You’ve probably seen many of these ads, but why are you seeing so many now?
For the most part it’s because you’re thinking of retirement or about to retire. But one of the biggest mistakes you could do is buy into something that you’re not 100% sure of. Because these mistakes can actually put you in the hole for years.
Income Annuities and the Unwritten Truth
So what do we mean about misleading annuity advertisements?
If you see anything with guaranteed rates of return, like 5% or 6%. Most of you probably think that it’s too good to be true, and for the most part, you would be correct. If you thought that your actual money will be growing 5% or 6%, you would be wrong. .
But the company does give you a 5% or 6% guarantee, it’s just on something completely different. They give it to another count that is made by the company.
You see, it would be illegal to guarantee stock market returns, but it’s completely legal to guarantee something that the insurance company provides, because the market and the company are two separate entities.
It’s not a lie when you see that they say they can guarantee something, but it’s guaranteeing that your income account will grow by at least 5 or 6%.
For many of you, you’re probably thinking, what the heck is an “income account”?
To put it simply, annuities were originally designed to pay out people for the rest of their life. Social Security and Pensions are fancier names for an annuity. But for annuities to work, you have to drop in large sums of money for it to work effectively.
What the insurance company does is they take that money you drop in and tell you that they’ll be able to give you a portion of that money for the rest of your life (and spouse if you choose that option). Usually if you live past a certain age, you’ll have actually taken out more money than what you put in.
But back to the main question, how and what does the income account do?
If you drop $100,000 into an income annuity. You’ll have two accounts, your actual account value and income account value, your account value is what is actually invested in the market, as well as where you need to take personal withdrawals from. The income account is where you get your guarantees from and for most companies, they guarantee that your income account will not go down.
So as the market goes up or down, your account value will go up or down, but your income account will only go up. Either by the guaranteed percentage or because the market performed well.
In the end, there will more than likely be a gap between what your account value is and what your income account is. I.E. You actually have $150,000 in your account but your income account states $175,000. The insurance company will then base your income off the income account and not the actual account. So when you read that they have an annuity that guarantees 5% or 6%. Know that it does guarantee a certain return, but it’s only for your income account.
Accumulation Annuity as an Alternative
So what about annuities that guarantee that your account will never lose money? And it’s not an income amount, but your actual money.
That’s true as well. Again, it’s illegal to guarantee stock market returns, but the insurance company can guarantee you something.
These annuities work off a crediting system. Your money isn’t actually in the stock market, but it’s being held at the insurance company. What they’ll allow you to do is take credit off the performance of the fund, usually an index, and apply it to the account that is being held at the insurance company.
What they’ll do next is credit your account positively whenever the market goes up, or nothing if the market goes down.
Sounds great right?
Again there are negatives, based off of something called a participation rate and cap rate.
Cap rates are the most you can earn in that year or in the contract, based off the language inside the contract. A simple example is if the annuity states that the annual cap rate is 10%, that means the most your money will be credited at the end of the year is 10%, so if the market finished at +15%, you’re only going to receive 10%, and the company receives the extra 5%.
One side note, all annuities have a surrender period, meaning that you cannot access the money for a certain duration, whether it’s 5, 10, or 15 years. So if the annuity states that the cap for the entire contract is 30% and it’s a 5 year annuity. It means that by the end of the 5 years, if the market ended up doing more than 30%, the company will take the difference.
The last thing about these annuities is the participation rate. Remember how this is based off a crediting system? Well a participation rate is how much they’ll credit you based off how much money you have in your account. For example, if the participation rate is 80%, if you invest $100,000, they’ll treat your account as if it only had $80,000.
So if the market went up 10%, you wouldn’t $110,000, you would see $108,000. Because 10% of $80,000 is $8,000.
You want to be careful with when these annuity ads state something that sounds too good to be true, because there’s always a caveat.
On the same note, annuities are still great investment vehicles for those who want security or income for life.