One common complaint against annuities is that they are so complex.
And in some cases this is true.
Heck, in a lot of cases this can be true. And I guess if all annuities were easy to understand then my website (all about making retirement planning easy to understand and all) would have one less topic to talk about.
Not All Annuities Are Complex
But there are some annuities that are not complex. Annuities called SPIA’s (Single Premium Immediate Annuities) are very simple to understand. Here’s how you would explain a SPIA to your grandchild:
“Grandpa and I are going to give some money to an insurance company, and they agree to pay us an income for the rest of our lives. Even if we live to be 150 years old.”
That’s pretty straight forward. Also, DIA’s (Deferred Income Annuities) are pretty easy to understand. Here’s how you’d explain them to your grandkid:
“Grandpa and I are going to give some money to an insurance company, and they agree to pay us an income for the rest of our lives. Even if we live to be 150 years old. But they won’t start paying us until 5 years from now.”
Or whatever number of years you want to delay. Now that’s easy to understand.
But being easy to understand doesn’t always make it the best thing. For instance, with many SPIA’s and DIA’s, once you activate the income stream, it’s a done deal. There’s no going back and changing your mind and getting your lump sum (or what remains of it after withdrawals) back.
And that’s not necessarily a bad thing… if you use them wisely. And obviously you wouldn’t want to commit all your money to a strategy that causes you to lose access to all liquidity.
And SPIA’s and DIA’s are great at increasing the amount of guaranteed income you will have in retirement. And they are very pro-consumer with low agent commissions and highly efficient at using your dollars for the specific purpose of income generation.
But this is just an example of something being simple, yet at the same time it may not be something very appealing to you.
Which Annuities Are Complex?
The most complex annuities are generally the Variable Annuity (VA) and the Fixed Index Annuity (FIA). Why are they complex? Let’s look at their value propositions first to see why.
The Variable Annuity’s value proposition is to allow you to invest your money in variable investments (sub-accounts that act much like mutual funds inside the VA) while typically giving you some other protection guarantees.
For many VA’s the protection is a death benefit of at least your original deposit. The other form of protection is usually an income rider that you can add for an additional fee.
This income rider acts as something of a “bail-out” for you if the sub-accounts in the VA do not perform well. The income rider will step in and guarantee you a certain amount of income for the rest of your life, regardless if the VA performs well.
To give these protections the VA’s have to charge you for the benefit. That’s why there are mortality and expense costs associated with VA’s. It’s also why income riders have a fee of approximately 1% depending on which companies and contracts you choose.
And if your VA performs well and goes up in value, the income rider may have a step-up provision where it will guarantee you even more income.
There is a certain level of complexity associated with this. And the actuaries that help design these products have to determine just how much extra income benefits they can give you based on the underlying account value’s performance.
They also may have to put restrictions in place for how aggressive the composition of your sub-accounts may be inside the VA. Here’s why… if the VA company is on the hook to pay you lifetime income under the income rider, they don’t want you investing so aggressively that you could potentially lose a lot of your account value.
After all, the income they agree to pay you for the rest of your life first comes from your own account value. It’s not until your account value falls to $0 that you are digging into the insurance company’s pockets.
To make sure they can offer these guarantees in a very uncertain world, they must introduce a certain level of complexity.
Hence you will see:
- Certain restrictions on what you can invest in with your sub-accounts
- Different values on your quarterly statement: account value, death benefit value, highest daily lifetime income value, highest daily death benefit value, protected withdrawal value, income account values, surrender values, etc.
This can be a lot to take in. And the complexity doesn’t necessarily mean it’s a bad place to put a portion of your retirement dollars (although I’m generally not a fan of traditional Variable Annuities on the market today).
It’s just that to provide protections that are important to many retirees it can be complex.
What About Fixed Index Annuities?
Even Fixed Index Annuities (FIA’s) can be complex. The complexity with these products typically centers around 2 things: 1) the interest crediting method and 2) the income rider.
Interest Creditng Methods
There are so many interest crediting methods. I ought to make a cheat sheet as a reference and post it on this site. Some of the different crediting methods include:
- Annual point-to-point
- Monthly point-to-point
- Monthly average
- Point-to-point with participation rates
- Point-to-point with spreads
- Monthly sum with cap
And that’s just scratching the surface.
Then there are tons of indexes whose performance will determine the interest income credited to the account. Tracking the S&P 500 is a very popular one. But some FIA’s track the Dow Jones, the Russell 2000, Nasdaq 100, and many others.
In a nut shell, the insurance company is buying options on a particular index. If the index performs well, the options are worth money so the insurance company exercises their rights under the options and generates a gain. They then credit some of the gain to the annuity account.
If the index performs poorly they don’t exercise the options. Hence, when the market goes down you don’t lose anything in the Fixed Index Annuity.
This is such a great benefit to many retirees for a portion of their portfolio that it is worth the added complexity in many cases.
And really, how much complexity does this add to a retiree’s life? Think about it. You don’t have to understand how to buy options, or which indexes are good ones to buy an option on.
You don’t have to understand how actuaries determine payout rates that they can guarantee to annuity owners.
Think of this way: You don’t have to understand how a light bulb and electrical currents work. You just have to know how to flip the switch.
How To See Through The Complexity
Having said this, it is still important to keep your eyes focused on specific things when you are considering an annuity. Don’t get caught up in all the complexity and details that are unimportant.
And to be honest with you, much of the annuity world makes this very difficult. So let’s look at 2 examples of how to keep things simple.
#1. Principal Protected Growth
One good use of a Fixed Index Annuity is principal protected growth. If the market goes down you don’t lose money with these products.
However if the market goes up you will not get all the gains of the market. Listen closely:
Expect no more than conservative growth from Fixed Index Annuities. Something in the range of 3-6% is a reasonable expectation in the current environment.
Could they do better (or even worse) than the 3-6% range? Absolutely. But that is where I would have my expectation.
If an advisor is insinuating that you will make more than that, run (don’t walk) out of their office and find another advisor.
You cannot get phenomenal growth in this world when you essentially are taking little to no market risk. Remember: there’s no free lunch in life. If you want higher returns, you have to take more risk, and potentially risk losing your original investment.
Since a Fixed Index Annuity protects you from market risk, don’t expect phenomenal growth. I’ll repeat: 3-6% is a reasonable expectation.
The crazy thing is, that FIA’s have such a strong value proposition (protecting principal with the potential to do slightly better than other conservative investments) that there is absolutely no reason for an advisor to try and over promise, over hype potential returns on these products.
So all the interest crediting methods that FIA’s offer today can make it complex. Here’s my advice:
If you are looking for conservative growth with principal protection, try to find an FIA with an uncapped strategy or at the least a very high cap rate.
An uncapped strategy will use a participation rate or a spread. A participation rate will only give you a percentage of what the index it tracks did. If the index is up 10% and your participation rate is 40% of that, then you get credited 4% that year.
If the index performs very well, then you can get some better returns. There is no cap on what you can earn, but in reality the returns will still be modest. But they may outperform a capped strategy that does have a limit (the cap) on what they can earn.
And a spread takes away some of the market gain. If the index goes up 10% and your spread is 3%, your annuity would be credited a 7% growth that year. You can also conceptually see there is no limit using a strategy like this too.
So to simplify it and not get caught up in the myriad of interest crediting options… a good place to start is to look for uncapped strategies.
Moving on to point #2…
#2. Annuity Income Guarantees
Today the income rider is a popular thing to add to an annuity contract (like Variable Annuities as well as Fixed Index Annuities). If generating a stream of income is the most important feature for you, then you’ll want to pick the one that gives you the most income.
Income Riders are fantastic as a delivery mechanism of guaranteed income for retirees at some point in the future. But they are marketed in the most complex and asinine way possible.
Too much emphasis is put on “roll-up” rates. Things like the “8% Annuity” are promoted.
Since the roll-up rates only apply to the Income Account Value (not your real money account value), they are not real growth.
They only help boost up the Income Account Value so they will have more guaranteed income from the annuity.
But wouldn’t it make more sense to focus on what the Payout Rate is? Instead of focusing on roll-up rates, and bonuses applied to the Income Account Value, let’s just focus on the Payout Rate.
It would work like this:
“If I put $100,000 into this Fixed Index Annuity with income rider and wait 6 years, I will receive $7,000 dollars each year for the rest of my life.”
That would be a 7% payout rate in year 7. Pretty easy to understand, huh?
Then you could take things like the “8% Annuity” and see what it’s payout would be if you put $100,000 in it and waited 7 years. Is it better than $7,000? Or is it worse?
Then pick the annuity that gives you the best payout.
So, for all the complexity that the industry has introduced into this product, all you need to do is focus on the income payout rate. That’s it.
And until the industry catches up by simplifying this, just know that you can keep it simple right now. You can make it much easier to understand right now.
And you know what? You may even be able to teach your financial advisor how to understand income riders better as well.
For all the complexity associated with annuities, they can still be viewed under a simplified lense. If you just keep your eyes on what is important to you, you can tune out all the other noise.
Don’t let all the index crediting methods intimidate you. Start by looking for uncapped strategies (if principal protected growth is the most important thing for you). This is a good starting place.
Don’t let all the “roll-up” rate hype distract you. Concentrate on income payout rates (if maximizing the income stream is most important to you).
And always start with your end goal in mind. Whatever goal you are trying to accomplish, determine what it is. It’s much easier to find a product that will meet your goal if you know what you are aiming for.
And you really shouldn’t even be having a “product” discussion with your advisor until you have both determined what you are trying to accomplish in retirement.
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