Despite the fact that annuities are uniquely designed to provide guaranteed income for life, over the last 30 years, they have been used mostly as a means to provide tax-deferred accumulation.
The commonly held belief has been that as the baby boomers continue to age, much of the $3 trillion-plus in estimated annuity assets will eventually be used to generate income. Twenty years ago, the expectation was that much of this money would flow into immediate annuities. However, given that immediate annuities have never captured more than 3 percent of industry sales, insurance companies have found it necessary to develop other ways to create income.
Advisors today must choose between an alphabet soup of income options, each with its own industry-adopted acronym. So how does one decide between SPIAs (single premium immediate annuities), DIAs (deferred income annuities) and GMWBs (guaranteed minimum withdrawal benefits) — especially now that the latter can be added to fixed and indexed annuities as well as variable annuities? Let’s first look at the unique characteristics of all of these options.
Single Premium Immediate Annuities (SPIAs) can be thought of as purchasing a personal pension. A policyholder turns over a lump sum of money to an insurance company in exchange for a promise to pay a regular income — usually monthly or quarterly — for a predetermined amount of time. While that time period can be a specific number of years, it typically is guaranteed for at least one lifetime. Two important characteristics to keep in mind: (1) Each payment is partially a tax-free return of principal (unless it’s bought in a qualified plan) and (2) Immediate annuities have little if any liquidity.
A close look at the equity-indexed annuity market reveals an anomaly.
Deferred Income Annuities (DIAs) are essentially immediate annuities where the guaranteed income starts at least one year after purchase. Often these are purchased to provide income at a much later age (i.e., 70, 80 or 85). They have the same tax treatment as SPIAs and offer little if any liquidity.
Guaranteed Minimum Withdrawal Benefits (GMWBs) offer much more flexibility and liquidity than either SPIAs or DIAs, and therefore have become the most popular income option for annuities. When one cuts through all of the long and sometimes complex descriptions of GMWBs, they are really nothing more than a guaranteed lifetime systematic withdrawal based on an amount that is calculated separate from the account value (commonly referred to as the income base).
Since the income base grows by a predetermined amount each year and the allowed systematic withdrawal is contractually guaranteed, if the policyholder can tell the advisor when she wants to begin receiving income, the advisor can tell her exactly how much she will be guaranteed at that time. This guarantee cannot be negatively impacted by poor performance of the account value. Since the income is considered a withdrawal from the policy, unlike with the SPIA and DIA, the income can be started and stopped and any remaining policy value can be cashed out or paid out to a beneficiary. The big tradeoff is that every income payment will be fully taxable to the extent there are earnings in the contract at the time of the withdrawal.
Before I move into general guidelines and strategies for choosing between these options, it’s important to note the biggest difference between GMWBs on variable annuities versus index annuities. Variable annuity companies tout the potential for an increase in income should the account value grow faster than the income base that generates the guaranteed income (known as a step-up). While this is certainly true, given the fees charged for this benefit combined with the investment restrictions that exist on most variable annuity GMWB designs, I would caution against over-selling this potential benefit.
Technically, index annuities could also have a step-up in income, but given today’s interest rates and current product designs, that is never going to happen. But there is one very important difference. Variable annuity companies must protect against the possibility of a significant drop in the account value. Index annuity companies do not. Therefore, at today’s pricing, an index annuity with a living benefit is always going to guarantee more income initially than a variable annuity with a living benefit. A variable annuity is always going to require at least one step-up of the income base to ultimately provide as much guaranteed income as the index annuity.
Annuities cannot escape the basic laws of finance. As investment flexibility and liquidity increase, we would expect income guarantees to decline. The case studies below provide hypothetical illustrations of some possible income options given a specific type of client’s income plan.
Case 1: 55 Year Old
Desiring Income at 65
Using CapitalRock’s Annuity Wizard Income Tool, I solved for a 55-year-old male that wants $40,000 in annual income at age 65.
Not surprisingly, the DIA required the least amount of capital ($341,536) to generate the required income. The index annuity required an additional $51,400, and the variable annuity with investment restrictions required yet an additional $57,427. And if you wanted a variable annuity without investment restrictions, then you would need to pony up a total of $470,588. Keep in mind also that if the annuity is funded with after-tax dollars, the DIA income would be 42% tax-free, while the index and variable annuity options would be 100% taxable until all of the growth is withdrawn from the account value.
In choosing between the various options, you must ask the following questions:
The DIA was quoted as life only, therefore, is the additional liquidity worth the extra $51,400 that is required to provide the same income using the index annuity?
If the answer to No. 1 is yes, then is the potential for better account value growth and possibly a step-up in income worth the additional $57,427 to choose a variable annuity over an index annuity? And if the answer to No. 2 is also yes, then in all likelihood its worth investing an additional $20,257 to get total investment flexibility, thereby significantly increasing your chances of getting a step-up in income.
Case 2: 65 Year Old
Desiring Income Now
We see similar results if the income is needed immediately rather than 10 years later. The graph above summarizes the numbers for a 65-year-old who wants $40,000 in income immediately.