Annuity Income Riders: To Win, You Must Lose

Hypothetically (and not representative of any specific annuity), let’s use this example:

• A 55-year-old married male purchases a variable annuity inside of an IRA with a $500,000 rollover and elects the lifetime-income rider just for his lifetime:

• • Rider guarantees 5% withdrawal rate for life at age 65; and
  • Rider guarantees that you can withdraw 5% of the greater of your cash value or the guaranteed income base, which is calculated by taking your initial deposit and adding 5% per year to that value.

• The annuitant invests moderately in the annuity sub-accounts and chooses 60% stock-market investments and 40% bond-market investments. Let’s assume he averages 6% a year for 10 years. (Almost all insurance companies will force a client to use some type of broad-based asset allocation fund to control risk, so assuming annual returns in the 8%-9% range is unrealistic.)

• The hypothetical (but typical) annuity fees are as follows:

• • Mortality and expense fee: 1.2% (charged on cash value)
  • Administration fee: 0.15% (charged on cash value)
  • Lifetime-income rider fee: 1.4% (charged on guaranteed base)
  • Average investment sub-account fee: 1% (charged on cash value)
  • Total annual fees: 3.75%

Let’s fast forward. The client is 65 and retiring and he wants to turn on his retirement income. The annuity guaranteed income base has been accumulating at 5% interest for 10 years, so the income base is calculated to be an estimated $823,504.75. This income base is what the 1.4% lifetime income rider fee is being charged on, so the annual fee for the rider is now $11,529 per year (823,504.75 x 1.4%). The client can take either 5% of $823,504.75 per year for life or 5% for life of the current cash value, whichever is greater. As mentioned above, the annuity contract deposit earned an average hypothetical annual return of 6% over the 10 years, but had annual fees of 3.75%, so it had a net return of 2.25%, which means the actual cash value is only $626,029.

Therefore, in this example, with typical rates of return (not guaranteed of course), the client made only 2.25% annually on the cash value. Considering bank savings accounts rates are nearing 4%, this growth is extremely minimal. But this wasn’t bought for growth; it was bought for the guaranteed annual income, so let’s look at that!

The guaranteed annual income is 5% of $823,504.75, so $41,175 per year. But that money is taken from the real cash value, not the insurance company’s guaranteed income base, so that is a 6.6% withdrawal rate against the cash value ($41,175/$626,029). In example, let’s look at the first five years and once again assume 6% ongoing average growth:

In five years, the cash value goes from $626,029 to $465,508, which is a loss of $160,521, which is a percentage loss of 25.6% when the investments earned 6% annually. The annual fees started at a total of $26,241, which when divided by the starting balance in year 1 ($626,029) is an annual 4.2% in cost. By year five, the annual fee increased to 4.65% because the income rider fee stayed the same on a decreasing cash value ($23,278/$499,963). If you continue this math, the balance will drop to zero in about 20 years (rounding up), while the insurance company collects fees the whole time. After the balance hits zero, only then does the insurance company have to pay you anything out of their pocket.

The client at 65 turns on his income rider. He begins to receive $41,175 per year. By the time he hits 75, he is concerned, as his income has not risen at all, but inflation has, and his cash value has dropped. Fast forward again to age 85; he has the same annual income (with his buying power significantly diminished due to normal inflation) and his cash value has gone to zero. He unfortunately passes away a year later at age 86, so the insurance company had to only pay out the guaranteed income for one year of $41,175. His wife gets nothing going forward, and nor do his heirs.

In this example, for the client to win and beat the insurance company, he would have had to live well into his 90s to make the insurance company pay for multiple years after his contract cash balance went to zero. And even then, the insurance company has been collecting fees for 30 years totaling hundreds of thousands of dollars (age 55 to 85 is 30 years of annual income rider fees of $11,529, which is $345,870 in fees, and that is not counting mortality and expense, admin, or sub-account fees).

I once had a client make a perceptive observation. He said, “If I took all my money and put it on a table in my kitchen and used 5% of it per year, it would last 20 years. Just sitting on my table collecting dust. And I will probably die before using all of it, so why would I want to pay someone for that?” A very good point indeed.

With a variable annuity, good sub-account performance could mean an increasing income in the early years of the contract, but the high fees and high withdrawal rate make it very difficult to keep pace. Using my example again, in year one of his withdrawals, he takes out $41,175 and pays fees of $26,241, for a total of $67,416. When compared to his cash value of $626,029, the account would have to grow greater than 10.76% just to break-even. In all mathematical likelihood, once an income rider is turned on, the cash value will drop over time.

Fixed-indexed annuities (FIAs) typically have lower fees, but you run into another problem, which is performance caps. FIAs are bond proxies. They are not regulated by the SEC, because it doesn’t consider them a security and they are not designed to get stock market returns. According to Forbes, market research company Cannex estimated in 2018 that, over seven years, an FIA might yield 3.26% on average annually. Therefore, when the guaranteed withdrawal amount is 5% on the much higher guaranteed income base instead of the real cash value and your client is paying a hypothetical (but typical) 0.75% for the rider fee, you have a mathematical near-guaranteed loss of cash value over time.

When I look at marketing material from insurance companies for guaranteed-income riders, they typically show how good the guaranteed income is through some a combination of charts and graphs. The information often shows people buying an annuity right before a stock market collapse and how bad someone invested in the S&P 500 would have done comparatively. If a sequence-of-return risk chart is also included, all of this information together will give a one-sided illustration. I became a wealth manager in 1998 and I have seen three bear markets in my career so far (Y2K bubble, financial crisis, and COVID). The stock market has grown tremendously overall during that time (On 1/2/1998, the S&P closed at 975.04 and on 9/29/23 it closed at 4,288.05). I believe, from historical data, that it is far more probable that investing outside of annuities with lower fees will lead to outperformance over time versus worrying about the low probability of a bad sequence of returns.

I’m not saying all income riders or annuities are not a useful tool; they are not all the same. There are annuities with lower fees and better guarantees that can include spousal income and death benefits. Clients who haven’t saved enough and will most likely run out of money in retirement would benefit from lifetime income. I sold some annuities myself years ago when guarantees were higher, and fees were lower. But annuities are extremely complex. The guaranteed income will most likely not keep pace with inflation. It is most likely that a client will pass away while still having a cash value and the insurance company has to pay nothing for all the fees it collected.

I remember having a debate about lifetime income riders with another advisor who sold annuities almost exclusively. He told me proudly that he almost never had a client annuity cash value go to zero, to which I responded, “Well then your clients paid all those fees for nothing”.

As a wealth manager and fiduciary, I have to weigh the probabilities and risks of any investment. Any annuity must be deeply analyzed before purchase. I hope this gives advisors who sell annuities a perspective they don’t normally see or hear about. I hope to see advisors in the future telling clients that are considering an annuity income rider that, “To win, you must lose.”

William C Reynolds, CFP ™ CRPC, is a fiduciary wealth manager with G5 Financial Group, which is based in Prescott, AZ.

This information is for educational purposes only and is based on sources believed to be reliable. It is not intended to provide specific investment advice or recommendations. It includes hypothetical information which is for illustrative purposes only. All investing involves risk including investing in a Variable Annuity. Variable Annuities are long-term investments designed for retirement purposes and are only offered by prospectus which should be carefully read before investing. Past performance is not indicative of future results. Investors should consult with their financial advisor before acting on any information contained in the article. The opinions expressed are the author’s alone and not necessarily those of Geneos Wealth Management, Inc.

Securities offered through Geneos Wealth Management, Inc., member FINRA/SIPC. Advisory services offered through Geneos Wealth Management, Inc., SEC Registered Investment Advisor

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