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 The amount that can be withdrawn is based on a percentage of the total amount invested in the annuity.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.
Asset erosion. Based on our research, in 10,000 Monte Carlo scenarios, a GLWB/GMWB will deplete an annuity’s contract value 7 out of 10 times (assuming a 30-year time horizon with average annual returns of 8% for equities and 4% for bonds). If average annual returns jump to 10% for equities and 6% for bonds, the chances of avoiding tapping out annuity assets are 66%–still not great odds.
Worse, if an emergency forces the client to take more than the annual percentage allowed by the withdrawal surrender charge, the benefit base is recalculated downward. This emergency withdrawal will negatively, and usually quite substantially, impact the client’s income stream going forward.
The high cost, but low probability of living benefits. By design, VAs already have built-in annuitization features that allow clients to turn their nest eggs into guaranteed retirement income they can never outlive. How many clients realize this important protection is already available to them? With a GLWB/GMWB, clients pay additional annual fees–sometimes as much as 1%–for a lifetime income benefit that many will never use or need.
Inflation protection that doesn’t truly “step-up.” Withdrawal benefits are capable of providing annual income increases, but only if the account value happens to hit a new high-water mark on the VA’s anniversary date. However, the stars must truly align in order for these so-called step-ups to kick in.
Unfortunately, market volatility, high fees that can rise unpredictably over time, and restrictions that frequently confine investments to only the most conservative portfolios can make it difficult to attain the returns necessary to trigger the step-ups. Therefore, if retirees want guaranteed income increases at predictable intervals, there are probably better options than withdrawal benefits.
For some, a GLWB or GMWB provides valuable peace of mind. But there may be better ways to secure income guarantees. Other available options can provide valuable guarantees without the limitations described above.
For instance, look for riders that separate the income benefit from the assets, thereby providing an additional layer of income benefits that have no impact on the annuity’s account value. Find ones with predictable charges, income flexibility, and full access to investment choices. Finally, ensure that the client owns the benefit, meaning the client receives the rider’s benefits as long as the rider charges are paid, even if the client has withdrawn or transferred out of all his/her contract value.
These options, taken together, cannot only protect clients from market volatility, but also greatly increase the opportunity for more potential lifetime income.