In part two of our six part series on variable annuities and their use in structured settlement cases, or I should say in what are traditionally considered structured settlement cases, I've selected another common scenario we often see in settlements.
In this case we have a 32 year old woman, who is a widow as a result of the wrongful death of her husband in a work related accident. She has two small children, ages 8 and 10 and she has not been working outside the house since they were born. Her husband was the primary source of income and support for the family. In most wrongful deaths such as this you have immediate cash needs, comp liens or medical liens, as well as a loss of immediate income. The illustration I'm using will assume a net of $250,000 into the structure to try and get her back to some degree of financial soundness.
In the typical structured settlement scenario, you would look to provide immediate income to this family, assuming that their most pressing short term debt was cleared up, and that they had a stable housing situation either with an affordable rent or a home with a normal mortgage. As there would be some Social Security payments to assist with monthly income you would need to look at trying to create something along the lines of a supplemental income to the age at which the youngest would stop getting survivor payments, and then kicking in a supplemental life time income for the mother there after.
The company I used for this illustration was Prudential Life, which had the best combination of rates for the immediate income and life time income going forward for this client. What I outlined is a monthly income of $450 per month, guaranteed for 8 years certain only. This would cost $37,457 in premium using today's rates. The balance of the premium would be used to accumulate for the date when her SS benefits will end and to start a life time, inflation indexed income for her to supplement what will need to be a second income, or potentially remarriage. In this scenario it would then provide a life time income of $941.56 starting on 5-1-2015, 20 years certain with 3% annual compound. This program would have a solid tax free internal rate of return for this woman and would pay out $346,801 in guaranteed money, and approximately $1,133,543 over her life expectancy. A very good guaranteed, tax free return from a secure, top flight annuity market and an internal rate of return of 5.26%.
Now to compare this to the options provided with a variable annuity. I've chosen to use the product from AXA Life for this particular illustration and their Accumulator variable series. This product, in general, provides for a 6% annual guaranteed accumulation, and then either a 5% or 7% guaranteed life time distribution. A lot depends on the rider you select, the estimated holding period and the projected payout length. In this particular scenario I'm going to use the 5% rate in payout as it actually tends to favor the long term growth account and potential future income by taking less now.
However, as we start this illustration it becomes immediately apparent as to the biggest advantage of the structured annuity and the limitation of the variable annuity, and that is that the variable is not designed to commence immediate cash flow and income shortly after purchase, and it would require the use of an expensive product to achieve this. In short, there is no product that adequately provides for immediate, tax free income to someone like this widow quite like a structured annuity. So, rather then attempt to show a product that is clearly inferior in generating immediate income, lets just assume in this instance we are going to split fund this program, with the immediate portion for $$37,547 being allocated into the 8 year income, and then the balance of $212,203 being deposited into the variable annuity to be held for conversion into an indexed life time income after 8 years is up.
Under this assumption we would have a guaranteed accumulation in the annuity account would be no less then $338,219 at the end of 8 years, and if then converted into a guaranteed life time 5% pay out contract, would generate $16,910 in annual taxable income over the life of the contract, and approximately $1409.25 monthly. Clearly this is a major difference in the $941.56 paid on the structured settlement annuity, but again you need to keep in mind that the structure is totally tax free, and is also increasing each year at a fixed 3% compound. Taxes would take a very small bite out of the variable annuity as the exclusion ratio would reduce the taxable portion to approximately $1000 monthly, and an amount low enough to essentially put her in either a no tax, or lowest marginal tax bracket. The bigger issue in this comparison is whether or not the compounding over the life time on the structure will ultimately by pass the variable annuity in both cash flow and benefits.
If the variable only pays at 5%, and it pays for 46 years, the normal life expectancy of the woman over that duration, the structured income would catch up with the variable income in year 15 and surpass it the following year. Leading to a total life time payment advantage to the structured life time annuity of $1,000,000 vs $777,860 for the variable. Advantage structured annuity it would seem.
However, as with the other proposal and program we did, we need to look at the unique features and options provided by the AXA contract that when properly designed would allow for a a substantial boost in benefits beyond the guaranteed income amount.
1. Keep in mind that the variable has both an annuity account, and a cash value account. The annuity accumulates at the guaranteed levels, or at the stepped up basis amounts as I describe later. The cash value account is invested in the fund portfolios and essentially should track the market if indexing is utilized. Therefore, at the start of the payout phase, our young widow is probably sitting on top of a cash value of $335,000 or more that will continue to grow over the life of the contract.
2. The contract also has a death benefit feature that has an annual 6% growth rate on the initial cash value, or annual cash value amount, which ever is greater. This effectively gives the widow a cash or death benefit to her estate of at least $335,000 so we need to add this to the total value of the structure, boosting it up to $1,112,000, or essentially equal to the structured annuity payout.
3. However, lets also keep in mind we are talking just about guaranteed accumulation and guaranteed payouts. These contracts provide for increases in income each year during payout depending on growth of the cash account, as well as increases in the death benefit and cash value account. Lets once again use our 8.4% net growth figure, which is a full 3% less then the historical average of 11.4% for the S&P over the last 40 years, and make some projections on what might occur. Again, no guarantee, but we already know what the guarantee does provide us.
Assuming again this rate of growth, coupled with the annual step up we can make a reasonable assumption that over 20 years the cash account will grow to approximately $660,000, with step up's in annual income amounts every year, 3 years or 5 years depending on the option selected by the annuitant. The point is, the base for the income would double every 20 years in this illustration, as would the potential income and death benefit on the cash value. Therefore, it is a reasonable assumption to once again determine that on a long term, life time payout with the ability to index to market yields and increase monthly payouts, that the variable annuity will dramatically out perform the structure on the long term life time element. However, it is equally important to note that on a short term, fixed income plan such as what we start this illustration with it is almost impossible to top the structure for that part of the program.
I think we can pretty much conclude from this illustration that the structure is the best option for the fixed, predictable short term needs, but that the variable annuity is most likely going to be the best solution for her long term, indexed, income needs. Again, the advantages of the program are listed in the earlier post, but the tax free death benefit, the cash value, professional management and guaranteed income and accumulation make it a very desirable option for a widow looking for solid growth, some tax benefits, guarantees and a death benefit for her children. No matter how you cut it, the variable annuity will likely provide double if not triple the benefit over her life time if historical long term market yields are achieved, while still giving her the assurance of a guaranteed minimum program and total liqudity of her funds in the event her needs change.
Tomorrow's analysis will focus on older claimants and their options.