Income riders are the current "killer app" used to close most indexed and variable annuity sales, and the annuity industry is applauding all the way to the bank.
Increasing Fees....Contractually Guaranteed
Income riders are contractual benefits for future income guarantees that you can attach to a fixed index or variable annuity at the time of application. These attached benefits have an annual fee for the life of the policy, and that fee is based on the income rider calculation dollar amount at the time you start the payments.
That sounds harmless on the surface, but once you dig into the contractual math, it's apparent that the annuity industry has designed a money printing fee machine.
Monopoly Money Yield
Too many annuity sales pitches involving income riders unfortunately frame the contractual growth percentage during the deferral years as actual yield. Some riders have annual growth guarantees as high as 8%, which looks appealing at first glance when the current U.S. 10 Year Treasury Rate is less than 2. However, the contractual facts get in the way with annuity dreams sold.
Income rider percentages are not yield. You cannot peel off the interest, cash in the lump sum, or transfer that rider amount to another annuity. It is monopoly money and a phantom account that can only be used to calculate income payments. That's OK if you fully understand how an income rider works, but too many annuity owner's mistakenly think they own Jimmy Carter era CD returns. They don't.
The Longer You Defer, the Higher the Fees
As an example, if your income rider has a 1% annual fee, that deduction (cost) is based on your income rider total. If you have a rider that increases and compounds by 7.2% every year you defer, then your fee is going to increase by that amount as well. One hundred thousand growing at 7.2% every year will contractually turn into $200,000 if you defer for 10 years before the income starts. That means your fee started at $1,000 when you bought the contract, and is locked in permanently for the life of the policy at $2,000 if your lifetime income stream starts at year 10.
If you defer more than 10 years, the fees keep increasing until you finally turn on the payments. This is a detail that is predictably left out of most annuity sales pitches, to the delight of the annuity industry's bottom line. To say that the income rider "killer app" comes with a cost is an understatement!
Draw a Line Down the Middle of the Annuity Page
Income riders are completely separate calculations from the investment accumulation value, or walk away amount. If you visually draw a line down a piece of paper, the left hand side of the ledger is the accumulation value, and the right hand side of the ledger is the income rider valuation.
The accumulation value for variable annuities are the separate accounts (i.e. mutual funds), and index call options represent the accumulation value for indexed annuities. This is where the income rider fees are taken out, not the income rider valuation.
It's also important to point out that with most income riders, if you don't use that dollar value for income, then it disappears when you die. The last study that I saw a few years back showed that the majority of people that own income riders never use them. I guess they just like watching their monopoly money grow! Can you hear the annuity industry laughing their way to record profits?
Income Riders do work for future income
Annuities were introduced in the Roman Times as a pension for dutiful Roman soldiers and their families. To this day, most annuity types solve for income needs that are immediate or in the future. Income riders do have their place for future income guarantees and should be contractually compared with the other "Income Later" annuity strategy, Deferred Income Annuities (aka: DIAs - Longevity Annuities).
Both Income Riders and DIAs have unique benefit propositions and limitations, but unlike Income Riders, DIAs have no annual fees. Both guarantee lifetime income starting at a future date, but each take a different contractual road to get there.
Annuity Companies Have the Big Buildings for a Reason
Annuities are not investments in my opinion. They are contractually guaranteed transfer of risk strategies, and are commodities that should be shopped for the highest payout by quoting all carriers. This definitely includes income riders.
Annuity companies have the big buildings and "Trump size" logos on their planes for two primary reasons.
- They know when we are going to die and price the guarantees accordingly
- They love to charge fees for the life of the policy if they can contractually get away with it
This definitely applies to the increasingly popular income rider strategy. The lifetime payment is based on your life expectancy, and the annual fees will be deducted from the accumulation value as long as there is money in that side of the ledger. Call it "Grim Reaper wrap fees", call it smart business, call it hiding fees, call it what you want. I call it guaranteeing profits.
Regardless, the bottom line is you need to fully understand annuity contracts before signing the paperwork. Don't take the agent's word for it, and certainly don't trust the sales pitch.
This definitely applies when it comes to that too-good-to-be-true sounding income rider that agent is try to sell you. Don't be taken for an "annuity ride" without knowing the facts.
This article is commentary by an independent contributor. Stan The Annuity Man is the top independent annuity agent in the country, licensed in all 50 states, and a co-founder of Annuities.direct, the first direct to consumer annuity shopping platform.
Stan The Annuity Man has published six best-selling books on annuities, and will send them as a gift to all TheStreet readers under no cost or obligation. Simply email Stan (firstname.lastname@example.org) your physical mailing address or click to fill out the online form.