Tax-free Retirement - Part 3- Utilizing a LIRP As Part of a Tax-free Retirement

In Part 1, we discussed the different types of LIRPs and their basic setup. In Part 2, we discussed some typical engines (crediting strategies) within many LIRPs and how they might interact with market indexes. Here in Part 3, let’s discuss some common enhancements that many LIRPs offer that can make an even greater positive difference in your financial well-being.

I have to admit, these section is going to appeal more to the engineers out there, so you might want to have some eye drops handy for the plethora of upcoming tables. But, no one will be able to say I didn't put forth math in the to support nice sounding financial platitudes.

Enhancements

Beyond the basic engines discussed in Part 2, many well respected LIRP companies often give enhancements above and beyond the basic crediting strategy. Sometimes these enhancements are built into a LIRP’s contract, sometimes they aren’t. This is why choosing a highly rated, highly respected LIRP company is important. A “multiplier” or a “performance factor” has become a fairly common enhancement, along with a “persistency bonus.” For example, a 10% multiplier above the base strategy return beginning in year 1 and a .75% persistency bonus starting in year 11 is a popular combination.

So, if you have a cap of 12% and the market did 10% in year 1, you get that plus 10%, which is an additional 1 percentage point, for a total of 11% that year. What if the market did 13%, one percent above the cap? You would get 12% plus 10% of that return, being an additional 1.2% for a total of 13.2%. Starting in year 11, a persistency bonus of .75% would be tacked on top of everything, making a 13% market return 13.95% (12% cap, plus 10% (1.2%) plus .75%). If the market were negative in year 11, instead of getting 0% (the floor), you would get .75% (the persistency bonus). Let’s take the cap rate focus strategy discussed in part 2 and do a simplified hypothetical illustration:

• 12% Cap
• 100% Participation
• 0% Floor
• Annual Reset & Lock In
• 10% Multiplier Starting in Year 1
• .75% Persistency Bonus Starting in Year 11

As you can see, the upward ceiling of this strategy, stating in year 11, becomes 13.95% instead of 12%. That truly “enhances” the value over time.

One of my favorite enhancements is a “performance factor,” which is somewhat similar to a multiplier. Typically, a performance factor might start in year 3-5, and be a variable factor that is declared by the insurance company year by year (similar to declaring a dividend). On the conservative side, we’ll illustrate a performance factor of 1.5X starting in year 3. For the record, the least we’ve seen a performance factor is 1.9X and often in the 3-5X range. Let’s use the spread focus strategy discussed in part 2 to illustrate the performance factor enhancement—but remember that these “enhancements” are added on to whatever strategy you are using inside your LIRP.

• No Cap
• 5% Spread
• 100% Par Rate
• 0% Floor
• Annual Reset & Lock In
• Performance Factor 1.5X Starting in Year 3

So, take the positive market return, subtract 5%, lock in and reset. Starting in year 3, do the same but then multiply the return by 1.5. That’s it.

With the performance factor at 1.5X, this enhancement has significant potential. Again, the lowest we’ve seen the PF is about 2.4X, but we don’t mind being conservative in our examples.

Just as there are more "engines" than we described in part 2, there are various other "enhancements" available other than these two, but you get the idea. For the sake of brevity, we‘re not going to do an enhanced example of the uncapped, 110% par rate with 5-year lock in strategy. We think you get how it works by now.

In this and every example, the good folks over in compliance require us to tell you that fees would affect both the index fund and LIRP values. These examples are to help you get the concept of how typical strategies within a LIRP might operate. Past performance is never a guarantee or indicative of future results. I mean, no kidding, but we still have to say it.

Strategic Tax-free Allocation

Taking the first three strategies we‘ve discussed, let’s now create a strategic tax-free allocation within your LIRP by dividing a hypothetical $100,000 value into equal parts. We’ll also use historical S&P 500 raw returns since 1976 through 2019. Hopefully no one can fault us for using a 44-year historical return period, though your eyes might start burning. Why since 1976? ‘Cuz.

We’ll also use the performance factor enhancement of 1.5X starting in year 3.

Allow us to draw a few conclusions from the above. First, using strategic allocations of the various tax-free crediting strategies within your LIRP can be highly beneficial. Throughout time, any one of these three engines may have performed in a superior manner to the other 2 depending on the market conditions of that year. This can help to smooth out volatility and potentially make for a more predictable return. Also, the stock market does have years in which it beats any one of the index crediting strategies and/or the combined weighted average of them. So? The goal is safe and productive returns. Take a look at the end result. Getting all huffy about that is like pointing out that the losing baseball team scored more runs in one particular inning than your team even though you won the game by 15 runs. Are we really going to poo-poo things over one inning when we won the game?

From a pure average return perspective, the spread focus strategy seems to have produced the highest average rate of return in this example. So, why not put everything in that one allocation? Because history is not indicative of future performance or experience. Don’t forget that often-touted-but-true disclosure.

Take a look at 1992:

In this single year, the spread focus strategy produced nothing despite a positive return in the market (+4.48%). The cap focus strategy did well, especially with the performance factor enhancement, but the high participation rate focus strategy, the one with the lowest cap and lowest overall average historically, did exceptionally well, more than doubling the gross return of the market.

Let’s look at 1982:

Here, while all strategies did well, the cap focus strategy would have won, producing an 18% compared to the high par and spread strategies at 15% and 14.66% respectively.

The roaring 90s are quite revealing as far as the potential higher-end returning power of the spread focus strategy:

Here, where the first two crediting strategies "cap out," hitting their upward thresholds along with all enhancements, but the spread strategy has no cap. Along with the 1.5X performance factor, this strategy outshines everything else when the stock market is killing it.

This brings us to a very important point. The stock market goes through times of irrationally, inflated, super-high returns, such as the late 90s. These are bubbles, and when they pop, the value of many people’s accounts deflate—suddenly, without mercy. This is one thing those who are invested directly in the market constantly live with: the fear of the "bubble" bursting. While we want the upward swing of such an inflated, irrational market, we often bite our nails down to the nub worrying when (not if) we will see a massive decline. If you want the techno-babble, it’s called "mean reversion" or a "correction." Doesn‘t that sounds much nicer than “crash”? Yeah well the pain is just the same no matter what the talking heads call it.

Here’s the point: with certain strategies inside of a LIRP, you can allow yourself to potentially benefit from those crazy, insane, gravity-defying returns, capturing and locking them in annually, without having to worry about the bubble bursting and your account deflating like a balloon at your four-year-old‘s birthday party. Annual Lock in and the floor. We’ll take ourselves a piece of that birthday cake, thanks very much.

This is not an official insurance illustration. It is a simplified example to demonstrate how the crediting strategies/engines within a LIRP can potentially create respectable returns over time. No, it’s not this good on an actual illustration because there are fees that apply to both the index fund and the LIRP, and the actual illustration is going to be forward looking, not using historical market data like we did here to portray the principle. Therefore, the numbers you will see on an official illustration will be more conservative (which we applaud). You will also have different starting points with your money, typically in multiple monthly or annual contributions, rather than a single, one-time deposit as is illustrated here. That would change things, obviously. Further, you’ve likely read in our other posts about accumulation of retirement asset not being the bottom line of judging financial vehicles, but rather the projected net-spendable income. That is the bottom line in any retirement strategy. Rate of return and nest-egg size are helpful. But you will often find that a LIRP may not have the highest accumulation value or rate of return compared to other more traditional retirement vehicles. Shrug. Look at the projected net-spendable income. LIRPs are designed to maximize your retirement income over your lifetime, whereas pre-tax, tax-deferred vehicles such as 401Ks and lRAs are designed to maximize your taxes over your lifetime.

Hopefully this has helped you get the concept of how the various crediting strategies/engines within a LIRP might operate and potentially provide safe yet productive returns.

Oh what the heck, let’s do a couple more scenarios using different starting points for the engineers out there. If you get it, go ahead and skip to Part 4. If your juices get flowing by more tables and data, here you go.

Let’s start with a side-by-side since the turn of the century:

Well, compared the the market's 5.57% return (which doesn't take into account taxes), the LIRPs weighted average between all 3 strategies of 9.85% looks pretty darn attractive. Further, the S&P 500's actual return is a paltry 3.99% compared to the LIRP's respectable 9.44% tax-free return. For a discussion on average vs actual returns, please see our blog post, "How Wall Street Lies To You (Legally)". In a 30% combined federal and state tax-bracket, you would have to earn a 14.07% average return to equal the LIRP tax-free average.

For those who are screaming that this isn’t a fair comparison because we start off with three negative years in the market (only happened twice in our economy’s history) that don’t affect the LIRP negatively because of its floor (sorry, not sorry), let’s go to the other extreme and start with 1995, the best years of the market.

Notice anything? Well, I’m sure several things, but every single LIRP crediting strategy/engine outperformed, from a gross rate of return average perspective, the index. All with no negative years due to market losses. How‘s that for a Pepcid AC? And now comes the disclosure, once again: past performance is not indicative or a guarantee of future results or future experience. These are results considered hypothetical, as is all back-testing. These examples are to illustrate a concept. Fees are not assumed in either the S&P 500's or the LIRP's return, which would lower them both. Taxes would significantly reduce the values of the S&P 500's hypothetical illustrated values. Get it? Sigh, moving on . . .

In the financial world, 2000-2009 is often referred to as the "lost decade." We had the dot com bubble blow up as well as 2008 all within a 10-year span. Brutal for most people. Here’s how that would have worked out with our hypothetical strategic tax-free allocation inside the LIRP:

To us, this illustrates the absolute power of annual reset, annual lock in, and the 0% floor. The raw return of the S&P 500 over this ten year period was -0.59% per year. Starting with $100,000 on January 1, 2000, following the vaunted buy, hold, and pray philosophy (ya know, being "disciplined" and all) you would have had $75,985 at the end of 2009, not counting any fees, applicable taxes, and dividends.

During this same decade, the LIRP strategies all produced a gross return of over 7% per year, tax-free, basing their return upon the S&P 500 index. How can that be when the index was negative?

• Locking in gains once achieved
• Annual reset
• The guaranteed floor

Bowling with bumper rails.

Again, these are only a few examples of the crediting strategies and enhancements that different LIRPs may offer.

Indulge me for one more analysis. What if cap rates, participation rates or spreads were worse than the typical examples just shared? Let's lower the caps and the spread/margin a bit and do a stress test of sorts. Instead of a 12% cap for the first strategy, we'll assume 9%; 7.5% for the second instead of 10%; and an 8% spread/margin for the third instead of 5%. And here we go:

334

While the market's average return (before taxes) is slightly higher, the LIRP's actual return is higher. This is the more important metric. Further, the volatility in the LIRP is much lower, providing a superior risk-adjusted return compared the S&P 500. By its nature, the LIRP is an absolute return strategy, and a defining characteristic of such an approach is potentially much less volatility while still achieving respectable returns.

In Part 4, let’s discuss other features, including liquidity, long-term care provisions, access of funds through various strategies, and fees.

Ever notice how you're only good at the things you're really passionate about? We're passionate about tax-free retirement planning. Talk to us.

Kristen Cooper, NSSA®
President
Axios Capital Strategies