Annuity rule No. 1: Know what you’re buying — and why
May 15, 2015 by Andrew Murdoch
Unfortunately, most people don’t understand annuities well enough to make a fully informed purchase.
Shoppers need to focus on their fundamental goal — the amount of guaranteed income they wish to achieve. But the likes of roll-up rates and withdrawal rates — not to mention an avalanche of confusing jargon — sidetrack many annuity buyers.
Too often they wind up buying the wrong annuity, locking themselves into a long-term contract with high surrender charges.
Many annuities offer some type of bonus or so-called roll ups. One inducement is an account value premium bonus, which is a one-time payment — often 2% to 10% — on the cash invested. The insurance company typically pays for this by charging higher annuity fees or through a reduction in the way that interest is credited to a fixed-index annuity or a fixed annuity. In some cases, though, it is paid for by giving the broker a lower commission on the annuity sale.
Another inducement, an income base bonus, is typically a one- or two-time credit on your annuity benefit base. A third inducement, roll ups, is the rate by which the benefit base increases, usually for every year you don’t take withdrawals.
Most of the time, annuity shoppers falsely think that all these measures are boosting the contract value of the annuity. This may be true for the premium bonus but the other inducements impact only the calculation of the benefit base.
Why don’t people focus on their primary goal, not the bells and whistles? The latter is the way that annuities are marketed, not only in person but also via TV and the Internet.
I suggest that shoppers tune out the noise and realize that most of the time they are ultimately buying an income stream — in effect, a pension. They should weigh their comfort level with the worst-case scenario — that the account value grows less than the benefit base — and then focus on comparing income streams.
This can sometimes be easier said than done because there is more than one way to arrive at an income stream. Some annuities have higher roll-up rates and lower withdrawals rates, while others have lower roll-up rates and higher withdrawal rates. Then, too, some brokers over promise annuity benefits. To make sure you know exactly what you are getting, insist on a document from the insurance company itself outlining the minimum income stream, accompanied with an illustration showing how the calculation is made.
Lastly, bear in mind there may be a caveat on some of the higher income stream annuities —that is, when the contract value drops to zero, the amount of income can be reduced. The account value of the annuity — because of market declines or withdrawals or both — can drop to zero in a variable annuity. In a fixed index annuity, the account value can drop to zero through withdrawals and rider fees. In this case, the annuity has no cash value, which, depending on the insurance company, can also mean a reduction in the annuity’s income stream. Make sure you are comfortable trading market risk and added fees for a potential higher income stream before committing to such a contract.
Besides focusing on your monthly income stream, the other key step to take as a savvy annuity buyer is to make sure you are buying the type of annuity that best fits your needs.
Shoppers can choose from fixed, fixed-indexed, variable, secondary-market, immediate and deferred-income annuities. Instead of a fixed or fixed-indexed annuity, which protect your principal, you may want a variable annuity, which doesn’t protect principal but gives you market exposure and hence a chance of higher monthly income. A minimum income stream can also be guaranteed.
Annuity shoppers also must consider whether an immediate or deferred-income annuity appeals to them. Both offer tax benefits other annuities don’t and can generate a higher lifetime-income stream. The downside is that annuity owners forfeit their principal.
The last question you might have on annuities is whether or not they can truly guarantee lifetime income. Insurance companies guarantee lifetime income because they spread their actuarial risk over hundreds of thousands of contracts. As long as everybody doesn’t live as long as Methuselah, the insurance company makes money and you have income protection.
DISCLOSURE: Andrew Murdoch owns variable annuities from MetLife, Ohio National, Mass Mutual and secondary market annuities.
