Annuities 101

A message from the Northwest Financial & Tax Solutions Founder.

Just as an experiment, we sometimes ask an audience what they think of a financial product that we will describe in detail, but not yet name it. Then we proceed to list on a whiteboard or flipchart all the characteristics of this product as follows:

  • Guarantee of principal – subject to the financial strength and claims-paying ability of the issuing company
  • Potential to earn interest in up markets
  • Guarantees to your principal in down markets
  • Capable of producing guaranteed lifetime income
  • Limited liquidity for a specific time period, anywhere from 5-15 years, but no surrender or liquidation fees after that
  • Tax deferred interest potential
  • Unused portion of account passes to heirs upon death

Then we ask them to vote. We say, “Those who like the sound of this product and would like to know more, raise your hands.” Nearly every hand goes up. “Now, those who do not like this are not at all interested, please raise your hands.” Usually no hands go up.

Next we ask, “How many here like annuities?” Usually only a fourth of the hands go up, and those are people who own them and have had satisfactory results. Of course, most present are surprised to learn that this product we just drew on the board is a fixed index annuity with an income rider attached. It is an insurance product, not an investment, and your money is never invested in the market.

We can’t help but think of William Shakespeare’s famous and often misquoted line from Romeo and Juliet: “What’s in a name? That which we call a rose by any other name would smell as sweet.”

So why the bias? Why is it that when you say the word “annuity,” some people make the sign of the cross with two wooden pencils as if Dracula had just entered the room? Like most prejudice and bias, it has its roots in misinformation and a lack of education, which are two things people who know me well know that I just cannot abide. The cure for misinformation and ignorance is, of course, information and knowledge.

Growing in Popularity

The main reason many of our clients are in fixed index annuities with income riders, however, is not solely because of the cash value but also because of the feature that provides guaranteed income for the rest of their lives. They are, in effect, taking charge of their own retirement by forging their own guaranteed income stream. They know that their money has the opportunity to grow and compound. They know that they can use the guaranteed income feature and still pass on any unused portion to their spouse or heirs. This is a far cry from the old style of annuity, where you received an annuity payment but surrendered control of the balance of your account so that when you died the insurance company kept the money.

This is not Grandma Ruby’s Annuity

Grandma Ruby was born in 1900 and grew up in Colorado. When she was a young woman, she came to Portland via a covered wagon. She never had more than an eighth grade education. She worked as a clerk at Meier & Frank Department Store in downtown Portland for 45 years and retired in 1965. These were the days when corporations provided pensions for loyal employees, and Grandma Ruby’s pension would have guaranteed her $8,000 per year for the rest of her life, or she could take a lump sum of $100,000. Grandma Ruby had no formal education, but she was intelligent. She had heard from a fellow retiree that there was something out there called an annuity. She had also heard that if she took the lump sum offered her from the department store and parked it with an insurance company, they may be able to offer her a better deal. Ruby opted to take her lump sum and buy a single premium immediate annuity with a life only payout of $832 per month, or just short of $10,000 per year for the rest of her life. It was a sweet deal for Grandma Ruby. Female life expectancy in 1965 was 72. She lived to be 98 years old. As it turns out it, it was the single best financial decision she ever made.

I remember Grandma Ruby for many things. I am convinced she was the best cook west of the Mississippi. She made fried chicken in a black cast iron skillet that would have made Colonel Sanders’ mouth water. She served it with gravy and mashed potatoes that were the best I have ever tasted. But the first time I ever heard the word “annuity” was when my grandmother would occasionally mention it. If she had a purchase she wanted to make that was over and above her usual expenses, she would say, “I’ll wait until my annuity check comes.”

It would be years later that I would learn all about the inner workings of annuities and how the moving parts of them function. In her day, there were few options to choose from. Grandma Ruby could have received a greater monthly amount from the insurance company had she opted for a 5-year or a 10-year payout. She had no way of knowing she would live to be almost 100 years old. But regardless of which option she chose, once she “annuitized,” or opted for a guaranteed payout of any length of time, she no longer controlled the balance of the account. Had she died accidentally six months after purchasing her annuity, there would have been no death benefit for her heirs. That’s the way single premium immediate annuities worked in those days. In fact, it is how the traditional annuities work today, for that matter. But the old-style annuities aren’t “flying off the shelves,” so to speak. The baby boomers just weren’t too keen on the use-it-or-lose-it idea. The insurance companies re-tooled and came out modern annuities that (a) allow for a guaranteed income like Grandma Ruby had, but without sacrificing control of the account, and (b) predicate interest not on a fixed rate of interest but tied to positive movements in a selected market index, while not actually being invested in the market.

As in life, prejudicial thinking and misconceptions can warp our judgment when it comes to investing. Back in the late 1980s, there was a television commercial that used the catchphrase “This is not your father’s Oldsmobile.” The Oldsmobile had come out with a sporty Cutlass Supreme model. It was just a very attractive car with lots of power, class and style. But, for some reason, it wasn’t moving off the sales lots. The reason was that the perception of the Oldsmobile was that of a stodgy, gas guzzler, old person’s car. General Motors wanted to let the world know that this new Oldsmobile was a departure from the old one. To re-establish the brand’s identity and to appeal to a younger audience, the automaker aired thousands of 15-second spots with visual images of young people putting the perky new Cutlass through its paces. Each clip ended with the voice-over, “This is not your father’s Oldsmobile.”

These more recent annuities with their multi-faceted options are not your Grandma’s annuity by any stretch, which is why we need to rethink them as viable instruments for retirement income planning.

Fixed Index Annuities

One type of annuity is the fixed index annuity (FIA) with an income rider attached.4 They are sometimes called “income annuities.”Let’s say you put $500,000 into an FIA, and let’s say the company gives you a premium bonus6 of 8%. That means you’re starting off with $540,000. That is the actual account value. However, the bonus generally has a vesting period, which means that it isn’t available for you to withdraw until a certain period of time has elapsed. In addition, you often will receive the bonus only if you take withdrawals from the annuity under a prescribed withdrawal schedule. In many cases, surrendering the contract in full will mean forfeiting the bonus amount, depending on the terms of the annuity.  That same $540,000 is also going to be what is referred to as an “income base.” In essence, with this annuity, you have two annuity values to account for, simultaneously.

Simultaneously, as the actual accumulation account is growing, the $540,000 income base or income account may also increase as well, by a specific “roll up” amount. This percentage of growth varies from company to company and by product, but the idea is the same. If you had $540,000 to work with, for example, that income base rolls up at X% per year. So at the end of 10 years, in the income base account, your XXX is now $XXX. If, at that point, you want to turn on that income rider, you may do so.

What you receive in the way of income is based on your age. If you are 75, for example, your annuity might have a lifetime payout of 6.5%, or $69,047 per year. The income would come every year (or every month if you wish) for the rest of your life. To extrapolate that, let’s say you get $69,047 per year for 20 years. You could collect $1,380,940 when all is said and done, even though you only put in $500,000.

And what happens if you die sooner? Let’s say a tragic accident occurs and both you and your spouse are killed after having collected only three payments from your lifetime income. You would have collected a total of $207,141. Some annuities offer minimum guaranteed interest rates, which may be as low as 0%. Assuming your policy offered a minimum interest rate of 1.25% in this example, your actual account value (not your income account), at that time would have grown at only the 1.25% guaranteed rate and would be $634,642. So when you subtract what you have taken from the real account value, there’s $427,501 left for the heirs. Why is that important? Because in an immediate annuity, if you put the money in, and you got a payout for your life, but once you die it’s done, your heirs didn’t get any money. With the income rider, however, it works differently. You get a guaranteed income that you can’t outlive, and if you pass away, your heirs get the difference between the actual account value and the amount of income you took.

If you are looking for income you cannot outlive, an annuity with a guaranteed income rider may be a good solution for a portion of your assets. They are not for everyone and they are by no means a one-size-fits-all solution to every income planning problem. But they have some exciting features.

By using an annuity as an income source, you may be able to delay taking your Social Security until age 70, which will make that income as high as possible. You may also have an income that can address with inflation through the purchase of an inflation rider, and be larger than it would have been had you taken it at age 62, and you reduce your taxes.

We would be less than forthright if we told you that an annuity did not come with a few moving parts. It does. And no one should buy any annuity without understanding all the parts and how they work. If your financial adviser cannot answer every question you have to your complete satisfaction and so that you know the features and benefits of the annuity and understand them the way you understand that your right shoe is on your right foot, then you are working with the wrong adviser if you want to put one of these instruments to work for you. Annuities have fees and charges, particularly a surrender charge that will apply if you take money out prematurely, which could result in a loss of principal and/or any credited interest. Also, withdrawals from an annuity are subject to income taxes, and if taken before age 59-1/2, may be subject to an additional 10% federal tax penalty.

1 Income riders may be optional or part of the contract, and may come at an additional annual cost.

2 This example is shown for illustrative purposes only. It is not guaranteed and does not represent any specific product or company.

3 Bonus annuities may include higher surrender charges, longer surrender periods, lower caps, higher spreads, or other restrictions that are not included in similar annuities that don’t offer a bonus.

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