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Are Variable Immediate Annuities Obsolete?

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The minimum guaranteed withdrawal benefit for life on variable annuities is often mentioned as a logical solution to a customer’s income needs.

Also called the life withdrawal benefit, or LWB, it has a number of very attractive features that help overcome the typical consumer objections to annuitization. But an older VA design, the variable income annuity or VIA, was also built to provide an income that cannot be outlived.

This poses the question: Has the LWB made the VIA solution obsolete? Let’s see.

The LWB allows a customer to take out a fixed percentage of a withdrawal base every year for life. The percentage usually depends on client age at start of withdrawals. This base often ratchets up if there is favorable investment performance before the first withdrawal.

Once withdrawals begin, the opportunity exists for the customer to “re-set” the benefit if the account value has grown above the withdrawal base. (Note: In these situations, the insurance company may be able to increase the benefit charges.)

If the withdrawals exceed the “benchmark” amount (i.e., the percentage multiplied by the withdrawal base), the benchmark amount will reduce proportionally. But as long as the benchmark is not exceeded, the insurance company guarantees the customer can withdraw at least the benchmark amount each year the annuitant is alive–even if the VA account value drops to zero. Typically, the guarantee is conditional upon adhering to specified asset allocation rules.

Unlike a traditional income annuity, these products include a meaningful guaranteed death benefit (which is reduced by withdrawals); and the customer is free to surrender the contract anytime before the mandatory annuitization date.

What about the VIA? This is an immediate annuity. That fact means the liquidity is typically very limited, and the pattern of income payments has very limited flexibility once annuitization begins. Moreover, the death benefit is generally confined to the choice of the guarantee period of income payments.

Does the VIA deliver value to customers that compensate for its perceived faults? It is a matter of trade-offs.

To illustrate, consider the two charts. They show generic versions of each product type, modeled for a male buying the product at age 65 with a $100,000 single premium, receiving income every quarter, and earning a constant 8% before any charges. The first quarterly income payment is made three months after issue. (Note: This is a generalized comparison, made to show the major trade-offs between a LWB and a VIA. Real-life comparisons should reflect actual costs and benefit nuances of the actual products.)

Chart 1 shows the yearly income paid out under each product. It also shows the amount of the first withdrawal, increased at a compound rate of 2.5%. The income payments are considerably less under the LWB than under the VIA, even though the re-set feature is being used. The pop-up in annual income under the LWB is due to mandatory annuitization at age 90.

In this scenario, the build-up in account value under the LWB makes sense since the insurance company is guaranteeing a minimum level of investment performance (enough to fund a life annuity). Higher withdrawal levels would adversely affect this investment risk.

Chart 2 shows the customer’s internal rate of return from issue date through various years, assuming death occurs at the end of the period. For example: The internal rate of return, for the LWB at year 15, would have a cost of $100,000; the benefits would equal all income payments made through the third quarter of year 15 and the death benefit for the last quarter of year 15.

The initial negative rate under the VIA and the rapid increase in returns reflects the effect of survivorship–early deaths are contributing amounts that help fund the later payments. For the LWB, the customer’s return is fairly constant since there is no survivorship effect. But in the later years, the LWB rate differs because the maturity age of 90 forces annuitization.

In the accumulation years, financial professionals usually look at investment portfolios and think about diversification through a careful asset allocation process. The same concept can be used with respect to retirement income products.

The building blocks include: the customary approach of periodic withdrawals from a mutual fund or annuity; a fixed or variable income annuity; a variable annuity with a LWB; and possibly a fixed income annuity with a very long deferral period during which there is no liquidity (that is, “longevity insurance”).

Customers may be better served by intelligently allocating their resources among these products, rather than relying on a single product concept.