SPIA Liquidity Revisited

As many LinkedIners know, following the Secure Act (01.01.2020), I now spend most of my time on the Qualified side in the SPIA neighborhood.??It seems though, whenever a market debacle is anticipated looking out the “front window” (2022/23?), the “march” of the NON-Qualified (NQ) premium begins and I get to spend some time on the “other side of the tracks”. ??

In such cases, in my experience, it’s not unusual for wealthy individuals to get the jitters and start to re-consider “defined benefit” solutions and away from "savings" solutions for long term and steady income needs. ??But, people today, for the most part, have been re-programmed by the Financial Services Industry away from insurance solutions and towards investment solutions so, it’s only natural; many individuals attempt to impose investment solution demands on insurance products.?Under this pressure, the insurance industry caved.?

But, at the end of the day for the SPIA markets, it’s not a pretty picture.?In such cases, it’s inevitable the “liquidity issue” emerges because you are now mostly talking to potential investors and not to potential insurance purchasers. ??Of course, as in much of SPIA land, the carriers choose to not discuss.?Because, I’m not the last surviving SPIA agent, I have to keep reminding myself “we are not alone, we have never been alone” (Ha) perhaps, it’s time as we are all now “de-facto” Fiduciaries, to once again dive into the problematic SPIA liquidity issue.

?As you probably noticed, in all the marketing literature, every carrier offering a SPIA liquidity feature has it highlighted with ASTERISKS directing the contract Owner to “consult with a tax advisor”.?This is the carrier’s legal CYA.?Carriers approach these various liquidity features from two equally weighted angles.?The first is; just how they want to administer and their overall P&L expectations for offering the feature.?The second regards an uncertain IRS tax treatment.???

The SPIA liquidity feature is referred to as a future “payment commutation” because; the carrier is offering to convert future scheduled payments set on the purchase date to a lump sum amount at any present date (permitted by the contract) if and when requested by the Owner.??The conditions for this commutation are laid out in the “contract” (not necessarily in the marketing literature):?max $ amounts, how frequently it can be utilized, when they are eligible to occur, the $ cost imposed, etc.?These features may be offered on lifetime income contracts with estate benefit features (period certain, etc.) and also on exclusively period certain contracts.

Depending on how much liquidity your client wants at any given time will depend on how liberal you need the selected carrier to be.?First thing to determine is; how much liquidity is the client expecting??The larger the estate benefit (period certain) the more liquidity the client can expect.?For obvious, mortality pricing reasons, typically, only the estate benefit portion is eligible for commutation and the life contingent benefit portion is not.?One thing to keep in mind as the contract ages because; payments have been made, the estate benefit portion of the contract shrinks relative to the life contingent benefit (if any). Therefore, the potential total available liquidity relative to the initial premium cost shrinks as well.

Problem #1 IRS issue (not clear)

SPIAs derive their tax benefits from certain IRS rules, one of which is; the “substantially equally annual payment" doctrine.?The IRS has never defined what “substantially equal” means.?So, that’s the nut of the first problem.?More liberal agents/carriers believe; the rule applies only at the contract issue date while others (like me, more conservative) and also some carriers believe the rule applies over the “life” of the contract.?And SPIA contracts with these features are a super tiny portion of the overall SPIA market which itself is; a tiny market compared to the deferred annuity (defined contribution/savings) market so the IRS, so far, continues to blissfully ignore.

An example is: A consumer purchases a 15CL (15 year period certain and lifetime thereafter) contract then, after five years, notifies the carrier now wanting to withdraw/commute the next 10 period certain years of payments.?If the monthly payment was $1,000, he would have received 60 payments then a $ lump sum in lieu of the next 10 payment years and no more income until the life contingent payment kicks in at the start of the 16th?year (if he/she survives).?

While some carriers with this feature allow this "deep" commutation, the “substantially equal" annual payment rule is violated and hence, the carrier’s admonishment (first asterisk) to “consult with your tax advisor”. For these contracts with this particular feature and latitude, I typically urge the client to not withdraw/commute payments in a such way to reduce the $1,000 payment to less than $500.?Because, post issue, if IRS push came to shove many years later, the Owner could argue with the IRS the new $500 (or more) payment (for the next 10 years) is still “substantially equal” (50%) to the initial $1,000 payment.?If the remaining payment (following the payment commutation request) sinks to lower then 50%, most likely, the IRS will consider it NOT “substantially equal”.

To get around this IRS potential problem; an even smaller group of carriers will permit a “cross the board” payment reduction impacting estate benefit payments (period certain) and also the "life contingent" payments.?However, because some of these payments are “mortality pooled” (life contingent), the carriers’ max “liquidity feature” typically produces a lower $ lump sum vs. the previous method (above). Carriers don't want "post issued" sick or injured individuals commuting life contingent payments, that's why it's a limited feature. So given our example 15CL and the $1,000 monthly payment; the max reduction might be limited to say 25% of all future payments and perhaps it’s a one-time election and only after several contract years.??So, the minimum monthly payment can’t be lower than $750 for the life of the contract.??Since the new $750 payment is definitely “substantially equal” to the initial $1,000 payment and the payment never changes again in the future, the IRS would be hard press to argue it’s isn’t substantially equal.?

Another work around (but much less liquidity) is; a few carriers will allow a monthly payment “advance” (very crafty re IRS issue).?So, for example; the contract Owner might have several opportunities over the life of the contract to request 6 months (typical) payments paid in advance (lump sum).?This is merely an advance of the scheduled payment, the payment itself doesn’t change and therefore, there is no “substantially equal” payment doctrine problem because they are still getting 12 identical payments in any given contract year.?(I actually like this one, because it's safer from an IRS perspective) but, a six payments advance is not much $ liquidity relative to the premium cost, so much lower potential liquidity here.

?Problem #2 IRS issue (not clear)

Unlike deferred annuity contract taxation re contract “withdrawals” (mostly LIFO now), believe it or not, the IRS has never opined on the income taxation of immediate annuity future payment commutations!?Another reason for all the carrier asterisks to make sure you consult with your “tax advisor” before electing.??So, what you have with a SPIA (NQ) contracts is; the “tax basis” premium cost issue.?Normally, as one of the IRS tax benefits (for "substantially equal" payments), the premium cost is recovered evenly over the life of the contract (the exclusion ratio).?But now you want to commute future payments and there is a wide tax treatment by carriers about how to deal with the cost basis.??Some carriers for various reasons (admin, P&L impact of contract modifications to support changes/reporting or just their attitude, “it’s the taxpayers problem”, etc.) ignore the cost basis!??

For these carriers that means; any lump sum amount is 100% attributable to future gains. So, if your lump sum amount is $50,000 contract Owners will get a 1099R for $50,000!?Ouch and a nasty surprise if the client isn’t prepared for this.?After the client FLIPS OUT, I consulted on quite a few fixes for this.?But, for a lifetime income contract, it’s messy and the fix (with the tax outcome, not certain) is annually every year, done by a CPA, until the client dies.?These problems are primarily driven by “investment advisers” who don’t know anything about these contracts and encourage a liquidity event, you know, so as to get the Owner "better investment returns!" ?(But, I digress).

The second more reasonable tax treatment some carriers take is; the lump sum represents future gains AND also a return of tax bases (purchase premium).?Going back the $50,000 example perhaps $35,000 might be a non-taxable cost basis return and $15,000 is attributable to gains and a 1099R will be sent for the $15,000.?These carriers will make the tax calculation at the time of Owner request and might use a couple of methods to determine the non-taxable portion going forward for new future annuity income payments.?

The point is, going forward, post commutation, the tax basis amount reflected in the future annual income will be lower and more of the future income will be taxable because they are reporting a distribution of cost basis in the lump sum payment that will no longer be available for future cost recovery calculations.?And of course there are different methods of doing this depending on the carrier.??One is to make more of the current payment taxable.?So the initial $1,000 payment that was 85% non-taxable and 15% taxable might equate to a new post commuted payment being 50% non-taxable and 50% taxable.?Another method is to just keep the new post commuted payment 85% non-taxable and 15% taxable but reduce the time until it takes to recover the entire tax basis.?So originally, at issue, it might have taken say 22 years to recover the entire tax basis.?But since the carrier reported an early cost basis return ($35,000 lump sum) now all the tax basis is recovered say in 15 years and all the payments following that time become completely (100%) taxable.?

So either way, a lump sum cost basis recovery results in an increased taxable income adjustment for the life of the contract.?But of course, the carriers never explain any of this and most people just get surprises.?And of course tax reporting is at the complete whim of the carrier, there are no guarantees!

[Carrier] “Well, I know, we told you (verbally!) when the contract was purchase we would report a payment commutation request with a return of cost basis but, since that time, we changed our minds and are now reporting payment commutations as 100% taxable”.?"What? You didn’t get the Memo?” "Oh, and you didn’t speak to your tax advisor! Really!? ?You know, when you bought the contract 15 YEARS AGO, we told you to speak with your tax advisor, it’s in writing, should we re-send that to you?" - nonsense!]

?All this future cost basis changing stuff is why some carriers just report the entire commuted lump sum as 100% taxable and they don’t have to worry about spending any $ on post issue SPIA systems administration that for these carriers, don't meet their 2022 ROI expectations.

?Bottom Line (solution)

To avoid all this potentially inconvenient tax stuff, “primarily” attributable to a “single” contact.?If the agent bifurcates the transaction into component parts (period certain and lifetime income contingency parts) you can “probably” achieve most of what you want and avoid post issue tax consequences.?

But even if two contracts; any "partial" withdrawal from the period certain?contract?and you would need to address the income tax reporting issue so better to consider only “full payment” commutations as opposed to “partial payment” commutations.? For period certain only contracts there are different ways a carrier can alter future payments to account for payment commutation requests. The carrier can reduce all the future payments to some new lower payment (possible a "substantially equal annual" payment doctrine issue) or just reduce the number of payments on the "back end". Going from 10 years remaining to say only 5 years remaining (but keeping the same payment). This is actually "safer" from an IRS perspective.

But, for the agent, there?becomes a “brokerage” dependency issue because you now have to “coordinate” two pieces fitting together.??What’s available (pricing wise) at any given time is a guess.?However, you might also get unexpected improvements in estate benefits.??

For example on a single 15CL contract, if the owner dies during the guarantee period only the remaining guaranteed period certain portion is paid to the Beneficiary.?However, if done in pieces (if pricing permits) a two contract brokerage would permit not only the return of the remaining period certain payments but a full return of the life contingent contract purchase premium as well because many contracts (for a price concession, of course) will return the purchase premium to the estate/Beneficiary if Owner death occurs prior to the payment start date.?For this example; that would be, for an Owner death occurring prior to the 16th year.?And so-forth and so-on.??

Looking at a two contract brokerage solution utilizing our example; the first contract is a 15 year period certain (fully or partially commutable) and the second contract is a life-only deferred income annuity (DIA) (not commutable) with the initial payment starting at the beginning of the 16th contract year. ?So, when combined, they create a 15CL arrangement.

You can even utilize the same carrier for each portion as these types of annuity contracts ARE NOT SUBJECT TO THE ANNUITY SERIAL CONTRACT RULE – only deferred annuities are) After five years (in our example), you could entirely commute the remaining 10 years period certain and not have to worry about the “substantially equal” payment rule because the DIA (life contingent portion) remains as a separate contract. And obtain a fairly decent size lump sum relative to the overall two contract total premium cost.?And if you do a full commutation for this portion some part of it will be reported as a return of cost basis because it’s really only “partial commutations” that can land you in tax trouble. So, more work for the agent and mostly likely reduced agent compensation vs just purchasing a single SPIA contract, but overall, perhaps a better consumer/owner out come.

I think, if an agent decides to go here, as a Fiduciary, you have to try to explain all this in a nutshell, particularly if you end up going to two contracts because; a two contract brokerage transaction will most likely not produce the same premium cost pricing that you would expect with a single contract issue.?And the consumer is most likely going to want to know the reason for the pricing?differences.?In other words, if the one contract solution costs $200,000 and the two contract solution cost $203,000, the client is going to want to know what benefit he or she is getting for the extra $3,000 premium cost. So, agent, be prepared to explain!

?That's It “Always Keep Your Hands Up!” – The Immediate Annuity Book