One of the most common things I see when someone comes into our office for the first time if they own or have been pitched an annuity is the belief that the annuity is “earning 7% guaranteed.” Usually this is due to either a salesperson misrepresenting how the annuity works or a consumer misunderstanding.
The fact of the matter is, to my knowledge, there have been exactly zero annuities in the last 25 years that actually guarantee 7% growth of your account value. What is actually guaranteed in most of these cases is that for every year you wait to take income from the annuity the amount of income that is guaranteed to be paid to you goes up by 7% per year, which is an entirely different thing. With these kinds of products there are really 2 different buckets. One is your actual account value, which is what you can cash out and typically goes up and down with the price of stocks and bonds. The other is what I sometimes refer to as ‘funny money.’ Companies call this a variety of things, like ‘income value’ or ‘protected value.’ Basically it is just a mythical bucket that is used for only 1 purpose; to calculate what your guaranteed income stream will be. It is NOT something you can ever cash out and take the money. It is this bucket that is commonly touted as having ‘7% guaranteed growth.’
Let’s go through a hypothetical example of how this might work. Let’s say you are 65 years old and you put $100,000 into one of these products. At a growth rate of 7.2% your money doubles over the course of 10 years. This is what would occur with your ‘funny money’ bucket. Your actual account value, again, will fluctuate usually with the prices of stocks and/or bonds. Let’s just assume, though, that it doesn’t gain or lose anything over those 10 years. So now you have an account value that is $100,000 (this is what you can actually cash out) and a ‘funny money’ value of $200,000. Let’s say that in this case the annuity guarantees an income stream of 5% of whatever the ‘funny money’ value is (I’ve seen these range from 4%-7% in most cases, usually depending on age). So, 5% of $200,000 is $10,000. This is the guaranteed annual income amount that you will receive. As long as you never take out more than this amount each year you will continue to receive it even if it causes your account to run out of money. The issue is, though, that if you signed up at 65, waiting for the ‘funny money’ bucket to double over 10 years with its ‘guaranteed 7.2% growth’ puts you at 75 before you start your $10,000 guaranteed income stream. At $10,000 a year it is going to take you 10 more years just to get back your original $100,000 investment assuming your actual account value never grows at all! So, just to get your own original money back it takes 20 total years and you are now 85 years old. If you have any account growth at all it would take even longer. When explained this way that ‘7.2% guarantee’ doesn’t sound so attractive now does it?
This kind of income rider or benefit (sometimes called a Guaranteed Lifetime Withdrawal Benefits, or GLWB) is often times an additional optional feature that comes with extra cost on a fixed indexed or variable annuity above and beyond standard annuitization. Typically with annuitization you are required to give up your entire account value in exchange for guaranteed income payments.
Annuities can be very complex and hard to understand investments. Because of this you should be sure you fully understand exactly how the one you are considering works and all of the costs and fees associated with it. I’ve seen ‘7% guaranteed’ annuities that have annual fees totaling over 5% per year! It is very difficult to get ahead with these levels of fees. Many annuities are also very long term and sometimes lifetime commitments. Knowing exactly what you are getting as a guarantee and the fee you are paying to get that guarantee should be carefully considered.
Sometimes how something is presented when it is sold and how it actually works can be two very different things.
–Ryan Shumaker, Smartvestor Pro at The Retirement Team
401(k) Plan Owners: Watch Out
