As a consumer planning for the future, it’s important to understand what an annuity is, how it works, and how much income you’ll receive for the rest of your life.
An annuity is a vehicle that is designed to provide income for the rest of your life. The three most common types of annuities used when planning an income include: fixed, variable and indexed.
To keep things very simple:
- Fixed = A set interest rate.
- Variable = Based on the stock market and has market volatility.
- Indexed = Protected from market volatility with upside potential, because interest is credited based upon the value of an index like the S&P 500, but you don’t lose any interest earned when the value of the index goes down
Inside each of these annuities are two different account values. One is called the Accumulated Account Value and the other is called the Income Account Value. These are two strategies that occur simultaneously, and from which, you choose which to use for your retirement.
First, we must understand the difference between the Income Account Value and the Accumulated Account Value, in order to make an informed decision. Simply put, the Accumulated Account Value is money that you can access as a lump sum, while the Income Account Value is an account from which the guaranteed lifetime income is formulated, and is known as an income rider.
The purpose of an income rider is to provide higher income than would normally come from the annuity, however this option has additional fees. The important thing to remember is that the income account value is only used to determine income. You will never actually be able to walk away with the income account value.
In today’s market of annuities, many companies are offering bonuses to the client’s immediate Accumulated Account Value and/or their Income Account Value, some as high as 20 percent upfront, credited to the client’s initial deposit.
At first glance, the annuity with the larger bonus sounds like the better deal. Who doesn’t want $100,000 added to their $500,000 rollover? Although a bonus can offer an instant feeling of return, this is not why most annuities are purchased.
Most annuities are purchased to provide a source of income that cannot be outlived. So, even though the bonus can dramatically increase the account value, this does not mean that it will provide a higher income than an annuity without a bonus.
The only way a company is able to provide guaranteed income, that cannot be outlived, is through the purchase of an income rider. Income riders typically have a cost, anywhere from 0.5 percent to one percent per year, charged to the account value. Income riders also guarantee a certain interest rate to be credited each year up until the client turns on the lifetime income.
The average guaranteed income rider interest rate is anywhere between four percent and seven percent, credited to the income account value yearly. Regardless of how the market index performs, this interest rate will be credited to the income account value. This is in addition to any bonus credited to the income account value.
The real focal point for consumers, when shopping for an annuity, must be the amount of income provided by each plan. Regardless of bonuses or riders, consumers want to know “How much income will it offer for life?” To discover this, pay close attention to the percentage the annuity provider allows you to take from your income account value.
Let’s say you have $100,000 in your income account, and in year seven you want to take out income. In order for the company to guarantee lifetime income, they have to control how much you can access per year by offering you a certain percentage of the income account value – the higher the percentage, the higher the annual income.
The percentage paid as income changes, based on how old you are when you want to start the lifetime income stream. Generally, the older you are when you start the income, the more your income will be yearly. Keep in mind that most companies stop crediting your account any interest once you elect to start your income. The tradeoff is never having to worry about running out of income again.
Don’t let large bonuses and high interest rates sell you. Not all income-producing annuities are created equal. Sometimes the ones with the smallest bonuses and lowest interest rates per year can be the one with the highest payout for the consumer.
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