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Portfolio > Economy & Markets > Fixed Income

What I Learned From Investigating a Prospective Client’s Annuity

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This past week I met with a prospective client who purchased a non-qualified annuity in 2004. He handed me the original contract, a pile of statements, a few annual reports and just about every other document he had saved over the years. My task was to determine if he should keep the annuity or cash it in. 

I found this was a perfect example of how the real story can only be found when you dig beneath the surface, a place that clients rarely visit. If annuities are a part of your practice, if they affect you in any way or to any extent, you’ll want to read this closely. Here’s what transpired. 

This client invested $100,000 in a non-qualified annuity in mid 2004. This annuity had a few bells and whistles. For example, there are three separate account values to consider: the actual market value; a minimum guaranteed income benefit (MGIB); and a minimum guaranteed death benefit (MGDB). For the latter two, each year the account grows by 7.0% until its value reaches three times the original investment ($300,000 in this case). After a minimum period of 10 years, the client is free to annuitize it and trigger an income stream. The income would be based on the greater of the actual market value, the MGIB (if the annuitant is alive) or the MGDB if the annuitant is deceased (the 10-year minimum period is waived for death). Moreover, the income would also be based on the applicable annuity factor as written in the policy at the time of issue. 

In this particular case, according to the most recent statement, the market value was $117,600 and the MGIB and MGDB were $182,554. The client asked me to assume he would annuitize it eight years from now as this would be the point when the MGIB would be approximately $300,000. 

The first step was to determine the internal rate of return (IRR) during the income period. Per the client’s request we used a period certain of 20 years. Therefore, the entire period covered in the analysis was 27 years (7 for accumulation and 20 for income). 

Using the contract’s annuity rates, I discovered the IRR varied based on the length of the period selected. For example, with an income stream of five years the IRR was 2.50% and for 30 years it was 2.89%. For the 20-year period chosen by the client, the IRR was 2.86%. 

This leads us to question number two. Before we introduce it, we need to clarify the parameters surrounding the question. To do this, we need to run two scenarios.

Scenario A would be to keep the annuity and earn the guaranteed 7.0% annually for the next seven years, at which time the value of the MDIB would be $293,142. This would be the amount that the income stream would be based upon. Scenario B assumes the client cashes in (he’s over 59 ½ years of age), pays the taxes, and invests the net proceeds in a taxable account. 

Immediately, we observe Scenario B is at a disadvantage. 

Now for the second question: What annual interest rate would the taxable account need to average per year to make each scenario equal? In other words, if the taxable account were to average x%, the client would have no preference. I found this annual rate to be 5.935%. Hence, if the client earned 5.935% per year, at the end of the 27th year, the taxable account value would equal zero.

We also had to consider that part of the annuity’s income payments are subject to taxation. Therefore, I assumed the after tax income payment was also deducted from the taxable account beginning and ending at the same time. In the annuity, each income payment comprises a return of basis plus growth. At some point, when the basis has been fully recovered, the entire income stream is subject to tax.

Hence, in each scenario the applicable tax rules were applied. In the taxable account I had to assume a portion of its annual return was also subject to tax (i.e.; interest, dividends and capital gains). 

To summarize, if the taxable account were to earn a gross annual return of 5.935%, the client would be indifferent as to which option was best. For curiosity, I also used an average annual rate of 7.0% and at the end of the 27th year, the client would have  slightly more than $102,000 remaining in the taxable account.

The conclusion is this: Actuaries are very bright individuals, and it’s probably best for this client to cash it in and invest in a taxable account. That is, if we can exceed 5.935% per year.


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