Income Guarantee

By James Alden

Annuity Contracts Guarantee Lifetime Income With or Without an Income Rider

The current boom in equity indexed annuities being sold on street corners like Kool-Aid on August afternoons has a lot to do with the invention of the lifetime income rider on annuity contracts which came out in late 2008.

The lifetime income rider was a feature that the insurance industry devised only recently (probably as a result of the historically low interest rate environment and consequent stagnating annuity sales) as a way of offering annuity policy owners the delicious carrot of a guaranteed lifetime income, regardless of how long one lived.

After all, in these times of longevity, market risk and invisible interest rates, the phrase "guaranteed lifetime income" has become almost like a dinner bell for baby boomers across the land.

The one caveat to the the lifetime income rider offer is you must pay for it, and the cost is usually anywhere from .40% annually to as much as 1.25%, depending on the policy. In return, however, the insurer has a (rather complex) way of showing you what your lifetime payment will be.

However, annuities have actually ALWAYS been purchased for the security and lifetime income potential that they provide — even before the so called "invention" of the lifetime income rider.

Traditional retirement annuities from employers, for example, would pay a monthly stipend for life, and sometimes for the life of the spouse as well. Teachers, Nurses, Law Enforcement, etc. have often used these types of arrangements with annuity carriers as a way of receiving their retirement salary.

Furthermore, any individual, if they have an existing lump sum annuity contract, can always tell their insurance company that they wish to turn their lump sum of annuity money into a lifetime guaranteed monthly payment and their insurer will tell them what that payment amount would specifically be. This process of turning a lump sum of money into a lifetime payment is called annuitization. This feature of annuities, (the ability to annuitize a lump sum) has ALWAYS BEEN AVAILABLE in annuity contracts in this country.

However, as already mentioned, the industry in 2008 suddenly "invented" a lifetime income rider that could be purchased for equity indexed annuity contracts. But wait, I thought you said lifetime income was already always available on annuity contracts prior to 2008? Correct, I did. So, what gives?

In 2006 the fixed annuity (including the equity indexed plans) industry began to recognize that their market share was going to be affected by historically low interest rates as well as competition from the variable annuity marketplace. Variable annuities had pioneered most of the "longevity innovation" features common currently such as minimum income amounts and minimum death benefits. Since Equity indexed annuities do not allow direct participation in the market and consequently less risk, the possibility existed for equity indexed providers to offer superior contractual minimums, especially in the "guaranteed income" department.

With the advent of the lifetime income rider now a policy owner could know specifically in advance what their lifetime payment might be at a certain age by purchasing this rider at the time they sign up for the policy. This new option of an income rider at the beginning of a contract would now contrast with the more traditional method of not having an income rider and instead opting to simply annuitize the lump sum of your contract at a later date.

The challenge, of course, with preplanning an annuitization strategy when a policy is first issued is that at the time the policy is issued you cannot know:

The accumulation value will be at the point in time that you choose to annuitize.
The interest rate environment will be at that the point in time that you choose to annuitize.

The advent on the income rider cleared both of these hurdles immediately by giving the policy owner essentially the equivalent of a defined benefit in advance. Therefore, the obvious question for the inquisitive ambiguous annuitant is this: what is the mathematical difference in lifetime annuity payment values between the two options?

Option A

A 55 year old man buys an annuity now for $400,000 and doesn't purchase an income rider. He then annuitizes that policy at a later point in time, say in 8 years.

Option B

A 55 year old man buys that same annuity now for $400,000 and does purchase the income rider for 8 years. He then "turns on" income in the beginning of the 8th year.

Option A

A 55 year old man buys an annuity now for $400,000 and doesn't purchase an income rider. He then annuitizes that policy at a later point in time, say in 8 years.

Option B

A 55 year old man buys that same annuity now for $400,000 and does purchase the income rider for 8 years. He then "turns on" income in the beginning of the 8th year.

The answer to the above question is not so simple, nor black and white, and I might be in legal jeopardy by even making it seem so!

First, the reason why the answer is not so easy is because insurance companies actually price their annuity plans based on the current interest rates at the time the policy is issued. The reason for this is because when the annuity is purchased by the consumer, the bonds that make up the "backbone" of the new policy are from bond pools that have been (recently) purchased by the insurer. Obviously, a current bond environment with higher yields will allow an insurer to design policies with higher crediting guarantees built into the contract as well — and of course this works in reverse as well.

Then how can one know what the interest rates will be at a certain future point in time? Obviously, no one can answer that question.

Second, nobody can answer the plausibility factor of whether or not insurers will necessarily price their policies in the future as they do currently; perhaps they will use a different mortality table (the determinant of life expectancy) than they do now. There could also be other industry developments that we might not know about currently.

Now, let's put those uncertainties aside and try to make an academic guess at what might be a better option. Using things as we know them to be today, which is going to pay more, annuitization or income rider?

One of the higher lifetime income plans comes from Security Benefit. They have one of the more popular equity indexed annuities in the market right now (2014) called the Secure Income Annuity (SIA).

Option B First

Using the example we have noted, a 55 year old with $400,000 paid into the SIA, after 8 years of deferral (not touching one penny of the money), as well as being charged annually the income rider fee of 0.80%, will have a guaranteed lifetime payment of $49,340, regardless of how long he lives.

If he lives to his life expectancy of 76, then from age 63 to 76 he will have received $641,420!
If he lives to 85 he will have received $1,085,480!

Option A Second

Let's do the same annuity without an income rider and annuitize in 8 years in order to compare to Option B. In order to match the same $49,340 income amount in the foregoing income rider scenario, there must be a annualized rate of return assumption for those first 8 years. I repeat, we must assume — and you know what has been said about the word assume.

In order to match the same income amount of $49,340 for life, we are going to have to turn the $400,000 into $740,000 by the 8th year of his policy; this is an 8% guaranteed return. Now, this is possible, but it certainly is not guaranteed. That is the first caveat of going down this road of not buying an income rider.

After all, at the time of this writing, the highest fixed yield is in the neighborhood of 3.65% annually. So it would appear that the income rider has won — at least this round. At least as far as lifetime income is concerned in terms of guarantees today.

Keep in mind, there are 3 unknown caveats that could make the annuitization better (see Option B) .

If perchance we were in a better interest rate environent at the time of annuitization, the annuitization option could prove somewhat more attractive, and
You will not incure the income rider fee expenses of approximately $25,600 over 8 years (using simple math) leaving you with $25,600 more in the non income rider fee scenario.

So, have we made a definitive conclusion here? Probably not! Sorry. The choices are complex enough based on:

Interest rates at the time of annuitization
Age of the owner at the time of annuitization
Discretionary pricing of the insurer at the time of annuitization
The unknown growth rate of accumulated principal until the point of annuitization

Keep reading, eventually you'll figure all this stuff out!