Despite the continued low interest rate environment, indexed annuity sales continue at near record levels. According to Jeremy Alexander, CEO of Beacon Research, this is at least in part due to “the lifetime withdrawal benefits offered by most indexed annuities.” When living benefits were introduced on variable annuities, the idea was to protect the client’s future retirement income from an untimely bear market. By creating an alternative account from which the client could draw income, the client can have the peace of mind of knowing his or her income is protected. However, the value of an indexed annuity never falls from year to year. The product itself is designed to protect the client’s principal from market volatility. Therefore, putting a living benefit on an indexed annuity is like buying insurance on insurance.
Unlike variable annuity companies, indexed annuity companies don’t have to worry about the policyholder’s account value going down. As a result, they can always offer more generous living benefit terms than a variable annuity. In fact, the current pricing of these riders on indexed annuities guarantees that the policyholder will always have a higher income benefit base than account value.
The graph to the left shows how an indexed annuity might perform for a 65-year-old female who earns, on average, 4.5% per year on an indexed annuity. This also assumes that she bought a living benefit that credits 7% each year to the income benefit base until she begins to receive income via the living benefit at age 80. Finally, it assumes that she receives a 10% bonus on both the account value and the income benefit base.
The red bars represent the $100,000 initial account value growing at 4.5% for 15 years and then declining over time as the $21,245 withdrawals, beginning at age 80, slowly erode its value. The blue bars represent the income benefit base growing at 7%. Since the only purpose of the income benefit base is to calculate the amount of the allowable withdrawal under the rider, it is eliminated from the graph once the income begins. The income benefit base will grow to 303,493, so the annual income payment will be 7% of 303,493 or $21,245 (I left off the “$” sign because an income benefit base has no cash value).
At the time the withdrawals begin, the account value would be $212,881, thereby creating a 9.98% withdrawal rate for life. Despite the high withdrawal rate, the lack of volatility of the underlying account value allows the policy to support withdrawals for 12 years—or until the client is 92 years old. Then, and only then, will the insurance company have to pony up to make the remaining lifetime income payments. Of course by then, the insurance company would have collected 27 years of living benefit fees.
The policyholder essentially paid $100,000 for the right to get $21,245 for life beginning at age 80. The account value in this scenario really is nothing more than the amount received by the beneficiary should the policyholder die prior to the account value reaching $0. Of course, the policyholder always has the right to access or liquidate the account value, but this can be done only by eliminating the future income payments that have been paid for with the annual rider fees.
I would argue therefore that an indexed annuity with a living benefit is really just a deferred immediate annuity that allows for liquidity at a discounted value. Interestingly, the industry cannot give away deferred immediate annuities. Yet, when disguised as an indexed annuity with a living benefit, it can find buyers for billions of dollars every year. That’s not necessarily a bad thing. Due to different pricing assumptions, an indexed annuity with a living benefit will typically guarantee significantly more income than a deferred immediate annuity. For example, as of this writing, a leading annuity carrier could guarantee my 65-year-old female only $16,054 a year beginning at age 80. Of course, this comparison becomes apples to apples only if indexed annuity purchasers know they are actually buying a deferred immediate annuity.
In my opinion, an indexed annuity with a living benefit is an appropriate option only if all of the following apply:
- The client has a strong desire to insure against living too long.
- The client fully understands the guarantees and has no expectation of cashing the annuity out before he or she dies.
- The client expects to use the annuity for a steady income stream sometime in the future rather than for legacy purposes.
Not coincidentally, this is the same profile of a potential deferred immediate annuity purchaser.