Have you ever wondered how the “guarantee” works in an annuity? Annuities may seem like an attractive investment to those who are trying to decrease risk, but annuities may not be near as risk-free as perceived. Annuity guarantees vary from contract to contract, and you can often alter your contract to include an annuity rider—an add-on to the initial annuity contract. However, these features are rarely free and may include additional fees.
Riders may be able alter your annuity contract to seemingly fit your needs. While riders may offer additional flexibility or security, the benefits come with additional fees and risks. Perhaps the biggest pitfall of annuities is the high fees, and while these add-ons can make these contracts seem more attractive, they come at a price that could negate any potential benefit.
While riders come in many shapes and sizes, they typically fall into two categories: living benefits and death benefits. Some of the most advantageous features of annuities such as monthly income guarantees and lifetime payouts do not come with the annuity contract as is. For these features, you may be required to purchase additional riders—adding to the fees and potentially inhibiting any growth you required. While living and death benefit riders may make you feel safer, they may not necessarily help you reach your long-term goals depending on your situation.
One reason people look into annuities is to create their own income stream. However, these investors often find they must purchase some sort of living benefit rider to achieve this goal. Living benefit riders come in a variety of forms, with the majority focusing around ongoing income.
A common living benefit rider is a guaranteed lifetime withdrawal benefit (GLWB). This rider’s main feature is to pay out the annuitant a guaranteed amount for the rest of your life regardless if the account value is depleted. Sounds great! But how does the insurance company remain profitable offering features like this? When the insurance company negotiates what rate they will be willing to pay out, they assess the probability that you will live past a certain age before they have to pay out the entirety of your portfolio and price the rider accordingly. As such, these guaranteed benefits can be costly and the fee for this type of rider is in addition to the other fees charged by the annuity provider.
If you wish to leave a legacy or annuity benefits for family members after you pass, you may be able to purchase a death benefit rider for another fee.
Annuities generally offer you a guaranteed income for life. But what happens after you die? If funds remain in your account, are they passed on to your heirs? Not necessarily. This is why some annuity owners consider adding death benefits to their annuities. For an additional fee, you can add death benefit riders to help ensure that your heirs can receive the money you invested if you die.
Just as with living benefit riders, death benefit riders come with a variety of features. A basic death benefit allows the money that you invested into the contract to be paid out to your heirs; however, this comes with a catch. Once you elect to annuitize—start receiving your monthly payout—there is no death benefit.
Often, investors need more flexibility than is provided within the basic death benefit and this leads them towards looking into enhanced death benefits. While these benefits may enhance the amount that can be passed on after you die, the benefit goes away once your monthly payout has started. This could leave you in a difficult situation. Leaving a legacy to heirs is an important piece of retirement planning for many investors. If it’s important to you, an annuity with a death benefit rider may not be the best investment option out there.
Many investors start looking into annuities as a way to mitigate the volatility associated with the stock market, but annuities come with risks of their own. In addition to the risks associated with annuities, adding riders create additional risks and restrictions.
In an attempt to receive guaranteed income for life, investors often do not account for inflation. For example, with a GLWB rider, you agree to a pre-determined amount to receive on a monthly basis for the rest of your life. Five percent of your contract value at the time of the investment may seem sufficient, but that percentage may not account for inflation, which has averaged roughly 3% a year since 1925. Inflation can eat away at your long-term returns, and the smaller your guaranteed income, the more vulnerable it may be to inflation costs, potentially reducing your purchasing power over time.
A common restriction associated with living benefit riders is a waiting period (often 7-10 years) before you can receive a cash flow, which creates liquidity risk. Waiting periods can be detrimental if unexpected costs—such as hospital bills or home repairs—may come up. In these cases, you may incur surrender fees in order to access your money, further adding to your total costs.
One of the most detrimental risks associated with riders is the additional fees that you pay on top of existing annuity fees. Excessive fees affect you in the short-term with out-of-pocket cost and in the long-term, because every dollar spent paying fees is money that is not earning you a return. These fees reduce the effect of compound interest and can further inhibit your ability to meet your long-term goals. For example, consider the fees of an average variable annuity with one common rider:
In the above example, the hypothetical variable annuity fees with one rider could amount to 3.44% annually! When compared to other investments, these fees can be excessive and make it difficult to achieve your long-term goals. So when considering an annuity, understand that annuities may not be the best way to limit risk or create ongoing investment income.
Exhibit 1 displays how annuity fees affect the returns of a70% equity and 30% fixed income strategy. The chart assumes hypothetical performance equivalent to the chosen index less assumed expenses if you had invested $1 million on December 1, 1997 and held through October 31, 2017. Can you afford to miss out on nearly half the return just from the additional fees?
Is someone trying to sell you an annuity or do you currently own one and want further clarity on your cost and results? For those interested in learning more about annuities download our free educational guide: Annuity Insights. If you currently own an annuity and are interested in learning more about your specific contract, contact our free Annuity Evaluation service at (888) 886-8546 to see if we can help you today.*
i Source: Global Financial Data, Inc. as of 01/09/2018. Based on US BLS Consumer Price Index from 1925-2017.
iiSource: Insured Retirement Institute, 2016 IRI Fact Book (Washington, DC: IRI, 2016), 114.
iiiSource: Investment Company Institute, 2017 ICI Fact Book, https://www.ici.org/pdf/2017_factbook.pdf, 89.
ivSource: Insured Retirement Institute, 2016 IRI Fact Book (Washington, DC: IRI, 2016), 102.
v70% MSCI World Index/30% B of A Merrill Lynch US Treasury Index. Performance is presented inclusive of dividends and interest.
vsHypothetical investment equivalent to 70/30 blended index, less an assumed annual mutual fund expense of 0.81% (the average asset-adjusted expense ratio for balanced funds in 2011 per Morningstar).
vii Hypothetical investment equivalent to 70/30 blended index, less an assumed annual annuity expense of 3.95%. Fund expense for underlying funds in a variable annuity includes all funds available and does not assume a 70% equity and 30% fixed income blend.
*For qualified investors with $500,000 or more.