Episode #13 – Prepping for Income – Part 4

Where are we at so far

  • We’ve defined a couple of things
  • Pensions are all but history for most Americans
  • Accumulating assets for retirement is pretty much up to you
  • You better figure out how you are going to get a steady paycheck when you retire
  • Annuities can offer a guaranteed income for life

Have you ever looked at investing in an annuity?

It can be overwhelming. There are a lot of choices and some have many moving parts that it’s hard to decide which one is best.

In addition, I have to admit there are some bad annuities out there and worse there are some really bad annuity peddlers.

I call them peddlers because they really aren’t professionals and care more about what they earn then doing what’s best for the client. I know, pretty sad, but true.

Let’s dissect the annuity for a minute. I want to say from the outset that there really is no such thing as the perfect investment. Every place you could ever secure your money has some give and take. The important thing is that you get as close as you can to meeting your objectives, you should be okay.

Where we start is by identifying the three basic types of annuities.

Here they are:

  • Fixed
  • Variable
  • Indexed

Next, we want to identify characteristics that are the same in each of them. By the way, when it really gets down to it, the differences are in how they credit your interest or growth. For the most part, they are all trying to accomplish the same thing, even though their crediting methods are different.

What they have in common:

  1. They grow tax-deferred. All annuities grow tax-deferred until such time as you take it money out. You aren’t necessarily required to take money out, unless it’s owned by a qualified plan, such as an IRA where the government makes you take destitutions beginning at age 70 ½. This means you can defer the income taxes on the growth as long as you want.
  2. No upfront sales charges – The vast number of annuities have no sales charges to get in. This means 100% of your money goes to work. There are some variable annuities that have sales loads, so you’ll want to make sure you understand those charges if part of the annuity.
  3. Surrender Charges – Instead of charging a fee/load upfront most annuities have a surrender charge period. This means if you take money out of the annuity during the surrender charge period it could cost you. The surrender charge period might be as short as 5-7 years and as long as 20 years. Be sure that the surrender charge period lines up with your overall objectives. This is generally not an issue if you are using the annuity for lifetime income.
  4. 10% free withdrawal – As a general benefit, most annuities will let you take out up to 10% each year without a surrender charge. This is typically more than adequate for those looking for a bit of additional income and also want to keep their principal intact. It’s also nice for an emergency of some sort if you need to get at some of your money.
  5. The 59½ rule – The IRS will add a 10% penalty to ANY of the funds taken out before age 59½. This means you would be liable for the taxes on the growth and the penalty if you are not of age. The only time this penalty is not applied is to a single premium immediate annuity (SPIA). A SPIA is where you make a deposit and immediately begin taking income. There is no inside cash build up or “deferment” of taxes as income has begun immediately.
  6. Guaranteed Lifetime Income – The term for this is “annuitization” or “annuitizing” your annuity. One of the key strongpoints to an annuity is to be able to generate a guaranteed lifetime income without ever worrying about your next paycheck. Although it seems many people who own annuities manage their income stream by taking withdrawals each year without annuitizing. There are pros and cons to this that we’ll discuss as we go along. For instance, once you annuitize, there is no turning back you can’t change your mind. The paycheck is not coming and won’t quit until the predetermined time. However, you do not have to annuitize your annuity; you can take systematic or partial withdrawals each year as well.
  7. No Probate – An annuity bypasses probate at your death and makes transferring your assets more efficient and without courts interfering. Many people invest in annuities for that simple reason alone. Privacy, ease, no losses.

Those are some of the benefits that pretty much run through every annuity out there. As I said earlier, the crediting method is what really differentiates each one.

Crediting Methods

FIXED ANNUITY:  As you may have guessed by its name this credits a FIXED rate of return. Very similar to a CD each year the annuity company assesses it’s assets and where they are at and then sets a fixed rate for the year. You can get 1, 3, 5, and even as long as 10 year fixed rates.

There are typically no costs or fees in a fixed annuity. The annuity company sets the rate and makes a little bit more. After it pays you the company uses the difference to keep its doors open. By the way, you want a profitable annuity company. You want them to be there throughout your lifetime.

The problem with a fixed annuity right now is the low-interest rates it pays. Most of the time the rates are better than bank CD or Money Market rates, but still low. If interest rates do rise these can become more attractive.

There are still many investors who do not want to take any risk or chances are perfectly happy with the compounding of a fixed annuity, even at these interest rates. Think about the trillions of dollars still in CDs. CDs are taxed each year as well. A lot of that CD money will be passed on to heirs. An annuity can provide tax deferral on the funds. I mean why pay tax on money you didn’t use that year? Why not control when, if ever, you want to pay the tax?

You can hold a fixed annuity almost indefinitely without taking any income unless as stated earlier it’s in an IRA, then you’ll have to take distributions at 70½. So again, you can control when the taxes are paid.

And again, bypasses probate. Your annuity goes directly to whom you’ve named. Your beneficiary sends in a death certificate, the check is cut. A piece of cake!

VARIABLE ANNUITY (VA): The next annuity we’ll talk about is the variable annuity. As the fixed annuity described its “fixed” return, the variable annuity describes its “variable” return.

A variable annuity is made up of sub-accounts. What is a sub-account? It’s essentially a mutual fund. Most sub-accounts are managed by the same mutual fund companies and often with the same management and philosophy as the mutual fund.

Because the underlying investments are essentially mutual funds, you take the risk of the market. Will it go up, will it go down, who knows?

You bear the risk and you get the rewards.

There are some things about VA’s that you should understand as well. The fees can be quite high. There are normal management fees charged by the mutual fund company. Then there are advisor fees charged for portfolio creation and management. Then there are mortality and expense fees. Finally, some VA’s do a sales load on top of all that. In all, you may find VA’s have between 3-5% in fees each year.

Fees can obviously eat into the returns each year. If you happened to hit a VA on a good market year and the market goes up 10%, then you may only realize 5-7% depending on the fees being charged. Keep in mind that these fees are charged even in DOWN markets. You can lose money due to the market and then lose even more due to fees.

The other unknown is if the sub-accounts (mutual funds) will meet or beat the market returns. This is a subject for another time, but statistically, only about 4% of all mutual funds beat the S&P 500 market returns. Even then the ones that do, rarely repeat. Consistently picking the right fund that beats the market year after year could be quite a feat.

Most VA’s have a death benefit guarantee. This is possible because of the Mortality and Expense fee that is charged. The fee is typically 1.25% to 1.75%. What this does is guarantees that if you die and the market is down, your beneficiaries will at least get what you put in.

Suppose you put $100,000 into a VA. The following year the market tanks and your account value is now $75,000. If you were to die, your beneficiaries would at least get the $100,000 you put in.

When its time to take income you have the option to annuitize, just like any other annuity. Once you do this you effectively take your funds out of the market, as the annuity company now has to guarantee that income and will not take a further risk with the funds.

It’s not a big deal in that once you annuitize all you care about is the steady paycheck.

The real question is this, is a VA worth the risk? You have unlimited downside loss potential (except at death). You have to pick funds that you hope do at least as well if not better than the market. You have to subtract fees that can run as high as 5% against any market gains and even when the market goes down.

The final type of annuity is called an Index Annuity.

INDEX ANNUITY (Hybrid): Often times you’ll hear an Indexed Annuity referred to as a “Hybrid.”

The indexed annuity is more than 21 years old. Long enough to experience a few market cycles, including the massive market drop in 2008 and 2009.

This is really a simple concept but can be very confusing as well. Let’s start out with the simple concepts.

An indexed annuity is essentially a fixed annuity. You can’t lose, your account value can’t go backwards due to the market returns, and the underlying investment is guaranteed. Of course, the guarantees behind any annuity relies on the strength of the issuing company.

The difference in an index annuity is the returns participate with an INDEX, such as the S&P 500.

One thing to understand is that your money is never invested in the index. Your funds simply participate with the index.

Okay, so how does that work? To understand how this works you have to have a little knowledge about options.

Options can be risky and usually best left to those who understand them completely and how they work.

Let me explain it like this. Suppose you were driving along and noticed a piece of property you like. You go and talk to the owner and explain that you’d like to buy the property, but not for a year, and you may not be able to get the financing either.

You strike a deal with the owner. You work out an arrangement. You are going to pay him $1000 for an option to buy the property. In return, you lock in the current price and you have a year to buy the property.

If you decide to buy the property you must purchase it within the year. If you decide not to buy the property or can’t get the financing before the end of the year term, you lose your $1000 and walk away.

That is referred to as a buying a CALL option. You have the right, but not the obligation, to buy that property at the stated price, before a determined date.

You might ask how does an option work in an index annuity.

An Index Annuity is really a fixed annuity. The money is not invested in the market and your investment is not subject to risk.

The annuity company takes the fixed interest that they earn on the money, but instead of crediting you a stated interest rate for the year, they take that money and buy an option on an index.

Let’s suppose the annuity company can get 3% on the underlying investments and they were going to credit you 2.5% for the year.

They take the 2.5% and instead of putting it into your account they buy an option on the S&P 500. By the way, there are options on several indexes, but the S&P 500 is the most popular.

Okay so now what? Well, if the market goes up then you will participate with the market increase. If the market goes down the worst you can have is a flat year. You can’t go backwards if the market goes down.

The only money at “risk” is the interest from the underlying investments, not the investment itself.

Now, this is where it gets a bit complicated. You see in this low-interest rate environment there is not enough interest to purchase an entire option.  In other words, an option is much more expensive than the 2.5% interest we have to spend in our example.

If you or I didn’t have the money for the full price of the option they would simply say, see ya, come back when you have more dough.

Because the annuity companies deal with sizeable chunks of dough, the options dealers will “share” in the cost of the option. Again, this is a simplified example, but suppose we only had enough money to buy 50% of the option. Essentially the options dealer will put up the other 50% and then share in the profits 50/50.

In the end, you’ll see an indexed annuity have what are called CAPS, SPREADS, PAR RATES. All these are various ways to share in the option.

For instance, you may see a CAP of say 5%. This means is that you get all the upside of the index option up to 5%. The option dealer is taking the chance that the option will do better than 5% as he gets everything over 5%. Your return will have a CAP at 5%.

The other way to manage this is by using a SPREAD. In this case, the company may have a spread of say 2%. This means that the first 2% goes to the option cost and you get the rest. If the market goes up 8%, they take the first 2% spread and you get the other 6%.

Finally, PAR RATES. These are participation rates. Say for instance the participation rate is 50%. This means you will participate in the return. You get 50% of the upside. The market goes up 10% for the year; you participate up to 50% or 5%.

There are other methods and more coming out regularly. It’s a good idea to have someone you work with understand all these methods.

All the rates are dictated somewhat by the current interest rate environment. Since the annuity company is not taking a risk and investing your principal in the market, they can only use the interest earned.

If interest rates are high you will see caps, and par rates higher, and spread lower.

It’s also good to know that the option and market gains are not a profit center for the annuity company. They would love to see you get 100% of the market. Their hands are tied so to speak to interest rates as well.


Now we better talk about income riders.

What is an income rider?

It’s essentially a combination of both the accumulation phase of an annuity and the income phase of an annuity.

This rider starting showing up about 10 years ago, and now you see it as an option in just about every annuity out there.

Here is the gist of it.

It’s essentially a way to take income without annuitization. See, when you annuitize you lose control over your principal. That’s not a bad thing in a lot of situations as the intent for that money was to generate an income – an income you can’t outlive.

Annuity companies played with the payouts and mortality credits and came up with a way that you could get income, that you couldn’t outlive, and still have access to your capital. Of course, the income stream would go against your capital like any other investment.

Let me give you a 30,000-foot overview. There are several different ways companies go about this, but this will give you a general idea.

Suppose after you looked at all the options and benefits you felt the income rider was a good option for you.

Here’s what will happen.

During the accumulation phase, the annuity company will continually use two different calculations on your account. I often say they keep two sets of “books” regarding your annuity.

Here’s what I mean.

In one calculation, or on one set of books, the annuity tracks your actual performance. Suppose you chose an indexed annuity and it has a participation rate of say 60%. Remember this means if the market goes up 10% you would be credited 6%.

The other calculation would be the income rider. Income riders have an annual rate applied to them, no matter what happens to the actual account value. For this example, we’ll say that the income rider’s compounding rate is 5%.

This means that each year the income rider side of the “books” would be calculated at 5%. This set of books would be calculated at 5% no matter what the annuity actually credited.

For this rider, most annuities charge around 1%. Each year your actual account value is reduced by 1%. This will not affect the 5% compounding on the income rider side of things.

In the years where the index crediting was 0% on the actual side (remember in an index annuity 0% is your worst year) the income rider would still credit 5% on its side of the ledger.

Year after year you have two calculations, what actually was credited and the 5% income rider calculation. With each annual statement, you see both calculations.

Fast-forward 10 years and you are ready to take some income from your annuity. Now you get to make a choice. Which side of the ledger will you take your income, from the actual account value or from the income rider value?

Here is where it gets a bit tricky. You would probably assume that you would take income from the side of the ledger that had the most money in it. I would agree, that makes the most sense.

What if the market had 4 horrible years that produced no returns and yet the income rider continually compounded 5% every year over the same period of time, there is a very good chance that the income rider side would have a higher value.

Here’s how it works. Let’s assume we are completely out of the surrender charge period so you have access to all your funds without a surrender charge. Further, let’s assume you are over 59 ½ and you there are no penalties for withdrawal. Most likely you are past retirement age when you begin to take income anyway, so both those assumptions are reasonable.

You can take out as much as you want from your actual account value. You can take regular income. You can take a percentage out each year. You can take a specified amount each year. You can even annuitize to assure you will have a guaranteed income the rest of your life. The payout for annuitization is based on your account value, your age, and of course if you want to provide income for a spouse or children after your death.

On the income rider side, the annuity company will determine how much you can take out each year. If you are under 65 years of age the payout percentage is around 5-6%.  Over 75 you may get more than 6%.

By the way, do you remember what the “Bulletproof” Withdrawal Rate according to the Wall Street Journal? You got it, 2-3%. This is the rate that the WSJ says you can take and have a pretty good chance that your money will last your lifetime.

The thing you have to understand is in order to take full advantage of the income rider, you shouldn’t plan on taking your money in a lump sum, you should take your money out using the set percentage rate as income. Hence the name – income rider.

If you do want more than the stated annual percentage or you want to take a lump sum, then that will come from the “actual” account value, which then reduces the income rider calculation on future payments.

Let’s talk about an example.

Suppose we put $200,000 into an indexed annuity at age 55. Over a 10 year period, we were actually credited year after year an average of 6%. Which, by the way, is pretty close to what they’ve done.

On the other side of the ledger, the income rider was crediting 7% each year. In the end, we have two account values:

The Actual Account Value = $358,169.54

The Income Rider = $393,430.97

You are now out of the surrender charge period.

You can do anything you want with the actual account value. You can even take all your money buy an RV and cruise the country!

Let’s suppose that you decided to take your income out at the “bulletproof” withdrawal rate of 3%. That would give you $10,745.00 per year. This is a safe amount based on current economic conditions.

On the income rider side, they say that at your age, now age 65, you will get an annual payment of 5%. This would give you $19,671 per year. About $8,900 more per year.

Run that out over 10 or 20 years and it’s a pretty decent chunk of change.

One thing to consider is that if you take the payments set by the annuity company from the income rider, you are assured that your income will continue the rest of your life. You can’t run out of money!

You will get a payout or what I’ll call a “paycheck” every year even if you live to be 150 years old and have received much more income than was ever in your account.

It’s my opinion that the income rider calculation will most likely be greater than the actual account value. However, this means to take full advantage of it, you will need to make sure the income payment is sufficient and that you can live with the payouts.

The older you are the higher the income rider’s percentage may be. I’ve seen them as high as 6%-7% for someone 75 an older. That is twice as high as the bulletproof withdrawal rate and you are guaranteed to never run out of money, not a bad deal if income is your objective.

At death, some income riders will pay the balance of the income rider’s account value to your beneficiaries. If you started your income payments with $200,000 and over the years withdrew $100,000 and passed away. Your beneficiaries would get the remaining $100,000.

Some annuities will pay out the balance of the ACTUAL account value, so you’ll want to make sure you understand exactly what the death benefit guarantees are.

If you foresee needing lump sums and annual payments are out of the question or maybe you’ll need your money all at once after the surrender charge period, then the income rider is probably an expense you don’t need to incur.

Again, this is all based on your needs and your objectives.

You may want a couple of annuities. Maybe you have one with the income rider and one without. This will give you access to a lump sum and also a higher income payout on the other. It’s not uncommon as people approach retirement to have several annuities.

The bottom line is that at some point you will likely want a guaranteed income for life. An income rider can give you peace of mind and assure you that you will not outlive your money. This can be a huge relief to retirees who don’t have the ability to produce additional income.

Wrap up or the PreludeSummary:

So what is this all about?

In a word, it’s HAPPINESS

Retirement happiness seems to be the goal for most people, but what does that mean to you?

What is the purpose of saving all this money, maybe even sacrificing while are you putting away your money for later if you don’t have a plan?

Are you rolling the dice? Are you hoping it will all turn out? Hope is NOT a strategy.

Do you want to be happy during in retirement? What if I told you it’s not that hard, it’s not as painful as you may think to put a well-designed plan into action. In fact, it’s relief, a burden lifted, and peace of mind.

Did you know that 91% of those who have a plan have a better chance of lifelong happiness? In fact, there are even researchers who study lifelong happiness.

The research went on further and depicted those who have a steady paycheck tend to be happier in retirement versus those that have varying incomes.

In 2012 Time Magazine came out with an article titled – Lifetime Income Stream, Key to Happiness.

The cushioning effect of lifetime income brings in a satisfaction and happiness in life. Those that have annuitized income tend to be most happy.

Here’s a question. Answer out loud…Do you want to be happy or unhappy? Seriously, Do you want to be happy or unhappy? I hope you yelled HAPPY!

Let me refer back to the Wall Street Journal article that said the SECRET to happiness in retirement are:

Good Friends

Good Neighbors

And a Fixed annuity with Lifetime Income.

It went on and listed 7 keys points to a lifetime of happiness:

  • Value your time
  • Think ahead
  • Expect less
  • Pick your neighbors
  • Work at retirement
  • Invest in friendship

Do you want freedom? Get a steady paycheck.

Almost every conversation amongst retirees without a guaranteed paycheck is wondering how long will their money last?

I cannot stress enough the need to guarantee your retirement income.

Did you know that those with a guaranteed income that they can’t outlive, actually live longer? Seems no one wants to leave behind a steady paycheck.

I recently read a thought-provoking study containing evidence by both The Urban Institute and The Center on Society and Health[1], about how income and longevity play into a person’s overall happiness. The higher a person’s income, the longer, happier, and healthier their lives will be. Higher income = longer lives.

You all might be thinking, “Is it really as simple as that?” Well, check this out: “The greater one’s income, the lower one’s likelihood of disease and premature death.

  • Studies show that Americans at all income levels are less healthy than those with incomes higher than their own.
  • Not only is income (the earnings and other money acquired each year) associated with better health, but wealth (net worth and assets) affects health as well.

Retirees don’t live on ASSETS, they live on INCOME! Your assets can be lost, they can be stolen, swindled, sued, divorced, or decimated in a market crash. The ULTIMATE success of your retirement is not about assets. It is all about INCOME!

Time to plan?

Many people say they don’t have time to plan. Yet they spend 4 hours a day watching TV. They spend more time planning a vacation which lasts a week or two then for planning for the longest vacation of their life, retirement.

Some think they can just wing it, but that doesn’t work. There is too much uncertainty! Longevity can put a tremendous amount of strain on your investments.

A Hartford study called the Hartford Retirement and Investment Study in 2009.

In it, they found that many people just don’t like to plan.

They found that 1 in 2 Americans say that planning is too difficult.

35% said they don’t want to spend any more time on financial planning.

They also found that those that do plan for retirement income have 3 times more likely to be confident that they will have sufficient income during retirement.

Nearly 1/3 of those that planned said they were VERY confident about their retirement.

Why don’t we plan?

Some have good intentions but never get to it. The weeks, months and years go by and suddenly the day of retirement is here.

In the same study, they found that the volatility of the market especially after 2008 has made many feel like it’s hopeless.

Many are still recovering from 2008 and 2009. It’s depressing.

Optimism is in decline! Many have given up hope that they will ever be able to leave their employment and have adequate income.

There is also the likelihood that the huge burden is on you. As we discussed, 100% of the responsibility is on you, if you don’t have a pension and the pension is all but history. The 401k has replaced the pension and how it performs and the decisions you make are squarely on your shoulders.

However, any success you will have in retirement will begin with planning. And you know what? It’s not that difficult, but you’ll never know unless you plan!

How would you feel if you knew you had a paycheck for life? One that you could never outlive…

  • Peace
  • Comfort
  • Satisfaction
  • Worry-free

You may be fortunate to have plenty of assets to produce all the income you’ll need. The only thing that could throw a wrench in your plans is if you LOSE money. Protecting your assets that you can never replace is imperative, even if you have plenty of income.

No matter what you need to do, planning will give you peace of mind. It will give you the confidence you need to enjoy your retirement.

Do you know what a “just in case retirement is?”

When we are working we have all kinds of dreams when they retire. Join the country club, buy an RV, travel, go on cruise see the grandchildren, buy a boat, but they never get around to it. Why?

“Just in case”, “just in this”, “just in case that”. They live a Just In Case Retirement.

They live a basic and maybe even sub-standard life and leave all their money to their kids.

Then you know what the kids do? They go and buy the boat, go on a cruise, and join the country club and have fun spending your money.

There isn’t anything wrong with leaving your kids money, but there is a new thought process that now wonders “what leaving a bunch of money might do TO their children rather than FOR their children.”

Here’s a good question for you to think about.

If you could look down on your children 20 years after your passing, what must happen with your assets in order for you to be happy with your planning? How about 100 years?

How do you keep your net worth from poisoning their lives? What is the purpose of your wealth? Do they know what to do with the money?

How do you provide tools for your kids rather than toys?

How do you keep it protected from creditors?

Will the date of your death be the date of your children’s retirement?

This can all be addressed with proper planning.

Now this series of podcasts has revolved around a guaranteed income for life. The annuity being the best way to accomplish this as only annuity companies can guarantee your income no matter how long you live.

As we discussed there are 3 different types of annuities. Fixed, Variable, and Indexed. I would be less than honest if I didn’t say I had by bias towards one flavor over another.

When you lay out all the pros and cons, features and benefits of each one I think it will be easy for you too to find the one that works best for you.

There are latterly hundreds of annuities, each with a slightly different emphasis. There is no way you can research every one of these on your own. It’s time for some help.

We have resources available to us to crunch the mounds of data into a few that might work best for you based on YOUR goals for retirement.

Who knows if this is a good way for you to go, but I’d say, it’s at least worth exploring.

If you have plenty of assets, plenty of income, no need to protect your assets from risk, no issues with passing assets to your heirs, and are comfortable with where your funds are, then this probably isn’t a good fit for you.

However, if you are wondering where your income will come from, how long it will last, worried about the risk of loss, like having a plan for your future, you might want to contact us and see if any this makes any sense at all.

There is no need to try to cram a square peg into a round hole. If it doesn’t fit, let me be the first to tell you.

Finally, I’ve tried to give a talk in facts, in Math and Economics. This isn’t conjecture or speculation. There are some tried and true principals. There is real scientific evidence as to what produces a happy retirement.

Let’s talk about the facts, the math and economics and even the science behind designing a retirement for you.

That is the only way you’ll ever have a peaceful retirement and a paycheck for life.

That’s it for now…keep educated, keep informed, and be wise!


Acknowledgement –

There are many who have written and contributed over the years to this report. Tom Hegna being one innovative thinkers that I really appreciate. He wrote a book titled, “Paychecks and Playchecks” which is full of helpful content. Also, the Met Life Survey and other studies and articles from the various sources noted herein.

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