If you’re thinking of purchasing a fixed indexed annuity, the first question you should ask yourself is “what is your objective?” Like any financial product you are thinking of purchasing or strategy you want to implement, it is very important to first be very clear about your objective.
Unfortunately, it is not unusual for people to be unclear of what the outcome is supposed to be because most people have spent too much time interacting with salespeople who have sold them products without first truly understanding their needs.
So if you don’t really have a clear picture of the outcome you want, and the salesperson doesn’t help you figure it out, what kind of product is he going to sell you? Whatever he has in his bag!
“Got a round hole? I’ve got just the square peg you need!”
Step 1. Choose the right advisor
Most people come to me because they’re trying to figure out how to make the best use of the dollars that they saved for retirement. They have savings, but they don’t have a plan and that’s why I personally believe that before you go looking for places where to invest your dollars, or what account you should use, you should first choose your advisor wisely.
Captive or Independent
- A captive advisor works with one company and is limited to finding solutions from the products that company offers (Square peg – round hole).
- An independent advisor has the ability to represent any company he chooses, as long he meets that company’s prerequisites. An independent advisor thus has a bigger selection of products and strategies to choose from and to bring to the table.
Fee Only, Commission, or Fee-Based
- Fee only advisors put together financial plans and manage your investments. They usually charges a flat fee, usually a percentage of the assets they manage.
- Commission only advisors are usually insurance agents get paid a commission for the sale of a product such as an annuity or a life insurance policy.
- Fee based advisors are a combination of the two. They put together financial plans, charge a fee based on a percentage of assets under management, and receive commissions from for the sale of annuities or life insurance policies.
Step 2. Educate Yourself on Fixed Indexed Annuities
Fixed indexed annuities may not be the end-all and be-all to all of your retirement plan concerns, but more and more people are choosing to move a portion of their retirement savings to these products for three good reasons: Protection of principal – Protection of gains – Guaranteed lifetime income
Protection of Principal
Money invested in a fixed indexed annuity cannot be lost and often times, if they do have fees, the insurance company guarantees to reimburse any fees deducted over the course of the contract if you have not made any money.
Interest Protected Growth
Growth inside of a fixed index annuity is linked to an index (never invested in the market) and credited using any number of crediting options. Insurance companies invest the majority of the premium payments in long term bonds and allocate a small portion of those premiums to invest in options on the index selected. If the insurance company makes money with the options, they credit a portion of their gains to your contract based on the crediting method selected.
On each contract anniversary date, gains are locked in and this becomes your new protected principal that you can never lose.
- The most common index is the S&P 500, but insurance companies are free to use different indexes and sometimes develop their own proprietary indexes that try to minimize volatility and provide more steady and consistent growth.
- The most common crediting methods are:
- annual point-to-point
- monthly point-to-point
- monthly average
- point-to-point with participation rate
- point-to-point with caps
Guaranteed lifetime income
Fixed index annuities offer the owner the option of purchasing an income rider which guarantees to pay income for life even if the cash value of the annuity goes to zero.
An annuity illustration with an income rider will show the actual cash value growth column and an additional column called the Guaranteed Lifetime Income Base (or similar). The dollar value in this column will have a “roll up” rate that guarantees a specified annual increase of your Guaranteed Lifetime Income Base on each contract anniversary.
Once income is activated at some point in the future, the accumulated value of the income base is multiplied by a payout factor to generate the actual annual income payment.
It is important to understand that the roll-up rate only applies to your income account, not your cash account. Its only purpose is to grow your income account at a guaranteed rate so when you do activate your income, the income account value is as high as possible.
You’re still only halfway there!
Step 3. Understand The Big Difference Between The Two Main Types of Fixed Indexed Annuities
So let’s assume that you’ve worked with an advisor who helped you paint a clear picture of the outcome you are looking for and that you’ve determined that a fixed indexed annuity is the right tool to get you there…
Now, you need to decide what’s more important:
Maximum protected growth potential or
Predictable guaranteed lifetime income?
This is a very important question that can mean the difference between getting stuck with an annuity that you are unhappy with versus one that fits perfectly in your overall retirement plan.
Although all fixed indexed annuities will protect your principal and lock in your gains…
- Some are designed for maximum protected growth.
“The S&P 500 index as of August of 2009 finally reached 1,000. It has taken 12 years for the S&P 500 index to break even due to the volatility and risk with the two economic bubbles experienced from technology stocks and the real estate crisis. While the S&P 500 index has produced near zero total return over 12 years, the Fixed Index Annuity using the S&P 500 index on average produced returns of 5.79% using a 5-year annualized rolling return from 1997-2007. Even if you add taxable dividends to the index, the Fixed Index Annuity has performed better, at least based on the data we have reviewed –Wharton Financial Institutions Center white paper.” Real World Index Annuity Returns. October 2009
- Others are designed for maximum guaranteed lifetime income.
“Which brings us to the central difference about generating income from your savings by yourself vs. buying an annuity: unless you’re willing to take more investment risk, you as an individual can’t match the guaranteed income an immediate annuity can provide. This is probably one of the few statements that you can get most economists to agree on, as two Wharton finance professors pointed out in this policy brief on investing for retirement.” CNN, When Is An Annuity Worth It?” May 4, 2010
Step 4. Choose between the two types of indexed annuities
“Normally”, a fixed indexed annuity designed for maximum growth might be right for you if:
- You don’t need additional income and want to safely grow your money;
- You want additional tax deferred growth;
- You are comfortable with 4% to 6% returns
- You like the idea of being in the market because of the potential for higher gains but don’t want to suffer the losses that come with market downturns;
“Normally”, a fixed index annuity designed for maximum income might be right for you if:
- You have little or no additional sources of income aside from Social Security &/or pension payments;
- Your Social Security benefits &/or pension payments aren’t enough to cover your living expenses;
- You have enough income now but want to build an annuity portfolio that will provide additional income that you can activate at different times in the future to keep up with inflation;
- You want income that can be leveraged to pay for long-term care.
Sounds like it’s an “either / or” decision right? Here’s the kicker:
“There are some new fixed indexed annuities designed for maximum protected growth that can not only generate 20% to 40% more income than guaranteed lifetime income annuities, they can also do a better job of preserving your principal.”
“Normally”, If you choose a fixed indexed annuity designed for maximum growth:
- You are giving up guaranteed income. Even if an income rider is available, why pay a 1% fee which is only going to reduce your growth potential. You’d be better off just buying an indexed annuity designed for maximum guaranteed income.
- Expect (+-) 5-6% growth;
- Look for a nice bonus
- Look for an uncapped strategy (or at least a very high cap rate);
- Look for a high participation rate;
- Look for little to no spreads.
The reason why you want to look for these is because you want the highest Internal Rate of Return
“Normally”, If you choose a fixed indexed annuity designed for the maximum income:
- You are giving up cash value growth. Your income base may roll up at 7%, but your actual cash value will usually have very low caps or high spreads which limit your actual growth to the lower end of the spectrum => (+-) 3%.
- Your money is basically being handed back to you until you surpass your life expectancy. Only then will you start to benefit from the guaranteed lifetime income. This is due to the following; since 2010:
- Income rider charges have increased
- Caps have decreased
- Roll-up rates have decreased
- Roll-up periods have decreased
- Age based payout factors have decreased
- Forget about roll-up rates
- Forget about bonuses
- Forget about crediting methods, etc…
- Focus on nothing else but the payout. NOT the payout percentage… the actual dollar amount, the actual cash flow!
The reason why you want to forget about these is because you want the highest Internal Rate of Return
A few other guaranteed lifetime income annuity factors to consider
- Single payout vs joint: If you choose a single payout option, the income will be higher but the contract will terminate upon your death. Your spouse will no longer receive the income but she will get the full cash value remaining.
- Fixed vs. increasing Income: there are many ways for you to receive an increasing income from your annuities.
- One way is to use a laddering strategy where a combination of annuities are used in their income stream activated at different times
- Another way is to choose an annuity that offers inflation protected income that increases along with the rise in the consumer price index
- If you chose this option, expect lower income payments in the early years after you activate the income rider.
- Yet another way is to opt for an annuity that doesn’t have a guaranteed roll-up rate but rather one that is pegged to an index
- If you choose this option, you may have lower payments in the early years after you activate the income rider if the index under-performed, but that income could surpass what the guaranteed income would have been.
- Impact of excess withdrawals: if at any time you need to take out more than the guaranteed lifetime income payment, future lifetime income payments will be reduced.
As I mentioned earlier, “normally” if you want a guaranteed lifetime income, than a guaranteed lifetime income equity indexed annuity is your best bet.
But some new fixed indexed annuities provide enough consistent growth potential so that you can make free withdrawals in excess of what the insurance company would be willing to pay you, and potentially have money left over to pass on to your beneficiaries.
Does this mean that annuities with income riders no longer have value? NO. I believe that balance is the key to any good retirement income plan. One major expense that can wipe out your savings and leave your spouse with very little is long term care.
Some fixed indexed annuities with guaranteed lifetime income riders will double your income for up to five years for long term care costs. For these to really have value, just make sure that this income doubler can be activated for home health care and not only for nursing home confinement.
If you’d like help figuring out which annuity will pay you the highest cash flow, just book a time on my online calendar and we can have a 20 minute exploratory call & Q&A after which we can both decide if it makes sense to set up another time for us to meet.