Tax-free Retirement - Part 2 - Utilizing a LIRP As Part of a Tax-free Retirement

Let's jump right into Part 2 of this 4 part blog post on utilizing a LIRP as part of a tax-free retirement by discussing various engines or crediting strategies that LIRPs can use to potentially grow your money.

The Engines (Crediting Strategies) Within a LIRP

“CAP FOCUS” STRATEGY

THE CAP & ANNUAL LOCK IN

In just about every LIRP that uses an index-based approach, there will be an annual cap or ceiling on your participation of the market’s or index’s upward movements. This is typically referred to as “the cap.” Cap rates are always subject to change, up or down. Current cap rates vary widely but generally are in the neighborhood of 10-15% per year. So, assume your cap rate on your LIRP is 12%. Is there something wrong with a 12% tax-free rate of return that gets locked in at the end of the year and is contractually protected against market losses in the future? We thought not. Does your index fund do that? Uh...

This is a beginning (point A) and end (point B) of year comparison. If the market’s end of year value is higher than the beginning of year value, your LIRP is credited with that return and locked in, subject to the cap.

THE FLOOR

All index LIRPs have a “floor,” or minimum interest rate that you can earn. Most of the time, this floor is 0%, meaning you cannot earn less than 0% contractually. You might wonder why that is a good thing when you first read “minimum interest rate,” but this is simply the guaranteed protection against market loss. In other words, you cannot have a negative year due to the market. In 2008, when the S&P 500 was down 38.49%, LIRPs protected all previous years’ gains and did not experience a market loss despite the massive losses in the equity markets at large. The floor feature within a LIRP is of major importance to the potential success of your LIRP.

Most of the time, the floor is 0%, but sometimes you might find a LIRP policy with a floor of 1% or so, meaning that when the market returns less than 1%, you still get credited 1%. If the market is down 10%, you still get 1%, for example. This sounds attractive, and is, but you often pay for that by having a slightly lesser cap on the upside. Still, it might be worth it.

ANNUAL RESET

To us, when combined with the features of a cap and floor, the annual reset feature is paramount and often overlooked. Every year, you get to participate in the market’s upward movements and will earn interest somewhere between the floor and the cap on a tax-free basis, and have those gains locked in at the end of the year automatically and protected from future market losses. Now we come to the feature of annual reset.

Let’s assume you have a LIRP tied to the S&P 500 index with the following parameters:

• 12% Cap
• 100% Participation
• 0% Floor
• Annual Reset/Lock In

In a simplified example, if the S&P 500 stock market went up by 9% in the first year, your LIRP would be credited with 9% (100% participation in the market‘s positive movements up to the cap), and that gain is “locked in." In the second year, assume the market crashes, losing 30%. You would not participate in that loss because of the floor (0%), nor would you lose that 9% earned from the year before. If you were in an index fund/ETF, you would have gone up 9% year 1 and down 30% year 2. Ugh. In year 3, if the S&P 500 earned 15%, your LIRP would earn 12% (100% participation up to the cap) and lock that return in.

Now, here‘s the kicker. You never went backwards. In year 2 when the market lost 30% and you held firm, the value at which you start potentially earning interest from for the next year is that low point in the market. In other words, you do not have to wait for the market to recover in order for you to start earning interest again. You get the upswing in the market in year 3 even though the market itself is still far off from recovering. This is so key to understand. It’s like buying low without having to go low in the market.

Keeping things simple, let’s say you had $100,000 in an S&P 500 index fund and $100,000 in a LIRP with the cap, floor, and participate rate discussed above. Ignoring fees for the sake of simplicity, here’s what it might look like graphically.

You can easily see how the S&P 500 index fund is well below it’s starting point. Despite year 3 being a decent year (positive 15%), it is still a good distance from recovering. This notwithstanding, the LIRP would benefit from the upward movement in year 3.

The market does not have to catch back up to you in order for your LIRP to start earning again. With an index-based LIRP, there is no such thing as a recovery year. Really ponder upon this. No recovery years. You are either holding firm (because the market is flat of negative) or making new highs. This is the power of the annual reset feature. Yes, fees would reduce the values of both the S&P 500 index fund and the LIRP. This is an example to illustrate the concept.

Oh, and taxes.

If you own the hypothetical S&P 500 index fund in a brokerage account, then you will pay taxes along the way when gains are realized, lessening the returns further. If you own the index fund in an IRA or 401K, you will pay taxes on the backside when used for income or RMDs, lessening the returns further. If you own it in a Roth IRA, then the gains are tax-free so long as you use them after 59 ½ years old and owning the account for 5 years, but still have no protection against losses or locking in of gains. In the LIRP, you have tax-free access to the surrender value at any age along with all the protections discussed.

Bowling With Bumpers

I love going bowling with my younger kids because we put up the bumper rails and they have a great experience. And so do I, because I’d be lying if I didn’t admit to using the bumpers to get some strikes here and there (don’t judge me). I don’t have any pride in that, I just want to have fun and see my kids laugh and have a good time, right? With regard to retirement planning, we love the idea of bumper rails on our money. With the peace of mind that comes with those in place, you can hang out with your kids and grandkids, making memories instead of being locked onto a computer screen watching every minute movement of the stock market.

In a nutshell, this is how most of the engines within an index-based LIRP operate. We’re going to go into a few other options that we typically find (and really like), but now you have a foundation. Please also spend some time reading our post on absolute Return vs. Relative Return. The mechanics of the LIRP‘s engine make it by default an absolute return strategy, which, as you will see in Part 3, can potentially provide safe yet productive returns to you.

Other Index Strategies Inside of a LIRP

The above index strategy is a “cap focus” strategy. In each strategy, however, a couple facts remain: 1. The floor still exists, so you are always protected against market downturns; 2. Once achieved, gains are still locked in and contractually guaranteed from that point forward; 3. Annual reset still applies. Here are a few other index strategies:

HIGH PARTICIPATION RATE FOCUS

In this strategy, you have a higher participation rate (par rate) and a bit of a lower cap. So, it might look like this:

• 10% Cap
• 140% Participation Rate
• 0% Floor
• Annual Reset & Lock In

This strategy is excellent in a low to moderate yielding market, (say, 4-6% annual average). If there is a positive return in the stock market, that return is multiplied by 1.4 (140%, the participation rate) and credited to your LIRP, subject to the cap. So a market return of 4% would yield 5.6% (4 X 1.4=5.6) to your LIRP. Here’s a simplified multi-year example:

Again, the floor plays a huge role as does the annual reset feature. While the market is trying to recover, you are making new highs. Note in year 3 that the stock market provided an 8% return. A par rate of 140% applied to an 8% return would give us an 11.2% return; however, the 20% cap still applies, so 10% is the tax-free return that is locked in for that year. See how simple? Imagine a prolonged mediocre market where the average is only 5%. This par rate focus strategy would return a gross return of 7% instead. Talk about potentially beating the market...but, though it’s nice when it happens, that‘s not really the goal here.

Competitive tax-free returns with minimized market-risk is the goal. Safe and productive.

MARGIN/SPREAD FOCUS

This strategy really has high return potential when the market is slamming. Think late 90s, 2003, 2009, 2013, 2017, 2019, 2020 (after the initial pandemic scare) etc. With this option, you get all the market return (100% par rate) less a “margin” or “spread” of say, 5%.

• 5% Spread
• 100% Par Rate
• 0% Floor
• Annual Reset & Lock In

Understand that this strategy has no cap, no upward limit except for the spread. So, if the market does 20% in a year, you would get 15% tax-free locked in. If the market does 8%, you would get 3%. If the market did 2%, you would get 0% (the floor still applies if the spread would cause you to be otherwise negative). But, if the market did 37%, you would get 32%, tax-free, locked in, contractually protected against future downturns. That raise an eyebrow?

Again, a simplified multi-year example:

In a mediocre returning market, this strategy isn’t great, but the previous “par rate” focus strategy is not great when the market is giving consistent healthy double-digit returns. That is when this strategy shines. Being able to earn well into the teens or higher for annual tax-free returns that are locked in can be a tremendous boost to your retirement planning. But, a long-term average of 6-8% tax-free with minimized market-risk is hardly insulting. Keep in mind that the S&P 500 Index Fund examples would likely have taxes to deal with, eroding those returns, not to mention periods of significant negative yields.

NO CAP HIGH PAR FOCUS

Imagine this: Having no cap plus a par rate higher than 100%. This index strategy also exists within LIRPs but is rarely used because of one catch: the returns are locked in once every 5 years instead of every year. The specs are as follows:

• No Cap
• 110% Par Rate
• 0% Floor
• 5-year Lock In and Reset

The power of this strategy is hard to overstate. You get 110% of the market’s upward movements not subject to a cap. The drawback of only locking in the gains every 5 years is something to consider, and it is possible that you could end up with nothing for that 5-year period depending on where the market begins and ends over that period. This has happened historically, but is rare, especially if you are continually contributing to your LIRP on a monthly or annual basis, using the potential advantage of dollar-cost averaging. Again, remember what we’re comparing to: an index fund that has no floor, no lock in whatsoever (unless you sell, creating taxes and trying to time the market . . . ask DALBAR how well that has worked out for investors at large).

If you’re starting to wonder about a mix of these strategies within your LIRP, that is where we are getting to inPart 3. There are other strategies than this that exist within LIRPs, but this gives you a good foundation.

Before we get to strategic tax-free allocations within a LIRP, it gets more exciting than this with “enhancements” that many well respected LIRP companies offer.

Read on to Part 3.

Kristen Cooper, NSSA®
President
Axios Capital Strategies