The Investment Scientist

Would You Buy This Variable Annuity with Income Guarantees?

Posted on: March 10, 2011

Annuity without Risk

Annuity without Risk

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?

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12 Responses to "Would You Buy This Variable Annuity with Income Guarantees?"

Sure, this annuity is without risk… to the insurance company. Their contract guarantees that they will make money. They wrote the contract after all. Why else would they employee an expensive lawyer to write a 30-50 page document? (To protect you? Hardly! To protect themselves.) Why else would they pay such high commissions to their sales agents? Why else would they guarantee to pay you 3-5% per year, when the return on a good mixed portfolio of stocks and bonds has historically been 7-9% per year including dividends?

Jerry, you hit the nail right on its head. You would be surprised though how many people fall into their traps because they just listen to the salesmen, they don’t read the contract.

I was thinking about starting a business just to help people read their annuity/life insurance contact. Do you think there is a future in that?

[…] all guarantees are the same. CDs are guaranteed by the full faith and credit of the US government; annuities are guaranteed by the words of insurance companies, e.g., AIG. Last time I checked, insurance companies didn’t own the franchise to print dollars, […]

Every time I sign papers (contracts) I would always read the whole content of it before signing it. No matter how long a representative to wait before I sign it. Afterall, it is my right to know what I am signing for.
And we all know that there are a lot of people who would fraud you for money.

That’s a very prudent practice. The problem with many annuity and life insurance contracts is that they are purposely written in a way that is impossible to understand. Check out my post on this subject, how they intentionally mislead.

Reblogged this on The Investment Fiduciary and commented:

I have a new client who suffers from the same problem: her retirement accounts are choked full of Allianz’ variable annuity products very similar to this Lincoln product I reviewed a year ago. They are not as deviant as the Lincoln product in term of hiding fees, but they are nowhere close to being a keeper.

Hi Michael – as always I enjoy your thoughtful blog posts. I was reviewing a similar annuity for a client today and recalled this post so I revisited it. In general I have come to the same conclusions as you regarding variable annuities, but in reviewing your information above I noticed something that might make me less negative about them.

What struck me is that as you point out by using a 6% discount rate the client exchanged $1m for a guarantee of $640k; but assuming a 3% discount rate the exchange is $1m for a guarantee of $1.1m. Now, I’d argue that over 20 years one should be able to realize more than a 10% cumulative gain even using Treasuries and FDIC insured vehicles, but still it’s not a guaranteed 35% loss.

I’m not saying 3% is the right discount rate to use (although it is in the ballpark of inflation long term as well as being double the current yield on the 10 year Treasury), I’m just saying that the discount rate variable makes a significant impact on the calculations. I’d be interested in your thoughts on this. Thanks!


You raise the good question.

At the time I wrote the post, 30 year treasuries were yielding 4%. I added 2% to reflect the credit risk of the insurance company. So I think my 6% assumption is sound.

Secondly, to qualify for “money double” provision, the client is put into a liquidity straight-jacket. If he were to withdraw more than 5% in any given year, he automatically lost the provision and back to his contract value. (Judging by how much expenses are charged to the contract value, it would not be much.) So the guarantee is really the maximum guarantee, not the minimum one which most people assume.


Michael: We’ve been offered a variable annuity from Transamerica called Retirement Income Max, and I wonder if you’d hazard a comparison of that product to the one in your original post. On the face of it, two features seem to be different: one is that the fee is charged on the cash value and not the Withdrawl Base (which I’m assuming is the rough equivalent of the GA above); another is that the withdrawal % is fixed and not a maximum (5.3% for single life if you start withdrawals at age 65, FYI). I don’t know if this is different or not, but the cash value is allowed to grow and would thereby increase the amount that’s “inheritable” if we die before having withdrawn it all. My disclaimer is that I’m working off the sales materials and not the contract.

Admittedly, the appeal to us is that we want significantly less risk for part of our portfolio, as we’ve lost faith in “historical” performance. That said, yes, the fees feel hefty. Thanks if you have any thoughts.


Without knowing your situation and without reading the actual annuity contract, I really can’t comment.

I personally have not seen any variable annuity that make economics sense for the buyer, but I admit many of the annuity designs do feel comforting psychologically. So it might be right for you if the veneer of guarantee give you a great deal of comfort. (I myself trust an insurance company’s guarantee as much as I trust GM’s guarantee, their guarantees are as good as they are solvent.)

However, before you sign on the dotted line, you do want to do the following:

1. Read the whole contract, not the marketing material.
2. Make sure you understand every terminology, for instanced the term “fixed rate” may mean the rate is fixed for one year. A lot of games are played with terminology.
3. Make sure you understand the total costs of the product. If your product is indexed on S&P 500, most of the time that does not include dividend, that’s 2% cost there.
4. For the most appealing features to you, make sure you know how to get them or how not to lost them. Some appealing features would require you to do something 20 years from now, not people forget, other will be lost if you do something by accident. Many of the contracts are designed so that you pay for the appealing features every year but only 1% of buyers actually get them. You want be that 1% if you have bought the product.

Lastly, you may want to use my free 2nd opinion review service, it will takes about one hour, i won’t be able to read the annuity contract for one hour, but I can take a look at your portfolio and your overall financial big picture and I maybe able to give you some useful advice. .

Hope this is useful.


Yeah i am sure about the annuity, it is without risk…But once you start withdrawing money from your variable annuity, earnings will be taxed at the ordinary income rate.

While purchasing the variable annuity you should ask about all the fees and expenses,how long my money will be tied up.

I hope this information will be helpful.

Yes, that’s another selling point of annuity that falls apart – though earnings grow tax free, withdrawals are taxed at ordinary income rate. If you invest in a regular mutual fund, earnings are taxed at the much lower capital gain rate and withdrawals are tax-free. Which is more advantageous, I am afraid it’s not the annuity.

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Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.


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