The first step in this strategy acquires longevity insurance?protection against outliving assets?while significantly increasing Sara's current income above short-term CD rates. Her life expectancy (at age 72) is about 15 years. Since she is in good health, she might expect to live longer than average, which increases her longevity risk. To transfer this risk to a life insurance company, she purchases an immediate (income) annuity that will pay her monthly income for life.

Applying $500,000 of her $800,000 nestegg to the premium, Sara takes the "max income" immediate annuity payout based on a single life (with no payments to a beneficiary after her death). At today's rates, she might receive about $3,600 per month for the rest of her life. Aside from transferring longevity risk, this solution achieves a second goal in that it helps Sara "go father out the yield curve." Immediate annuity quotes for a person age 70+ reflect interest rates on high-quality bonds of intermediate maturities. Based on Sara's life expectancy of 15 years, $3,600 of income per month represents an internal rate of return of 3.6%, much better than the 2% she earns in short-term CDs.

Sara could divide her immediate annuity into two parts: one qualified and the other non-qualified. She then could use her IRA money to purchase the qualified part, and this income would be taxable. As a side benefit, annuitizing all her IRA assets into an immediate annuity with life payout automatically (and permanently) meets IRS minimum distribution requirements.

If Sara uses personal savings to purchase the non-qualified part, about 77% of the income from this part would be received tax-free as return of principal. Assuming that she keeps $300,000 of her $800,000 total assets in CDs, this strategy would result in increasing her after-tax income by about $2,560 per month, assuming income tax at 15%.

Providing for Heirs

Since Sara has selected the "max income" immediate annuity payout, she has reduced the amount of principal available to heirs at her death by $500,000. The second part of this strategy replaces that capital with variable life insurance. For a program with a level death benefit of $500,000, a 72-year old female might pay a life insurance premium of about $1,200 per month. In other words, approximately half of the extra after-tax income that Sara generates from her immediate annuity goes to pay life insurance premiums. The rest, she pockets.

You may be asking?why variable life (VL) for a 72-year-old single woman? The answer is that VL can accomplish a third type of protection that no other solution can, and that is to protect her purchasing power with a high degree of assurance and tax efficiency. Of course, following the bear market of 2000-2002, few seniors now believe that common stocks are a secure way to hedge against higher inflation. A much surer way to protect purchasing power, an inflation-adjusted U.S. Treasury fund, is being introduced to some variable product menus. By allocating a significant part of life insurance cash value to this type of fund, Sara can obtain a total return approximately equal to that of 5-10 year U.S. Treasuries, assuming CPI inflation remains about the same in the future. But if inflation goes higher, so will the principal value of Treasury Inflation-Protected Securities (TIPs) held in these managed portfolios, on a dollar-for-dollar (indexed) basis.

Participating in TIPS inside variable life has an added tax benefit?namely, the income produced by these securities' semi-annual coupon payments is not currently taxable at the federal level. Also, policyholders don't have to report the annual accretion in principal due to inflation adjustments, as occurs if TIPS are held outside a tax-advantaged account.

Where can you find a TIPS portfolio in a variable life contract? The leader in this niche is Nationwide with its America's Future Life Series of VL products, all of which offer American Century VIP Inflation Protection Fund. American Century was among the first fund group to offer a professionally managed inflation-adjusted securities fund when TIPS were introduced by the Treasuries in early 1997. (The Nationwide VL product line is issued to age 85.)

In a retail mutual fund format (outside variable life), you can select among several funds that invest in TIPS, including American Century Inflation Adjusted Treasury, Fidelity Inflation-Protected Bond, Pimco Real Return Bond, and Vanguard Inflation Protected Securities. In a variable annuity structure, yet another choice is the CREF Inflation-Linked Bond Account from TIAA-CREF.

Explaining TIPS to Clients

It's important to be able to explain to seniors how inflation-adjusted Treasury funds help to protect purchasing power. This has become easier now that the performance of these securities can be measured against a benchmark, the Citigroup Inflation-Linked Index (CILI). In a stable inflation environment, this index is subject to the same rate-driven performance factors as intermediate Treasury notes and can be expected to perform about the same. In 2003, for example, when rates were trending down, the CILI returned 8.26%. For the first six months of 2004, when rates trended up, the CILI returned 1.89%. Due to diversification requirements, many inflation-adjusted funds do not invest 100% of assets in TIPS, so their performance may not exactly track the CILI.

The yield of TIPs has two components. One is equivalent to the "real yield" on coupon Treasuries of comparable maturity (after inflation). The other is an "inflation expectation yield," which is proving to be one of the best measures of inflation sentiment in the U.S. If CPI inflation actually goes higher, or if investors believe it will go higher, the inflation expectation component increases, causing TIPS to yield more than comparable coupon Treasuries.

Seniors are protected against loss of purchasing power in TIPS by the U.S. Treasury's promise to index the principal amount to future increases in the CPI. Technically, Treasury uses the CPI-U for All Urban Consumers published monthly by the Bureau of Labor Statistics. Since the index publication lags actual changes in CPI prices by two months, the inflation adjustment of TIPS has this same lag, but otherwise it is dollar-for-dollar down to the decimal point.

Had a senior purchased TIPS when they were first introduced in early 1997 and held them through the end of 2003, every $1,000 of principal would now be indexed to a par value of $1,183. Also, the current semi-annual coupon on those securities would be paid at the coupon rate of the bond multiplied by $1,183. Both the par value and coupon value will increase as long as inflation is positive. If inflation is ever negative (deflation), the coupon payments will decline, but the principal returned at maturity can't be below original par value.

Anticipating Higher Inflation

Imagine that a few years from now, CPI-U inflation has increased to 5-6% or higher, and many seniors are scared of losing their purchasing power. How would you like to be able to tell clients in their 70s or 80s that they haven't lost one dime of purchasing power on their TIPs? Also, because they have bought TIPs inside variable life insurance, they haven't paid one dime of income taxes on either bond interest or annual accretions of principal. Of course, interest rates could rise and TIPs prices could decline, along with prices of other Treasuries. But in a variable life program, as cash value builds gradually, TIPs can be acquired with the equivalent of a dollar cost averaging discipline, which help to reduce the potential for principal losses.

It's important to note that there is one other source of retirement income that most seniors won't outlive?Social Security retirement benefit. Under current law, these benefits also are indexed dollar-for-dollar with the CPI. Of course, Social Security benefits (and the Cost of Living Adjustment) could be whittled back in the future. Perhaps that's all the more reason retired clients should index some other assets to protect purchasing power.

The Strategy Summarized

To summarize the strategy described in this article:

1. Annuitize part of a senior client's nestegg into a single life ("max income") immediate annuity with no benefit to survivors.
2. Replace the annuity premium with a variable life insurance death benefit.
3. Allocate part or all of the variable life cash value to an inflation-indexed Treasury portfolio for automatic dollar-for-dollar inflation indexing in a high-quality debt obligation.

The benefits are summarized as follows:

1. More current income after-tax.
2. Guaranteed current income you can't outlive.
3. Automatic compliance with minimum distribution requirements, if IRAs are converted into immediate annuity income with lifetime payout.
4. A predictable amount of life insurance paid to your beneficiary income-tax-free at death.
5. The opportunity to participate in high-quality U.S. Treasuries in which principal and coupons are indexed dollar-for-dollar with the Consumer Price Index.
6. A dollar-cost averaging discipline for purchasing shares in an inflation-adjusted fund.
7. No current income tax on TIPS interest or principal accretions.
8. The professional services of a qualified advisor helping you implement this program and keep it on track.

Now is the time to "break out of the box" of any preconceived notions that seniors and insurance don't go together. Help seniors live better on the assets they have, without taking more risk, and they will appreciate your services for the rest of their lives.