Annuities have always been the only financial instruments that can provide an income that cannot be outlived. Historically, this meant annuitizing the contract — exchanging the lump sum account value for a guaranteed series of payments for a specified period or life. The thought of forfeiting principal for income, however, was unpleasant to most consumers and therefore annuitization was rarely used.
Living benefits — often called income riders — first appeared on variable annuity contracts to provide a “safety net” in the event the underlying accounts did not perform as hoped. Today, living benefits are available on all types of annuities.
Guaranteed Minimum Income Benefits (GMIBs) and Guaranteed Minimum Withdrawal Benefits (GMWBs) are typically offered as riders on annuity contracts. The rider fee varies based on the type of contract (fixed or variable) and the benefit being provided. Rider costs vary between .70% and 1.40% of the account value each year.
While creating a “drag” on contract performance, they also provide peace of mind for the owner. Purchasers are assured that funds set aside for retirement income still provide a guaranteed minimum level of income no matter what happens to interest rates, the market or an index.
Income riders have two components — an accumulation phase and a distribution phase. During the accumulation phase, the company essentially keeps two sets of books on the contract.
One set of books is based on the actual performance of the underlying account(s), less the cost for the rider. The other set of books is a “phantom account” called the income base. This is merely a calculation that takes the initial premium and accumulates it at the rate specified by the rider (6.00% per year for example).
When the owner reaches a point where he/she is ready to take income from the policy, the income will be based on the greater of the two accounts and the age at which the annuitant began taking income.
For example, if Mary (age 60) purchases a $100,000 annuity contract with an income rider at 6% and five years later (at age 65) wishes to begin an income stream, the company would compare the actual performance of the policy to the income base.
Let’s assume her cash account grew to $120,000, which would be compared to the value of the income base. At a 6% compound rate, her income base would have grown to $134,885; therefore, her lifetime income would be based on that greater amount. If the contract provided for a 5.00% lifetime withdrawal for a female age 65, Mary would receive $6,744.25 per year for the rest of her life ($134,885 x 5.00%).
This income would serve as a series of withdrawals, but not annuitization. Her base account would continue to react to interest credits, but also reflect an annual withdrawal of $6,744.25. Upon Mary’s death, her beneficiary would receive any “change” left in the account. If, at some point, these withdrawals depleted her account value, the insurance company would step in and continue the same income stream as long as Mary lives. But there would be no death benefit, because no real cash remains.
Things to consider with an annuity plus income rider
1. Don’t place too much emphasis on the step-up rate. An unrealistically high step-up rate will grow the income base at a quicker rate. Often, carriers will “tweak” the interest rate, caps and participation rates on the underlying contract to compensate. Keep in mind that once income begins, you are spending “your money” first and the insurance company only begins to participate once you have spent your funds.
2. Be aware of the difference between simple interest and compound interest. Some carriers may choose to increase the income base using simple interest. This design only increases the income base by a fixed amount every year. Compound interest not only credits interest on principal but interest on interest. For example, a 7.2% compound step-up will increase the income base exactly the same amount as a 10% simple step-up over a 10-year period.
3. Be sure you understand how the rider fee is charged. Many providers calculate the rider fee based on the income base rather than the contract account value. In the example above, if the fee for Mary’s rider was 1%, that fee would be based on the income base of $134,855 resulting in a rider charge of $1,348.55. This would be deducted from the lower account value of $120,000. If, on the other hand, the fee was based on the account value, the rider fee would only be $1,200.
4. Is the cost for the rider a fee or a spread? More jargon, but this one is important. A fee is assessed every year no matter what. So, theoretically, you could own a fixed or index annuity where you were promised you could never lose money. That is true to an extent. You will never lose money due to a market decline. The worst you will ever do is a 0% return. However, if a fee is still deducted from your account, you will see a decline in account value. A spread, on the other hand, is only deducted to the extent there is a gain in the contract. If you earn no interest, there is no fee deduction.
5. Is the contract RMD (required minimum distribution) and free-withdrawal friendly? This is one of those little “gotchas” that drive people crazy. Let’s assume Harry, age 52, buys an annuity with an income rider attached. He plans on letting the policy grow until his planned retirement age of 70. At age 54 he has an emergency and needs to exercise his 10% free withdrawal provision. At age 70, he is surprised to find out that his withdrawal at age 54 locked in that age as the payout age (rather than age 70). His payout rate would be 3.5% (the lifetime payout for ages 50-54) rather than his expected 5.5% (the lifetime payout for ages 70-74). Another “gotcha” is when any withdrawal is made prior to taking a lifetime income; the rider step-up for that year is forfeited. Be sure to choose a contract that is friendly to withdrawals prior to retirement.
Although the discussion above may seem like all insurance companies are out to get you, the truth is that benefits cost money. Carriers often curtail benefits in order to enhance other product features – like squeezing a balloon to make it pop out somewhere else. Be sure you understand all the trade-offs (squeeze) in order to provide this benefit.