Understand Your Options Before Committing a Large Sum to Providing Guaranteed Income For Life by Scott Stolz, CFP, RICP (week 32)

 

A friend called me last week to get my opinion on an annuity recommendation he received from his financial advisor.  Here’s the scenario.  He’s looking to retire at the end of 2028 when he will be 67 and his wife will be 65.  He plans to apply for Social Security at that time.  Based on his expected expenses and Social Security benefits he wants to add $40,000 per year in guaranteed income in order to cover his essential expenses.  His financial advisor recommended he fill the income gap by putting $745,000 into an annuity that will pay $40,000 a year for as long as he or his wife is alive, with a minimum guarantee period of 20 years should they both die prior to 2048 (joint life with 20 years certain).  He liked the idea of getting the income for life, but he was uncomfortable with putting so much of his retirement savings into any single investment – especially an annuity.  Hence, his call to me. 

While everyone likes the idea of creating their own pension (who doesn’t like a pension?), the thought of seeing so much of one’s hard-earned savings essentially disappear from any financial statement is hard to wrap your mind around.  This is probably the number one reason more people don’t buy either immediate or deferred income annuities.  I told him he really had to think about this in a different way.  First and foremost, what he is really purchasing is peace of mind rather than a different investment.  And second, while the annuity might not be valued on his financial statements, there is real value to a $40,000 per year payment over 2 lifetimes.

Having said that, I actually recommended he explore a different option.  I recommended that he consider a fixed income annuity with a lifetime income benefit that is designed to maximize income rather than return.  This is the approach I took with one of the annuities I own (I Just Earned 3.3% on My Indexed Annuity, So Why Am I Happy About That? | Advisorpedia).  According to my calculations, this solution would actually only require about $500,000 to generate the desired $40,000 per year for as long as he and his wife were alive (but it would not carry a 20-year minimum guarantee).  Or if he still decided to invest $745,000, he could get slightly more than $60,000 per year.

It’s important to understand the difference between annuitizing an annuity to generate income versus using a lifetime income benefit to generate income.  When you annuitize, as my friend’s advisor recommended, you give your money to the insurance company in exchange for the agreed upon income.  This is an irrevocable choice.  You can’t later say I no longer want or need the income, so send me my money back.  When you generate income with a lifetime income benefit, you are actually making systematic withdrawals from your policy.  In addition, the account balance in your policy can continue to earn interest.  Since, over time, the income withdrawals will exceed any interest paid on the policy, your account balance will gradually decline.  Should it go to $0 before you die, the insurance company must continue to pay the guaranteed income amount out of its own pocket.  Essentially therefore, the annual fee you pay for the lifetime income benefit is to guarantee a specific systematic withdrawal rate that is always much greater than the typically recommended 4% per year.  And here’s a key point.  Because you are making systematic withdrawals rather than annuitizing the policy, you maintain an ongoing account value.  You are not making an irrevocable choice.  You can actually stop the withdrawals and ask for your remaining account balance.

This raises a perplexing question.  Why does a fixed indexed annuity with liquidity often pay more income than an annuitized policy with no liquidity?  Typically, liquidity comes with a cost – either lower returns or lower income.  Why is that not the case here?  It comes down to what a former associate of mine refers to as policy behavior credits.  Since the income from a lifetime income benefit first comes from your account balance, the insurance company is just giving you your own money.  Until your account balance goes to $0, these withdrawals cost them nothing.  Therefore, if you decide not to take the income or you cash in the policy, the insurance company has collected the annual income benefit fee and never paid out a claim.  In addition, if you wait until you are in your late 70’s to start taking the income, it is likely you will die before you fully liquidate the account.  Based on their experience to date, some of the insurance companies have concluded that a significant number of policyholders will not efficiently utilize these benefits.  Therefore, they are willing to guarantee higher levels of income in order to make their policy more attractive and gather more assets.

This creates a great opportunity for people like my friend that have a specific plan for how to utilize the policy and more importantly, stick to that plan.  He and his wife can get more income than they really should simply because other policyholders will not stick to their original plan. 

But what if the insurance company is wrong?  What if all of the policyholders start taking their income while they are still in their 60’s and their account balance gets liquidated while they are still in their 80’s and have years to live?  Will the insurance company be able to make all of these income payments?  And if the company can’t, what happens then?  Tune in next week for the answer to those questions.