The pitch goes something like this:
“ You get lifetime income that you can’t outlive. We can get you 7% for the first 10 years and then you can make 5% for life…. guaranteed… no matter what the markets do.”
Or something to this effect. Wow, sign me up!
What’s the catch? Well, it’s HUGE!
The first thing to understand is the difference between your account value and what is termed something like benefit base or income base. And this is sold so wrong. I will give you examples under the illustration section. We are so used to being shown our account values that we don’t realized the subtle difference. So in very basic plain language here you go.
The benefit or income base is a number stated in dollars that is not money, much less your money and shown to grow by interest rates .
It is a number from which your lifetime income is based. You might think, “Well that’s OK, as long as I get a good income for life.” We’ll get to that.
The other number is your account value. This is your money. You are told you have to keep a certain amount of this money in the insurance company’s investments or asset allocation and the rest you can invest in funds just like a normal investment. “And if the account value exceeds the guaranteed value on the benefit base you will reset the benefit base to a higher number.”
The fees for this kind of account can exceed 4 to 5 %. The fees when charged are a percentage of either the assets in the account or the benefit base. But ALL the fees come out of your account value. So if the benefit base is guaranteed to rise 7% the account value has to do around 12% to keep up. Since most contracts force you into a moderate investment allocation there’s no way to do 12% every year.
Now watch this carefully. The moment the account value goes below the benefit base the annuity contract begins to cannibalize itself. The 2% per year fee for the lifetime income rider (or whatever the fee is) is 2% of the benefit base, which is contractually guaranteed to rise 7% (in this example). So the insurance company gets a 7% rise in fees each year regardless of market conditions and regardless of your account value. But the 2% fee on the benefit base becomes an increasingly higher percentage of YOUR MONEY (the account value) as the account value decreases. Then it can never catch up and your account value is lost. And over time you will lose your money.
“But never fear, your income is guaranteed regardless of your account value.” “Even if your account value goes to zero”. Did you catch that part of the pitch? And if you live long enough it will go to zero. Unethical sales people use ridiculous illustration rates to show you that you won’t lose all your money.
So ask yourself, is that a real good trade-off? In essence the insurance company is supplying you a decent lifetime income using your own money to do it. Reminds me of the scene from the Mask of Zorro where the bad guy governor of the region wants to buy Texas from Santa Anna using gold mined from Santa Anna’s own mines.
Another thing has to do with the continuing sleight of hand. One such illustration claims to give you 7% for 10 years. Again this is 7% of the income or benefit base which isn’t really money. But the rule of 72 says that money will double at 7.2% in 10 years. At 10% money doubles in 7.2 years. So the illustration showed a benefit base of $142,000 at the end of the ten years. Why? More lies. The 7% for ten years is simple interest not compound interest. It goes on and on.
Following are more “technically” written papers including a paper from the Certified Financial Planner folks. Enjoy the study.
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