How to easily understand fixed-indexed annuities. I joke around because insurance carriers are great at taking something so simple and making it complex, but picture this before we get started. Let’s say you’re on a road trip with your friends driving through the Mojave Desert. Everything’s great. No complaints. As the miles go by on your drive, if you are not careful, suddenly, your gas tank is close to empty. Sure enough, the next gas station is 100 miles away. Panic starts to set in, AC gets turned off, now all eyes are on the fuel gauge, but imagine this being you in retirement. All the cash left in your lifetime is almost gone and you are 80 now.

The fear of running out of money in your later years creates this constant state of worry. To avoid this, lifetime income annuities can act as that guaranteed quarter tank of gas, allowing you to get to your destination without having to constantly be looking at the fuel gauge. Fixed index annuities are a great tool to supplement pensions, to supplement Social Security. When you’re getting ready to retire and are in that red zone with 5 to 10 years away from retirement, it’s now time to think how to start converting assets into income.

We’re going to talk about the two different phases of the contract. The accumulation phase and the distribution phase. We’ll start on the accumulation phase where we’re going to answer 3 common questions I receive from my clients, what’s the expected rate of return? How does my liquidity work? What are the annual fees?

Now to answer the first one, expected rate of return. Fixed-indexed annuity contracts are built to replicate CD-like returns. If people are selling equity like returns, it’s time to be cautious. That said, we’re going to earn on this cash accumulation value side anywhere from 3% to 6%.

What about fees? How do these contracts work? Most of the time, there’s no cost inside these contracts. In other words, there’s no fees during both accumulation and distribution periods, which is great, right?

The third piece is liquidity. During the surrender charge period (5-10 years) you can access up to 10% of your cash free of a surrender charge or MVA fees, this ends after your surrender period and from then on you have 100% access to your cash. The other piece of your annuity is the future income account, it is only a ledger. This future income account is an accumulation of your initial cash, bonuses, and interest credits that you receive, this total accumulation is used to determine how your future paychecks are calculated. They take you total accumulation times a payout factor, when you decide to turn in income for life, and this is the starting income you will receive.

Day one of your Fixed Index Annuity, you’ll notice that the income values is drastically higher than the cash account value. That’s by design. Since the ledger account is artificial, they’re typically going to be an accumulation of premium bonuses, interest rate enhancements or roll up rates that are either guaranteed or performance guaranteed to amplify this account above the cash accumulation value. Remember this account determines the future income that you will receive, we want it to be the highest number in your annuity.

I mentioned earlier, there’s also a penalty known as a surrender penalty. Now these carriers are buying large duration bonds, so they’re at risk if you were to walk away from the contract early.  What they’re going to do is apply a small charge which will remain level in the first couple of years but then decline and go to 0 after approximately 7 to 10 years.  Should you not need income later in life and you want to walk away from the contract, there would be no more fees applicable, and you can take your accumulation value and walk away.

If we look at that example, if you put $100,000 into the cash accumulation value, you’ll have a $90,000 day one in terms of your surrender value because of the surrender charge, if you chose to cancel the contract. At the same time, you will have $125,000 in the future income value because you receive a 25% premium bonus when you start this annuity. Over time during this cash accumulation period, your cash is going to earn anywhere from 3 to 6%, but your future income account value will grow more based on your initial bonus and interest credits, it maximizes the Future income account value, to maximize your future income that you will receive. There comes a point, when you reach retirement, that you will activate the income for life.

What the insurance carrier is going to do is take the income value at that day before you retire, and they’re going to apply a withdrawal rate anywhere from 4 to 5%, depending on your age and if it’s single or joint life. What that’s going to do is initiate your first paycheck. This paycheck will increase over time based on the future credits you earn annually. Typically, it will increase and outpace the rise of inflation. What we have here is an increasing income on a depreciating asset that eventually goes to 0. But what doesn’t stop, that’s the lifetime income you’re able to receive from these carriers.

How do these insurance carriers guarantee this income that increases? It’s through the help of mortality credits. These insurance carriers are large enough that they know actuarial tables, they understand pooled risk, so you don’t ever have to worry about whether they’re going to pay it out. Your future income is dependent on the claims paying ability so it’s so important to work with an advisor that can write A-rated carriers, A-rated products, so that concern is eliminated from the discussion.

One of the questions we typically get is, this is great, I love guaranteed lifetime income, what about death benefits? I heard once that the carrier locks up my principal and if I die, they maintain and retain those dollars amount. With a Fixed index annuity there is a death benefit associated with the contract. Whether you die prematurely before you activated income or during the income payment stage. That death benefit is typically paid out in a lump sum or in a five-year spread option. Your beneficiaries get to choose the payout method.

Another question we get is tax treatment. You know, I love the increasing income, I love that it’s guaranteed, and I won’t outlive that income, how is it taxed? It is taxed as ordinary income on qualified accounts and on non-qualified accounts the interest earned is taxed. There is no capital gains tax, unfortunately, so this would all be calculated as ordinary income, whether it is qualified money or the earnings with after tax dollars.

Here is what I shared with you today. We talked about fixed index annuities in general, the accumulation phase, and the distribution phase. There is absolutely a need in everyone’s portfolio to provide additional paychecks to supplement pensions, to supplement Social Security, and worst case, eliminate the risk of running out of money in retirement. We don’t want to have you look at that fuel gauge in retirement and worry about if you’ll run out of money. Fixed index annuities are not as complicated as you may think. They absolutely can serve as a necessary, secure tool to supplement and provide security in your retirement portfolio. And this money will outlive you.

To make an appointment with Mel Samick to discuss safe retirement strategies, call 888-839-3536.