We all have a tendency to hear what we want to hear. It seems to be especially true of financial products and services.
I am often asked about the guarantees that variable annuities and equity index annuities offer. For example, this week I spoke with an individual who owned an annuity that offered an annual 7% step up in calculating the lifetime income benefit rider. The client thought that meant they earned at least 7% per year on the money they had invested in the variable annuity. Here is how the guarantee actually works:
Every year the insurance company looks at the value of the annuity contract and if the value of the underlying investments (after the insurance company had extracted about 3.4% in fees) was less than 7% higher than the previous anniversary date, the account was credited with a 7% increase for the purpose of calculating the 4% annual guaranteed lifetime income benefit. That is not 7% that the client can withdraw, but an increase in the calculated annual income benefit.
Still not clear?
Investment in a Variable Annuity: $100,000
Initial Guaranteed Lifetime Benefit: 4%
Annual Income for Life: $4,000
Here the insurance company is only guaranteeing that should you earn net zero on the account and withdraw and spend your principal for 25 years, they will step in and send you $4,000 for however long you live. If you live 30 years, then the insurance company is on the hook for $4,000 for the 5 years after your account was depleted. The cost of this rider is 1.1% per year.
If the underlying investments in this account earn 3% by the first anniversary date, the client can withdraw $103,000 less any contingent deferred sales charges, but the account is credited as if it had earned 7% for purposes of calculating the guaranteed lifetime income benefit.
Income Benefit Base: $107,000
Annual Income for Life: $4,280
Now the insurance company is promising to return your principal for 23.36 years and step into the breach if you live longer to the tune of $4,280 per year. So the longer you wait to receive income the bigger your guaranteed check, but also the less life expectancy you have to draw the check and the longer the insurance company gets to pick 3.4% per year from your pocket.
Still not clear? You are not alone. Seek help from an advisor who doesn’t get paid to sell you a product!
Photo:By Ion Chibzii from Chisinau. , Moldova. - "Problems, problems..." (70-ies)., CC BY-SA 2.0, https://commons.wikimedia.org/w/index.php?curid=32730682
Variable annuities are often confusing and hard to understand. In addition to the fees charged for managing the sub- accounts (read mutual funds) within the policy consumers also pay for the insurance portion of the policy (mortality expense) and various riders and options offered with the policy. If you want to compare the expenses of owning or buying a variable annuity here is a simple grid that you can take to your insurance agent ( yes your broker is an insurance agent if she is offering you an annuity) for help comparing.
E-Z annuity fee disclosure checklist
Before you buy any annuity, ask your advisor to fill in the blanks.
What you pay each year
Annual fee (as % of account value) for: Number Typical
The insurance (a.k.a. mortality and expenses) _____% 1.35%
The investments within the annuity _____% 0.95%
Riders and options _____% 0.65%
Total annual fee: _____% 2.95%
What you pay to get out
Max. surrender charge (as % of withdrawal) _____% 7.00%
Number of years before surrender charge expires _____ 8
Source:Morningstar, National Association of Variable Annuities, Money research
Note: Max. surrender charge may not apply to all withdrawals.