Understanding Income Riders
By Robert Kelly|
Income for life is in reach
As I speak to so many callers to my Safe Money and Income Radio Show, I find that I spend a lot of my time undoing a lot of the misconceptions and even outright misrepresentations that a lot of them have about annuities and income riders.
These problems arise because they have received bad information or sales pitches that were not completely forthright. It is especially disturbing when it is a person who already owns an annuity and thinks he has certain guarantees of growth in his annuity and then I must clarify to him that what he has is much different.
Many times, I hear I am guaranteed to gain at least 5% a year in my annuity and if the market does well even more. This is from people who own Variable Annuities, but sometimes from people with Indexed Annuities as well. I have had people argue with me that I am mistaken, and they are getting 5% guaranteed at least, and they can show it to me on their statements. Of course, when we get together, and I review their statements it always turns out that they do not have any guaranteed growth for their account value. The part of these annuities that has a guaranteed increase in the fixed account and those are typically earning between 1-2%. People are understandably upset when I point all of this out and explain what they have. So, what causes this confusion?
Well, without placing blame on either side, it could be the agent misrepresented how the policy works, or the client, for whatever reason, over time forgot how the policy works, and what the guarantees were and how they could enhance the product’s performance. So, let me try and clear all of this up.
To begin with, I like to say that life Insurance companies only manage two risks- dying too soon or living too long. Everyone knows that dying too soon is covered by life insurance. At the other end, living too long is covered by annuities. In both cases, the Insurance Company is betting that they will take in more money than they will pay out in claims, and they have actuaries who run the numbers to make sure that is the case. The “Law of Large Numbers” is what they use. For example, they may have to pay a death benefit of several hundred thousand dollars to someone who has only paid a few hundred dollars into the policy. But they collect premiums from so many people whose policies expire or lapse, or who take the cash value out during their lifetime, that they can easily afford the few that cost them money.
It is the same thing with annuities. For the most part, people are only taking out their own money and any gains earned from those funds. It is only a few people who outlive their money that wins the bet, so to speak, and are now living on the insurance company’s money. When someone decides to annuitize their policy, they are now drawing down from the principal to generate a monthly income for as long as they live- guaranteed. The problem with annuities for most people though is that they are not willing to give up that principal in exchange for a monthly paycheck. And that is where Income Riders come in- you can keep control of your principal and even have the account value continue to grow for your benefit after starting to take income. You also get guaranteed growth for your lifetime income.
Of course, while people are holding their annuities, they want to see them grow in value. Fixed annuities can be compared to CDs in that they give a guaranteed rate for a specified period. For example, a 5-year Fixed Annuity now will return approximately 3% compounding interest over five years, significantly higher than a 5-year CD. But most people are looking at their money being able to grow at a higher rate, and so they look at Indexed Annuities and Variable Annuities for the potential of higher returns.
I have many clients over the past few years who have seen gains of 8%, 9%, 10%, even as high as 16%, without the fear of loss from a market correction with the use of Indexed Annuities. With Variable Annuities, the same types of returns can be achieved but the gains are not locked in, and the fees internally are too high, so I do not recommend them. The problem though, with both Indexed and Variable Annuities, is they rely on the market going up to have ANY gain in the annuity’s account value.
So, all of this brings us to the discussion about income riders. Insurance companies know that people do not like to annuitize and give up control of their money. They also know that people want to benefit when the market goes up to increase the value of their annuity. With this, they introduced Income Riders about ten years ago to address some of these concerns. And this is where the confusion comes in- they are fantastic features if you understand them and what they do for you. But too often they are not presented correctly.
Simply put, no one can guarantee a 5%-7% gain every year from a market-based product. With Variable Annuities, your principal is always subject to significant losses, and even with Indexed Annuities, there is no guarantee that the principal will ever grow. Income Riders solve this problem for those who are looking for income. The Rider value- which is just an accounting procedure- is guaranteed to increase in value every year regardless of market performance, but that does not mean your account value will increase.
For example, we have just had a tremendous Bull Market for the past nine years, and sooner or later we will see a substantial correction. We have seen Bear Markets in the past that have lasted well over a decade. Looking at history it is entirely possible that a $100,000 account may not be worth much more than that $100,000 ten years later, and if you were to draw income from it at the point, you would be drawing down from $100,000. By adding the Optional Income Rider to the policy, you could have guaranteed growth of the Income Account of a guaranteed rate- say 7%. That would mean in 10 years the Income Account would have grown to $200,000. Granted, the real Cash Value of the Account has not grown, but the purpose of this money was to have lifetime income.
Now, drawing income at a payout rate of 6% you would be receiving $12,000 a year instead of the $6,000 you would have received if you did not have the rider. What happens here, of course, is that your Cash Account could deplete faster and then you would be living off of the Insurance Company’s money. Therefore, the Insurance Companies charge a fee for the rider (Usually around 1%) as they have increased their risk of having to pay out some of their money to the policyholders. But the benefits of the Rider, if understood correctly, make the fee worthwhile. You get guaranteed growth for income without market risk, and you still get the benefit of the up years in the market and lock in those gains. With the Rider, you can also change your mind after starting to take income and withdraw all your remaining funds in a lump sum. Many of these Riders will also double the amount you can withdraw if you need Home Health Care or Institutional Care. Whatever funds are left in the Account will pass on to your stated beneficiaries. Some of them will even pay out the full Rider Value as a Death Benefit. There are many variations on these riders, including some with no fees at all, and still with great benefits.
There is not one Rider that best suits every situation, but they are extremely valuable in helping people plan for retirement income, basing their plans on guarantees- not guesses. In fact, a two-year in-depth study of Fixed Indexed Annuities by six Ph.D. Economists & two Senior Actuaries led by Professor David F. Babbel of The Wharton School of Business and Professor Craig B. Merrill of The Marriott School of Management at Brigham Young University found that income annuities (FIA) can provide a secure income for one’s entire lifetime for 25-40% less money than it would cost to provide a similar level of secure lifetime income through traditional means. (Annuity Digest July 26, 2009).
By using Income riders to guarantee substantial growth of 6-7% EVERY year for income purposes, without ever having a down or flat year, You can reach your goals for retirement with a lot less money and a lot less worry and stress than the conventional ways of using stocks, bonds, mutual funds, and money market funds in any combination, according to this same report.
And that is the bottom line- peace of mind and security!
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