A 6% Guaranteed Return?

June 18, 2015

Would you like a guaranteed 6% return on your investments? Is that even possible? I recently got a helpline call from a woman who thought it was. Her advisor had suggested that she roll her 401k into an annuity that paid “a guaranteed 6% return regardless of what the stock market does.” She thought the only downside is that she had to leave the money in the annuity for 10 years and that there was a 1% fee so the guaranteed return would be 5% after fees.

That still didn’t sound right to me. After all, even 30 year bonds are yielding about half that so how could any company provide a 6% return with no risk after just ten years? After doing some more research, it turns out that she wouldn’t really be getting a 6% return on her investments. Her advisor had recommended a variable annuity that would grow or lose value based on the performance of investments within the annuity.

However, it also had a guaranteed “income base” that would increase by at least 6% each year. She could eventually choose to annuitize (exchange her account value for a monthly payment that would last as long as she lived) based on the higher of her account value or the income base. This provided her with a guaranteed minimum income regardless of how well or poorly her investments performed. That sounds great but there are a few downsides to consider:

1) Limited investment options. If she were to roll her 401(k) into an IRA, she could invest it in almost anything she wants. However, the annuity would limit her to certain sub-accounts.

2) Cost. The “guaranteed minimum income benefit” added a 1% fee on top of the regular “mortality and expense” fees for the annuity, which were more than 1%, plus probably another 1% or more for the investment management fees. That could easily add up to more than 3% per year and if she tried to take her money out early, she would have to pay a “surrender charge,” which typically start at 7% of the amount she withdrew.

3) No guarantee on account value. That might be worth paying if she would get a 6% or even 5% return on her account value but she would only get that guarantee if she chose to annuitize. If she wanted to withdraw her money, it would be worth whatever the investments returned minus all those fees.

4) No inflation protection. If she did annuitize, her annuity payments would not increase with inflation.

So did the pros outweigh the cons? It all depends on whether she might want to annuitize it since that’s the only way she would get any value from the guarantee she would be paying for. In her case, she already has more than enough money to retire with her Social Security benefits plus a less than 2% withdrawal from her nest egg. That means she could essentially live off treasury bond interest and/or stock dividends (which tend to grow faster than inflation) without even touching her principal. As a result, she decided not to purchase the annuity.

Does this mean all such annuities are bad? Not necessarily. I can imagine them being  a good fit for a conservative investor who’s worried about outliving their savings in retirement. The key is to do your homework and make sure you understand any investment before you purchase it…especially if it sounds too good to be true.