Am I Locked In With An Annuity?

February 20, 2015
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Have you ever heard someone exclaim, “I don’t want an annuity because I don’t want to be locked in!” Certainly being locked in does not conjure up happy thoughts, so is this true or not?

Let’s talk about a Fixed Indexed Annuity (FIA) as an example. Generally speaking, FIA’s provide a variety of features and benefits. A FIA provides tax-deferred growth and is linked to an index like the S&P500. When the S&P500 is up, account holders are credited interest up to a declared cap based on a selected interest crediting strategy. This crediting strategy can be changed each year on the policy’s anniversary date. Simplistically, the S&P500 can be followed on a point-to-point basis, meaning measure the index from the beginning of the year to the end of the year or on a monthly basis. Once interest is credited the policyholder gets to keep it.

If the S&P500 falls, the account holder does not experience a drop in account value, thereby protecting principle and historically credited gains. For liquidity purposes FIA’s allow penalty free annual withdrawals. FIA’s also offer optional guaranteed lifetime income riders. FIA’s avoid probate by going directly to named beneficiaries at their passing. Each of these features provides a range of benefits, but understanding surrender charges is also important.

For those plagued with low rates of return on today’s savings accounts and CD’s, Fixed Indexed Annuities have become a strong alternative to achieving capital protection as well as earning a more competitive rate of return.

Consider a case study. A 76 year-old woman has $300,000 in an IRA invested in the market. Worried about market volatility she converts her IRA holdings to cash. Feeling safer, she soon finds she is only earning .2% annual interest. She considers a CD, but learns a 3-year CD is paying only 1.45% (Bankrate.com). Understandably, she desires a more competitive return without risking her capital. Being over 70 ½ she takes her IRA Required Minimum Distribution (RMD) each year. She uses this to supplement her Social Security and pension income. She has a sizable emergency fund of $50,000 as well as an asset-based long-term care strategy and other assets. In this situation, a Fixed Indexed Annuity could be a viable option. The positive features noted earlier apply, but what about the feeling of being locked in?

Annuities have what are called surrender charges. A surrender charge works just like it sounds. A charge is assessed on any amount withdrawn (surrendered) above what is called a penalty free withdrawal (PFW). Read the contract language! For a typical 9-year FIA, surrender charges would start at 9% and fall each year by one point (9, 8, 7, 6, 5, 4, etc..) to 0% by the end of the contact period.

Most FIA’s allow an annual 10% PFW, beginning in the second year. In our example, the owner can take up to 10% of the account balance each year without incurring a surrender charge. Most are not aware of this yearly benefit. At the end of the first year, assuming the S&P500 index went up with a cap of 4%, the account would be credited $12,000 ($300,000 x 4% = $12,000 + $300,000 = $312,000). Accordingly, the account holder could withdraw $31,200 in the second year (10% of the previous year’s balance). This could be accomplished without incurring a surrender charge, penalty or fee! Does this sound like she is locked in?

Using this example, she could take $31,200 out of the IRA in the second year, but should she? Being 76, her RMD in year two would be $14,717. This would be considered part of the $31,200, if she elected to take the full 10% PFW. But would she want to take the full PFW. She could, but remember all withdrawals from a traditional IRA are taxable so taking a large lump sum could pose a tax problem. The asset was positioned to provide on-going lifetime income so taking only the RMD each year seems reasonable. Is she locked in? I would argue she is not. Remember, she has a generous emergency fund and other liquid assets if she needs more cash. If she wants to exercise a 10% PFW in any year she can and as contract years progress the applicable surrender charge percentage drops!

But what if she had a true emergency and needed to take out $40,000 in year two? She would pay a surrender charge of $704 ($40,000 – $31,200 = $8,800 x 8%). $704 may seem like a lot, but it is only .226% of the entire account value ($704 / $312,000 = .226%). This is far less than the likely 1%+ annual management fee she was paying on her old brokerage account. FIA’s do not charge annual management fees. Again, does it seem like she is locked in? Not at all! She has all the liquidity she needs and has a safe, growing asset. Even if the S&P500 drops, her asset avoids market down turns.

The key to financial strategy work is suitability. What is suitable in one situation may not be suitable in another. What is the bottom line? Annuities should never make an owner feel locked in. If so, the strategy has not been designed properly.