Annuity Arbitrage

Annuity arbitrage is a sophisticated financial planning technique that can be used to transfer wealth out of an estate tax-free and create income for life for a surviving spouse or other beneficiary. Annuity arbitrage is remarkably simple to implement: An investor purchases an annuity and uses the income from that to purchase a life insurance policy. The life insurance significantly leverages an investor’s assets because the death benefit purchased is considerably larger than the cost of the annuity.

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  • Written By
    Thomas J. Brock, CFA®, CPA

    Thomas J. Brock, CFA®, CPA

    Investment, Corporate Finance and Accounting Expert

    Thomas Brock, CFA®, CPA, is a financial professional with over 20 years of experience in investments, corporate finance and accounting. He currently oversees the investment operation for a $4 billion super-regional insurance carrier.

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  • Edited By Michael Santiago
  • Financially Reviewed By
    Rubina K. Hossain, CFP®
    Rubina K. Hossain

    Rubina K. Hossain, CFP®

    Client Advisor for MEIRA

    Certified Financial Planner Rubina K. Hossain is chair of the CFP Board's Council of Examinations and past president of the Financial Planning Association. She specializes in preparing and presenting sound holistic financial plans to ensure her clients achieve their goals.

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  • Updated: August 23, 2023
  • 6 min read time
  • This page features 4 Cited Research Articles
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APA Brock, T. J. (2023, August 23). Annuity Arbitrage. Annuity.org. Retrieved June 22, 2024, from https://dev.annuity.org/annuities/strategies/annuity-arbitrage/

MLA Brock, Thomas J. "Annuity Arbitrage." Annuity.org, 23 Aug 2023, https://dev.annuity.org/annuities/strategies/annuity-arbitrage/.

Chicago Brock, Thomas J. "Annuity Arbitrage." Annuity.org. Last modified August 23, 2023. https://dev.annuity.org/annuities/strategies/annuity-arbitrage/.

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Key Takeaways

  • Arbitrage is a term describing the simultaneous purchase and sale of the same (or substantially equivalent) asset in different markets to capitalize on price discrepancies without assuming any risk.
  • Annuity arbitrage refers to an investment strategy that capitalizes on differences in the way insurers underwrite annuity products and life insurance policies.
  • It can be an effective way to enhance your financial position, augment retirement income and optimize an estate plan.
  • Before implementing an annuity arbitrage strategy, be sure to carefully plan how to fund it. Ideally, implementation should be tax-efficient and have minimal impact to your income streams and liquidity reserve.

Introduction

An annuity arbitrage strategy is implemented by purchasing an annuity and using the income generated by it to purchase a life insurance policy. This maneuver leverages your assets and amplifies your wealth-accumulating potential, because the death benefit purchased via the life policy is considerably larger than the cost of the annuity.

The strategy is most effective when you purchase an annuity that pays out the highest possible lifetime income and couple it with the least expensive form of life insurance. Generally, this means buying a single premium immediate annuity and a term life insurance policy.

A single premium immediate annuity (SPIA) is a pure form of annuity. It entails a single, lumpsum purchase and begins paying a lifetime income stream immediately after purchase. There is no accumulation period and no deferred growth.

A term life insurance policy is the least expensive form of life insurance. It provides coverage for a specified term, usually, between 10 and 30 years. If you die during the policy term, your beneficiaries will receive a death benefit payout, assuming you make all required premium payments. If you outlive the term, the insurance coverage ceases to exist and no death benefit is paid.

Why Is this Strategy Characterized as Arbitrage?

Arbitrage is a Wall Street term that refers to the simultaneous purchase and sale of the same (or substantially equivalent) asset in different markets to profit on price discrepancies without assuming any risk. Annuity arbitrage takes advantage of a different type of discrepancy.

According to a report by Ernst & Young and the Life Insurance Marketing Research Association, buying an annuity to finance the purchase of an insurance policy creates arbitrage, “because of the differences in the insurance industry between mortality assumptions for annuities and for life insurance.”

Insurance companies assume one life expectancy when underwriting an annuity and a completely different one when underwriting a life insurance policy. This provides a shrewd investor the opportunity to strategically leverage an annuity position to generate, otherwise, unachievable wealth for his or her beneficiaries.

For example, a 70-year-old male in good health that purchases a $500,000 SPIA will earn approximately $2,850 a month for life. This amount is more than enough to buy the same man approximately $4 million of 10-year term life insurance.

If the man implements an annuity arbitrage strategy with a single insurance company, the financial impact is as follows:

  • Initially, the man gives the insurance company $500,000 for the annuity.
  • Each year, he receives $34,200 of income from the SPIA (until death).
  • Each year, he also pays the insurance company some amount less than $34,200 for the term life insurance coverage.

If the man dies within 10 years, both the $34,200 annual SPIA inflows and the less than $34,200 annual life premium outflows cease. However, a $4 million death benefit is paid to the man’s heirs.

Clearly, if the man dies prior to the expiration of the life insurance policy, his family stands to reap a significant return on the strategy. However, for everything to work out, some planning and consideration of life expectancy is integral.

Using Annuity Arbitrage to Augment Retirement Income

Many shrewd investors incorporate annuity arbitrage strategies into their retirement plans. The annuity component of the strategy generates income during the annuitant’s life, a portion of which is used to purchase the life insurance component. Upon the annuitant’s death, the annuity income stream ceases, but the annuitant’s spouse or other beneficiary receives a tax-free death benefit from the life insurance policy.

The annuity arbitrage strategy is an excellent way to optimize income streams for you and your spouse (or other beneficiary) over your lives. However, it assumes that the annuitant will die before his or her life insurance beneficiary. If this is not the case, the purpose of the arbitrage strategy is defeated. One way to overcome this is to buy a joint life policy.

Using Annuity Arbitrage to Optimize an Estate Plan

Annuity arbitrage can be very useful for people with large, taxable estates. The strategy makes it possible to transfer wealth out of an estate without incurring any tax. The approach entails an investor buying an SPIA and utilizing the income it generates to buy a term life insurance policy covering his or her life and naming an irrevocable life insurance trust (ILIT) as beneficiary.

When the annuitant dies, the death benefit is paid to the trust and then distributed to the trust’s beneficiaries. The transfers are tax-free, because they are life insurance proceeds.

Issues to Consider

Investors contemplating annuity arbitrage should examine the composition of their current portfolio before engaging in this strategy. Funds used to purchase the annuity must come from somewhere. Investors need to understand how changes to their existing portfolios will affect their income streams and liquidity reserve.

Generally, the funds used to buy the annuity should come from low-yielding assets whose income won’t be missed. This is because the cash flow generated by the annuity will be largely offset by the life insurance premiums.

If you own a deferred annuity in its accumulation phase, this could be an excellent source of funds. In this situation, executing a 1035 exchange and transferring the funds into a SPIA is the optimal approach, allowing you to avoid liquidating other long-term assets and incurring any tax. 

Beyond the funding considerations outlined above, be sure to carefully assess your tax position prior to implementing an annuity arbitrage strategy. Generally, those in the highest income and estate tax brackets benefit most from annuity arbitrage. That said, the strategy can help anyone maximize the legacy created for his or her heirs.

All things considered, annuity arbitrage can be an effective way to enhance your investment portfolio and improve the financial security of your heirs. However, it’s just one of the many tools you can leverage to optimize your financial position. Consult with a fiduciary financial advisor to flesh out the other opportunities available.

Frequently Asked Questions about Annuity Arbitrage

What is the difference between an immediate annuity and a deferred annuity?

With an immediate annuity, you begin receiving payments within a year of purchase. With a deferred annuity, you begin receiving payments after a specified period that usually lasts between six and 10 years. This period, which is commonly referred to as the accumulation phase, is designed to give your invested money time to grow on a tax-deferred basis. 

Can you lose money on an annuity?

Assuming you purchase an annuity from a reputable, well-capitalized insurance company, you will not lose any money with fixed annuities. They are the safest type of annuity, because they generate stable, guaranteed rates of interest. 

Indexed annuities are a little riskier, because their returns can fluctuate. However, most of these instruments provide downside protection. 

Variable annuities are the riskiest type of annuity you can buy, because they entail assuming investment positions in volatile assets, such as stocks and bonds. 

How are insurance companies regulated?

Insurance companies are regulated by the states in which they conduct business. The various state insurance departments are supported by the National Association of Insurance Commissioners – an association of U.S. insurance regulators that provides data collection, technical analysis and a forum for the development of regulatory standards, procedural guidelines and best practices.

Please seek the advice of a qualified professional before making financial decisions.
Last Modified: August 23, 2023

4 Cited Research Articles

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  1. Drinkwater, M. et al. (2006). Substandard Annuities. Retrieved from https://www.soa.org/globalassets/assets/files/research/007289-substandard-annuities-full-rpt-rev-8-21.pdf
  2. Internal Revenue Service. (2022, September 9). Estate Tax. Retrieved from https://www.irs.gov/businesses/small-businesses-self-employed/estate-tax
  3. National Association of Insurance Commissioners. (n.d.). Life Insurance. Retrieved from https://content.naic.org/consumer/life-insurance.htm
  4. National Association of Insurance Commissioners. (n.d.). Our Story. Retrieved from https://content.naic.org/about