If you’re planning for retirement and you want to receive sustainable lifetime income beginning at a future date, deferred income annuities (DIAs) and fixed index annuities (FIAs) with income riders are potential suitable choices. These are the two types of deferred fixed income annuities that are sold by life insurance companies. The question is which one better meets your needs?
This isn’t an easy question to answer, especially if you don’t work with fixed income annuities on a regular basis. Furthermore, the answer to this question has become more complicated the last four years. While the choice is still driven primarily by one’s personal financial situation, and although FIAs with income riders continue to offer more features than DIAs (see FIAs with Income Riders vs. DIAs: Which is Right for You? – Part 1 of 5), changes in the variables used to calculate income payouts from FIA riders combined with increased income rider charges have reduced the attractiveness of FIAs with income riders compared to DIAs.
Reduced Income Payouts
When I first began writing about, and working with, fixed income annuities in 2009, there were a handful of DIA products to choose from. Income payouts from the ones that were available were sometimes greater, and were often less, than those from FIAs with identical premium amounts, premium timing, and income start dates. The presence of an accumulation value with growth potential combined with a flexible income start date with a FIA vs. an optional pre-payout return of death benefit and a fixed income start date with a DIA often favored FIAs with income riders.
Beginning in 2011, in response to declining interest rates, life insurance companies began reducing income payouts on fixed income annuities. This is easy to do with DIAs since insurance companies simply declare a new payout rate.
FIA Income Rider Payout Reductions Less Transparent Than DIAs
FIA income payout reductions have been less transparent than DIAs due to the fact that income needs to be determined as part of a side “income account value” calculation that’s separate and apart from a FIA’s accumulation value, with multiple variables coming into play. Carriers can pick and choose the variables that they adjust to achieve desired income payout results.
Assuming no additional premiums or withdrawals prior to the income start date, the variables include the following:
- Roll-up, or interest, rate
- Type of roll-up rate, i.e., simple or compound
- Roll- up rate term, e.g., 10 years, 20 years, age 85, etc.
- Availability of premium bonuses
- Inclusion/exclusion of premium bonuses in income account value calculation
- Lifetime income withdrawal percentages
FIA and DIA income rider payouts have also been reduced in the last year in response to IRS’ revised mortality tables with longer life expectancies.
FIA Reduced Accumulation Values
While FIA accumulation values have generally increased in recent years as a result of positive performance of stock market indices to which FIA interest crediting is tied, the increases have been diluted by increased income rider charges resulting from increased income rider charge percentages beginning in 2011. This is in addition to increasing income rider charges resulting from annual income account value increases.
Charges that were in the 0.65% to 0.75% of income account value range increased to 0.95% or more in some cases. Although it doesn’t affect income payouts, increased rider charges result in erosion of a FIA’s accumulation value and death benefit.
Furthermore, the income rider charges for some FIA income riders have the potential to double after a specified period of time. With one product, the carrier will declare a new income rider charge in year eleven with a maximum charge of double the original income rider charge percentage if you want to extend the application of the roll-up rate to the income account value for an additional ten years beyond the first ten years of the contract. Although you will receive a higher income payout by doing this, the accumulation value of your contact will be adversely affected.
Income Optimization is Still the Name of the Game
As stated at the beginning of this post, DIAs and FIAs with income riders are potentially suitable choices if you’re planning for retirement and you want to receive sustainable lifetime income beginning at a future date. While income payouts aren’t as generous as they were four years ago, income optimization is still the name of the game.
Income optimization needs to be driven by your targeted income start date and projected ongoing retirement income needs. Income payouts beginning at different ages with different DIAs and FIAs should be compared. Whereas one product might have the highest income payout beginning at age 65, this may not be the case if the income start date is deferred to age 75.
A DIA vs. FIA comparison should be done on an after-tax basis for nonretirement accounts. DIAs apply an “exclusion ratio” to the income payout for these types of accounts that results in the exemption of the portion of payouts attributable to a return of principal from taxation.
FIAs often have the edge In situations where you’re not certain when you will need your income due to their flexible income start date. Multiple DIAs with different income start dates can also provide income start date flexibility. Although most DIAs have a fixed income start date, some offer flexibility, allowing income to begin within a specified number of years before or after their contractual start date.
Side-by-side comparisons of FIAs with income riders vs. DIAs should always be performed in order to determine which one makes the most sense in a particular situation. Combinations of multiple FIAs and/or DIAs with difference income start dates and premium amounts can be used to dovetail with projected retirement expense needs while also providing diversification.