The mortality credit: It's what makes the income annuity different
It is the pooling of mortality that makes the income annuity different, and that is why they can make the guarantees that they do. The lunch ended with my CPA friend having a different point of view. Later that day he called me and asked me to show him my best carriers for income annuities.
I was having lunch last month with a CPA friend of mine. He was telling me his new plan for retirement, not because he wanted my advice, but because he wanted me to see how cool his projection system was. His system was smart, and it showed all of his investment history over a long period of time. According to his numbers, he would be able to retire in nine years. I reminded him that at a similar lunch five years earlier, he told me he could retire in seven years. So I asked him what had changed.
He said that his formula of projections is based on his own investments and his 10-year history of returns. Five years ago, he was averaging close to 10 percent a year over the prior 10 years, so the projection model showed a seven-year horizon for retirement. Unfortunately, the market had a “correction” and his new 10-year average was closer to 4.5 percent — so it will now take him longer to retire.
I listened to his explanation and then I asked him one more question: "Why would you have all your money at risk to try to earn 4.5 percent a year? Wouldn’t it be better to have a guaranteed 6 percent return that will guarantee an income you cannot outlive?"
Of course to him, that question did not make sense. In his mind, there is no way you can guarantee 6 percent in any vehicle (legally), and so he brushed me off. I took some time to explain an income annuity to him, but he was skeptical. He wanted to know what the insurance companies invested in and how. This is not an uncommon response when dealing with CPAs (or engineers). They want to know the “anatomy of the income” so they can dissect it and understand it.
Here is my take on the anatomy of the income in a guaranteed lifetime income annuity: All income is not alike. An income annuity is an effective generator of income. It can provide high levels of guaranteed payments that cannot be outlived. In fact, it would be difficult to find another strategy that can offer the amount of income that an income annuity produces, coupled with its high level of security and stability. The anatomy of income changes over time. Let’s look at a representation of how the payments of a guaranteed lifetime income annuity would look for a 65-year-old-man, based on a premium of $100,000, which produces an annual income of $6,500. So, how can an income annuity provide the attractive levels of income it does? An income annuity that is guaranteed for life is different in makeup than any other product on the market. It is the nature of the income payments that is different and can only be guaranteed by an insurance carrier. Guaranteed lifetime income annuity payments are comprised of:
Return of premium — Each payment includes the return of a portion of the original investment made by the policy owner.
Interest — There is a portion of each payment that comes from interest earned from the insurance company’s investment of premiums.
Mortality credit — Each payment includes income that is directly linked to the current age of the annuitant. This portion is known as mortality credit. While the payments remain the same, the proportion of the individual components changes over time. They start off mostly comprised of interest and the return of your premium, but the longer you live, the more the mortality credit comes into play.
What is mortality credit? A mortality credit is also known as the "mortality yield." With an income annuity, premiums paid by those who die earlier than expected contribute to gains of the overall pool and provide a higher credit to survivors than could be achieved through individual investments outside of the pool. This is the secret formula that makes the annuity sizzle.
Clients can easily understand the idea of mortality when we talk about life insurance. My CPA friend actually has a term policy that he bought from me. He pays $3,000 per year for a $2 million term policy. So I asked him: "How do you think an insurance company can afford to pay your family $2 million if you die and only asks you for a premium of $3,000?" He did not hesitate to answer: "They pool the mortality." (I told you he was smart.)
Income annuities work the same way. It is the pooling of mortality that makes the income annuity different, and that is why they can make the guarantees that they do. The lunch ended with my CPA friend having a different point of view. Later that day he called me and asked me to show him my best carriers for income annuities. Surprisingly he has invested some of his own money into the concept (not all of it), and since that lunch, he has referred me three different clients who turned into sales. Sometimes, one simple explanation can help you convince even the smartest of clients.