Don’t Be Confused By Guaranteed Income Riders

Today one of our support staff received a call from an agent who was upset because he wanted to illustrate an 8% return using our Stretch IRA software and it allows him to show a maximum of only 6%. He told us that “the policy guarantees an 8% lifetime interest rate” and he wanted to illustrate 8% to his customer.  Unfortunately, this is a common question from agents who misunderstand how indexed annuities with guaranteed income riders work.

First of all, selecting an income rider is not a suitable option for someone who wants a Stretch IRA because the income produced by the rider will very likely deplete most of their indexed account if they live until age 90 or more. Also, a person elects a Stretch IRA because they want to leave as much money to their heirs as possible. The income rider defeats this purpose because over 10 years, the difference in indexed accumulation value between electing the guaranteed income rider is substantial; at age 70, it can be as much as $8,000 per $100,000 premium.

Many agents do not understand that the indexed account and the guaranteed lifetime income account are different accounts, with different purposes. The indexed account is an accumulation account; it is money the customer can touch. The income account is just that – an account from which the guaranteed lifetime income is formulated. The account holder cannot touch this money; it does not exist in any tangible form.

Here’s the math. After 10 years, the income account growing at the 8% guaranteed interest rate accumulates to $215,892 which will produce a $17,271 guaranteed lifetime income. The $17,271 annual income is impressive, but what is the $215,892? Can the account holder withdraw this money? No. It is simply a number used to calculate the $17,271 annual lifetime income. What happens if the account holder decides not to exercise the lifetime income option? It all vanishes. The $8,000 cost for this rider [calculated by doing a illustration with and without the rider and comparing the difference] is completely wasted. In my view, agents shouldn’t even talk about this phantom guaranteed 8% interest rate or the income account. Throw around this “8% guaranteed interest rate” and this will be all customers will remember. It leads to false customer expectations, unhappy clients, and opens the doors for lawyers.

To illustrate my point, let’s look at two hypothetical scenarios on a $100,000 deposit into a Fixed Indexed Annuity for a 70 year-old man held for 10 years, after which the guaranteed lifetime income option is exercised:

Scenario One: The index does poorly and account earns only the guaranteed minimum surrender value of $128,208. In this case, the guaranteed lifetime income is a blessing because the account holder will be able to withdraw $17,271 each year for the rest of his life. Let us assume that he lives until age 92, about six years beyond normal life expectancy. The $17,271 annual withdrawal will deplete the policy by about age 88, so there will be no remaining cash value at death. The average rate of return for this scenario is 4.90%. If the policy holder dies at age 86, which is his normal life expectancy, his rate of return will be only 1.64% This isn’t too bad for a worse-case scenario.

Many agents don’t seem to understand that once the guaranteed income begins, this income is withdrawn from the indexed account, not from the “guaranteed income account,” which no longer exists.

Scenario Two: A hypothetical historical point-to-point, 10% cap, 0% spread, 100% participation rate product issued on January 1, 1990 grows to $190,152 after 10 years, an impressive 6.64% return. Based on the income available under the guaranteed income option, the customer begins to withdraw $17,271 each year. The hypothetical historical return in 2000, 2001, and 2002 for this product was 0%. Withdrawing $17,271 per year reduces the indexed value to $138,338 after three year of these guaranteed withdrawals. Even if the indexed annuity receives 10% per year every year thereafter, the indexed value will decrease quickly because the withdrawal is higher than the interest rate. In the unlikely event that the policy earns 10% every year for the next 8 consecutive years, and death occurs at age 92, the indexed account will have been reduced to $68,212, providing an average rate of return of 6.04%. If the policy holder dies at age 86, which is closer to his his normal life expectancy, his rate of return would be about 5.29%.

What happened to the “8% guaranteed interest rate?”  It never existed. I cannot find a hypothetical historical scenario where it is possible for a policy holder to achieve anything close to an 8% of return from a fixed indexed annuity contract from a guaranteed income rider on a hypothetical basis, let alone on a guaranteed basis.

Am I saying that guaranteed lifetime income riders are bad? No. In fact, I believe the opposite. Go back to the fundamental reasons annuities exist:

·         To provide safety

·         To provide predictable, steady, guaranteed, lifetime income

A fixed indexed annuity with an income rider is an ideal vehicle to plug a specific income gap in a prospective client’s retirement income stream. As shown above, however, the agent should not promise both income and a sizable cash inheritance after death.  Generally, income riders provide either high guaranteed income or safe cash accumulation; they rarely provide both.

Annuities are ideal financial tools when they are used in ways that meet the customer’s needs. This happens only when agents understand what annuities can do – and what they cannot do.

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