Split Annuity Guide

A split annuity is an investment strategy that involves simultaneously purchasing at least two annuities with a single premium payment. As this definition shows, the term “split annuity” is something of a misnomer, since it doesn’t represent one single annuity but rather splitting a lump sum of money between two or more annuities. It is not a product, but multiple products purchased pursuant to a unified strategy.

A split annuity is a conservative strategy aimed at providing current income, preserving principal value or capital, and quite possibly reducing interest-rate risk as well.

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Basic Outline of the Split Annuity Strategy

A suitable candidate for the split annuity would be a high net-worth individual at or nearing retirement. That individual’s goals will include current income and preservation of principal. It is reasonable to assume that an individual nearing retirement has a fairly large sum of money available to devote to these goals. For simplicity’s sake, the split annuity concept can be illustrated using two basic annuity products.

The first annuity product is a single-premium immediate annuity, which provides current income to the annuityholder. This will not be a life annuity but rather a fixed-period or “term certain” annuity that provides income for a specified time period only. In principal, that time period could range from 3 to 20 years. In practice, many split annuities are structured to cover a period of 5-10 years.

The second annuity product is a deferred fixed annuity calculated to grow its premium contribution to equal the original combined single premium (the investor’s total principal value) in the course of a 5-year accumulation period. At the end of five years, the investor has enjoyed current income and ends up with an accumulation value in the deferred annuity equal to his or her original principal value.

Provided that the income provided is sufficient to sustain the annuityholder, the process can be repeated ad infinitum.

Purposes of the Split Annuity

The first purpose of the split annuity is to provide current income. That is what the immediate annuity does. The term-certain feature of the annuity allows larger income payments than would a life annuity. The payments are guaranteed.

The second purpose of the split annuity is to preserve capital or principal value. That is why the deferred fixed annuity is programmed to grow the accumulation to equal the original principal value over the term of the annuity.

Split annuities utilize a principle, called “laddering,” often found in bond investing. The principle seeks to minimize risk by designing a series of short-term investments to “leap-frog” their way over a longer time period. That is, proceeds can be reinvested at maturity to span a time period longer than the time structure of the investment itself. One of the risks avoided is “interest-rate risk.” This is the risk that interest rates may rise after the purchase of a fixed-income investment product, leaving the purchaser stranded with an asset whose rate of return is inferior to current market substitutes. Avoiding or minimizing interest-rate risk is a third potential purpose of split annuities.

Other purposes may be served. Deferred fixed annuities usually offer limited liquidity, usually in the form of penalty-free withdrawals equal to 10% annually or perhaps equal to interest earned in the previous year. That provides an emergency buffer in case the sudden need for more liquidity arises. If the deferred annuity features medical-emergency waiver of premiums or surrender charges, these add to the buffer available to meet contingencies.

Tax-efficiency is another purpose of the split annuity. Although payments are subject to tax, most of each payment will be return of principal and therefore not taxable. Meanwhile, the proceeds of the deferred annuity are growing tax-deferred inside the annuity, allowing the principal and reinvested interest to be compounded.

Although split annuities are primarily a retirement-oriented strategy, they are sometimes used in conjunction with the discharge of a regular obligation, such as mortgage payments. The income from the immediate annuity makes the mortgage payments, while the deferred annuity restores the investor’s principal over the course of the term.

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The Term-Structure Tradeoff

The reason why split annuities often cover a 5-year time period is that this enables the annuityholder to “reinvest” at the higher interest rate, should interest rates rise over the period. The single-premium deferred annuity will provide a market-competitive interest rate. At the end of five years, a new split annuity can be structured for another five years at current interest rates. In every case, the deferred annuity will grow to equal the value of the original principal over the 5-year time frame.

One difficulty with a 5-year term is that annuity surrender charges often exceed five years. Paying a surrender charge would reduce the effective yield on the investment. Lengthening the term to 10 years would allow a wider selection of annuities whose surrender charges can be outlasted. Unfortunately, this significantly worsens interest-rate risk by making the investor wait longer to reinvest.

Split-Annuity Limitations

The primary limiting factors on split annuities are the age-range limitations on the issue of the annuity policies. The allowable age range for non-qualified (after-tax) annuities is from 0-85; for qualified (untaxed) annuities it is 0-70.

A Pitfall of Split Annuities

One potential pitfall of a split annuity is that the internal rate of return (IRR) of the immediate annuity may fall short of yields on competing short-term investments, such as U.S. Treasury securities. The necessity for the insurance company to pay interest while simultaneously covering mortality and expense charges and insurance administrative costs may squeeze the investor’s rate of return; e.g., reduce the immediate-income payout to the investor.

Split annuities are an ingenious idea, but the concept of securities held in tandem for a unified purpose is not unique to annuities. Other investments might conceivably fulfill the same purposes as do the annuities. Consequently, a would-be split-annuity buyer should ascertain the IRR being offered on the immediate annuity before committing to purchase of a split annuity.

Summary

A split annuity is one premium payment split so as to purchase multiple annuity products. It is a strategy rather than an annuity product. The strategy involves the purchase of an immediate annuity and fixed deferred annuity.

The purpose of a split annuity is to provide needed current income to the purchaser while growth inside the deferred annuity replenishes the investor’s principal value. Properly executed, the split annuity can reduce interest-rate risk by allowing the contract to be recalibrated in line with now-current market interest rates. This reduction in interest-rate risk is one of several risk-reduction components. The income payments are guaranteed. The restoration of the investor’s principal value at the end of term reduces the risk to the investor’s principal value. Split annuities improve tax efficiency since most of the income payments constitute untaxed return of principal while accumulations in the deferred annuity grow tax-deferred.

Thus, the needs served by a split annuity are income, capital preservation, risk-reduction, and tax efficiency.

Potential purchasers of a split annuity should verify that the internal rate of return on the immediate annuity is competitive with the yield on alternative fixed-income market instruments.

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