“You’ve probably run across at least one of those “too good to be true” annuity ads. But, what’s the real story behind those 7% rate promises?”- Jerry Yu
Chasing after anything that promises a decent return is understandable. In an economy where interest rates have been held tightly in check by the Federal Reserve for what seems like a lifetime, promises of extraordinary returns on an investment are enticing.
Punishingly low-interest rates are one reason why so many pre-retirees find themselves chasing after returns and exposing their wealth to risk.
Unfortunately, annuity marketing companies understand this and are eager to capitalize on the quest for returns by creating somewhat misleading ads that promise rates of 7-8%.
Not FALSE, but not altogether TRUE either.
Annuities are one of the most time-tested, proven ways for pre-retirees to protect their principle, create streams of guaranteed, predictable income to offset longevity risk, and provide a legacy for loved ones. Modern annuities are the most flexible and customizable safe money option for most retirees.
However, there is no “magic” annuity that offers a return of 7% or more when others are giving you 3%.
You see, the high rates you see in print ads or on the internet are the result of what are called Income Riders or Roll-Up Rates. Riders are add-ons that take a plain vanilla annuity and customize it to a person’s particular goals or financial circumstances.
You may have heard of long-term care riders, death benefits riders, or impaired risk riders. Each rider you select to customize an annuity comes with fees, terms, and conditions.
Although rates vary among annuity issuers, a typical Income Rider costs around 75 basis points. You’ll pay these basis points from the very first day of the annuity’s inception through the payout phase or until your death.
I may hop into the weeds in a future article and talk more about basis points and why insurance companies use them. For now, though, think of basis points as simplified units of measure that the financial services industry uses to express percentages.
You can mathematically interpret basis point cost as reduced interest return. For example, if an annuity advertises a 3% rate and offers a rider costing 75 basis points, your actual net yield would be an annual return in the neighborhood of 2.25%.
Now, about that 7% rate of return…
Your annuity marketer may toss out the term “Roll-Up Rate.“A roll-up rate is your guaranteed rate of return, but only as long as you are deferring payments.
When you purchase an income rider, something called an income calculation base, or benefit base is created. Essentially you now have two different accounts for your one annuity. Account A has your principal investment, growing at one rate. Account B has your principle PLUS the 7% roll-up earnings.
Here are the critical things you should understand when it comes to these two accounts:
- You can never take a lump sum withdrawal of funds in Account B.
- No roll-up earnings in Account B are paid out to a beneficiary if you die.
So, the 7% guaranteed rate isn’t guaranteeing an annuity’s actual return. Instead, this rate merely ensures the growth of a “phantom” account’s value created by an optional annuity rider.
Don’t get stuck in the annuity marketing MUD.
If you’re confused, you’re not alone. Annuity companies and their marketers often run confusing ads promising 7% (or higher rates. This confusion is unfortunate because both annuities and riders work well for many people as long as they clearly understand these products.
Summing it up.
Don’t let hype and misinformation keep you from discovering the many positive aspects of having annuities in your retirement portfolio. An annuity gives you certain tax advantages, can help you create lifetime income, protect your principle, assist you in planning for long-term care needs, and create a legacy for your loved ones. If you’re investigating annuities or riders, find a reputable annuity agent and have them explain what you must know to make the best choices.
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