The Misleading “Guaranteed Rate of Return” on an Annuity

“Can you guarantee an 8% rate of return like the annuity salesman?”  I have had a variation of this question a hundred times in my planning career. The minute I get the question my blood starts to boil, hairs raise on my neck and I try to fight the urge to yell out, “You’re being lied to!” I calmly explain how this “guaranteed rate” is not what you would expect. You probably aren’t guaranteed anything, and in fact, can lose money on this product. People are shocked, or sometimes still confused how someone can tell them this if it isn’t true. Now, that’s a great question. This article addresses the biggest lie in finance, the “guaranteed” rate of return on annuities.

Of course, in the middle of writing this article, this advertisement below showed up in my inbox.

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Hopefully, after reading this article, you will know the truth behind the “guaranteed” rate of return on an annuity.

Annuity basics

There are many different kinds of annuities, but they all have a basic concept. You give a life insurance company money now, and in return, the insurance company gives you a lifetime stream of income. There are two types of annuities; immediate and deferred. A deferred annuity is just as it sounds. You give the annuity company money today, and you receive an annual stream of income later in life. Your income stream may start 3, 5, or even 10 years in the future. These are the most common types of annuities sold. Immediate annuities are just like deferred annuities, but you start an annual income stream now, as opposed to waiting. Almost all annuities sold are deferred annuities, and this is because of one big reason. Deferred annuities pay higher commissions to the annuity salesperson.

The cash or surrender value of an annuity

Deferred annuities almost always have two different values; an income account value and a cash surrender value. The cash value, or surrender value, is the most important value to the consumer. However, it is the income account value that has a high guaranteed rate of return. Let’s start off by talking about the cash or surrender value of an annuity.

The cash or surrender value of an annuity is the amount that is actually your money to withdraw. This is the reason most people are most interested in the cash value of the annuity. If I need my money now, how much do I actually have? This is your cash or surrender value. However, the cash value is almost never guaranteed. Also, the cash value typically has huge surrender fees if you take the money out early.  Many times this surrender fee will exceed 10% of your account value and last for over 10 years. This is the reason the Financial Industry Regulatory Authority, FINRA, issued a warning about how you can actually lose money in a product “guaranteeing” a high rate of return.   

The amount that your cash surrender value goes up, or down, depends on the type of annuity. Variable annuities are typically invested and the cash value of your annuity can go up and down. If the investments in the variable annuity go down, so will your cash surrender value. Yes, that “guaranteed” annuity that you were promised, can actually lose money. Equity Index Annuities (EIA) or Fixed Index Annuities base their cash value on the performance of an index. For example, you may return 60% of the S&P 500 index in a given year. Also, sometimes they have floors in which you can’t lose money in a year. If a fixed index annuity sounds too good to be true, it probably is. For more clarity on fixed index annuities, read my article “5 Reasons to Avoid Fixed Index Annuities”.

As you can probably tell, however, there is no guaranteed rate of return in either of these products. In fact, in both products because of high surrender fees, you can lose money. So much for your guaranteed 8% rate of return. So, what is earning this hypothetical 8% rate of return?

The guaranteed income account value or withdrawal rate

So, how does an annuity company get away with claiming a “guaranteed” 7 or 8% rate of return? Because typically there is a part of the annuity that is growing by 7 or 8%. However, it’s not what you would expect, and you will never be able to withdraw this money all at once. I mentioned before that there are two parts of an annuity; the cash value and the income account value.  The cash value is typically what is important to you, however, it is the income value that actually has a high rate of return. However, once you do the math, the rate of return is actually pretty ugly.

So, how does the guaranteed income account value part of the annuity work?  As I mentioned, an annuity is really a contract between you and an insurance company.  You give the insurance company money, and in return, they provide a steady stream of income at a later date.   This is the most common type of annuity, called a deferred annuity. The amount that the annuity company guarantees, is called the guaranteed income account value or guaranteed withdrawal rate.  Typically, you will get either 4%, 4.5%, or 5% of the income value per year for the rest of your life. For example, let’s say that you give an annuity company $100,000 and the annuity “guarantees” an 8% rate of return. In 10 years, the income account value would be $180,000 (this is typically not compounded interest) and if the withdrawal rate is 5%, you would get $9,000 per year for the rest of your life ($180,000 multiplied by 5%).  

As you can see in the above example, the income account value is growing at 8% annually, however, you will never see that return. After those 10 years, you can’t call the annuity company and ask them to send you the $180,000. This is really a fake value, in which your lifetime income is based on. No, you aren’t getting a true 8% rate of return in your money. In fact, you may not even see a quarter of that return.

The ugly math behind a guaranteed 8% rate of return

The income account value of the annuity is growing at 8%, however, that is not your money to withdraw.  You can only collect an annual stream of income. For an explanation of the columns and terms, see below.  

A few assumptions. $100,000 annuity, 8% annual growth, non compounding interest (yes, this is common), 5% withdrawal rate, death benefit for heirs, income begins 10 years from annuity start date. The death benefit is your initial premium minus principal payments received. Read later how this isn’t as beneficial as you may think.

Year Income Account Value Annual Cash Flow Total Cash flow Annual Rate of return
0 $100,000 $0 $0 0.00%
1 $108,000 $0 $0 0.00%
2 $116,000 $0 $0 0.00%
3 $124,000 $0 $0 0.00%
4 $132,000 $0 $0 0.00%
5 $140,000 $0 $0 0.00%
6 $148,000 $0 $0 0.00%
7 $156,000 $0 $0 0.00%
8 $164,000 $0 $0 0.00%
9 $172,000 $0 $0 0.00%
10 $180,000 $9,000 $9,000 0.00%
11 $180,000 $9,000 $18,000 0.00%
12 $180,000 $9,000 $27,000 0.00%
13 $180,000 $9,000 $36,000 0.00%
14 $180,000 $9,000 $45,000 0.00%
15 $180,000 $9,000 $54,000 0.00%
16 $180,000 $9,000 $63,000 0.00%
17 $180,000 $9,000 $72,000 0.00%
18 $180,000 $9,000 $81,000 0.00%
19 $180,000 $9,000 $90,000 0.00%
20 $180,000 $9,000 $99,000 0.00%
21 $180,000 $9,000 $108,000 0.37%
22 $180,000 $9,000 $117,000 0.72%
23 $180,000 $9,000 $126,000 1.01%
24 $180,000 $9,000 $135,000 1.26%
25 $180,000 $9,000 $144,000 1.47%
26 $180,000 $9,000 $153,000 1.65%
27 $180,000 $9,000 $162,000 1.80%
28 $180,000 $9,000 $171,000 1.93%
29 $180,000 $9,000 $180,000 2.05%
30 $180,000 $9,000 $189,000 2.14%

Guaranteed Income Account Value:  This is the value that is growing by 8% annually, but this isn’t really your money.  You determine your annual cash flow by multiplying the Guaranteed Income Account Value by the withdrawal rate, which we assume is 5% in the example.  As you can see the Guaranteed Income Value grows each year by 8%, but stops once withdrawals are started. Another misleading part of the “Guaranteed 8% rate of return” claim, is that even the income account value stops growing when distributions are started.

Annual Cash Flow:  This is the income that the annuity generates each year.  This is an example of a deferred annuity, which means that the income doesn’t start for a predetermined amount of time after you purchase the annuity.  I have seen this start as early as 5 years and as long as 10 years. The older you are when you start the annual cash flow, the higher the withdrawal rate.  In this example, we use a 5% withdrawal rate, but I have seen this number be anywhere from 4% to 6%, depending on your age when you start the annuity.

Total Cash Flow:  The amount of total income you have generated from the annuity.  Want an ugly number? It takes 21 years to breakeven on this annuity.  Meaning that you don’t get your $100,000 initial investment back until you have owned and collected income from the annuity for 21 years.  Pass away before you own this annuity for 21 years, and you may not even get back your initial principal. That leads us to the next, really bad investment returns number.  

Annual Rate of Return:  This is your annual return given the initial investment and amount of cash flow that you have received. I only went out 30 years, because typically annuities don’t last this long. Most annuities don’t allow you to turn on a yearly stream of income until after age 65. If you start earlier, you will probably see a much smaller distribution rate than 5% annually.

A few notes on the annual return:

    1. You will see that you earn 0% for the first 20 years of this annuity. Essentially, if you were to die within 20 years of starting this annuity, you would never get your principal back.
    1. However, the reason the return is 0% is that I mentioned that this annuity has a guaranteed income rider. This means that if you don’t collect all of your principal back, the remaining principal will be distributed to your heirs. This is sold as a benefit, but think how awful having a 0% rate of return is after 20 years. However, without this rider, you (or really your heirs) can end up actually losing a ton of money on this annuity.
    1. After 30 years of having this annuity, you would have earned a grand total of 2.1% annually. This is awful. How bad is it? As of this writing, you could buy a 30 year U.S. Treasury Bond, one of the safest investments in the world, for 3.0% annually.
  1. Remember, how you were being guaranteed an 8% rate of return? How if I told you that you would get about a quarter of that, and it would take holding this investment for over 30 years to get much of any return.

So, I should never buy an annuity, right?

Yes, the numbers are ugly and there is a really good chance that the annuity salesperson is misleading you. However, an annuity may actually make sense in your situation. Here is the situation in which purchasing a deferred annuity may make sense:

    • You are 5-10 years from retirement. Don’t make the mistake of buying a deferred annuity at retirement, and have to wait 5 to 10 years to start collecting income.
    • You have other investments and would like to have a steady stream of income in retirement.
  • You are looking for a low risk, low return investment in the years leading up to retirement, with the option to have a steady income in retirement.

Annuities are the perfect example of, “If it sounds too good to be true, it probably is”. Most people know that there is no such thing as a guaranteed 8% rate of return, with no downside. However, that is exactly how annuities are sold. In fact, the returns are typically a fraction of this guaranteed rate. If any financial advisor guarantees a 7 or 8% rate of return run, don’t walk as fast as you can. There are plenty of us advisors that won’t mislead you in order to receive a high commission.

Disclaimer:  I’m a financial advisor, but probably not your advisor and don’t know your complete financial picture.  Therefore, please use this as education only and I strongly suggest talking with your financial advisor or tax preparer before implementing any of the above strategies.

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