The Annuity That Pays You While Going to Zero
The hidden math inside guaranteed income annuities that most advisors never draw out on a napkin.
I sat down with a couple a few months back. Nice people, both in their mid-60s, both retired, both doing exactly what they were supposed to be doing. Saving. Planning. Working with an advisor for years.
They handed me a statement. A fixed indexed annuity with a guaranteed minimum withdrawal benefit they had owned for four years. I did the math in my head.
In four years, their account had gained $2,400.
Not $2,400 a month. $2,400 total. In four years.
Their income was coming in right on schedule. The checks hit every month. But the account sitting behind those checks had barely moved in nearly half a decade.
This is the thing most people have never been told about certain annuities. The income can be real, and the account can be dying at the same time.
The Income is Real. The Asset Might Not Be.
Most people think of an annuity as one thing. It is not. The word “annuity” covers a range of products so different from each other that using the same label for all of them is almost misleading.
The one that catches people off guard most often is the guaranteed minimum withdrawal benefit, or GMWB. These products became popular in the early 2000s and were sold heavily through the 2010s.
The pitch was simple: put your money in, get a guaranteed income for life, no matter what the market does.
That pitch was accurate. The income is guaranteed.
Here is what the pitch usually left out.
The income is not being paid from your account balance. It is being paid from a separate calculation called an income benefit base. That base is what determines how much income you receive. In many products, that base rolls up at 6 or 7 percent per year, regardless of what the market does.
Sounds good. Now read the next part carefully.
The fee you pay every year is also calculated against that benefit base, not your actual account balance. That fee typically runs between 1.5 and 3.5 percent annually.
So, your benefit base has been rolling up at 7 percent for 8 years and is now sitting at $300,000. Your actual account value is $180,000 because the market had a few flat years and fees have been running 3 percent against the inflated number the whole time.
You are paying $9,000 a year in fees against an account worth $180,000.
That is a 5 percent fee drag on your actual money. Before you take a single dollar of income.
Where the Balance Goes
Once income begins, the account faces pressure from three directions at the same time.
The income distributions are going out. The fees continue to run against the inflated benefit base. And market gains have to be extraordinary just to offset both headwinds.
The result is predictable. The account balance trends down. Not always quickly. But the direction is not ambiguous.
These products are often illustrated out 15 years before the account reaches zero. That is not a flaw in the modeling. That is the design.
The insurance company planned for the account to eventually hit zero, at which point the insurer simply continues paying the guaranteed income directly, converting the policy into something closer to a traditional annuity.
The product did exactly what it was designed to do.
The problem is that most clients did not know what it was designed to do. They thought they had a growing asset behind their income. They had a shrinking one.
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The Reaction That Tells You Everything
I have had this conversation with a handful of advisors over the past year who had never seen a registered index-linked annuity, or RILA. The reaction is almost always the same.
I explain that with certain RILAs you can get 115 percent of the upside of the S&P 500, no fee, with a buffer that limits your downside exposure. The advisor looks at me like I have suggested something illegal and says something along the lines of: you are telling me clients capture more than the market gains, pay nothing in fees, and have downside protection built in.
I am not very bright, but I knew that was an unbelievable rate the first time someone explained it to me.
The answer is yes. And the reason it works is that the insurance company operates at an institutional level, using options contracts and structured products that are not available to retail investors.
They can do this at a scale that makes the math work. It is the same concept that allows a life insurance company to invest policy premiums into private equity and commercial real estate and then pass a dividend back to policyholders.
They have hundreds of billions of dollars to deploy. They get access to investments you and I cannot walk across the street and buy.
The RILA passes some of that institutional access to the client. 115 percent participation. No fee. A buffer on the downside.
This is not the same product as the GMWB sold in 2009.
Same Three Weeks, Two Different Outcomes
The wife of the couple I mentioned owned her own account. She had been in index funds inside her IRA, and the volatility had worn on her. After talking through her options, she moved a portion into a RILA with 115 percent upside participation and no fee.
Her husband moved out of the GMWB and into the market.
Three weeks later, he had gained $11,000. She had gained $9,600 inside her RILA.
Two different vehicles. Both moving forward. Both of them breathing easier than they had in months.
Here is the thing. Neither of them was necessarily wrong to own what they had originally. The GMWB solved a real problem at the time. The income guarantee gave them peace of mind, and the checks came in every month without fail. That part worked.
The problem was the expectation. They thought the account was growing behind the income. It was not. Nobody ever drew it out on a napkin for them.
They also thought they were going to need that income every month, they don’t. This allows them to save the money on fees and distribute what they want when they need it.
Not All Annuities Are the Problem
The instinct after a story like this is to conclude that all annuities are bad. That is not the point.
Some annuities are excellent tools for specific situations. A RILA for a pre-retiree who wants market upside but cannot absorb a 30 percent drawdown is a compelling option.
A fixed annuity in a high-rate environment can lock in a yield unavailable anywhere else. An income annuity for someone without a pension who needs a guaranteed monthly floor has legitimate uses.
The question is always: what problem you are solving and is this product actually solving it.
A GMWB solves the problem of guaranteed lifetime income. If guaranteed income is your only priority and you understand that the underlying account may go to zero over time, that is a legitimate trade-off for some people.
The problem is that most people were never told they were making that trade-off.
You cannot fix a problem you do not know you have.
Three Questions for Your Next Meeting
If you own an annuity and you have never had this conversation, bring these three questions to your advisor.
First: Is my income being paid from my account balance or from a separate benefit base? If there is a benefit base involved, ask to see both numbers on the same statement.
Second: What is the fee, and what is it calculated against? If the fee is charged against the benefit base rather than your actual account balance, do the math yourself.
Take the benefit base number, multiply by the fee percentage, and compare that result to your real account value. That is your actual fee percentage.
Third: Run the illustration out to year fifteen. What does the account balance show? If it goes to zero, that is not automatically disqualifying. But you need to know before you make any decisions.
The goal here is not panic. The goal is clarity.
A dollar you do not fully understand is a dollar you cannot protect.
The Pot That Keeps Dripping
There is a coffee maker in a lot of offices that has been running on the same pot since nine in the morning.
The warming plate keeps it hot. Coffee still comes when you pour. Nothing feels wrong.
Nobody notices until the last person reaches for a cup.
That is the GMWB experience for a lot of retirees right now. The income is real. The checks come in every month.
But the account behind those checks has been on the burner since 2007 or 2009, fees running 3 percent annually against an inflated benefit base while the actual balance has quietly gone from $300,000 to $180,000 to something approaching zero.
There’s absolutely nothing wrong with annuities in a financial plan if solution matches the goal. The problem is when people inherit an annuity that’s been drained over time.
It’s like going to grab the last cup and getting 25% of your cup full of coffee.
See you in a few days, cheers!
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