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?
For this writing I will use a Fixed Indexed Annuity (FIA). Generally speaking, FIA’s provide a variety of features and benefits. For example, FIA’s provide tax deferral and insurance for a financial nest egg, garner upside potential with no downside market risk and often pay attractive upfront premium bonuses. In addition, they allow penalty free annual withdrawals, lock in historic credited gains, provide guaranteed lifetime income options and avoid probate. Each of these features provides a range of significant benefits to the holder, but understanding surrender charges is also important.
Consider a case study. A woman, age 76 has $300,000 in an IRA. Worried about market risk she converts her IRA equity holdings to cash. Feeling safer, she soon finds she is only earning .2% in annual interest. She considers a CD, but learns a 5-year CD is currently paying only 1.37% (Bankrate.com). Understandably, she desires a more competitive return without risking her capital.
In addition, she takes her annual IRA required minimum distribution each year, which she uses for income to supplement her Social Security and pension. She has a sizable emergency fund of $50,000 as well as a significant asset-based long-term care strategy and other assets.
In this situation, a fixed indexed annuity would be a viable option. The positive features noted earlier apply, but what about the potential feeling of being locked in?
Annuities have what are called surrender charges. A surrender charge works just like it sounds. A surrender charge is assessed on any amount withdrawn (surrendered) over and above an amount allowed by what is called a penalty free withdrawal (PFW). For a typical 9-year FIA, surrender charges would start at 9% and fall each year by one point to 0% by year 10.
Most FIA’s have an annual 10% PFW, which usually takes affect 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. Unfortunately, most are not educated on this benefit. If at the end of the first year, the annuity received credited interest of 4% ($300,000 x 4% = $12,000 + $300,000 = $312,000), then the account holder could withdraw $31,200 in the second year (10% of the year end balance) without incurring a surrender charge.
She could take $31,200 out of the IRA in the second year, but would she want to? The FIA also allows for required minimum distributions, which in year two would be $14,717. 100% of this is taxable because IRA monies are qualified funds. Taking out a large lump sum each year could pose a tax problem. Since the IRA is being used for annual income, is she really locked in by the annuity? I would argue she is not. Remember, she has a generous emergency fund and other liquid money if she needs more cash.
But what if she had a true emergency and needed to take out $40,000 in year two as opposed to the $31,200? She would pay a surrender charge of $704, 8% times the $8,800 ($40,000 – $31,200), which is the amount over the 10% PFW. $704 may seem like a lot, but it is only .226% of the entire account value ($312,000 x .226% = $704). As you know, most managed accounts charge an upfront sales charge or management fee of 1% annually. These fees do not apply for FIA’s since it’s not a managed product. In this situation, .226% would be 75% less than what she might have been charged in her old brokerage account in just one year. Again, does it seem like she is locked in? I don’t think so!
Remember, the key to financial strategy work is suitability. What is suitable in one situation may not be suitable in another. I had a client a few days ago that wanted to put $100,000 in an FIA. I asked her what the money was for. She noted it was to purchase a home for her son in 3 years. Clearly, a FIA would not be suitable in this situation because she needs the asset to be 100% liquid in 36 months.
What is the bottom line? Annuities should never make an owner feel locked in. If so, the financial strategy work has not been designed properly. This is where having a competent advisor pays off.