I Just Earned 3.3% on my Annuity. So why am I so Happy About it? by Scott Stolz, CFP, RICP (week 54)

 

For the second year in a row, I earned 3.3% on my Indexed Annuity, and I’m still happy about it.

By Scott Stolz, CFP, RICP

Two years ago, I bought a fixed indexed annuity (FIA) from Eagle Life.  On my first policy anniversary, the price of the S&P 500 increased 11.97%.  During the second year, it increased another 20.44%.  In each of the first two policy years, I selected a one-year crediting period with a 4.5% cap on the S&P 500.  Since the price increase was greater than the 4.5% cap in both years, I was credited with 4.5% interest in each of my first 2 policy years.  However, my FIA also comes with a lifetime income benefit.  Therefore, in each year a fee for this additional benefit was deducted.  This resulted in a net return after the fee of just 3.3% each year.  I can just hear the annuity critics now.  Why would anyone want a product that so severely limits the upside potential?  And why in the world would I still be happy with this investment decision – especially with the stock market continually hitting record highs since I bought the annuity?

It’s simple really.  I didn’t buy this annuity for the returns it can pay.  I bought it for the income it’s going to pay me in retirement.  Let’s take a closer look at that lifetime income benefit that I’m paying for each year.  This benefit will pay me income for life based on the income benefit value, not my account value.  This benefit value was originally set at the same value as my investment.  Eagle life guarantees it will grow by 14% simple interest each year for the first five years regardless of how fast or slow my account value grows.  Let’s look at an example to better see how this works.  In this example, we’ll assume I deposited $100,000 two years ago.

Year	Beginning Acct Value	Acct Value End of Yr	Beginning Income Acct Value	Guaranteed Annual Increase	Income Acct Value End of Yr
1	$100,000	$103,300	100,000	14,000	114,000
2	$103,300	$106,709	114,000	14,000	128,000

 

At my current age of 66, I can choose to take 6.3% of the 128,000 income value.  That comes to $8,064.  My plan is to start receiving this income after my 4^th policy year.  Since the 14% simple interest is guaranteed for the first 5 years, in this example, I know the income account value will be 156,000.  As I age, my allowable withdrawal percentage also increases.  At age 68, I’m allowed to take 6.5%, which would be $10,140 in this example.

Since retirement income planning is pretty much built around the concept of using 4% as a safe annual withdrawal rate, the question that must be asked at this point is how much money would I need at age 68 in order to “safely” withdraw $10,140 per year?  The answer is $253,500.  Put another way, most financial advisors will tell you that if you have $100,000 today and want to start taking $10,140 for life in four years, you will need to grow that $100,000 to $253,500.  The next question therefore is, what rate of return would you have to average each year over a four-year period to slightly more than double your money?  And that answer is 26.2% per year.  All I can say to that is that you better have a really good financial advisor or pray for record stock market returns. 

Do you now understand why I’m happy with my 3.3% annual return?  It’s nice that my account value is getting some growth each year, but that’s not why I bought the annuity.  I bought it for the income I will get two years from now.

This example illustrates a very important lesson for those that are considering using an annuity as part of their retirement income plan.  You must always understand the goal of the annuity.  Some annuities are designed to maximize account growth.  Others are designed to maximize income.  No annuity can do both.  I could have just as easily purchased an FIA that would have credited me at least 10% in each of my first 2 years.  But even with the higher account value, it would have provided me significantly less in lifetime income than the one I chose.  Eagle Life is essentially taking some of the money they could have credited to my account value and instead is using that money to give me more lifetime income.  If an advisor tells you that they have an annuity that will credit competitive interest as well as maximize your income, seek a second opinion. 

There’s a lesson in this for the annuity companies as well.  You might have noticed that every time I’ve provided a number for the income account value, I don’t put a “$” in front of the value.  This was not an omission on my part.  I left off the “$” sign because it is not money.  It is a number that is used to calculate my income.  The concept is similar to credit card or hotel points.  You’ll never see a “$” sign in front of that number.  Yet, when I look at my Eagle Life statement, I see a “$” sign in front of my Income Account Value.  I’m not picking on Eagle Life here.  I’m not aware of any annuity company that does not do this.  In my view, this is incredible misleading.  How many policyholders out there look at that number and confuse it with the actual account value? 

For you annuity nerds out there, I did not really buy an FIA.  I bought a deferred income annuity (DIA) masquerading as an FIA.  A DIA is an annuity that in exchange for a lump sum today guarantees a specific amount of income beginning at a specific age.  One drawback to a DIA is that it’s typically illiquid and requires you to decide in advance when you want to receive the income.  It’s a very inflexible income tool.  My FIA was funded with a lump sum deposit, and I know exactly how much income I can get at any age.  However, since my contract is an FIA, I have an accessible account value with some annual growth that I can reposition should I decide not to use it for income.  I also maintain the right to decide when to receive the income.  In fact, given how aggressively many annuity companies are pricing the income features on their FIAs today, I don’t know why anyone would choose to purchase a DIA.

The stock market has performed very well over the last 2 years.  Had I chosen to invest in a simple stock index fund, I’d be very happy with the 35%+ return I would have received.  That’s a remarkable two-year return.  But it also could have gone the other way.  And even with this stellar return, I still would need to find a way to create income from the investment.  Instead, Eagle Life’s annuity allowed me to choose an investment that maximizes my assured income for life for the lowest possible investment.  Any return on that investment is just a bonus.  And since I have this income locked in, I was able to confidently invest my remaining retirement income portfolio more aggressively than typically recommended for someone my age.  So, yes.  I am very happy with my measly 3.3%.  Thank you Eagle Life.