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ANNUITIES

What Guaranteed Income Really Means

Annuities are great for tax-free accumulation without stock market risk. However, given low interest rates, the interest rate caps on IAs are not very exciting.

Fortunately, an added income rider to an annuity contract (also called a guaranteed withdrawal benefit rider or GWBR or a lifetime income benefit rider or LIBR) can be a godsend when it comes to guaranteeing great income that will last if the client lives to 87, 97 or 127.

The problem is that producers must do an honest job of explaining what these riders do – and what they do not do.

To illustrate, consider the following discussion that I, Bill Kanter, (BK) often have with a Prospective Client (PC) while discussing retirement planning and longevity:

PC: “I have an annuity and I am making 6.5 percent annually compounded on my money, guaranteed!”

BK: “No, you are not making a guaranteed annual rate of 6.5 percent on your money. In this market that is impossible. The insurance company is only making 2-3 percent on the money you give them, how can they pay you 6.5 percent every year?”

PC: “Yes I am! My agent told me that as long as I defer taking out the money I am guaranteed to make 6.5 percent every year.”

BK: “No, the financial advisor who told you that was either misleading you or more likely does not fully understand how the product works. What you purchased was a rider to an annuity contract. The rider, which you pay for at the rate of about $650-$950 per $100,000 of annuity premium, guarantees that you will make 6.5 percent per year credited not to your money in the annuity (i.e., money that you can take out lump sum or that will go to your beneficiaries).

Rather, the rider says that the insurance company will credit that 6.5 percent to a separate income-only account from which you can only use to take out annual income for life (no matter how long you live). Not only that, but the insurance company tells you what percentage of that account you can take out. The amount credited to your money in the annuity (what they call the contract value) is more like 3-4 percent if the market goes up and nothing if the market goes down, so you cannot lose your principal due to market losses.”

PC: “So why exactly isn’t that considered 6.5 percent on my money?”

BK: “Let me give you an example. If you put $100,000 into an indexed annuity and you really did earn 6.5 percent each year compounded, then after 10 years you would have $215,892 to take out of your annuity (assuming a 10-year surrender charge) In actuality, however, that is not what you will have with the annuity you purchased with a cap (the maximum you can earn each year) of 3 percent and a floor of 0 percent (which you will get in some years when the market goes down).

Rather the $215,892 will be in your income only account and when you start taking out lifetime income, the insurance company will fix an annual lifetime payment amount based on a percentage of that $215,892. It may still be a great idea because you cannot run out of money even if you live a very long time. In fact, it is the only vehicle in the financial services world that can guarantee you income for as long as you live.”

To further illustrate this to clients and prospects, I use the different color chart that illustrates an IA with an 8 percent premium bonus and a 6.5 percent “rollup” (the industry’s term for the income rider annual guaranteed credited rate).

The following is based on a real case.

A potential client (Tom) who was 65 and retired told me that he had $250,000 in his 401(k) and he wanted to start drawing from it in five years at age 70. He wanted to take out $20,000 annually at that point to supplement his other pension and social security income. The problem of course is that even if he invested his money in a 5-year CD at 2 percent per year and then began withdrawals at age 70, he would run out of money after about 14 years of taking out $20,000 ($280,000) (see the note at the bottom of the chart). Tom expects to live beyond age 84 so he was worried.

Using the chart on page 40 I illustrated how the income rider will give him the income he needs and will pay him no matter how long he lives.

When Tom transfers in the $250,000 from his 401(k) to the IRA annuity he immediately gets an 8 percent bonus so the “day one” value of his account is $270,000 in both his Real (or contract) account value (the green column) and in his Income Only account value (the purple column). Note that Tom had already retired so there were no restrictions on transferring the money from his 401(k) to his IRA. Had he still been working he would have needed to check to see if his employer allowed for an “in service rollover” to the IRA annuity.

What the insurance company calls the “contract” value I make a point of calling the Real value because this is the amount that he can really take out if he needs a penalty-free withdrawal (or a penalty withdrawal) or if he passes away and the account goes to his beneficiary. The Income Only account value that gets credited the 6.5 percent each year is only used to determine his lifetime income payout. He has no access to this money.

As you can see, the Real account value grows with the S&P index based on the floor of zero and the cap of, in this case, 3 percent (based on the history of the S&P 500 returns over the 11 years from 1999-2010). As the asterisk indicates, it is from this account that the income rider fee is taken from each year.

When Tom turns 70 and is ready to start taking lifetime income, he intends to call the insurance company and he will be told that his Income Only account (or income rider account) has been credited with exactly 6.5 percent compounded every year and has a balance of exactly $393,968. At his age the company will fix his lifetime payments at 5 percent of that Income Only account or $19,698 (this rate changes based on the carrier and the age of the client). Note that there are some carriers that have this value start out lower but go up with the market in an attempt to keep up with inflation.

The key point to make to the client is that this $19,698 will be taken out of the contract, or Real account, value so in 14 or so years there will also be nothing left in that account. However, the insurance company will still continue to make the payments of $19,698 to him for as long as he lives (he could take a joint payout for the life of his wife as well but the payments would be smaller). It is peace of mind or “longevity insurance” that makes the income rider so important to the client.

It is also important to point out that if Tom dies while there is still money in the Real account value, his beneficiaries would get that money with no penalty.

By the time I am done explaining the income rider in this way my clients and I are speaking about the “green column” and the “purple column.” This way I know that there are no misconceptions.

To summarize: IAs with income riders are the only vehicle in the financial services world that can provide a competitive income stream and guarantee that income stream for as long as the person lives. Thus, they can offer great peace of mind for a client concerned about running out of money during retirement. However, it is important that the ethical advisor make sure that the client understands that the “rollup” rate is not credited to the client’s contract value and that the contract value will be reduced by the income withdrawals (and by the income rider fee).

Bill Kanter, J.D., MBA, has more than 20 years of experience in the field of estate planning, elder law and financial planning. He is a member of the National Academy of Elder Law Attorneys. Contact him at [email protected] [email protected].


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