THE POWER OF

ARBITRAGE IN
A RETIREMENT
ACCOUNT
MARK T. HOUSTON

The Power of Arbitrage in a Retirement Account

Being able to incorporate a financial strategy known as arbitrage in a retirement account can have a dramatically
effect on the overall value of the account. Although there is risk involved with arbitrage, the upside potential is
impressive due to additional interest that can accrue on the account if the spread of the arbitrage is positive.
When an arbitrage strategy is combined with an index universal life contract where market risk is eliminated and
the growth capped relative to the performance of the index it is linked to, the results are impressive when
projections are back tested on historical data of the Standard & Poors 500 Index, less dividends as the assumed
investment rate of returns. When compared to the Standard & Poors Index, less dividends while factoring in
market and sensitivity of sequence of return risk, the risk is minimal. Below we will examine an IRA funded using
the Standard & Poors 500 Index to an index universal life contract where the interest credit to the account is
also linked to the Standard & Poors 500 Index on an annual basis. Distributions from each account will net the
same net income after taxes. To recap the assumptions used for the future value calculations, both accounts
utilize the same historical data for the future value calculations with the exception that the index universal life
contracts interest credits are capped at 13%, negative performance receive 0% credits, whereas the IRA
receives the full gains and losses of the index.
Using the assumptions below lets look at an example of how arbitrage and the elimination of losses can affect
the value of a retirement plan when the same net distributions are taken from each plan.
Assumptions
Value of the IRA:
Conversion period from IRA to a non-qualified account:
Tax bracket prior to conversion:
Tax bracket during conversion:
Cost of arbitrage or variable loan rate:
Annual net income from IRA and from non-qualified account:

$400,000
3 Years
30%
33%
4.5%
$75,000

The table below is a projection of the future values of an IRA where the gains and losses are based upon past
performance of the Standard & Poors 500 Index, less dividends from 2013 backwards. Distributions are
increased to net the same net income after taxes that are available in the non-qualified account which is funded
with an index universal life contract. The net distribution from the account on an annual basis is $75,000.
Qualified Plan - IRA
YR

Age

IRA Beginning
Balance

1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17

60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76

$400,000
$510,520
$581,616
$582,580
$657,856
$815,973
$502,212
$520,215
$591,550
$608,909
$662,753
$730,947
$449,356
$280,428
$142,629
$62,565
$0

Year for
S&P Data
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997

S&P 500
29.53%
15.83%
2.07%
14.82%
25.94%
-36.55%
5.48%
15.61%
4.83%
10.74%
28.36%
-21.97%
-11.85%
-9.03%
20.89%
28.34%
0.00%

Gain or Loss
$118,120
$80,796
$12,015
$86,345
$170,616
-$298,257
$27,545
$81,219
$28,598
$65,414
$187,929
-$160,560
-$53,248
-$25,328
$29,789
$17,730
$0

Taxable
Income

Fees

Taxes

Ending Balance IRA

$0
$0
$0
$0
$0
$0
$0
$0
$0
$0
$107,143
$107,143
$107,143
$107,143
$107,143
$79,106
$0

$7,600
$9,700
$11,051
$11,069
$12,499
$15,503
$9,542
$9,884
$11,239
$11,569
$12,592
$13,888
$8,538
$5,328
$2,710
$1,189
$0

$0
$0
$0
$0
$0
$0
$0
$0
$0
$0
$32,143
$32,143
$32,143
$32,143
$32,143
$23,732
$0

$510,520
$581,616
$582,580
$657,856
$815,973
$502,212
$520,215
$591,550
$608,909
$662,753
$730,947
$449,356
$280,428
$142,629
$62,565
$0
$0
1

In this example, the IRA is depleted at the owners age of 75. This is due to a couple of factors. The first factor is
the amount of distributions being taken from the account. The second factor is the timing of the distributions
relative to the performance of the index. The third factor is the loss of the opportunity costs associated with the
distributions, and the fourth factor is the affect fees have on the account. It is important to highlight the market
losses in 2008, 2002, 2001 and 2000, and the affect these losses have on the portfolio due to distributions,
market risk and the sensitivity of sequence of returns. As a result, the account is depleted very early in
retirement. This is also assuming the individual rate tax does not increase in the future. If prior to the owners
reaching age 70, the owners individuals individual tax bracket increases by 5%, the accounts income would be
reduced by $36,872. A 10% increase in the individuals tax bracket would reduce income by $69,902. In order
to maintain a constant flow of income from the IRA based upon the assumed investment returns, net
distributions from the IRA would have to be reduced to $39,500.
Compared to a conversion plan funded with an index universal life contract with arbitrage implemented in the
contract on loans, the projections are much more favorable relative to the ending balance, the amount of
income available during retirement, the longevity of the account and the major tax advantages available to life
insurance contracts.
Converted Non-Qualified Plan
Premium Outlay

Interest Credit

Tax Free
Income

YR

Age

1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
36

60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
95

$133,333
$133,333
$133,333
$0
$0
$0
$0
$0
$0
$0
$0
$0
$0
$0
$0
$0
$0
$0
$0
$0
$0
$0
$0
$0
$0
$0
$0
$0
$0
$0
$0
$0
$0

13.00%
13.00%
2.07%
13.00%
13.00%
0.00%
5.48%
13.00%
4.83%
10.74%
13.00%
0.00%
0.00%
0.00%
13.00%
13.00%
13.00%
13.00%
13.00%
1.33%
9.97%
7.49%
13.00%
0.00%
13.00%
13.00%
5.81%
13.00%
13.00%
6.15%
13.00%
13.00%
6.51%

$0
$44,000
$44,000
$44,000
$0
$0
$0
$0
$0
$0
$75,000
$75,000
$75,000
$75,000
$75,000
$75,000
$75,000
$75,000
$75,000
$75,000
$75,000
$75,000
$75,000
$75,000
$75,000
$75,000
$75,000
$75,000
$75,000
$75,000
$75,000
$75,000
$75,000

40

99

$0

0.00%

$75,000

Credit / Debit
On Arbitrage

Interest on Non
Loaned Values

Ending Balance

$0
$3,740
-$3,960
$11,220
$11,220
-$5,940
$1,300
$11,220
$436
$8,237
$17,595
-$12,690
-$16,065
-$19,440
$43,095
$49,470
$55,845
$62,220
$68,595
-$39,690
$52,348
$30,857
$94,095
-$53,190
$106,845
$113,220
$18,432
$125,970
$132,345
$26,928
$145,095
$151,470
-$93,690

$17,333
$31,686
$7,453
$43,611
$50,740
$0
$23,936
$61,303
$25,758
$60,927
$74,206
$0
$0
$0
$44,190
$46,615
$50,185
$55,048
$61,372
$5,553
$40,047
$29,778
$58,038
$0
$53,058
$64,925
$29,502
$76,472
$93,868
$47,224
$115,073
$139,974
$91,416

$150,667
$275,426
$368,253
$379,084
$441,044
$435,104
$460,339
$532,862
$559,056
$628,220
$645,021
$557,331
$466,266
$371,826
$384,111
$405,196
$436,226
$478,494
$533,461
$424,324
$441,718
$427,353
$504,487
$376,297
$461,200
$564,345
$537,278
$664,720
$815,934
$815,085
$1,000,254
$1,216,698
$1,495,803

-$102,690

$0

$1,901,815

To explain the mechanics of the arbitrage on loans, lets look at the year 2011 on the index universal life table,
the account value is charged interest on the loan balance due to the 2.07% return on the S&P 500 Index. This is
true due to the cost of the arbitrage being greater than the annual return of the index (2.07% minus 4.5%).
Since the cost of the arbitrage is 4.5% and the return received was 2.07%, there is negative spread on the
arbitrage of 2.43% which equates to additional interest on the loan balance. Note the unloan balance of the
index universal life contract receives interest of $7,435 or an interest credit of 2.07%.
However, when we compare the IRA and the losses incurred in years 2008, 2002, 2001 and 2000 to the index
universal life contract, the losses in the IRA are considerably higher and have a dramatic affect on the ending
balance and longevity of the IRA. For example, in 2008 the IRA suffered a loss of $298,257, while the life
contract loss was confined to the interest charge on the loan balance or the amount of the arbitrage or $5,490.
In 2002, the IRA experienced an additional loss of $160,560, compared to $12,690 on the life contract due the
negative spread of the arbitrage. In 2001, the IRA lost $53,348 compared to $16,065 on the life contract, and in
2000, the IRA lost $25,238 compared to $19,440 in the life contract.
In the years the arbitrage in the life contract experienced a positive spread on the loan balance, the loan balance
is credited with additional interest, as opposed to a charge. This result from retaining the opportunity costs
associated with the loan balance, which was used to meet the tax obligations on the conversion of the qualified
plan, as well as the income needed in retirement. During the first 16 years of the projection, the arbitrage
strategy is positive 10 years and negative 5 years. This produced $99,437 of additional income credits to the life
contract.
When an arbitrage strategy is combined with the ability to eliminate market losses, the value of a retirement
account becomes very attractive. Prior to and during the distribution phase of a retirement plan, market risk
can affect the longevity of an account due to the sensitivity of sequence of returns when the portfolio suffers a
loss and distributions are taken prior to the market loss or congruent to the loss. The graph below illustrates the
ending balance of a qualified plan to a non-qualified fund when the same net distributions after taxes are
withdrawn from both plans. Market losses are eliminated from the life contract, gains capped at 13%, while the
IRA experiences the entire gains and losses of the S&P 500 Index less dividends. Since market losses are
eliminated from the insurance contract, the sensitivity of sequence of returns is also eliminated. The tax
deferral on the growth inside the life contract is always positive since income is tax free via loans. However, tax
deferral on the IRA may or may not be beneficial depending upon the owners individual tax rate when
contributions were made to the IRA and the individual tax rate when distributions are taken from the IRA
account.

The Affect of Market Losses on a Portfolio

Standard & Poor's 500 Index (less dividends)
$3,000,000
$2,000,000
$1,000,000

IRA

100

98

96

94

92

90

88

86

84

82

80

78

76

74

72

70

68

66

64

62

60

$0

Conversion Plan - IUL

Based upon an annual net distribution of $75,000 with an individual tax rate of 30%, the IRA or qualified account
is depleted at age 75. When compared to the life insurance contract, the ending balance at age 75 is $405,196.
At age 90, the life contract has an ending balance of $1,000,254.
To summarize, although there is some risk with an arbitrage strategy inside an index universal life contract, it
also offers additional growth potential to the contracts accumulation value. Based upon the historical
performance used for above projections, the IRA produced $430,473 of net income before being depleted at age
75. At the individuals current tax rate the owner paid $184,446 in taxes on distributions from the IRA compared
to $132,000 when converting the IRA to a non-qualified account. In comparison, the index universal life contract
had an ending balance of $405,196 at age 75, had tax-free income of $582,000 including the loans used paid to
meet the taxes on the conversion, and a tax-free death benefit to his beneficiaries. After age 75, the IRA offer no
wealth transfer to the owners beneficiaries since the account was depleted. Any wealth transfer available
based upon the ending value of the account at the owners death would be taxed to the beneficiary unless the
beneficiary was the spouse of the owner. Any subsequent wealth transfer from this spousal transfer would be
taxable to his/her beneficiaries.
If you are interested in learning more about this unique strategy, please contact the advisor would provided this
report for you and a complimentary comprehensive IRA analysis would be provided for you to see if a
conversion is right for you.

IRS CIRCULAR 230 DISCLOSURE: To ensure compliance with requirements imposed by the IRS, we inform you that, to the extent this communication
addresses any tax matter, it was not written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or
(ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein. You should consult with appropriate counsel or
other advisors on all matters pertaining to legal, tax or accounting obligations and requirements. The above tables are for illustrative purposes only and
are based upon historical statistics and past results are not a projection or promise that future results will be the same as illustrated above. For investment
advice please consult a FINRA registered advisor.

MARK T. HOUSTON
President
215 S. 88th Street
Omaha, NE 68114
Direct: (402) 880-7008 | Office: (402) 399 9925
Email: mark@fidfin.co | Connect: