A hybrid income annuity is a catchy term used for the more technically accurate ‘fixed index annuity with guaranteed lifetime income rider’. I will admit that the catchy phrase is easier to type so we can go with that from here. But, before trying to understand how the hybrid income annuity works, you must first understand how a basic fixed index annuity works.
Essentially, an index annuity gives you the opportunity to capture a portion of market gains without the risk of losing your principle. Annuities are backed by conservative investments like bonds and treasuries. With an index contract, the insurance company takes the interest earnings on those investments and purchases an option in a market index. If the option turns a profit, the gain is credited to your account. If it expires worthless then nothing is lost. So, you can win but you can’t lose.
A hybrid income annuity adds an income rider component to this basic index annuity contract, and is designed to offer a future guaranteed level of income regardless of market performance. In addition to income, you will see options for an enhanced death benefit and long-term care riders. As layers are added it can seem to get more complicated but it’s fairly simple if presented properly. Let’s briefly explain each component in order to keep things organized.
- Guaranteed Lifetime Income– This is the level of lifetime income you will receive. There are really two guarantees here. There’s a guarantee that the level of income will increase by a certain percentage for each year of deferral and the guarantee that when payments start they will not stop or decline in amount as long as you are living.
- Enhanced Death Benefit– At death this benefit guarantees that your heirs will receive a greater amount of cash than would be available if just the account balance were paid out.
- Long-term Care Rider– This allows for a substantial increase to your guaranteed lifetime income amount in the event that you require long-term care assistance. Definitions, requirements and enhanced payment amounts will vary greatly between contracts.
Now that we have those defined I need to show how they all work together to create a hybrid income annuity.
For starters you have your initial deposit that grows as only a fixed index annuity can, which means you achieve interest credit according performance of a market index but cannot lose money in any given year.
Next you have the death benefit that is paid to your heirs when you pass away. This will equal either the enhanced death benefit amount or the account value, whichever is greater.
And finally we have the guaranteed lifetime income rider that accumulates for every year of deferral and is paid out on an age based percentage, guaranteed for life.
Let’s take a look at this plan in action… I assumed the purchase of a contract on January 1, 2001 and deferred for ten years. This happens to have been a wonderful time to have owned an index annuity as the volatility of that time period wreaked havoc on retirement accounts for most people. For this example I will use the annual returns from the S&P 500 including the following contract components that are essential for making all the calculations:
- Annual Index Annuity Cap Rate: 5%- indicates the maximum growth available in your account
- Income Account Value: 8%- each year of deferral, your future income benefit will increase by this amount regardless of account performance. Additional fees may apply.
- Enhanced Death Benefit: 4%- each year of deferral, your death benefit will increase by this amount regardless of account performance. Additional fees may apply
- Income Payout Rate: This is an age based percentage applied to the income account value in order to calculate your level of guaranteed lifetime income. Generally ranges from 3.5% up to 7% of the Income Account
- Long-term Care Rider: 2X Guaranteed Lifetime Income should you be in the need of long-term care assistance. This varies with every carrier but 1.5-2X is fairly typical.
Please note that this example is used for illustrative purposes only as availability of contract terms varies by state and depends entirely on current market conditions. We’ll assume the contract was purchased at age 56 and held to age 65. Please note that additional fees for some of these riders and benefits may apply but have been eliminated from this illustration for purposes of simplicity.
Here’s the table…
In the table above the colored columns indicate the different riders. This is where all the confusion starts but I’m going to make it as simple as possible… you will only get the value of ONE of these columns.
Notice that the Income Account Value column is not highlighted. I should not even have a $ sign on those numbers. You WILL NOT receive that in a lump sum or in any other way because it is not your money. It is simply an amount used by the insurance company to calculate the lifetime income amount shown two columns to the right.
If what you just read seems contrary to what someone else is telling you, then stop talking to that person because they are lying to you.
Here are the basics of what you can expect:
- If you decide to cancel the contract, you’ll get the account value less any surrender charges.
- If you die, your heirs will receive the death benefit.
- If you take the lifetime income benefit, you will receive the scheduled payment annually for life.
- If you qualify for long-term care, you will receive the indicated boost in lifetime income.
It’s hard to make it more complicated than that but apparently plenty of advisors do. Now, you must remember that if you begin taking lifetime income, your income payments will be deducted from your account value. Your account value may continue to grow in the market, but the balance will also be going down by any income payments taken.
However, even after you start the income stream, there will be a remainder account value and death benefit for a certain period of time, until your cumulative withdrawals deplete the account value and your payments are made fully by the Insurance Company. It is possible for you to still walk away with a chunk of cash or pass money to your heirs before that time, but as time goes by and the income payments are subtracted from both the death benefit and cash value, the account value dissipates.
These contracts have a definite place in the retirement portfolios of many individuals. They work very well for a variety of situations, but must be understood clearly in order to be used correctly. For case studies and to see how this type of annuity can work for you, please give us a call.