The addition of income riders to fixed index annuities expands the functionality of the safe and steady accumulation platform into a single tool that offers elements of safety, growth, AND income.
Index Annuities With Income Riders Are Also Known As Hybrid Annuities
In recent years, the term ‘Hybrid Annuity’ entered into marketing materials as these contracts are a hybrid of benefits and features.
Just remember, though, that a Swiss Army knife is a hybrid also- there’s a saw, a knife, a toothpick, and a corkscrew and 57 other features. If you want everything in one package it’s great… but if all you need is a stout sharp knife, you’re sacrificing quality for a quantity of extras you don’t need.
Often, index annuities with income riders end up like a big clunky Swiss Army knife, which is why when you contact us we’ll start our conversations by making sure we both understand what you need, before looking at contracts, options, features and riders.
That said, there are attractive elements of many of these contracts, as they can alleviate the key fears of many retirees. People are attracted to index annuities with income riders as they do truly provide:
- Safety of principal, guaranteed by the issuing carrier
- Potential for growth of principal, through the market index and crediting methods chosen
- Lifetime Income, for the contract holder or a couple based on joint life
- Flexibility and liquidity options, but subject to contract terms and surrender schedules
- Additional disability and death benefits, depending on the contract
They truly do give that peace of mind of knowing you can never outlive your income… but when you do the math, to get the value out of the contracts you need draw the income and live a long time. When buying an index annuity with an income rider, you should consider it a lifetime commitment. Surrendering contracts can be costly and the income values take time to accumulate.
With that overview (and, admittedly, a little bit of bias) out in the open, lets dive in to the specifics of these contracts.
Brief History of Fixed Index Annuities and Income Riders
Annuities originated in Roman times. The name itself has its root in the Latin “Annua” meaning annual stipend, often paid to Roman soldiers in compensation for their service.
Over time, traditional annuities evolved into pure income contracts. They are frequently described as the opposite of life insurance. With life insurance, you pay a periodic premium for the carrier’s promise to pay your heirs a lump sum if you die. With the simplest form of a lifetime income annuity, you pay the carrier a lump sum in exchange for the promise to make monthly payments to you as long as you live.
Annuities filled a small financial niche for hundreds of years, but growth picked up after the 1929 market crash. Variable Annuities entered the marketplace in 1952, and the features and permutations have increased exponentially ever since. The lines have blurred between the traditionally pure income contract structure and newer contracts with investment features like accumulation.
The year 1996 saw the introduction of Fixed Index Annuities. As we’ve discussed on other pages about fixed indexed annuities, the name itself indicates that it is a fixed yield contract whose gains are re-invested in an index strategy.
Fixed index annuities are a known as a safe accumulation contract as they may go up in value with market growth, but won’t go down. The addition of an income rider turns them into a multi purpose tool for safety and income.
How Income Riders Work
There are many different variations of income riders which we’ll describe in a moment, but first lets understand the basic structure.
With any income rider you will have an additional calculation column for an income account in addition to your actual account value.
Your account value– your invested premium and any gains- is real money that you can withdraw.
The ‘income account’ is not real money. It is just a baseline from which the carrier calculates income payments made to you.
Carriers will use a variety of terms for this income account- withdrawal base, benefit base, income account, income base credit, income calculation base- but all mean essentially the same thing.
Here’s a quick and very simple example-
You invest $100,000 in an index annuity contract with an income rider.
The income account ‘rolls up’ at a rate of 8% per year, and your actual account is invested in a market index strategy.
During the first year, the index crediting method you selected resulted in a 5% gain to your contract.
At year end, your account value is $105,000 and the income account is 108,000. The payout rate would be applied to the income account, but income drawn comes out of your actual account.
Note, there is no “$” on the income account. It’s not real money.
The Main Components of Income Riders
No matter what the name or the specific details of the income rider, the performance is driven by three main components, and an occasional fourth element:
- The Rollup Rate
- The Time Period
- The Payout Rate
- The Bonus Rate
The Rollup Rate refers to the rate of increase to your income account. This is the flashy rate you see advertised in misleading ads promising an “8% Annuity”. While not exactly dishonest, these sorts of ads are misleading as most consumers think they are earning 8%, but they are not.
In our earlier simple example, we used an 8% rollup rate.
The Time Period is self explanatory- how long you let the income account base roll up. Different carriers have different methods- some offer a simple interest 10% rollup rate which is advantageous for time periods less than 7 years… others offer compounding rollups, which are in your favor over longer rollup periods.
How long do you plan to let this contract ‘season’ before taking income? In our prior example, we showed 1 year.
The Payout Rate is a percentage of the income account that is used to determine your income when you turn on your income rider. Again, different companies have different provisions, but in general, the older you are, the higher the payout rate. 4% to 6% is typical, with slightly lower payouts for joint life contracts.
An important note, while the payout rate is applied to the income account to determine your income (eg, 5% of 108,000 from our earlier example), the income payment is drawn from your actual account value. This would be $5400 taken from your account value.
The Bonus Rate is another term you will see on some index annuities with income riders. Usually this is a bonus amount tied to the income account base- eg, a 10% bonus and 8% rollup.
If there were a 10% bonus on the prior example, your $100,000 investment would post as a 110,000 opening value to the income account, and at the end of year 1 the income base would be 118,800 (110,000 * 1.08).
Many carriers use bonus rates to attract premium, but often the bonus comes with additional vesting schedules and may come with longer surrender schedules as well. Be wary of making decisions on bonus alone.
Putting the Income Rider Pieces Together
These three main components plus the bonus rate all work together to determine your income from a contract. Some contracts are optimized for certain deferral time periods, like 5 to 7 years, others better at 10 years. Some contracts continue to roll up after taking income, others do not. Some have flashy and eye catching bonus rates, but often that is a smokescreen to cover up other less attractive terms.
Because each income rider is slightly different, it’s critical to work with a professional who can assist you understanding your needs first. Too often, investors are first exposed to income rider annuities at dinner seminars and other ‘pitch’ events, without any discussion of needs. At first glance, all the features and benefits of these contracts may sound essential in retirement, but perception and reality often differ.
Are Income Riders Bad?
It’s very hard to say if a particular contract is good or bad because so much depends on your situation, your needs, and timeline. So instead of asking if it is ‘good or bad’, ask if it’s appropriate for you.
In most situations, you should approach the purchase of an index annuity with an income rider as a lifetime commitment. There are significant surrender penalties with these contracts, and the rollup rates usually take several years to gain in value.
You should not look at index annuities with income riders as very efficient growth tools- income riders have fees attached, usually 1%… Sometimes this is 1% of the account value, sometimes it’s 1% of the benefit base and taken from your account value. Either method is a drain on performance.
In nearly all illustrations and past market scenarios, the income value grows in excess of the account value. When this happens, it makes a surrender decision much more difficult 5-10 years into a contract, because the income benefit may be significant and yet you may not need the income. If you have years of poor actual account performance coupled with fees, you may have with little actual capital in the account value.
Clearly knowing your needs before buying the contract helps avoid this problem, and furthermore, if you’re not completely sure of your needs, using other safe contracts that provide more flexibility might be a better option. Index annuities with income riders are great tools for a specific job- just make sure it’s a job you need done!
Pros of Fixed Index Annuities With Income Riders
There are many advantages to index annuities with income riders . These are as follows:
- One Stop Shopping – Fixed Index Annuities and their Income Riders allow for a single-stop shopping
- More than just security – They cover income security, potential for growth, and longevity protection all in one product
- Access and control – While annuity holders enjoy a lifetime income guarantee, they also keep both access and control to the principal invested in the annuity
- Dependable and stable income levels – Even if principal goes up or down (given interest rates and equities markets) the income level will not decline
- Superior retirement planning possible – With lifetime income secured, pressure on other retirement assets is relieved.
Cons of Fixed Income Annuities With Income Riders
- Complexity – Income riders unfortunately can be complex and difficult to comprehend
- Performance – Don’t expect an index annuity to do all things well. Account growth will be lower than pure growth-oriented contracts, and income may be lower than purely income focused options.
- Hidden costs – Income riders carry fees and may be coupled with lower caps, participation rates, or spreads.
Final Thoughts on Fixed Index Annuities with Income Riders
It is important to remember that Fixed Index Annuities with Income Riders create two accounts. The one is the actual account value. The second is the separate benefits base that determines the income amount.
Income accounts may include bonuses and rollup rates but are not actual money. The actual account value may be subject to caps, spreads, and fees, as well as a surrender schedule
Income will be drawn from the account value, but is determined by the income base. As a result, when you do decide to take income, you may be withdrawing from your account value at a fast pace.
Typical illustrations that roll up for 3 to 5 years then start drawing income show the account value to be depleted in about year 17 to 20 of the contract. After the account value is depleted, income continues and is paid by the insurance carrier, so the contracts DO provide lifetime income and longevity protection.
Income riders are often confusing for would-be annuities buyers. Do not wait to have your questions answered. Call DCF Annuities today. We are here to help you make the best choice for your financial and retirement future.