It's About the Income, Not the Return - Why I Replaced by VA with a FIA (part 2) by Scott Stolz (week 20)

 

 

In last week’s blog post, I explained why I had decided to replace my variable annuity that was paying me $10,100 per year with a fixed indexed annuity (FIA) (Why I'm Replacing My Variable Annuity with an FIA by Scott Stolz (week 19).  The bottom line is that some of the FIAs available today pay considerably more income than my existing annuity.  I’ll use Fidelity & Guarantee’s SecureIncome 7 – the product I chose – as an example. I’ll be moving approximately $200,000 from my Voya variable annuity to the SecureIncome 7.  I’ll be adding their lifetime income living benefit to the policy.  This optional feature will cost me 1.15% per year, which will be deducted from my account value.  It will add an income base to my contract which is the value that will be used to calculate my lifetime income payment.  This income base will initially be set at the amount I deposit in the annuity and will grow by 7% simple interest per year.  Assuming a 200,000 initial income base, I therefore know that the income base will grow by 14,000 each year until I start taking income.  When I turn 68 in 3 short years from now, my income base will be 242,000.  As a reminder, I have omitted the “$” in front of these numbers because it is not a sum I can receive as cash.  It’s just a value that is used to calculate my income.  Unfortunately, most (all?) insurance companies do in fact put a “$” in front of this number, but don’t let that confuse you.

So, what happens when I turn 68?  At each specific age, the SecureIncome 7 has a payout rate expressed as a % of the income base.  At 68 that rate is 8.12% if I choose to take income only over my lifetime or 7.42% if I choose to take it over the life of both me and my wife.  Since I don’t want either of us to take a cut in income when the other one dies, I will choose the joint life payout and be able to get $17,956 per year – almost an 80% increase over what I’m getting from my current annuity.  By forsaking the $10,100 in income I’m getting from my current income for the next 3 years, I will start getting almost 80% more income each year for as long as either my wife or I are alive.  Seems like a pretty decent trade-off to me.

But once I decided to replace my existing annuity, I had to consider if another annuity was even the right option.  Since this policy is in my IRA, I have the option of using the funds in the annuity to buy any other investment without worrying about any income tax implications.  Here’s my thought process.  Remember that this is money that is earmarked for retirement income.  Assuming I was comfortable with a 5% withdrawal rate, what return would I have to get on this $200,000 over the next 3 years to allow me to withdraw 5%?  That math is pretty simple.  $17,956 is 5% of $359,120.  For $200,000 to grow to $359,120 in just 3 years, I would have to earn 21.6% per year.  That doesn’t seem likely to me.

At this point it would be logical if you are asking what’s the catch?  Why is the insurance company willing to pay such a generous amount of income?  When designing these income features, insurance companies have to make the following four assumptions:

1.      How much can they earn on my policy and the 1.15% I am paying in fees each year

2.      How long my wife and I are expected to live

3.      How many policyholders will actually start taking the income from the policy

4.      For those that take the income, at what age are they likely to start taking it

The truth of the matter is that the behavior of retirees has led the insurance companies to believe that a significant percentage of the policyholders that pay for this lifetime income feature will either cash the policy out before they liquidate the account value (like I’m doing with my variable annuity), never turn the income on at all, or turn it on so late in life that they will never liquidate their account value before they die.  In all of these cases, the insurance company collects the 1.15% annual fee and never has to make lifetime income payments to the policyholder out of its own pocket.

If you tell policyholders that they can get more income by waiting, many will continue to wait.  This is especially true if that policyholder is not confident they will have enough.  The best way to not run out of money in retirement is to not spend what you have, which is why so many retirees actually underspend in retirement.  And that is why it’s so important to work with an advisor to set up a retirement income plan.

Here's the most important message of all of this.  A good part of the reason FIAs are paying so much income relative to the amount you invest is because so many policyholders do not use the policy efficiency.  But that creates a great opportunity for those that buy these policies and actually turn the income on.  Essentially, their income is being subsidized by the policyholders that either don’t start taking the income or just wait too long to take it. 

One final note.  There is a price to be paid when you buy a policy that guarantees so much income.  You are going to get a lower return on your actual account value. Should you chose the commonly selected annual cap option, the most the SecureIncome 7 will credit in the first year is 4.5%.  And then the 1.15% income feature fee is deducted.  There’s no free lunch.  FIAs with less generous income can be found with significantly possible returns.   Therefore, no one should buy this policy if they are not sure they are going to turn on the income.  But that’s exactly my goal.  I’m buying the policy for the income it will generate, not the return it will pay on my funds.  That’s the objective of my other retirement assets.