One of the most common things I hear from people who own or have been pitched an annuity is the belief that the annuity will “earn 7% guaranteed.” Usually this is due to either a salesperson misrepresenting how the annuity works or the 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 that are still in force today. 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 entirely different.
With these kinds of products, there are typically two different buckets. One is your actual account value, which is what you can cash out and which typically goes up and down with the performance of chosen stocks and/or bonds. The other is what I sometimes refer to as “funny money.” Many companies call this “income account value” or “protected value.” Basically, it is just a bucket that is used for only one purpose: to calculate what your guaranteed income stream will be. It is not something you can cash out and take the money. It is this bucket that is commonly touted as having “7% guaranteed growth.”
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Let’s go through an 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 income account value bucket. Your actual account value, again, will usually fluctuate with the performance of chosen stocks and/or bonds. Let’s just assume, though, that it doesn’t gain 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 an income account value of $200,000. Let’s say that in this case the annuity guarantees an income stream of 5% of the income account value (I’ve seen these range from 4% to 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 income account value bucket to double over 10 years with its “guaranteed 7.2% growth” puts you at 75 years old 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?
Many annuities can be complex and hard to understand products. Because of this, you should be sure you fully understand exactly how the product works and all of the costs and fees associated with it before making a buying decision. Many annuities are very long-term and sometimes lifetime commitments if you are older. 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 are two very different things.
(reprint from Forbes.com) Material discussed is meant for general/informational purposes and is not intended to be used as the sole basis for any financial decisions, nor be construed as advice to meet your particular needs. Please consult a financial professional for further information.
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