It’s all over the television, the web, and in print: financial vehicles, promoting guaranteed lifetime retirement income, so you don’t “run out of money before you run out of life.” With a market that really hasn’t made any concrete gains since 2000, the timing couldn’t be better. These products are gaining widespread approval with baby boomers.
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One effective Principal-Protected retirement vehicle that offers this additional lifetime income benefit is called a Fixed Index Annuity, or FIA, and the ADD-ON guaranteed lifetime income benefit is called a Lifetime Income Rider.
Before we start talking about Lifetime Income Riders, let’s review how a Fixed Index Annuity works. An FIA is a fixed annuity that accrues interest via market-linked gains. It won’t necessarily enjoy 100% of the upside of the selected index, but any market-linked, interest-bearing gains are real gains that are locked in. They will never be given back. Maybe more importantly, the policyholder will never be impacted by any of the losses: he/she will get the attractive upside, with locked-in gains and none of the downside.
Although these principal-protected, equity-linked financial solutions were not intended to be the best-performing asset class, that’s exactly what they’ve become in a market where most investors have made exactly zero in a decade. With an average annual real rate of return of 7.2% on stocks between 1948 and 2008 1, not including any fees, these retirement savings vehicles look even more impressive. They offer competitive performance with the most broad-based market index, but none of the risk.
Approximately 90% of all FIA’s acquired by consumers are done so with an additional, extremely beneficial feature-- probably the most important feature for one’s safe, comfortable retirement: a guaranteed income rider. Since an FIA is an insurance vehicle, think of it as similar to your homeowner’s insurance, except that it protects your portfolio against loss. One could think of it as “portfolio insurance.” Why not insure what may be the most important asset you have: your safe, comfortable retirement? To take things just a step further, if you had valuable jewelry, you would also insure this via a homeowner’s insurance rider. Think of an FIA with the guaranteed income rider like the add-on to your basic portfolio insurance. It guarantees that once your start the income stream at some point in the future, no matter how long you live, the income will never stop. You will never run out of money before you run out of life. This, to most people, is the most important worry they have. We are more afraid of running out of money than we are of death.
Here’s how the Guaranteed Income Rider works. Usually the parent insurance company adds on this lifetime benefit by signing one document when the FIA is established. While generally there is no management fee or commission to hold or obtain an FIA, there is a small annual fee of approximately 0.5%, varying slightly per carrier, for this guaranteed lifetime income benefit. To imagine how both the base FIA works in conjunction with the lifetime income rider, envision a “T-square”:
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On the left side on the T-square is the FIA, the market-linked side. On this side, you’ll see a gain or a zero every year. The FIA is linked to a market index, and most insurance companies offer a 5%+ bonus on day one. Any interest is accrued to the account based upon the change from day one to day 365 in the client’s calendar year. For example, if the S&P was 1000 points on February 15, 2012 and 1200 on February 15, 2013, that would represent a 20% change in the market. As such, an appropriate amount of interest would be credited to the account, subject to a cap. He/she will get none of the loss in a down year. You would see an attractive upside with none of the market downside. Historically, again, when you compare the long-term actual performance of the S&P 500 Index, 1948-2010 at 7%, the FIA has still been extremely competitive, in most cases vastly outperforming the market the past 10 yrs. Most people have made nothing since 2000 in the actual market.
On the right side of the “T square” is the income rider. Here, for income purposes, the insurance company compounds your money by perhaps 6.5%, guaranteed every year, no matter what the actual market-linked side does on the left. The longer the money is left to compound, the greater the income basis--and thus the larger the yearly lifetime income. Let’s use an actual client example to tie all of these concepts together. Mr. Darwin is 60 years old and has $500,000 to invest. He wants income at 65, maybe 70. He will get a 5% premium bonus day one, totaling $25,000: both on the market-linked side (left) and the income side. The right side of the T-square, the guaranteed income rider side, will compound by 6.5% (based on the rate as of 12/2011 from one carrier) every year for as long as he leaves it there, until he begins taking lifetime income. For example, at age 65: $719,275 times a factor of 5.5% comes to $35,964 per year for life. At age 70: $985,497 times a factor of 6% (since he is over 70) results in $54,202 per year for life.
As the Fed continues to print money to get us out of the big financial mess we are in, and as we look down the barrel at the inevitable inflation boogie man, it’s comforting to know that there are features that allow for guaranteed increasing income as well.
1 Kopcke, R. W. and Muldoon, D. “Why Are Stocks So Risky?” Boston College Center for Retirement Research. November 2009, IB# 9-23. 2. http://crr.bc.edu/images/stories/Briefs/ib_23.pdf
Disclaimer: this article was written in January, 2012 and these rates may change; see your advisor for current rates.
© 2012 Scott Mann