstances.

When Harry and Happy are on the cusp of retirement, they might consider immediate annuities, also called “income annuities.” These products feature fixed payments, with variations on the theme, such as variable payouts tied to market performance. This type of product might eventually be of interest to Harry and Happy because it's an income stream they can't outlive; the insurer bears the investment and longevity risk; and the product might (emphasize “might”) generate more income than Harry and Happy could prudently take from their investment portfolio. But there are downsides, such as a lack of liquidity (generally) and lack of inflation protection unless the couple purchases a variable option. And, the income annuity might generate less income than the couple could prudently take from their investment portfolio. Oh yes, the Featherstones also might outlive the insurance company issuing the annuity. Here again, they might find it difficult to get objective advice on whether they should use the income annuity. And, even if the discussion is entirely objective, the planning team would not be complete without an astrologer who can tell Harry and Happy how long they'll live, what level of income their portfolio will generate if allocated according to their risk tolerance and where interest rates are headed so that they can figure out whether and how to ladder their purchases.


So, what are the implications to estate planners who have clients like Harry and Happy? Will the products become the plan? The short answer is “No.” Well-informed clients will realize that a blend of approaches best meets their retirement needs. But the estate planner's role will change, and perhaps even broaden, as they begin to realize that “estate planning” is about a lot more than death and taxes. The estate planners who redefine their roles in estate planning — not by becoming “product people” but by creating the structure for the intelligent integration of these products in a planning continuum that starts with retirement planning and ends with testamentary planning — will be happier with their own retirement projections.

The views expressed herein are those of the author and do not necessarily reflect the views of Ernst & Young LLP. This document should not be construed as legal, tax, accounting or any other professional advice or service. No one should act upon the information contained herein without appropriate professional advice after a thorough examination of the facts of a particular situation.