Financial Advice That’s Too Good To Be True

7501727_sI tell my kids that if something seems too good to be true, it usually is. That logic surrounded a discussion I had in my office last week with a very nice couple from Marstons Mills, Don and Kathy. They had read an article I wrote on variable annuities highlighting questions to ask before purchasing one. These questions help to determine if a variable annuity is an appropriate investment and income strategy.
Don and Kathy are retired and moved to Cape Cod from Connecticut about nine years ago. Their current advisor suggested they purchase an annuity. They were told they would have a guaranteed 6 percent return, no matter what. They were also told that the cash value would be transferred to their kids upon their death.
Hmm … sounds too good to be true.
Upon review, I discovered that Don and Kathy’s advisor suggested a variable annuity (VA) with an income rider attached. Let me explain what an income rider is.
An income rider attached to a VA ensures that once the annuity changes from the accumulation stage to the distribution stage (once it is annuitized), the income stream will continue until death; even if the “cash” account is depleted.
When a VA is issued with an income rider, the carrier will essentially keep two sets of books, one for the cash account and one for the income account. The cash account is real money. This balance reflects the initial premium plus credited interest or investment returns from subaccounts, minus any fees for riders, investment accounts and/or administration costs. The cash account is the account the annuity owner can take withdrawals from and the amount that would be transferred upon death of the owner.
I looked at Don and Kathy’s current policy and determined that their cash account absorbs a costly 4.85 percent in fees. I explained to them that they pay those fees whether their cash account rises or falls depending on market performance. The fees are paid no matter what.
The second set of books that I mentioned above for the income account is phantom money. It does not exist. It is only a formula used to calculate what is referred to as the “income base.” Don and Kathy’s income rider has a 6 percent simple interest step-up. This means that the income base is the initial premium plus 6 percent per year.
At any point in time, the cash account and the income base can be two different numbers. When an owner is ready to begin taking lifetime withdrawals from his policy, the company will compare the two account values and apply the greater of the two to the specified payout factor; this is the lifetime income amount. For example, if the initial premium is $200,000 and at some point in the future when the owner annuitizes the contract, the cash account has grown to $225,000 and the income base has grown to $250,000, the income base (the larger of the two) would be applied to the payout factor. If the payout factor is 4 percent, the owner would receive $10,000/year ($250,000 x 4 percent) for life.
Once lifetime income is triggered, the income base vanishes but the cash account continues to operate as usual reflecting market gains and losses. However, in addition to all the fee deductions, the annual payout is also deducted from the balance of the cash account.
Until the cash account is depleted, it is available for emergencies and is transferred to a beneficiary as a death benefit. Once the cash account goes to $0, the insurance company continues the annual payment for the life of the owner.
I explained to Don and Kathy that a strong accumulation “engine” will maintain cash much longer than a poorly performing “engine.” Unfortunately, their “engine” is loaded with expensive mutual funds demonstrating significant losses in past bear markets … not good. Secondly, I explained that their cash account initially funds the annual payments. Therefore, a higher income base just means they are spending their own money down faster, which could significantly impact any type of legacy planning for their kids.
Lastly, I explained to Don and Kathy that there are three primary parts to an income rider; the fee or cost of the rider itself, the accumulation benefit (often referred to as the step-up) and the payout factor. While there are an overwhelming number of additional factors to consider when analyzing these riders, for the sake of this discussion, we will focus only on these three.
Rider fees are essentially the cost to “insure” the income stream. We determined that the income rider on Don and Kathy’s variable annuity is 1.5 percent. The insurance company charges such a steep fee because they must cover the potential for significant market losses in the cash account.
The accumulation benefit, or step-up, is usually the sales pitch for a VA with an income rider. As I explained above, Don and Kathy’s VA has a 6 percent accumulation benefit.
The payout factor is the least visible of the income rider variables, often buried somewhere in the policy fine print. Because fees and step-ups are fairly visible rider features, payout factors can be compromised at the expense of a large step-up.
Don and Kathy now understand that they do not in fact have a “guaranteed” 6 percent return on their cash value and that in this case, it was too good to be true.
Folks, we need to be vigilant and to stay alert, because you deserve more.