Would You Buy This Variable Annuity with Income Guarantees?
Posted March 10, 2011on:
Recently, I was approached by a prospective client named John, who has all of his retirement in one annuity.
I have always been intrigued by how annuities and life insurance are sold. Listening to John explain his decision-making process and reading through the annuity contract is like turning on the light bulb in my head.
It turns out that the unique selling point of this product is the “200% Step-Up of the Guarantee Amount (GA).” The way John puts in, if he just keeps the annuity for 10 years, he will get back 200% of what he put in. What is there not to like about that! After all, he gets guaranteed upside with absolutely no downside risk.
But insurance companies are not in the charity business. How could they give their customers such a good deal and still make money for themselves, their producers, and their shareholders? To answer this question, I read through the whole contract. I was not disappointed.
The answer lies in the GA itself, which is defined in the contract as the value used to calculate the Maximum Annual Withdrawal (MAW). Each year, MAW must be less than 5% of GA. Aha! Let’s apply the contract to John to see how it works.
John is a 71-year-old retiree. He invested $1mm in this annuity this year. When he is 81 years old, he will get the 200% step-up of GA that will be “valued” at $2mm. From age 82 until he is 101, he will be able to take out at most $100k each year, 5% of $2mm.
Let’s just assume he will live to get all the $2mm. Using a discount rate of 6%, I calculated that the present value of this income stream is $640k. By signing the contract, John exchanged $1mm for a guarantee of $640k. And it does not stop there. For the privilege of being ripped off, John has to pay a 1.5% rider charge on the GA amount!
If you were in my shoes, what would you recommend John do? More importantly, I am interested in your opinion of the financial advisor who put him in this product. Am I the only one who thinks he is unethical—at a minimum?
Get my white paper: The Informed Investor: 5 Key Concepts for Financial Success.