A large percentage of annuities, both variable and fixed are sold with an optional income rider these days. These riders have become the main selling point and in many times, the reason the buyer is deciding to purchase the annuity. So the question becomes, how do these riders really work?
The story usually goes something like this: An advertisement offers a guarantee that seems too good to be true like a 10% annual guarantee. The question is how could an insurance carrier offer a 10% guarantee in an interest rate environment like the one we are currently in. And the answer is that they can’t.
So how does it work?
The “guarantee” is not really an interest rate guarantee, but rather just a formula for calculating the lifetime withdrawal benefit. This value will grow by the guarantee until the client is ready to turn on income. At that point they will be able to take a max payout percentage based on their age at that time. Basically, it’s like creating your own pension plan. So if a product is promising a 10% guarantee, and the client puts in 100k, the income rider value will grow by 10k a year until they turn on income. Let’s assume the client is 60 when they purchase the annuity and they want to turn on income in 5 years at age 65. The income account value is guaranteed to grow to 150k. At this point, the client can turn on income. At age 65, they can probably take out around 5% of that value (this varies from carrier to carrier). So in this example, the client could take out $7500/year for the rest of their life. If the client passes away, the beneficiaries will get the true account value which would have been growing based on the market.
So what is it not?
It’s not a death benefit (there are exceptions to this). It’s not a real value that you can walk away with. It’s not transferrable to another contract meaning if you transfer your money out of the contract; you’ve paid for a benefit that you never used. It’s not a guarantee the way a CD has a guarantee. The truth is once you turn on the income, the insurance carrier is just paying back your own money until you zero out the account. So truth be told, you are really buying longevity insurance.
So what is the real value?
The real value is having a lifetime income stream off an asset even if the value of that asset becomes zero. This provides the client with the piece of mind to know that they will never run out of money.
Who should buy one?
Someone who wants the piece of mind of knowing that they will never run out of money.
Who should not buy one?
Someone who is not planning on turning on income. There is no point of having a 10% guarantee that will disappear when you move the money somewhere else or pass away. You’ve paid for an imaginary value that does no one any good.