The annuity reset secret revealed


There still seems to be many financial professionals who do not understand the true power of annual reset within an annuity. 

I can still recall a conversation in 2003 with a Raymond James advisor who had just heard about annual reset for the first time (pre 05-50 and 151A of course). The advisor and I had covered a few different market scenarios and how each of them would play out in regards to an annuity with annual reset. 

At the time, the most influential example of the magical power of annual reset was the bursting of the dot-com bubble in 2000 and 2001 and assuming a purchase date at some point in 1998. 

For example, the first year in your new annual reset annuity, you got to lock in your gains in 1998 based on your annuity cap. (Keep in mind we were selling 12 percent and 14 percent annual caps back in 2003 so the power was even more apparent.) 

And then you locked in your annual gains in 1999 as the market went up again. Of course we all know in 2000, our ever-hot technology bubble burst and the gains went screeching to a halt. “However, Mr. Advisor, this annuity just took a zero for the year.” 

The same thing happened in 2001 and then happened again in 2002. However, in 2003 when the S&P started to rise, we locked in the gains for that year right on top of the previous gains from 1998 and 1999. 

While some were playing “let’s pray I can get back where I started,” we were building on what we already had locked in and never had to recover from any losses. And Mr. Advisor, keep in mind we are still at a lower S&P 500 index value than we were when we purchased this annuity. 

I distinctly recall the moment it clicked. The questions stopped, and he said, “Thank you so much for opening my eyes.” 

He began to call some of his retired clients who he thought might be a fit with a small portion of their retirement money. That particular advisor ended up being one of my top producing advisors throughout the country that year. 

Fast forward to today, and there still seems to be many financial professionals who do not understand the true power of annual reset within an annuity. And not just the fact it locks in your gains each year and protects you with a flat return when the market is down. There is actually a little more magic that our annual reset feature bestows on its lucky recipients. To what could I possibly be referring? 

Although I won’t reveal the secret just yet, a benefit not mentioned above is the power annual reset annuities have in regards to deferring taxes in an increasing tax rate environment.

With high unemployment, out of control national and state debt, and a government who believes its job is to spend our way out of a deficit, there is nowhere for taxes to go but up. The only questions are when and how much?

As most financial professionals are probably aware, one of the key benefits to annuities is tax deferral. So as rising tax rates will most likely affect everything from state and federal income to capital gains and estate taxes, our annual reset annuity shields us from the tax implications as long as we hold it in deferral. 

To summarize, our friend annual reset is not only locking in our gains each year with our annuity, it is also ensuring that we get to defer our taxes to a time when we feel ready to pay them. But of course, tax deferral comes with all annuities regardless of annual reset or not. 

So what is this big secret that most financial professionals and consumers either don’t know or overlook when it comes to annual reset within an annuity? The secret lies within the market’s negative years when the client has to take income. 

This might be due to required minimum distributions or a regular free withdrawal to supplement their income. Let me explain. 

A popular discussion in our industry is talk about average rates of return.

“Some years you might be up 15 percent, some years you’re down 15 percent, but on average, the market should get about an 8 percent to 9 percent rate of return over the years.” 

I am sure everyone reading this has heard the expression before. Well, that can usually work while a client is younger and still in the accumulation phase of life. In their 30s, 40s and 50s, they are earning their best income and they can almost afford to play the averages because they’re not taking any income out. 

But what happens when they start withdrawing consistent income out of their portfolio every single year regardless of whether or not the portfolio’s performance is positive or negative? 

Here is what happens for both RMDs and free withdrawals. When your clients withdraw income every year during retirement, it makes the bad years much worse, and can make the good years not nearly as good. Still need convincing? 

Think for a moment about what happens to their $100,000 retirement balance if they lose 30 percent of their account value in a down economy at the same time they withdraw $5,000 as income for the year. Their portfolio balance would go from $100,000 to $65,000 in one year. 

Now this is typically when they try to convince themselves to stick it out because they believe that the market will come back and average out with the next big rebound year. Let’s see what really happens. 

Let’s say for hypothetical purposes that the market actually does rebound the next year. Not only does it go up, but it goes up 30 percent in one year. So their $65,000 retirement balance has a 30 percent rebound return the very next year. Are they really back up to where they started at $100,000? Did the averages really work out like they thought they would?

Not even close. One of the key points they forget to remind themselves is that they are retired now. They don’t have a paycheck from their employer anymore. They are completely dependent on their retirement income to provide for buying health insurance, food, and paying their mortgage and electric bills each year. So they still need to withdraw income from their portfolio this year, and the next year, and the next year. 

How many retirees do you know that have the luxury of shutting off their monthly income for a couple of years to allow things to rebound first? Certainly not too many. 

So let’s go back to our $100,000 example. Assuming their current $65,000 participates in a 30 percent rebound the following year, let’s see how everything will “average out.” 

An amount of $65,000 receiving a 30 percent gain would temporarily bring their retirement balance back up to $87,750. However, once they subtract their annual income of $5,000 for bills and living expenses, they are back down to $82,750. That is almost an 18 percent reduction of their life savings in only the first 24 months of retirement. Does that instill peace of mind for a 62-year-old with a 25-year life expectancy? 

So how much better would they have been in an annuity with annual reset? Let’s look at it in detail. As I mentioned earlier, the market dropped 30 percent in the first year of the example. The great news with our annual reset is that we didn’t lose a dime. 

We still need to subtract the $5,000 for living expenses to give us a total of $95,000 at the end of the year. The next year the market has a skyrocket recovery of 30 percent. However, the client’s annuity is subject to caps. 

Let’s assume for illustration purposes that they had their money allocated to a 2 percent monthly cap and even though the market was up 30 percent, they only made 6 percent (to give “average it out option” the benefit of the doubt). 

Their $95,000 grows to $100,070 and after their $5,000 withdrawal; they are right back at $95,700. This amount is just shy of a 5 percent decrease in their life savings after two wild years. Much better than the 18 percent reduction they would have suffered in option number one. 

So what did we learn from this exercise? 

First, losses are always twice as powerful as the gains if you don’t have annual reset. If you have $100,000 and you lose 50 percent the first year, but then have a 50 percent gain the second year, you’re only back up to $75,000. 

Notice how it takes a 100 percent gain in order to offset a 50 percent loss? And that is assuming one is not taking any withdrawals for income. 

Finally, withdrawing income from a retirement account each year totally skews the average. There are few things that can destroy a retirement account faster than drawing income in the same year that the underlying investments are losing value. And although annual reset certainly can play a powerful role in protecting retirement nest eggs during bad years, the annuity is what will contractually guarantee lifetime income.