How do Annuity Income Riders Work?
Annuity income riders are among the most popular and most misunderstood features on today’s annuity products.
What makes them popular
Income riders, also known as guaranteed lifetime withdrawal benefits (GLWB) or guaranteed lifetime income benefits (GLIB), are optional add-ons to annuities that offer another method of generating a lifetime income stream.
Using an income income rider is similar to annuitization of your contract with one key difference: You retain access to the principal in the annuity. An annuity paired with an income rider becomes almost like a bank account in that each income payment from the rider is deducted from the annuity’s account value. However, even if the account value falls to $0, the insurance company must continue to pay the contractual income amount. The annuity’s account value will also continue to earn interest during the income phase.
Another major difference between income riders and annuitization is that an income rider allows you to turn off the income stream after you’ve started it. So if you receive money from another source and don’t need the rider income for a few years, you can stop it and preserve what’s left of the account value. Then when you do need the income, you can turn it on again. Keep in mind some carriers may limit the number of times you can do this over the contract’s lifespan.
Some annuity carriers even provide for the income to substantially increase in case the annuity owner is confined to a nursing home, further sheltering the annuity owner from risk.
What makes income riders misunderstood
Much of the confusion regarding income riders relates to the roll-up rate. This is the percentage the rider’s value grows each year. To fully understand the rider’s roll-up rate, you should realize two characteristics of the income rider value.
First, the value is completely separate from the base annuity’s account value. The two values will begin with the same number: the amount of premium you pay into the contract. So if you give the insurance company $100,000, both the annuity’s value and the rider’s value begin at $100,000. But they will more often than not have two different rates of growth, especially if your annuity is a variable or indexed annuity because income riders always grow at a fixed rate.
Second, unlike the main annuity’s account value, the rider’s value is just that: a value. It is not an account you can access. You can not take free withdrawals from the income rider and you will never be able to receive a lump sum of the income rider value.
So when insurance companies or agents talk about the roll-up rate, they are simply referring to the annual rate of growth of that value. This roll-up rate can be either compound interest or simple interest. Some buyers mistakenly think their “money” is growing at 6 percent or 7 percent guaranteed each year when in fact it’s just the value of their annuity’s income rider.
Annuity buyers also need to know how long the rider’s roll-up rate is guaranteed for. Some will guarantee the rate for as long as you own the contract. Others might guarantee the rate for, say, 10 years, after which the roll-up percentage may decrease.
More important than the income rider’s roll-up rate is its payout rate. The annual payout you receive will be a percentage of the income rider’s value at the time you start income.
For example, say you buy an annuity for $100,000 with an income rider that has a 7 percent compounded roll-up rate. You defer income for 10 years, at which time the rider has a value just under $197,000. If the payout rate is 6 percent annually, your lifetime income from the rider will be just under $12,000. Remember, that $197,000 is never available for lump sum distribution, although you retain access to the main annuity’s account value.
Like with annuitization, the older you are when you turn on the income stream, the higher your payout percentage will be.
Experts say buyers should focus less on the roll-up rate and more on the payout rate. In some instances, a rider with a lower roll-up rate will actual provide more lifetime retirement income because it offers a higher payout rate. The bottom line when comparing riders is to know how much income you can expect from the rider when you plan to take income.
Buyers should also understand that the income rider will carry an additional annual fee, typically around 1 percent of the account value.
Income riders on variable annuities
A common use for income riders is to attach them to variable annuities.
Variable annuities are the riskiest type of annuity contract you can buy. When you buy a variable you direct the insurance company to invest those funds in one or more subaccounts, which are mutual-fund like investments. Although they offer a greater potential income than fixed annuities, variable annuities do not guarantee your principal, interest, or income amount. The money in those variable sub-accounts will increase or decrease over time, depending on their performance.
You can hedge your risk by attaching an income rider. When you attach an income rider to a variable annuity, you are essentially creating two accounts: one that varies based on investment performance and one that grows at a guaranteed fixed rate. If the investment account grows at a higher rate than the rider’s guaranteed rate, the rider’s account will increase to that amount. If the investment portfolio declines in value, the rider account value will remain intact.
Experts caution two things about attaching income riders to variable annuities. First, many insurance companies will limit your investment choices when you attach an income rider. Second, variable annuities with income riders typically charge higher fees and offer lower payouts than fixed or indexed annuities with income riders because of the added investment risk the insurance company is taking on.