By John Rafferty
AnnuityNews
The 10-year treasury hit an intraday low yield of less than 2 percent during the week of August 15, and closed August 19 at 2.07 percent. At this pace, the “risk free rate” as we’ve known it for a half-century may soon be known as the “return free rate”.
That low rate is a reflection of confidence, or lack thereof. In addition, it is a reflection of the certainty provided by the Federal Reserve board of governors (the Fed) in their recent policy statement. In rare form, the Fed basically told the financial markets that they had no plans to remove the near zero rate policy they instituted in 2008 until at least the middle of 2013. For a major economic policy-setting institution like the Fed to essentially show their hand over the next 24 months is indeed rare. And it underscores both the severity of the current economic malaise and the need they saw for some certainty in one important area.
The certainty provided by the Fed is something of a gift for financial professionals and their clients, as it provides somewhat of a proxy for a crystal ball into what is likely to happen over the next couple of years, at least on the rate front. Absent a surprise string of consistent and powerful positive moves in leading economic indicators like employment, inflation, and manufacturing output, it’s reasonable to assume the Fed indeed does keep rates low for at least the next two years. Knowing that, where should pre-retirees think about putting some of their money to work?
With rates on bank products and traditional fixed annuities at historic lows, the relative value of the principal guarantees in index products is much stronger. For example, several years ago, when the going rate on five-year fixed products may have been around 5 percent, the opportunity cost of investing in an index annuity was fairly high. In the worst case scenario, earning nothing on the index annuity at the end of a five-year term would have been costly on a relative basis, since one could have earned $28,000 in a five-year, 5 percent guarantee product with an initial deposit of $100,000. Giving up a sure $28,000 gain for the prospect of potentially zero gain is a tough pill to swallow.
It’s a different story today, with the national average annual percentage rate on a five-year certificate of deposit at 1.45 percent, according to BankRate.com. At 1.45 percent, the total return on an initial $100,000 deposit over five years is $7,463, or roughly one fourth of the return from a 5 percent annual percentage rate. Giving up a sure thing — a guaranteed 7.25 percent cumulative return over five years with the CD in exchange for no upside potential, makes the prospect of today’s indexed annuities with living benefit riders look awfully compelling in comparison.
To make the comparison more apples/apples, let’s consider a ten-year term instead. Averaging the top ten 10-year CD rates from money-rates.com, which comes to around 2.7 percent, a $100,000 single premium would grow to $127,109 at the end of year ten. Compare and contrast that outcome with today’s crop of index annuities offering living benefit riders to help generate guaranteed, future lifetime income.
For example, consider an index annuity product offering a living benefit rider that includes a 6 percent rollup of the income benefit base, compounded annually. (The income benefit base is a feature that has no liquid cash value, but is used to determine the amount of guaranteed lifetime income). That same $100,000, which in a ten-year fixed product grew to a total of $127,109 at the end of the ten-year term, would instead generate an income base of $179,000 at the end of ten years in the index product just described. Again, this is not strictly apples to apples since the income base can only be used to generate income and is not accessible as a lump sum and should not be confused with the contract value. However, the income base of $179,000 can produce an income outcome that is not only 40 percent higher than the withdrawal from the fixed product, but it’s guaranteed for life so long as no excess withdrawals are taken.
Here’s how. If you were to take a 4.5 percent withdrawal from the fixed product’s $127,000 ending value, you’d generate $5,715 annually. The problem is that there’s no guarantee that those annual withdrawals won’t deplete the fixed product before the retiree stops needing income. But what about buying a single premium immediate annuity with the $127,109 ending value — wouldn’t that help even out the comparison? Not really. For a 70-year-old couple purchasing a joint payout, single premium immediate annuity with the $127,109, and including a 2 percent inflation adjustment (to be in sync with the annuity living benefit) – the initial income wouldn’t be much higher: $6,342.48. That’s still significantly less than the 4.5 percent withdrawal from the $179,000 index annuity value.
Assuming a 4.5 percent withdrawal percentage rate, the hypothetical index annuity product’s $179,000 income base would generate a guaranteed lifetime income of $8,055 a year, a 40 percent income improvement over the traditional withdrawal from a fixed product, and almost 30 percent more than using the $127,109 to buy a joint life SPIA. (Note: there is an annual fee associated with optional lifetime withdrawal feature, and this fee reduces the annuity contract value both before and during the income withdrawal phase. In addition, any withdrawals taken from the annuity will reduce the contract value.)
The icing on the cake is not only the higher guaranteed income stream. Some index annuity products also offer guaranteed growth of the income stream on an annual basis, to help stave off the long term erosive impact of inflation. Outside of Social Security and some pensions, are you aware of any other way to get a guaranteed lifetime income stream that: 1) has the opportunity to grow at a minimum guaranteed rate, in some cases 2 percent or more annually, and 2) still provides liquidity in case of an emergency need for cash?
This comparison of the powerful advantages of today’s indexed annuities in relation to traditional fixed products does not tell the whole story, however. The alternative is to invest in the equity markets and hope they do well in the time span between now and retirement. Those who ignore index annuity solutions like the one described in favor of equity investments may not be fully informed of their choices, or, even if they are fully informed, they are essentially betting that the equity markets will on a long-term basis deliver a better withdrawal outcome than the 6 percent rollup rate available in some annuity product living benefit riders.
Are your clients willing to make that bet today?
John Rafferty is vice president of marketing at American General Life Companies and offers a full line of life insurance, annuities, and accident and health products to serve the financial and estate planning needs of its customers throughout the United States. He can be reached at John.Rafferty@innfeedback.com. For Producers Only – Not for Dissemination to the Public.
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