Guide to Annuities Part 2
In the first part of this guide to annuities Guide to Annuities Part 1, I discussed the most basic features of annuities and reasons why you might buy one or be sold one. In part 2, I will explain how annuities work in their two phases: accumulation and income. I will also review the two more complicated types of annuities: Variable Annuities and Fixed Indexed Annuities. I will conclude by explaining the most complex aspect of all, the guaranteed income rider. Part 2 of this guide has become long and complicated. Sorry about that, but if you want to jump to the conclusions, go to the section titled: Buyer Beware.
How Annuities are Sold
Insurance companies sell annuities in two distinct ways, by an agent or broker who makes a commission, or by an investment advisor who is paid a fee. The difference is important because if the insurance company has to pay a commission, then it has to embed that cost into the annuity. That might mean lower interest rates or caps on performance. It also will mean restrictions on clients withdrawing their money from the annuity for some period of time. The advisor selling the non-commissioned annuity also has to be paid and they typically charge their clients a fee directly. The non-commissioned annuity might have better terms and no surrender or withdrawal restrictions, but clients are going to billed a fee explicitly. In this case, the advisor sets the fee.
Non-commissioned annuities are relatively new in the marketplace and not all types of annuities from all carriers are available. Single Premium Immediate Annuities (SPIAs), for instance, may only be available as a commissioned product. Variable Annuities (described in detail below) are widely available as a non-commissioned product.
Which is better? This will vary on a case-by-case basis. For the simple annuities (Single Premium Immediate Annuity & Deferred Income Annuity), commissioned products might be just fine and there are very few non-commissioned products in the marketplace. The fee you might pay for the non-commissioned product could be similar to the higher costs built in to the commissioned product. For the complex annuities, the better terms of the non-commissioned products means that these are generally more beneficial for clients.
How do you know how your annuity is being paid for? If you are confused, ask the person who sold it to you.
Here is a chart to help show the differences between commissioned and non-commissioned annuities:
|Fee charged by agent/broker/investment adviser||None. Commission built-in to product.||one-time or periodic fee based on account value|
|Surrender Restrictions||Yes||Not usually|
|Withdrawal Restrictions||Yes||Not usually|
|Income Rates on Riders||Lower||Higher|
|Caps on equity indexed performance||Lower||Higher|
|Availability of Products||High||Could be hard to find|
The Two Phases of Annuities
The life of an annuity can be divided into two phases. Phase 1 is known as accumulation. Phase 2 is sometimes called decumulation, but I will call it the income phase.
Annuity Accumulation Phase
During the accumulation phase, you are trying to make the annuity grow in value. The SPIA I described in part 1 doesn’t actually have an accumulation phase, you accumulated your money before buying this annuity and the income phase starts immediately. Other types of annuities are designed to gain in value during the accumulation phase. Some of them have simple interest rates and others connect their gains to the performance of the stock market or other securities.
Annuity Income Phase
During this phase, you are taking money out of your annuity. There are typically two ways to take money out of an annuity: withdrawals and annuitization.
As long as you don’t annuitize, you can generally make withdrawals from your annuity. Withdrawals come from the value of your annuity and reduce any benefits the annuity might give you, such as a death benefit, long-term care benefit, or income when you annuitize. There are often restrictions on withdrawals for annuities sold with a commission. When you withdraw all the money in your annuity, you are surrendering the annuity. Annuities sold using a commission almost always have restrictions on surrendering. These restrictions often last 10 or 15 years and some annuities charge surrender penalties forever.
Most annuities allow you to withdraw some percentage of the value each year without penalty. This amount varies and you need to pay careful attention to the safe withdrawal percentage because if you withdraw more than this, you may reduce the income guarantee in any rider you’ve bought. The worst thing in the world would be to buy an annuity because you wanted guaranteed income and then take a withdrawal that reduces or eliminates the guarantee or an income sweetener that the annuity company sold you. Rule #1 for complex annuities is to not withdraw more than the safe withdrawal amount.
The other way to take money out of an annuity is to annuitize it. I explained this in detail in part 1 of this guide Basically you are converting the lump sum in the annuity into an income stream. Many annuities are designed to annuitize when you want to take income, but there are others that use a guaranteed income rider which is designed to never annuitize. Instead you would use a safe withdrawal amount which is guaranteed for life. These annuities designed to use withdrawals will have a guaranteed lifetime withdrawal benefit rider on it. The underlying annuity can still be annuitized, but your income will usually be lower.
SPIAs and DIAs are always designed to annuitize. Variable Annuities (VAs) and Fixed Indexed Annuities (FIAs) are sometimes designed to annuitize and sometimes designed for withdrawals with a rider. You have to read the illustration or prospectus of both the annuity and the rider sold with it to know for sure.
I refer to Variable Annuities (VAs) and Fixed Indexed Annuities (FIAs) as complex annuities. The feature that makes them complex is that they offer owners gains linked to the performance of the securities markets. This provides greater potential for gains in value during the accumulation phase and sometimes greater gains can even occur during the income phase.
Here are some important terms to understand:
- Current Annuity Value, Policy Value, or Cash Value – Value of the investments in your annuity. Affected by investment gains and fees.
- Surrender Value – Amount you would get if you surrender the annuity and collect a lump sum. The only reason it’s not the same as the policy value is because of surrender charges. Many annuities will have surrender charges for the first 5 to 10 years.
- Death Benefit – Amount your heirs get when you die. Usually the same as the policy value unless you bought an enhanced death benefit rider. These riders act like a bit of life insurance on your annuity and will increase the death benefit.
- Withdrawal Base or Guaranteed Income Base – These terms all refer to an imaginary value which is used to calculate the income, once guaranteed income payments start. There is usually no way to directly withdraw this value.
- Rider – An addendum to the annuity which changes its terms. Provides enhancements to the basic annuity.
Variable Annuity Basics
Variable annuities allow owners to invest in mutual funds within the wrapper of an annuity. The product is really a combination of an annuity and an investment account. Variable annuities don’t actually provide downside protection for your investments. If you invest in the stock market within your VA and the value of your mutual fund goes down for the year, then you’ve really lost the money. The mutual funds offered by VAs vary by product and provider. Some providers of non-commissioned VAs allow you hundreds of mutual funds. Some providers of commissioned VAs only allow a handful. Income riders (described later in this guide) will usually restrict the mutual fund selection allowed.
The VA wrapper will cost something, typically charged as a percentage of assets every year. This fee is called a Mortality and Expense (M&E) fee and can vary between 0.3% and 2.5% a year with an average of around 1.25%. You will also have to pay a fee for the mutual funds in the VA and while these vary, they are typically higher than the same fund sold to retail investors. For instance an S&P 500 index fund could be had for 0.05% retail, but a similar fund on a VA platform might cost 0.30%. In addition, VA providers often charge an extra M&E fee to allow you to use low-cost index funds. So typical fund fees are around 0.65% with some as high as 1.7% or more.
Why would you want a VA? There can be more than one answer to this. If you have money in a taxable account (not an IRA or 401(k)), then you get taxed on realized investment gains, dividends, and interest every year. But a VA is considered a type of retirement account, so gains inside the VA will not be taxed. Instead, you pay tax when you make withdrawals (or annuitize). So this provides tax deferral and once gains are withdrawn (and they get withdrawn first), they are taxed as ordinary income instead of the lower capital gains tax rates. Personally I am not a fan of using an annuity to defer taxes because ultimately you might pay more in tax, but it could be useful under some circumstances.
The other reason to buy a VA is that when you combine the VA with an income rider (see below), you can get a guaranteed income stream, but still get the benefit of an investment in the stock market. Your upside potential in these products are limited, but in some products it is possible to have higher gains than a simple Deferred Income Annuity (based on a fixed interest rate) and just like DIAs, they provide protection against loss.
The Guaranteed Income Rider
Now we get to the most complex aspect of annuities, the guaranteed income rider. These riders have a variety of features and work in a variety of ways, but all of them ultimately take a VA with no guarantees and convert it into a product which provides a guaranteed income stream. Income Riders which guarantee withdrawals are often called Guaranteed Lifetime Withdrawal Benefit (GLWB) riders. Some are called Lifetime Benefit Riders. Some require annuitization to work, but GLWB riders support guaranteed withdrawals without annuitization, so your lump sum annuity value is still available to you, although probably reduced.
Insurance companies often provide several rider choices on the same VA. These riders will have various features including different sweeteners, guarantee features, and allowed withdrawal amounts.
The Guaranteed Income Base
Riders often come with sweeteners, such as a guaranteed 5% or even higher increase each year in something they call the Guaranteed Income Base (GIB). Clients get excited about these gains. “Wow, a guaranteed 5% a year for 10 years. You can’t beat that! ” Here is the truth about the GIB. It doesn’t really exist. It is not your money and its very difficult to get this “value” out of the policy. You won’t get it if you surrender and your heirs probably won’t get it if you die. The GIB works as a base value which is used for the income calculation once payments start.
Some Income Rider Examples
A leading insurance company might sell an guaranteed income rider on a VA which provides 10 years of guaranteed 7% gains to the income base. You buy this annuity when you’re 55 and expect to keep it 10 years to age 65 before starting to take income. For the moment, let’s ignore the performance of the underlying investments in the VA. Frankly, they are unlikely to outperform the rider’s guaranteed 7% increase per year because of the fees for the base VA and the rider probably take about 4% or more out of the performance. But you do get that 7% gain per year on the GIB. If you invested $100k in that annuity at age 55, then your GIB would be $161k at age 65. The value of the actual annuity (surrender value) at age 65 may be $120k if that annuity had decent performance. So what can you do with your $161k GIB? Remember, I talked about “safe” withdrawal amounts? The income rider will specify a percentage that you can withdraw each year once withdrawals start. If you withdraw more than this, you are making an excess withdrawal. Excess withdrawals will reduce the GIB and therefore reduce your guarantee. So they are to be avoided. The safe withdrawal amount for that rider that gives you the 7% increase at age 65 might be 3.75% of the GIB, so $6,037 per year for this case.
A second example is an annuity with a guaranteed income rider which only provides 5% gains to the income base. Again, lets assume you buy this for $100k when you’re 55 and start income when you are 65. You get 10 years of increases (again ignoring the possibility of increases from the base investments) and at age 65 your GIB is $141k. You might think the 5% guaranteed gains in this rider are not as good as the guaranteed 7% gains in the previous example. But in this case the insurance company will give you 5% of the GIB or $7,050 per year, guaranteed for life. This annuity rider will actually provide a higher guaranteed income than the previous example, even though the GIB is lower when income starts. You need to carefully examine the likely GIB value will be when income starts and then look at the actual guaranteed income stream to decide which annuity rider is better.
Investment Returns with the Rider
Even with the rider, the underlying VA is still invested in mutual funds which may provide some investment gains over time. The rider will usually guarantee the GIB won’t go down if you make no excess withdrawals and therefore will guarantee a lifetime income. In return for this guarantee, the insurance company will charge you fees and also restrict what investments you can make. You can almost never invest your VA in an S&P500 index fund as your only investment when you have a guaranteed income rider. Instead you will be allowed to invest in a number of balanced funds or fixed income funds which are far less volatile than the S&P 500, but are also likely to have much lower returns. A 60/40 mix of stocks and bonds is probably the most aggressive portfolio you will be allowed and even this might allow you to invest only in low-volatility stocks.
One of the feature of all income riders is that if your annuity value is greater than the GIB, then the GIB will reset to the annuity value, typically on the policy anniversary. This is great because you can lock in market gains when times are good. But for this to happen, the average gains in the annuity minus all the fees, has to be greater than the rider sweetener increase. This is possible, but its not that likely with a 7% sweetener. It is more possible with a 5% sweetener. This is another reason to be very careful about GIB sweeteners, especially if there is any chance you might surrender the policy instead of taking the income.
How do Fees Affect your Annuity?
Annuities with riders can have a lot of fees. There is the M&E fee and there will also be a fee for the rider. Sometimes in order to be allowed to invest in a more aggressive portfolio or a lower cost index fund, you will have to pay additional investment fees. There can be other rider fees for enhanced death benefit riders or long-term-care riders. How do all these fees affect your performance and what you can get out of your annuity?
The fees are always taken against the current annuity value each year. So if the investment gains do not exceed the fees, the current annuity value will actually go down. This is often the same as your surrender value and could be the same as your death benefit. The higher the fees, the less likely you will be able to withdraw a lump sum from this annuity. The good news is that the fees almost never affect the Guaranteed Income Base or GIB sweetener. But fees will affect the ability of the annuity value to reset the GIB higher. If you bought that 7% rider, there is probably no chance your annuity will increase in value due to a GIB reset, so don’t worry about the fees and don’t ever try to surrender your annuity. But if your annuity+rider is designed to allow GIB resets, then take a careful look at the fees.
Fixed Indexed Annuities
FIAs also allow you to benefit from market increases within an annuity platform. FIAs typically have the guaranteed income benefit riders built right in, so they almost always provide a guaranteed income stream. Unlike VAs, FIAs do not invest directly in the stock market. Instead they link the performance of the annuity to an index, often the S&P 500 index.
Important Terms for FIAs
- Participation Rate – The percentage of the index gain that increases the annuity value. If the participation rate is 50% and the index goes up 10%, then you will get a 5% increase in the value of your annuity.
- Cap – This is the maximum your annuity can increase each year. A typical cap might be 7%. If the S&P 500 goes up 22% and your participation rate is 50% with a cap of 7%, you will only get a 7% increase.
- Floor – This is the lowest rate of increase you can get. This is often 0% which means you cannot lose money, but your value may not increase.
- Fixed Account – This is an alternative investment which gives you a guaranteed increase.
FIAs can be very appealing because the insurance company promises that you can only get the increases and never market declines. The problem with FIAs is that the promises usually only last for a short time. Insurance companies are free to lower the caps and participation rates on these products and after a year or two they often do lower them. You may get a 100% participation rate with a 7% cap when you buy the product, but after a couple of years, the insurance company will change the cap to 3%. There is usually a fee as well, often higher than 1%. So if you had a 1.5% fee on this annuity, you would end up with gains of 1.5%. You would have been much better off with a deferred income annuity which might have provided a 3% increase or just leaving your funds in a CD.
FIAs almost always offer a fixed account as an alternative to the indexed account. While this option may not be appealing in the beginning when they are promising you the high returns, it can be very appealing when the caps are lowered. An annuity which might have a 7% cap, might give you 3.5% in a fixed account. Unfortunately insurance companies can lower the fixed account rates as well. You should pay attention to the minimum fixed account rate. For many FIAs, this will be 1%, but sometimes its 0%.
Should You Buy an FIA?
I’m not a big fan of FIAs. The problem is that insurance companies lower the caps and lower rates on existing FIAs all the time and then they just bring out new ones for the new clients. Meanwhile the FIAs typically have surrender charges that make it impossible to get out of them. They also often have the concept of a GIB (see the section on VAs above) so you won’t even get the value you think you have when you surrender. Even if the insurance company doesn’t lower the caps, they often illustrate the FIAs with unobtainable investment gains. I have never seen a client do better with an FIA than the would have with a different type of annuity. The person who makes out best from an FIA sale is the agent who got a commission for selling it.
You need to be very careful when buying one of the more complex annuities. Insurance companies make many promises. One leading company says “Guaranteed to double your withdrawal base in 10 years!”. This is very appealing, but now that you’ve read my guide you know that the withdrawal base is not real money and doubling your withdrawal base does not imply doubling your annuity value or the potential income you might get from this annuity. So as you evaluate annuities, what should you look for?
What Can the Insurance Company Change?
Always look at what the insurance company can change and when. Can it lower the cap on S&P 500 performance? What can it lower it to? What will stop the company from lowering that cap any time it wants to? All the illustrations presented should have minimum values for interest rates, caps, M&E charges, and participation rates. Pay attention to the minimums and what the insurance company can change. In this regard, VAs have an edge over FIAs because the only thing most VAs can change is the M&E charge and which mutual funds you are allowed to invest in. Also, because VA products are harder to bring out, insurance companies tend to leave them on the market longer before making changes to the old products and replacing them.
How is your money locked up?
With most, but not all annuities, there are significant surrender charges. When you buy an annuity, you may be told you can withdraw your funds, but the truth is it can be very difficult to get your money out in a lump sum and sometimes completely impossible. Surrender charges are only one way annuities lock up your money. Another way is by using the guaranteed income base (or withdrawal base) to hold all the promised gains. There is usually no way to withdraw this withdrawal base in a lump sum and the actual annuity value has been reduced by all the fees. When you withdraw, you get the actual cash value and not the withdrawal base. Surrendering or withdrawing could mean you lose money, sometimes a great deal of money.
Why Would You Ever Buy An Annuity?
There are valid reasons to buy an annuity. The most important is to create a guaranteed income stream. You have to want and need an income stream to make it worthwhile. Then you don’t need to worry about surrender restrictions and charges. You can evaluate your annuity purchase on the income stream its likely to produce: the minimum guaranteed income, the likely income if the annuity performs in an average way, and a maximum income stream that the illustration shows.
Another valid reason is if you are so afraid of investing your money because of your fear of loss, an annuity can provide downside protection and some upside potential. Just pay attention to how you plan to get your money out of the annuity. Typically a retirement income stream works the best. Remember that you are paying for that downside protection with fees, restrictions, and lower upside potential. It still can be worth it.
A practical application of annuities is to lower the risk that the market does badly just before or during the early part of retirement. Since you will stop earning when you are fully retired, you may not be able to make up for negative investment returns during this time period. It could affect your entire retirement plan, force you to work longer, or leave you destitute when you outlive your money. An annuity is a powerful tool to guarantee lifetime income and lower this risk (called sequence of returns risk). For more on sequence of returns risk, see this paper by Wade D. Pfau, Ph.D., CFA, Professor of Retirement Income, at The American College: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2544637
I am a Certified Financial Planner™ and investment adviser. I am also insurance licensed in several states. I don’t sell a lot of annuities, but occasionally I do work with my clients on existing or new annuities. If you are considering buying an annuity or wondering what to do with an annuity you already have, I may be able to help. Follow the link to find my contact information: Contact Cereus Financial Advisors.