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What To Look For In Comparing Immediate Annuities And GMWBs

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There is a growing schism in annuityland right now. On one hand, academics and the popular press, when writing positively about annuities, are recommending fixed immediate annuities. On the other hand, in the retirement planning world, most advisors are recommending deferred variable annuities with guaranteed minimum withdrawal benefits, especially since many of these now guarantee lifetime income after a certain age (usually no later than age 65).

The most recent numbers from LIMRA International, Windsor, Conn., bear this out. For the third quarter of 2005, only 2.6% of the $53.8 billion gross sales in annuities were for immediate annuities, while 65% were for VAs, many with GMWB riders (exact utilization not reported).

What is causing this schism? As usual, it is education and awareness on both sides. The academics and popular press are still largely unfamiliar with GMWBs. And most financial advisors are equally unaware of immediate annuities.

This puts soon-to-be-retiring, inquisitive baby boomers in an uncomfortable spot.

They are going to read up on retirement, including immediate fixed annuities. Then they are going to talk about them to their advisor, whose response will be, “Well, I prefer GMWBs to immediate annuities,” with no balanced reason offered. Worse, some advisors may sell the boomer a GMWB when an immediate annuity may have been more appropriate.

Here is a quick three-step process advisors can use with confidence to recommend the right product for the guaranteed-income portion of the client’s portfolio. It also will educate and impress the client, thus helping the advisor to gain referrals.

Step 1: Do The Simple Numbers.

Start by comparing the two products in a worst-case scenario as in Table 1. This table compares a $100,000 investment in a 20-year period certain immediate annuity and a GMWB for a 65-year-old who is taking income. The 20-year period certain payout is the closest apples-to-apples comparison to a GMWB that, at a 5% withdrawal rate, guarantees 20 years of income should the contract owner live or die. Both sets of numbers are after all expenses (including additional fees for riders). (The numbers are easy to create; the immediate annuity information is available from a simple online search for an immediate annuity calculator, and the GMWB numbers are simple math at $5,000 per year.)

Note: The Table 1 scenario assumes a truly worst-case 0% market every year for 20 straight years. Don’t confuse this with a sideways market that ends up in the same place 20 years later but has had peaks and valleys in the interim.

Once the client understands the worst case, present a hypothetical historical return as shown in Table 2.

The immediate annuity numbers stay the same ($100,000 premium, 65-year-old) because market performance does not affect them. The GMWB numbers can be filled in from a hypothetical illustration from a favorite wholesaler or VA website. These numbers are not historical replications due to regulatory concerns that the numbers could be promissory, but most companies will provide a 20-year hypothetical scenario that shows year-on-year fluctuating returns that net about 8-9% per year over the 20-year period, much like history. Variable scenarios such as this illustrate features like periodic step-ups or bonuses, either of which could increase the annual cash flow and total income provided by the GMWB.

Step 2: Help the client understand the decision in its most basic form.

The two tables show current cash flow without the additional considerations of taxes or residual value. The second step is important because it keeps the advisor from giving clients too much information at once.

Explain to the client that the basic choice is as follows: The immediate annuity offers the certainty of a 20-year cumulative income of $139,200, no matter what happens to the economy. By comparison, the GMWB lets the client know that the worst he/she will do is $100,000, but, should markets perform well, the client could receive $205,969 in cumulative 20-year income. Ask your client which scenario has the most appeal.

Step 3: Layer on the additional considerations.

The first consideration is taxes. Remember that the immediate annuity benefits from the exclusionary rule, which states that a portion of each payment is return of principal. So, the immediate annuity’s annual payment will be less diminished by taxes than the GMWB’s payment in nonqualified plans (the two products, however, are equally taxed in qualified plans, where 50% of annuities are sold according to LIMRA).

The second consideration is residual value, otherwise known as money left for the client’s spouse or beneficiary. The immediate annuity has no residual value after 20 years, once the client who is the annuitant passes. The GMWB, however, in the hypothetical historical case, has a remaining contract value of $187,184 or a GMWB that will still pay $17,419 annually for another 15 years to the surviving beneficiary.

At this point, the advisor plays the pivotal role in helping the client make the proper decision. The advisor knows the client’s personal need for certainty, the likely retirement tax bracket and whether other portions of the client’s portfolio are sufficient for the spouse or other beneficiaries. By starting with the three steps above, the advisor is certain to guide the client to the correct product.