Arbitrage. Many folks have no idea what the word means, or, more importantly, how you may be able to make money from the concept. Simply put, an arbitrage is exploiting a price variation.
For example, assume for a moment that I introduce you to a source that will loan you all the money you want, with no questions asked (O.K., this might require some imagination) and the interest rate that you’ll pay on your loan is 4%. On top of that great interest rate, you get another guarantee: the interest rate will also never go up (I said that this was an exercise in imagination, not reality). Now, assume that I introduce you to another source that will allow you to invest all the money that you want, and this source will pay you 6% interest on all the money that you want to invest. On top of that, the rate of interest credited is guaranteed never to change.
Armed with that information, here’s my question for you: Would you like to borrow all the money at 4% that you can and invest it at 6%?
The answer for many folks, is obviously ‘yes’.
That’s an arbitrage – taking advantage of a price variation.
The problem with many arbitrages is that they’re simply not that clean, neat, and predictable. Many arbitrages exist one day and then evaporate the next. There’s one arbitrage, however, that may be the proverbial exception to the rule. That’s the good news. The bad news is that while this arbitrage will work well for some clients it won’t work at all for others.
Let me explain by giving you an example:
1.) Chuck is 75 years old with an investment portfolio of bonds worth $2,000,000.
2.) Chuck’s current average yield on this bond portfolio is 4.5%. This means that Chuck is receiving investment income from this portfolio of $90,000 per year.
3.) Chuck looks into a strategy that may allow him to increase his income from his investment portfolio and guarantee his heirs a tax advantaged $2,000,000 inheritance.*
4.) Chuck uses his investment portfolio to buy a $2,000,000 medically underwritten, lifetime income contract* that pays him $285,480 annually for life. **
5.) Chuck also buys a $2,000,000 life insurance policy to provide a $2,000,000 inheritance to his heirs completely income and estate tax-free.
6.) The premium for the $2,000,000 life insurance policy on Chuck’s life is $121,000 per year. Chuck will pay the premium from the increased income he’s receiving from his investments*.
7.) By utilizing this strategy, Chuck will increase his spendable income and guarantee a tax advantaged $2,000,000 inheritance to his heirs.
8.) Here’s Chucks situation both before and after an asset repositioning.
Arbitrage strategies are not suitable for all investors. This particular strategy is designed for an investor who would not need access to the funds used to purchase the lifetime income contract and life insurance policy.
For more information on how this arbitrage might work for you, please call our office and set up an appointment to speak with Todd.
*The asset being illustrated here is a life insurance contract and the death benefit amount noted is guaranteed by the claims-paying ability of the issuing insurance company. The purchaser should consider the issuing insurance company’s credit rating when contemplating a purchase.
**The asset being illustrated here is a Single Premium Immediate Annuity and the income benefit is guaranteed by the claims-paying ability of the issuing insurance company. The purchaser should consider the issuing insurance company’s credit rating when contemplating a purchase. The identified strategy is an acceptable option when the retiree is certain that he or she does not need to withdraw any amount above the annual income amount at present or at anytime in the foreseeable future.
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