Over the past decade, annuities with income riders have become favorites of the baby boom generation. Why not? They’re advertised as providing a “guaranteed yield” that’s several percentage points higher than Treasurys’ without jeopardizing principal. But don’t believe it, some experts say. They contend that much of the hype is not true.

Yet that doesn’t necessarily mean these products are a bad deal either.

The Basics
“Annuities are the only products on the planet that provide a lifetime income stream, an income you can never outlive,” says annuity expert Stan Haithcock, also known as “Stan The Annuity Man,” in Ponte Vedra Beach, Fla. “They solve for what’s called ‘longevity risk.’ You can know to the penny what your lifetime income stream will be”—which is ideal for future income planning.

When you attach an income rider, you gain a degree of flexibility over that income: You can delay it until retirement age, say, or turn it on sooner in case of an unexpected financial need. “You can shut it on and off,” explains Haithcock. “It makes sense for someone like me, who is 50 years old and plans on retiring at 65. I want 15 years of deferral.”

But make no mistake: Drawing down funds this way does affect principal. With income riders, you do retain control of the principal—it can be invested in a variety of ways which may or may not grow, of course, depending on market conditions. But it does not remain untouched.

What’s more, payouts from income riders are not, strictly speaking, yield. “This is a separate calculation on an annuity, an attached benefit that you have to pay for, for the life of the policy,” says Haithcock. You cannot transfer it or get money out of it in any other way, except as scheduled income. “On that side of the ledger, independent of however the principal performs, you cannot get to a lump sum or peel off interest. You can only use it for income,” he stresses. “People who don’t understand this could be in for a big surprise.”

Bonus Withdrawals
On the other hand, when a client needs additional cash—perhaps to pay for a medical emergency—there are provisions in annuities that allow additional withdrawals. Such extra payouts, however, come at a cost. Since the total lifetime benefit of the income rider is calculated at the beginning, any additional disbursements will impact principal and the future income stream.

“The access to principal differentiates income riders from traditional single premium immediate or deferred income annuities,” says Judson Forner, director of investment marketing at Akron, Ohio-based ValMark Securities. “The insurance carriers backing these income guarantees, regardless of whether these contracts are depleted, are what make them so powerful.” These insurance guarantees hedge against longevity and market risk and protect investors against market declines early in retirement, things the 4% withdrawal rule does not, he says.

In addition, there are income riders with enhanced benefits to give retirees an increased payout for chronic or confinement care, as long as the annuitant is unable to perform at least two of six “activities of daily living”—bathing, dressing, toileting, attending to incontinence and feeding and transferring out of or into bed. Unlike long-term care, which is a tax-free benefit for what’s typically a temporary need, confinement care may be permanent, and the benefits are taxable.

Another advantage of many income riders is that, if the annuity is an IRA, you can name a spouse as a joint recipient of the income.

Income riders do have disadvantages, though. First, they typically do not adjust for inflation or cost-of-living increases. Second, once you start receiving the income, it is not tax efficient. In general, it follows the “last-in, first-out” (or “LIFO”) accounting rules that apply to most deferred annuities.

“Any non-qualified gains built up in the contract are taxed as ordinary income,” says Forner. “Any return of after-tax basis is non-taxable. One exception is a variable immediate annuitization rider. … These riders provide an exclusion ratio to non-qualified withdrawals and are treated as an annuitized stream of income. All withdrawals from pretax, qualified contracts are taxed as ordinary income as well.” (To be clear, most income riders are not annuitized. They are considered “drawdown” products.)

When withdrawals are taxed as ordinary income, you won’t get capital gains or interest and dividend tax advantages. Another thing is noteworthy, says Forner: “Strong income riders may increase [required minimum distributions], thereby increasing one’s income-tax liability.”

Yet another tax consideration involves inheritance. When you die, the value of an annuity doesn’t get reassessed for tax purposes for your heirs, as other investments might. “You don’t get the step-up in basis that you’d get if you had the money in stocks that had appreciated,” explains Joe Tomlinson, an actuary at Tomlinson Financial Planning in Greenville, Maine. “So your heirs may end up with a bigger tax bill.”

High Fees
Tomlinson has other qualms about annuities, too. “The problem is, the charges are very high,” he says. “You can take, say, 5% each year for life. But if you add up the rider charges and all the other insurance charges, they can be as much as 3.5% a year or more, which really eats away the capital. If you had a mutual fund with annual fees of 3.5%, you would say that’s outrageous.”

Over the course of 20 years, observes Tomlinson, a $200,000 investment in an annuity with an income rider could easily cost you $140,000 in fees.

It is, however, a safe investment—akin to a CD. Both Tomlinson and Haithcock agree that it offers downside protection more than upside potential. “If that’s what it takes to get somebody into the market, then you could make the argument it’s a good thing,” Tomlinson acknowledges. “I just think it’s an awfully steep price. My general rule is, if there’s a lot of money going to the people who sell the product, then there has to be less money going to the customers who buy the product.”

In fairness, though, these charges are not entirely associated with income riders per se. “The cost of the income rider is usually no more than 1.5%,” says Benjamin G. Baldwin III, president, owner and lead advisor of Responsive Financial Group, a fee-only firm in Arlington Heights, Ill. “It’s the cost of the income rider plus the mortality and operating charges plus the cost of perhaps a death benefit rider and perhaps the separate mutual-fund accounts that are underneath the annuity that add up to 3.5%.”

Not A Bad Deal?
All in all, he says, that may not be such a bad deal to guarantee a certain level of retirement income. “It can actually substantially reduce the likelihood that someone will run out of money,” Baldwin maintains. It also does not preclude using additional funds for a more aggressive, or at least less expensive, portfolio. “In fact, knowing they’ve got their living expenses covered will enable some people to invest more wisely—to wait for markets to cycle to normal levels, for instance, so they can achieve greater returns,” he says.

Oddly, anecdotal evidence implies that most people probably don’t use their annuities for income. They either forget to switch on the income rider at retirement or don’t know they can. “There is quite a bit of inefficiency in the market in terms of how people use these things,” says Tomlinson. He concedes there are few if any reliable statistics. The problem, he says, is that agents “have an incentive to sell the product and earn a commission, but not to help the client make the most of it after the purchase.”

More Complex Than People Think
That’s unfortunate. As Baldwin says, this is a “complex product that people buy to take care of themselves in the future, when they may become less capable of managing on their own, and the person they are relying on to help them use it got paid up front and will be long gone by the time they need it.” Financial products—especially those designed to “be with someone for decades,” he says—should not be delivered via a commissioned sales structure.
“To me, it’s on the consumer,” says Baldwin. “If you’re not smart enough to understand what you’re buying, don’t buy it.”

Haithcock goes a step further. “These products are sold improperly,” he says. “They are being misrepresented every day, and they’re misrepresented ridiculously.”

That’s surprising, considering income riders are not new. They were first offered on variable annuities about 10 years ago but have been available on indexed annuities for the past seven years. “Today, most indexed annuities are sold with income riders,” says Haithcock. “And those income riders tend to offer a higher contractual guarantee than similar riders on variable annuities.”

Consequently, indexed annuities are gaining in popularity. As measured by the Life Insurance Management Research Association (Limra), total sales of variable annuities increased 4% year-over-year in the fourth quarter of 2013 while sales of fixed annuities jumped 45%. Tomlinson says insurers have been cracking down on how variable annuities’ assets can be invested, which may be part of the cause. “After the financial crisis, insurers discovered they were too loose in their policies about what kinds of things customers could invest in. Some would put 100% in stocks and took quite a bit of risk. So now insurers are pulling back, putting limits on how much can be invested in certain ways or prescribing certain mixes of stocks and bonds,” he says. “This might be why you’re seeing the fixed indexed annuities playing a bigger role in the market.”

Or it could simply be the popularity of income riders. “I believe the income riders are driving the demand [for indexed annuities],” says Forner. “The rise in index annuity sales has occurred hand in hand with the availability of marketable income features in the indexed annuity marketplace.”

Nevertheless, variable annuities continue to represent the largest percentage of all annuities sold. Last year, they accounted for some $145 billion or 63% of the $230 billion worth of total annuity sales.