Annuities: Guaranteed Income Comes at a Price

By Mark Cussen Markets Fool.com

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If you're looking for a guaranteed stream of income throughout retirement, then an annuity may be the best option for you. Annuities offer lifetime income, tax-deferral, and many other benefits that can help to make your retirement financially secure. However, there's no such thing as a free lunch. Before you think about buying an annuity, you should know what those benefits and guarantees will cost you.

Guaranteed income riders

One of the key features that many indexed and variable annuities now offer is called an income benefit rider, or living benefit rider. This rider will provide you with a guaranteed payout that is based upon a hypothetical rate of growth promised by the life insurance carrier. For all practical purposes, your annuity will then have two values. One value is the actual value of the contract, which will depend upon the amount of interest that is credited to your annuity if you own an indexed contract, or on the combined value of the underlying mutual fund subaccounts if you own a variable contract. The other value of your annuity is the hypothetical amount that your contract would grow to based upon the rate of growth promised by the rider.

For example, Fidelity & Guaranty Life Insurance Company offers an indexed annuity (the Prosperity Elite 14) that has an 7% up-front bonus and a 7% guaranteed compound interest rate for 10 years with their Enhanced Guaranteed Minimum Withdrawal Rider. Let's say you're 55 years old and want to save money for retirement for the next 10 years. If you invest $100,000 in one of these contracts, you'll immediately be awarded a bonus of 7%of your contract value. The guarantee would stipulate that your initial balance of $10,000 would grow at a guaranteed rate of 7% per year for 10 years, at which point the balance would be $191,436. Then, when you annuitize your contract (i.e., irrevocably convert it to a stream of income), the payout you receive will be calculated based upon this hypothetical amount instead of the actual value that your contract grew to during that time. However, if the actual contract value happens to exceed this hypothetical amount at the time you are ready to begin taking withdrawals, then your payout will be based upon that amount instead. Your payout will always be based on the larger of these two amounts.

The cost of security

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However, this payout guarantee comes at a price. In return for providing guaranteed income that is based upon a hypothetical amount, the annuity contract will charge an annual fee to all investors who opt for one of these guaranteed income riders, and this amount will be drawn from your actual contract value. This will effectively reduce the actual return that you earn in the contract over time and can leave you with substantially less in your contract than you may have if you did not elect to carry this rider. For example, F&G's contract mentioned above carries a cost of 1.05% per year. This means that if your contract actually grew by 6.05% for the year, then the actual growth after the rider fee is paid would leave you at 5% for the year. The guaranteed rate of growth in the annuity contract therefore comes at the expense of the actual amount of growth in your contract over time. For this reason, in most cases, the hypothetical amount of growth that is promised in the rider is usually what is used to calculate your annuity payout at retirement. You will therefore need to decide whether you are happy receiving a payout based upon this hypothetical rate of growth before purchasing one of these riders, as the odds are that this is the rate of growth that will be used to compute your payout at retirement.

Keep in mind that the annual fee (in this case, 1.05%) is only deducted from your actual contract value; the rate of growth under the rider is the full 7%. However, in order to receive a payout that is based upon this guarantee, it is necessary to annuitize the contract, which irrevocably converts the contract from a growth vehicle to a payout vehicle. You will then receive a guaranteed stream of income from the contract for the rest of your life (or as long as either you or your spouse lives, if you opt for a joint life payout). But if you and/or your spouse doesn't live long enough to recoup your principal, then the insurance company will keep the difference.

It is possible to have your beneficiaries receive any remaining balance after you die -- in return for a somewhat lower payout. Nevertheless, the guaranteed rates of growth that are offered in these riders are usually much higher than the rates of other types of guaranteed instruments such as Treasury bonds or CDs.

Guaranteed income riders and living benefit riders can be somewhat complex in nature, and several rules must be followed in order to properly reap their benefits. Consult your financial advisor or insurance agent for more information on these riders and how they can benefit you.

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