Today’s question comes from Russ. He has some questions about the type of annuity he is looking for. He writes:
“I am looking at fixed index annuities. I am looking for a fixed index annuity that offers no cap, has a rider for fix income for life and an inflation guard. I would like one if possible that would have a 5 year surrender period… if that is possible… I would be taking income in about 5-6 years.”
What’s great about this email is that Russ has a clear idea of his different needs and what he’s looking to accomplish with an annuity.
Specifically, there are a couple of important issues Russ is looking for:
- Good growth (hence the “no cap” reference)
- Guaranteed income (hence the “rider for fixed income”)
- Inflation protection
- Short surrender period (5-years)
This raises an important question: Is it possible to get ONE annuity that can do all these things?
Let’s dig in to this little…
How To Choose the Right Annuity – Start with your ultimate goal
Different annuities are designed to do different things. These different objectives can include:
- Conservative growth with no market risk and principal protection
- Income for life
- Legacy maximizing
- Long-term care protection
These are the 4 main reasons people purchase annuities. And different annuities will specialize in these different areas.
The annuity that is best at maximizing your guaranteed income for life, will very likely not be the best at maximizing conservative growth potential on your account value. There are reasons why this is the case, which we will discuss shortly.
So the best way to approach an annuity purchase is to start at the finish line. In other words, what do you want to accomplish with this annuity?
Fixed Index Annuities with No Caps – The Growth Component
It is possible to get a fixed index annuity with no cap. In fact, in many circumstances a fixed index annuity with no cap gives you the best potential for conservative growth.
A cap puts a limit on how much interest your account can be credited. So even though the index (let’s assume it’s the S&P 500) goes up 10% one year, you may be capped to only earn no more than 5%.
An annuity with no cap means the sky’s the limit, right?
Not so fast.
If a fixed index annuity does not have a cap, it will typically have a “spread” or a “participation rate.”
If the “spread” is 2% and the index goes up 10%, then you earn 8%. Pretty simple.
If the “participation rate is 50% and the index goes up 10%, you earn half of it, or 5%. Also pretty simple.
So even if there is no “cap rate” there are still other methods of limiting your growth. The moving parts that go into a fixed index annuity require these limits on growth because the insurance company is conservatively investing your money. And there’s no way they can give you 100% market growth without taking market risk.
It’s just reality. And that’s fine.
Choose the Right Annuity – The Income Component
Another important feature our reader is looking for is lifetime income. Annuities are a great place to look for this. It’s what they specialize in.
One way annuities can guarantee a lifetime income is through income riders. They can be voluntarily attached to most fixed index annuities. The typical fee for this is usually 1% each year for that guarantee.
So if you want to maximize the conservative growth the fixed index annuity can give you, then you’ll want to not include an income rider. Unless of course the annuity has the best cap rates and gives you a good bonus up front that virtually offsets the income rider fee.
Income riders provide lifetime income, as well as the flexibility to change your mind later in the future if you no longer need the lifetime income guarantee.
In other words, your money is not locked up forever with the insurance company. You can pull out your account value at a later date if you want to reduce (or eliminate) your income guarantees.
This is a great benefit with flexibility to allow you to change your plans in the future if you must.
Choose the Right Annuity – The Inflation Component
The next feature Russ is looking for is inflation protection.
Some annuities will allow you to include an inflation protection benefit to them. But the cost of this is they will typically start out paying you a much lower guaranteed payout rate.
Keep in mind the insurance companies know how to price this stuff. And they know how much obligation they can take on.
So if you attach an inflation rider on your income guarantee, you will almost certainly start out receiving much less in income in the present.
When it comes to fixed index annuities with income riders attached, they can be presented in such a way to confuse the issue.
For example, the longer you delay drawing income under a fixed index annuity income rider, the higher the payout will be. This has the appearance that the income guarantee is keeping up with inflation.
But the thing to keep in mind is that when you begin drawing lifetime income under the income rider, that amount is probably going to stay level for the rest of your life. So the guarantee increases each year you delay, but once you start drawing income, it remains level at the amount you are drawing.
In other words, it won’t be keeping up with inflation. You’ll need to incorporate something else in your planning to keep pace with inflation, such market-based investments or using multiple annuities that you activate the income later in the future for a bump up in income.
Some fixed index annuities will include a benefit that allows your income guarantee to go up if the account value has some very strong growth in it. Even AFTER you begin taking income.
The reality is that this rarely materializes in greater lifetime guaranteed income for you. The index growth would have to be a lot. And a lot of planets and stars would have to align to make it happen.
So it’s best to just stick with what the actual income guarantees are. If the stars and planets align and give you more income, then that’s the cherry on top. Go out and buy yourself something nice if that happens.
Choose the Right Annuity – The Surrender Period Component
Most fixed index annuities will have a 5-10 year surrender value. The shorter the surrender period, then typically the less the earnings potential and income guarantees.
This makes sense. A shorter term CD will typically pay less interest than a longer term CD. Same thing for bonds. And insurance companies are under the same constraints since they must invest your money within this same reality.
Start at the Finish Line
So how do you choose the right annuity?
By starting at what is most important to you.
If you need additional income 5-6 years from now, then figure out how much extra income you need. Then an advisor can calculate how much premium you should put into an annuity that will guarantee that level of income in 5-6 years.
Pick the company that gives you the best payout rates. Pick a strong rated company too. Let them compete for your business. Your goal is to get the most income possible using the least amount of dollars on your part.
If you want conservative growth on your fixed index annuity, then look for the ones with the most favorable cap rates, participation rates, or spreads. Keep the income rider off it, because the income rider will typically cost around 1% each year, thus reducing your growth potential.
Use An Annuity Portfolio
When you have multiple needs from annuity, the best way to approach the solution is by using a portfolio of annuities. In other words, more than one annuity.
If you have income needs in the future, then put some funds in the annuity that will guarantee you the highest payout when you need the income.
If you need some conservative growth for a portion of your portfolio, then pick an annuity that is designed to give just that. And leave off the income rider and its 1% fee that will reduce your earnings potential.
If you need inflation protection, use more than one annuity. For example, one annuity can start paying in 5 years. Then another can start paying in 10 years to give you a bump up in income. Then set another one to begin paying you 15 years from now.
For each one of these annuities, you purchase the one that has the highest guaranteed income based on the amount of time you are delaying.
If you try to do everything with one annuity, you run the danger of having a “Swiss Army knife” approach. The Swiss Army knife can do a lot of things, but it can’t do any of them very well.
You don’t want to do this with your annuity strategy. You want to maximize the benefits from each annuity. This puts your dollars to work as hard as possible for you.
Thanks for the email, Russ. I hope this has helped when choosing the right annuity for you. Best wishes!