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November 02, 2008 at 02:00 PM
While most equity portfolios lack effective protections against market downturns and longevity, variable and immediate annuities do offer guarantees.
Among the most popular are some living benefit features in variable annuities that offer guaranteed withdrawal benefits. These features include the guaranteed lifetime withdrawal benefit and the guaranteed minimum withdrawal benefit.
Debate about the expense of these riders is robust. Fees, however, only tell part of the story. Clients, particularly those looking to VAs for estate planning, need to consider other hidden costs to withdrawal benefits–costs that could limit their upside potential in terms of income and account value.
Withdrawal benefits are essentially a guarantee to pay clients at least their own money and possibly more (typically 5% or 7% of the account’s “benefit base” per year).
Both GLWBs and GMWBs allow minimum withdrawals from the invested amount without having to annuitize the VA. The amount that can be withdrawn is based on a percentage of the total amount invested in the annuity. Because they offer a guaranteed benefit without having to annuitize, the basic value statement to the customer is straightforward.
But understanding the restrictions buried in the account when these options are exercised makes the features considerably more complex. This raises the question about whether a better strategy exists for downside protection.
Investment restrictions. VA carriers frequently limit their own risk by requiring clients to select from a prescribed list of relatively conservative investments. In fact, 83% of all GLWBs and 81% of GMWBs have some such restriction. These asset allocation restrictions generally prohibit the use of the most aggressive and thus higher return options. This can greatly affect a client’s wealth accumulation upside.
Changing the asset allocation by 20% can cause a 100 basis point (1%) reduction in expected annual return across a diversified portfolio. Over 20 years on a $100,000 investment, the opportunity cost could approach $100,000.
