Quick heads up: This article along with video is kinda long-ish. I get into some details that may bore the average person. But if you are considering an annuity, especially a variable annuity, this article and video will show you how to dissect the annuity illustration to better understand if this is a good deal or a bad deal.
Here’s the background on this story. Having a web presence with this website allows me to meet people from all over this country. This is one real life case (of many) of someone that reached out to me because they had been pitched a variable annuity. They sent me the illustration and we had an intelligent discussion about it. What I’m going to show you is how to look at an annuity illustration to truly understand what the real benefit is. Then you can decide if that benefit is worth it.
Why this deep dive into a variable annuity illustration will benefit you
I get lots of questions from readers of this blog. Especially questions about annuities. It seems there is a lot of interest in these products. I think the main reasons are:
- Annuities offer certain guarantees. Some offer principal protection guarantees. Others provide lifetime income guarantees. These types of guarantees are important to many people nearing (or already in) retirement.
- Variable annuities seem to be the most popular annuity sold currently. Probably because they provide guarantees but also have upside potential being invested in the market.
- There’s a huge number of people retiring every day. They have to figure out what to do with their 401(k)’s, TSP’s or other employer sponsored accounts. Also, many are taking pension lump sum buyouts from their employer and must invest the money somewhere.
With these economic factors all at play, many people turn to the internet for answers. Some answers are good. Others… not so much. It can be hard to decipher between the good and the bad information. That’s why I’m sharing how I approach variable annuity illustration. To help you understand how to can reach a conclusion on the matter.
One of the biggest mistakes I see people make when trying to understand a variable annuity illustration is getting benefits mixed up. The illustration can show not only projected growth on the actual account value. But it can also show projections on what the lifetime income guarantee will be. These different benefits really need to be isolated so an annuity shopper can make better comparisons between alternative options.
What’s covered in this variable annuity illustration discussion
In this article I’ll be covering:
- Understanding when the hypothetical growth rates are unrealistic
- What a good assumed growth rate alternative will be
- What the guarantees are
- What the fees are
- How to know if this is a good deal or a bad deal
What you’ll find is that as you dig deeper into a variable annuity illustration, you’ll start to see what the true benefits are. You’ll start to see when the illustration may be misleading you… even when everything it says is technically true.
Before we go any further, for anyone that has found my website for the first time and knows nothing about me, I am a fee-based financial planner. That means I charge a fee for creating financial plans and providing investment advice. I am also licensed to sell annuities and life insurance.
Here’s a little legal disclosure before we get started:
This deep dive into how to read a variable annuity illustration is in no way a recommendation to buy or not buy a variable annuity. It is for informational purposes only. All annuity contracts are different. And a different variable annuity illustration may function differently than the one we are analyzing here. Before making any investment decision, do your own due diligence and consult a properly licensed professional if you have specific questions about your own unique situation.
Should you include a variable annuity in your retirement portfolio?
The answer to that question will depend on your own personal financial situation. But as a general rule, variable annuities may be beneficial in a retirement portfolio for the following reasons:
- Many can provide income guarantees
- Many can provide protection of original deposit through a death benefit
- They can provide additional tax deferred growth if you have maxed out your other options (IRAs, 401(k) contributions)
When it comes to income guarantees it is wise to shop around. Often times you can get higher income guarantees for a lower fee using fixed annuity products. If you’ve maxed out other tax deferred options and need additional tax deferred investments, a variable annuity may be an option for you. But make sure if you don’t need any guarantees (like lifetime income or principal protection through a death benefit), that you look into a no-load variable annuity. It keeps the fees lower compared to a traditional variable annuity. And it typically has no surrender charges, all while giving you the same tax deferral on your non-qualified money.
The variable annuity illustration
Let’s start with the fees disclosed in the illustration. This will give us a good baseline for understanding if the benefits are worth the cost. These are the fees:
So the fees are 3.76% each year. This is unfortunately typical of variable annuities. They often times have high internal fees. And the fee will actual be higher than that since the 1.5% income rider fee is based not on the Contract Value, but on the higher Protected Balance value. You’ll see what that is coming up.
Here’s a screen shot of the variable annuity illustration showing growth rates and income guarantees (if these growth rates are achieved)
This is a hypothetical illustration. In other words, it includes estimates for annual return on the variable annuity. As you can see the returns look very good. In the far right column you can see returns for the first 8 years in this order:
These returns show incredibly strong growth. But they are hypothetical illustrations and they do not guarantee this performance going forward. In fact, if we look in the far left column we’ll see these results are for the time period December 1991 through December 1998.
This was an incredibly high growth period of the market. Quite different from what we’ve seen in the first part of the 2000’s. So this is red flag number one. The illustration clearly says this is not guaranteed, but it certainly paints an optimistic picture to the potential annuity shopper.
A more reasonable estimated growth rate would be looking at the investment’s performance over the last 10-year period. Fortunately, the illustration does provide this, however it’s not the figure that they used in the hypothetical scenario. The last 10 years average is 4.45%.
Using the strong growth rates from the early 1990’s not only allows the contract value to grow at these strong rates, it also allows the income guarantees to grow to very strong amounts. At age 65, the income guarantee under this hypothetical (non-guaranteed) scenario would be $116,023 per year for the rest of the individual’s life. That’s a strong income guarantee, but it is contingent on the investments having the phenomenal growth rates listed above.
When the Protected Balance grows to $2,320,461 it allows the lifetime income amount to be 5% of this, or $116,023 per year. So the more growth the annuity experiences, the better the actual Contract Value, and the better the income guarantee.
But again, these are all hypothetical growth rates.
What are the variable annuity illustration guaranteed income rates?
In addition to the hypothetical scenario, the variable annuity illustration also shows a guaranteed scenario. This scenario assumes zero growth. Therefore, the contract value declines each year by the fees within it. This is an overly pessimistic view of performance, but it’s good to see what the income guarantees actually are, regardless of how the market performs.
In this scenario it shows that the lifetime income guarantee is $63,386. This is what is guaranteed to the annuity owner, even if there is absolutely no growth in the annuity. Even if the annuity value drops to zero, the owner could still draw a lifetime income of $63,386.
This is the heart of the guarantee. This is an important benefit. It allows the annuity owner to know they won’t run out of income regardless of how long they live.
You’ll notice the Protected Income Balance increases each year, even when the Contract Value goes down in this scenario. That’s because the annuity has a guarantee built in to increase this balance regardless of how the annuity performs in the market.
This value is guaranteed to grow to $1,204,338 by the time the owner is 65. Then the company uses this value to determine the lifetime guaranteed amount the annuity can receive. At age 65 they multiply $1,204,338 by 5% to get a lifetime income of $63,386.
You’ll notice that the $1,204,338 is just a figure used to make a calculation. It is not money that you can walk away with in a lump sum. It is guaranteed to increase by at least 7% of the original deposit ($812,644) each year.
This really has 2 implications:
Since the rider fee of 1.5% is based on the Protected Balance of $1,204,338 at age 65, that’s a fee of $18,065 ($1,204,338 x 1.5%). Notice that the contract value at this time is $471,209. That means $18,065 is 3.8% of the Contract Value ($18,065 divided by $471,209 = 3.8%).
So the actual fee for this variable under this “no-growth” scenario would be
1.15% – M&E Fee
0.15% – Admin Fee
0.96% – Portfolio fee
3.8% – Income rider (rider fee as a % of Contract Value at age 65 under no-growth)
6.06% – TOTAL
This is an extreme scenario with no growth and admittedly very pessimistic. But it is a reminder that the 1.5% income rider fee is based on the Protected Balance, which is always going to be either greater than or at least equal to the Contract Value. If the Contract Value grows, the income rider fee as a percentage of the Contract Value will be less, but never less than 1.5% of the Contract Value.
What if the variable annuity illustration used the last 10-year returns?
If the last 10 years of performance had been used, which was 4.45%, then the Contract Value would be higher than it started due to the growth.
However, the Protected Balance would have outgrown the Contract Value. It would have ended at the same guaranteed value of $1,267,724.64 at age 64. This means the guaranteed lifetime income benefit starting at 65 would be 5% of this amount, or only $63,386. So even with the more recent (and more reasonable) growth estimate the guaranteed income is what results.
Like many variable annuities, when reasonable rates of return are used in a hypothetical illustration, the minimum guaranteed income becomes the reality. The high growth dreams rarely materialize into reality. And this makes sense if you consider the high fee nature of these products, the drag higher fees place on performance, and the reality that our current investing environment has not played out to be as high of a growth environment as the 80’s and 90’s were.
What benefit is most important?
In light of this, it is reasonable to expect the income guarantee to be around $63,386. And maybe if the variable annuity performs better in the market it could potentially be a little bit higher.
So if the income guarantee is most important, then it makes sense to check out other income guarantee options. In this case, at the time the reader reached out to me, there were significantly higher guaranteed income options available using fixed annuities and paying much less in fees. There were even some fixed annuity options with reasonable growth projections that would very likely give increases in the guaranteed income going forward to help offset inflation for the rest of the annuity owner’s life.
But if the benefit of Contract Value growth is most important for this investment, other options need to be looked at first. Is it possible to get higher potential growth rates with other market-based investments in a lower fee portfolio? The high internal fees of the variable annuity hinder it from getting higher returns in reality. Lower fee options need to be considered if account value growth is most important.
The main confusion comes when the annuity shopper is unsure what benefits are most important to them. Is it the Contract Value growth potential, or is it the income guarantees?
By waffling back and forth between the two benefits it is easy for a salesman to persuade the buyer into a decision that might not be the best for them. If you understand the benefits you need, it is much easier to compare and shop around to get the most benefit for the fees you pay.
Have questions about a variable annuity illustration?
If you have questions please let me know. [You can securely reach me by email by clicking here.] You can also leave a comment below with a question too. I know that shopping for an annuity can be confusing. And it can be stressful when you are nearing retirement or even officially retiring and you want to make the right decisions about what to do with your 401(k), 403(b), TSP, or lump sum pension buyout.
If you know anyone that is facing this situation, please share this post with them. I know a lot of people are retiring every day and feel lost about what to do with their portfolio when they leave their employer’s sponsored retirement plan or have to decide what to do with their pension buyout. My goal in writing this post is to provide objective information to help retirees make better decisions. When you share it, more people will be able to find it and hopefully benefit from it.