What Advisors Don’t Know About Variable Annuities: How GLWBs Work

In this post, the second in our series of blogs on what advisors need to know about variable annuities, we will examine the mechanics of the Guaranteed Lifetime Withdrawal Benefit (GLWB).

In a variable annuity with a GLWB, the underlying account grows each year based on the performance of the account’s investment portfolio net of withdrawals and fees. The highest account value attained is saved and this becomes the high-water mark for all future periods.

Withdrawals begin by taking the withdrawal percentage specified by the contract (5%, for example) and multiplying that figure by the high-water mark. The withdrawal amount, along with fees, is subtracted from the actual account value, and the returns of the underlying portfolio are added to calculate the new actual account value.

If the new actual account value is greater than the old high-water mark, then the new high-water mark is set to the new actual account value. If not, then the high-water mark remains the same.

Payments are calculated and made via the above mechanism until the actual account value goes to zero or the investor dies. If the actual account value goes to zero, then the insurance company steps in and continues making the annual payments for the life of the contract. If the investor dies, the remaining actual account value is paid as a death benefit.

The following graphs show sample calculation of payments, actual account value and high-water mark for a VA with a 5% GLWB where withdrawals begin immediately. The example begins with an initial investment of $100,000, has fees of 3% and a portfolio return of 5% a year.

The first two graphs show the gap between the actual account value, and the high-water mark starts for the first and second year once withdrawal benefits are taken.

Calculation for the first year with a return of 5% on the underlying portfolio

Calculation for the second year with a return of 5% on the underlying portfolio

The third graph shows 10 years of the calculation with each year having a 5% return on the underlying portfolio.

The fourth graph shows the full 10-year example, but with an annual portfolio return of 8%.

The final graph shows the full 10 year example, but with an annual portfolio return of 9%.

What these graphs demonstrate is that if the underlying portfolio generates 5% returns, an investor receives constant payments in nominal dollars but will never have an increase in payments.

It takes a return of at least 8% per year to keep the actual account value close to the high-water mark upon which payments are calculated. Even then, there is no increase in the payments.

All the examples show nominal amounts. Factoring in inflation would show that the payments have shrinking purchasing power, except when returns are high for extended periods.

Even with the 9% a year return the payments only increase slightly. The only way the investor receives an increase in payments is if the account value net of withdrawals and fees plus the returns on the remaining account balance during the year rises above the current high-water mark.

So to keep the account value even with the guarantee level (assuming they start out that way), the return must beat the guaranteed withdrawal rate (5%) plus the fees (3.0% on average), or at least 8.0%. To get an increase in payments, the returns must beat that return each year. To match a 2.5% inflation rate, that return must be around 11% per year.

The important things to remember are that in addition to paying fees based on the portfolio’s high-water market, the VA holder is actually making payments to himself from his own money until all those funds are exhausted. It is only then that the insurance company steps in for payments. You are paying yourself for many years before the insurance company pays anything.

Read the fine print: fees are taken in some policies on the high-water mark regardless of the actual account value. These fees lower your actual account value each year even more.

In the next installment, we’ll take a look at the mechanics of the Guaranteed Lifetime Income Benefit (GLIB).

View all posts in our series on What Advisors Don't Know About VAs.

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