As I mentioned in my Retirement Blog, Aging Americans face the major risk of needing convalescent care at some point in their lifetime.  Roughly 70% of those aged 65 and over can expect to need long-term convalescent care, and the probability increases dramatically with age.  If needed, the expense is staggering and can amount to as much as $155,000 annual for full-time in-home care.  How can this real risk be addressed using the hard-to-exit-from-with-full-value two-tier annuity?

Many two-tier annuity owners find attractive a linked-benefit insurance policy that provides the following all-in-one protection:

  1. life insurance that pays a tax-free benefits to beneficiaries at the death of the owner;
  2. long term care (LTC) expenses up to a multiple of seven-times the initial death benefit;
  3. a residual benefit of 10% of initial death benefit even if the maximum LTC benefits are paid for convalescent care;
  4. a guaranteed no-questions-asked money back return of the initial premium if the owner wants to cancel the policy at any time.  What’s more, to qualify the two-tier annuity owner only needs to answer eight questions as “no” and spend 30 minutes in a phone interview with an underwriter.  The policy is then issued in less than ten days.  Let’s look at an example.

Suppose Edna Algonquin, age 72, has $200,000 in a two-tier annuity.  The annuity was purchased “just in case she needed “rainy day money” to cover a medical emergency.  Unfortunately, she was not fully aware that a lump-sum withdrawal or transfer meant she’d realize only a fraction of the reported account value.  For example, if she has held the two-tier annuity for ten years and then surrenders it for a lump-sum payment or transfer it to another investment/savings option, she’d receive approximately $203,095 before income taxes are paid.  This represents a penalty of $190,335 since the tenth anniversary account value (assume a 7% annual rate of return during the ten years) was reported as $393,430.  Obviously, a lump-sum withdrawal or transfer will be very painful and agonizing decision.  Let’s look at another option.

Let’s assume she decides to take a lump sum withdrawal and is in the 25% income tax bracket.  She will have after taxes about $202,320.  She will then use $100,000 to purchase the linked-benefit insurance policy described above.  Once the policy is issued, here is the protection she’ll enjoy: (a) $183,000 in life insurance which will be paid tax-free to her beneficiaries at her death; (b) $500,000 in LTC coverage paid at a rate of $5,952 monthly tax-free while receiving convalescent care in her home or elsewhere; (c) $18,300 in tax-free residual death benefit even if she uses all the $500,000 for LTC expenses; (d) the return of her $100,000 tax-free at any time with no-questions-asked if she needs the money for other uses or just changes her mind.  The other $102,320 can be redeployed in another annuity or alternate investment to grow and double as “rainy day money” to cover any unexpected expenses she might incur.  The income tax-free life, LTC and residual benefits are regardless of any other income she might have.  She has taken the lemon (two-tier annuity that has punishing withdrawal and transfer penalties) and made lemonade (linked-benefit policy and other investment of her choosing).

Beginning in 2010 an annuity can be transferred to a Long term care policy without being subject to income taxes.  The linked-benefit insurance policy presented above will qualify for this tax-free transfer.  The full-benefits of the linked-benefits policy, except the no-questions-asked return of the initial premium, is also available if the payments are made in installments over a period of years; thus, the two-tier owner can annuitize the full account value and use some of all of the annuity payments to pay premiums for the linked-benefit insurance coverage.

Of course, you can do this with any annuity or other investment you might own.  I’ve chosen the toxic two-tier because it is by far the most egregious when it comes to penalties for lump-sum withdrawal or transfer to another investment.  Also, many billions of dollars of two-tier annuities have been purchased – and mis-sold by financial service professionals – over the past ten years.  Unfortunately, many two-tier annuity holders do not realize the “gotcha” lump-sum withdrawal/transfer penalty until they actually want to sue their money.  So if you have the roach motel two-tier annuity (easy to get into but hard to get out of), you now have a good option to exit without leaving your skin behind.

Shelby J. Smith, Ph.D.
December 4, 2008

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