Annuity Income Riders: To Win, You Must Lose

I’ve been getting many questions lately about the guaranteed income that some annuities offer and how they work, so I figured I would write an explanatory article as it can be quite confusing. At their most basic level, a lifetime income rider is an optional addition to many annuities that insurance companies offer. The rider typically guarantees income for as long as you live (or as long as you and your spouse live) and charges a fee for it. I will use a hypothetical example of a typical variable annuity with a lifetime income rider to illustrate the point. Unfortunately, this will be fairly math heavy when compared to my typical articles, but there really is no other way to explain this!

Hypothetically (and not representative of any specific annuity), let’s use this example:

  • 55-Year-old married male purchases an annuity inside of an IRA with a $500,000 rollover and elected the lifetime income rider just for his lifetime
    • Rider guarantees 5% withdrawal rate for life at age 65
    • Rider guarantees that you can withdraw 5% of the higher of your cash value OR the guaranteed income base, which is calculated by taking your initial deposit and adding 5% per year to that value
  • He invested moderately in the annuity sub-accounts and chose 60% stock market investments and 40% bond market investments, so let’s assume a hypothetically averaged 6% a year return for 10 years
  • The hypothetical (but typical) annuity fees are as follows:.
    • Mortality & Expense Fee: 1.2% (charged on cash value)
    • Administration Fee: 0.15% (charged on cash value)
    • Lifetime Income Rider Fee: 1.4% (charged on guaranteed base)
    • Average investment sub-account fee: 1% (charged on cash value)
    • Total annual fees: 3.75%

So now let’s fast forward and the client is 65 and retiring and he wants to turn on his retirement income. The annuity guaranteed income base has been accumulating at 5% interest for 10 years, so the income base is calculated to be an estimated $823,504.75. This income base is what the 1.4% Lifetime Income Rider Fee is being charged on, so the annual fee for the rider is now $11,529 per year (823,504.75 x 1.4%). The client can take either 5% of $823,504.75 for life OR 5% for life of the current cash value, whichever is higher. As mentioned above, the annuity contract deposit earned an average hypothetical annual return of 6% over the 10 years, but had annual fees of 3.75%, so it had a net return of 2.25%, which means the actual cash value is only $626,029.

Therefore, in this example, with typical rates of return (not guaranteed of course), the client only made 2.25% annually on the cash value. Considering savings accounts rates are nearing 4% right now, this growth is extremely minimal. BUT this wasn’t bought for growth, it was bought for the guaranteed annual income, so let’s look at that!

The guaranteed annual income is 5% of $823,504.75, so $41,175 per year. But that money is taken from the real cash value, not the insurance companies guaranteed income base. So let’s look at the first 5 years and once again assume 6% ongoing average growth:

YearStarting BalanceWithdrawal (Income)FeesEnding Balance*
1$626,029$41,175$11,529 (rider) + $14,711 = $26,241$596,174
2$596,174$41,175$11,529 (rider) + $13,963 = $25,492$565,277
3$565.277$41,175$11,529 (rider) + 13,284 = $24,813$533,205
4$533,205$41,175$11,529 (rider)+ $12,530 = $24,059$499,963
5$499,963$41,175$11,529 (rider) + $11,749 = $23,278$465,508

*ending balance calculated by Starting Balance plus 6% growth minus Withdrawal and Fees

So hypothetically, in 5 years, the cash value went from $626,029 to $465,508, which is a loss of $160,521, which is a percentage loss of 25.6% during a time period where the investments earned 6% annually. The annual fees started at a total of $26,241, which when divided into the Starting Balance in Year 1 ($626,029) is an annual 4.2% in cost. By year 5, the annual fee was 4.65% because the rider fee stays the same on a decreasing cash value ($23,278/$499,963). If you continue this math, the balance would drop to zero in about 20 years while the insurance company collects fees the whole time. After the balance hits zero, ONLY THEN does the insurance company has to pay you anything out of their pocket.

So following this hypothetical example: The client at 65 turns on his income rider. He begins to receive $41,175 per year. By the time he hits 75, he is concerned as his income has not risen at all, but inflation has and his cash value has dropped. Fast forward and now he is 85 with the same annual income (with his buying power significantly diminished due to normal inflation) and his cash value has gone to zero. He unfortunately passes away a year later at age 86, so the insurance company had to only pay out the guaranteed income for one year of $41,175. His wife gets nothing going forward and nor do his heirs.

So in this common example, to actually WIN and beat the insurance company, you have to live well into your 90’s to make the insurance company pay for multiple years after your contract goes to zero. And even then, in this example, they have been collecting fees for 20 years totaling hundreds of thousands of dollars.

I once had a client tell me something that really made a good point. He said, “If I took all my money and put it on a table in my kitchen and used 5% of it per year, it would last 20 years. Just sitting on my table collecting dust. And I will probably die before using all of it, so why would I want to pay someone for that?” A very good point indeed.

But rather than using an annuity with a lifetime income rider or leaving it on a kitchen table, what if you invested the $500,000, avoided the high annuity fees and instead paid an annual fee-based management fee of around 1.2% per year and earned 6%. Then you could potentially have an increasing account balance over time to keep pace with inflation and leave a legacy to heirs while still drawing an income. I would argue that is the best option of those presented here and my personal preference.

I’m not saying all income riders or annuities are not a useful tool as they are not all the same. There are annuities with lower fees and better guarantees that can involve spouse income and death benefits. I have sold some annuities myself years ago when guarantees were higher and fees were lower. I am simply pointing out that annuities are extremely complex, the guaranteed income will most likely not keep pace with inflation, and it is most likely that a client will pass away while still having a cash value and the insurance company has to pay nothing for all the fees they collected. I remember having a debate about lifetime income riders with another advisor who told me that he almost never had a client annuity cash value go to zero, to which I responded, “well then your clients paid all those fees for nothing”.

As a Wealth Manager and fiduciary, I have to weigh the probabilities and risks of any investment and it is important that any annuity considered be deeply analyzed before purchase.  Please reach out if you have questions or comments!

A more detailed version of this article was published here: Annuity Income Riders: To Win, You Must Lose – Articles – Advisor Perspectives