Ever creative in effort to meet the needs of the changing demographics and economics involved in American retirement income planning, the insurance industry has created a plethora of annuity products that offer “income for life, even if your account balance goes to $0.00”. As I discussed in a previous post, Income, Growth or Both?, today’s lifetime income products are much more versatile than plain old income annuities of yesteryear. But unlike people, all annuities are not created “equal”, and that may be particularly true for annuity Income Riders. Some understanding of the mechanics inside the products may help you decide which fits you best, and which is likely to produce the highest income for you.
So what are the factors that determine your income from a given Income Rider? I would categorize them in two basic ways. They may seem distinct, but they are directly related:
• Growth potential and/or safety of principal
• Guaranteed income that the rider will deliver
Income Riders are available on fixed, fixed indexed and variable annuities. Most would agree that the variable annuity has the highest growth potential, followed by the index annuity. Only the variable annuity involves risk to principal; both fixed and index annuities offer guaranteed minimum rates of interest and protection of principal, less any fees charged for the income rider in all cases of course. And so at first blush, the variable annuity may seem the most attractive: like the others, it guarantees income for life, even if the account balance goes to $0. So why not go for the gusto and try to really grow the money in the market? Worst case, the variable annuity income rider does provide a floor of guaranteed income for life, just like the fixed annuities. But how much income? How high…or low…is the floor?
Think it through with me. First question: When is the insurance company likely to “get into its own pocket”? When and if you run out of your money, of course. After all, that is the benefit that we are buying with the rider fee, isn’t it? The promise that if we run out of our own money, the insurance company will still pay us income for life (subject to the claims-paying ability of the insurance carrier). So the insurance company only gets into its pocket, to continue your lifetime income, when your well has run dry.
Second question: Which annuity exposes your money to potential losses? The one with higher growth potential, the variable annuity. So the variable annuity, while it may have higher growth potential, exposes the insurance company to higher risk: that being the higher risk of getting into its own pocket to support your lifetime income, because of the possibility that you will exhaust your money sooner due to market losses.
So imagine this: put yourself in the place of the insurance company and now YOU are on the hook to guarantee lifetime income to your annuity owners. Let’s assume that you offer two products; you earn your fees either way so that you can support the guarantees you promise, cover your expenses and make a profit. In Product V, the owner might lose money. In Product F, the owner cannot lose money. Until the owner runs out of his own money, you’re not at risk. On which product will you offer higher guaranteed income?
The answer provides insight into the other factors affecting guaranteed income. While the other factors are more straightforward, you may not hear much about one of them. What you will likely hear about the most is the “rollup rate”, and it is important. This is the guaranteed rate of interest at which the Income Account will grow, until you start taking income. It is a wonderful benefit to annuity owners, and perhaps as good of a marketing tool. The rollup rates range from 4% to 14%. And higher is better, right? Well, sometimes. It depends on that other, lesser referenced factor: The payout rate. The Income Account Value will grow at the stated rollup rate (subject to the terms of the annuity) and then deliver you income for life, based on the payout factor. The payout factor is based on your age at the time. For example:
Annuity “A” rolls up at 4% compounded for 10 years, at which time the payout factor is 6%. Guaranteed lifetime income is then $8,881 annually.
Annuity “B” rolls up at 14% simple interest for 10 years, at which time the payout factor is 3%. Guaranteed lifetime income is then $7,200 annually.
There are other factors to consider, for example: single or joint payout, beneficiary options, withdrawal provisions, surrender charges, etc. that are beyond the scope of this post. With any type of annuity, if the cash (Accumulation Value) value grows higher than the Income Value, your lifetime income may be based on that higher number. When it comes to creating the highest guaranteed income the primary factors are safety of principal, which affects the risk the insurance company assumes in offering to provide guaranteed income, and the combination of the rollup rate and payout factor.