Are some index annuities two-tiered annuities in disguise?

Although two-tiered annuities provided significant value to those clients who desired safety and were willing to receive their funds over time, they also generated quite a bit of heartburn for insurance companies and agents when clients who misunderstood the design tried to access their funds. 

Two-tiered annuities were big sellers in the late 80s and early 90s. The basic concept was that if a client agreed to hold (defer) his or her contract for a minimum of 1 to 5 years and, when he or she was ready to access their funds, was willing to take them as a series of payments (annuitize) for a minimum of 5 to 10 years, the company could afford to pay a bonus of 10 percent or more. The bonus was the “sizzle” that sold the steak. 

Essentially, the company kept two sets of books on each annuity. One (the annuitization value) was based on the initial premium plus the bonus compounded at a competitive current interest rate. The other (the surrender value) was the amount available to the client should he or she choose to take settlement as a lump sum. The surrender value was typically 87.5 percent of the initial premium, without the bonus, compounded at a minimum guaranteed rate. The net effect was a policy where the “surrender charge” actually increased over time. The longer you held the annuity, the greater the difference between the annuitization value and surrender value. 

Although two-tiered annuities provided significant value to those clients who desired safety and were willing to receive their funds over time, they also generated quite a bit of heartburn for insurance companies and agents when clients who misunderstood the design tried to access their funds. Class action lawsuits against companies like Allianz (the largest distributor of two-tiered annuities) created a bad taste for both clients and agents. 

Fast forward to today. The “sizzle” in today’s marketplace is the income rider. Originally designed as a safety net for variable annuities, income riders, or guaranteed minimum withdrawal benefits (GMWBs) have become the main talking point on annuity sales, similar to bonuses of the past. 

The second set of books is based on the rider itself (known as the income base). For example, if the rider offers a 6 percent compound step-up, this account would reflect the premium plus bonus (if any) compounded at a 6 percent rate. 

The income rider also guarantees a specific payout rate in the future. For example, the rate between ages 65 and 69 may be 5.5 percent. When the client chooses to take income, the income will be based on the greater of the cash account or the income base. Let’s take an example: 

If the client above is now at age 65, he could take income of $7,419 (assuming a 5.5 percent payout rate) for the rest of his life. Each withdrawal would be deducted from his cash account while it continued to work. If, based on the account’s performance and the withdrawals, the cash account went to zero, the insurance company would continue to make payments of $7,419 annually until the death of the client. If the cash grows to a larger number than the income base (which is what you would hope), income is based on that number. The concept is fairly simple.  Now, let’s complicate the process. Interest rates drop, the market (S&P 500) is volatile. The “steak” is harder to sell. Now everybody is talking about income riders. We had a variable annuity wholesaler visit our office last week and not once did he mention the contract itself or the sub-accounts offered. The entire discussion was about their new, improved income rider.

Just like two-tiered annuities, the insurance company keeps two sets of books. The first is the policy itself. Whether variable, fixed or indexed, the underlying policy must make sense for the client. This is the “cash” account and fully available based on the terms of the policy (free withdrawal, surrender charge, etc.)

Don’t get me wrong, but it’s a little like planning the cruise of a lifetime and spending all your time examining the lifeboats. Let’s not lose sight of the fact that an income rider is just that — a lifeboat — only to be used if the ship itself doesn’t perform as anticipated. 

Consider this. In the above example, if the client took the same $100,000 and buried it in a shoebox in his backyard for five years and then used it to purchase a single premium immediate annuity at age 65, he would receive about $7,692 per year — almost $300 per year more than the new and improved income rider. The moral of the story: Beware of the shiny object.