The sales pitch sounds too good to be true, and should instantly set off financial alarm bells. Here’s how it goes: “Give us your money today and we will guarantee you at least 5, 6 — and even 7 percent — for the next five, 10 or 15 years. And, if and when the stock market eventually recovers, you might earn even more!” This, remember, is being offered in an economic environment in which Treasury bills yield 0 percent and government bonds barely 4 percent.
Most of the promotional material touting “guaranteed lifetime income benefit” variable annuity (GLiB VA) products is very careful to emphasize that these guarantees — of 5, 6 or 7 percent — are applied to an income base and not to the account value, which fluctuates over time. However, I can attest that few people understand how to calculate the implied return on these products and convert it into a number comparable to interest in a bank account or investment returns on a mutual fund. Instead, the marketing material speaks the language of “investment Celsius” to human beings who are hard-wired to understand “economic Fahrenheit.” The numbers sound similar, but the scales are completely different. In an attempt to clear up this confusion, I would like to devote this inaugural article of Annuity Analytics to explaining the arithmetic of GLiB VAs correctly.
Let’s take an example. Say you are 55 years old and invest $100,000 in a variable annuity policy offering a minimum 7 percent guaranteed growth rate over 10 years. This growth guarantee implies that, at the very least, you will have an income base of $196,715 by the age of 65, for those companies who treat the number as compounding. (Some do only simple interest.) This number is computed in a straightforward manner by multiplying $100,000 times (1.07)^10. To be sure, the income base might be higher if the underlying investment subaccounts cooperate — by defying recession’s gravity and all management fees — and rise by more than 7 percent.
Your contract further stipulates that the income base — whatever it is at the withdrawal commencement date, and I have chosen age 65 — will be multiplied by a guaranteed withdrawal rate, say 5 percent, to determine your lifetime income benefit. I will refer to this pair of numbers, 7 percent and 5 percent, as the guaranteed growth rate factor and the guaranteed withdrawal factor. Every GLiB VA policy includes both factors. And, from the consumer’s point of view, larger numbers are better.
So, to recap our example, if you want to retire at 65 and start drawing down from your GLiB VA (purchased at 55 for $100,000 with a 7 percent growth rate factor and a 5 percent withdrawal factor), the absolutely worst case scenario you will face is a guaranteed yearly income of 5 percent of the $196,715 base, or approximately $9,836 for life. This number sounds nice, but is precisely where my problems start.
Did you ever wonder what it costs to purchase a basic pension at age 65 which pays the same $9,836 per year for life? This is not a hypothetical question. There is an active market for single premium income annuities (SPIA), which have been sold by major insurance companies for hundreds of years. In March 2009 the cost of a $9,836 per year income annuity was approximately $122,940. (This is an average at age 65 from a number of competitive insurance vendors. Some will charge less in exchange for taking on some insurance company credit risk.) But as you may have noticed, this is nearly 40 percent less than the guaranteed income base amount of $196,715.
The fancy hotel is giving you 10 percent off the official “rack rate,” but it’s even 40 percent cheaper on Travelocity.
In other words, the catch with GLiB VAs is that to get the enticing growth rate factor applied to the $100,000 base, you have to put up with a very distasteful withdrawal factor. The 7 percent growth can’t be disentangled from the 5 percent withdrawal rate. It’s like going to a sale at your favorite store where everything is 50 percent off, but the local sales tax has simultaneously increased to 100 percent.
In my opinion, advisors should provide clients with the embedded investment return (i.e., the cash-equivalent yield) for the GLiB VAs they sell. The proper way to calculate this uses a three-step process, and it behooves all financial advisors to both understand this process and to explain it to their clients. Here are the three steps:
o First, get a single premium immediate annuity income quote — with no guarantees or survivor benefits — for a given deposit premium and a hypothetical retiree aged 65, or whenever you plan to start the income. Divide the annual income into this premium to get what I call the market’s annuity factor.
o Secondly, multiply the worst-case-scenario guaranteed income amount — which is guaranteed income base times lifetime income rate — by the market’s annuity factor at age 65 (or whenever you plan to start the income).
o Finally, divide the resulting number by the original deposit premium to solve for the cash equivalent yield over the 10-year waiting period. In this step, you are computing the annual investment rate that has $100,000 become $122,940 after 10 years. This equation is (122940/100000)^(1/10)-1. (To repeat: $122,940 is the pure cost of buying a yearly $9,836 for life at age 65.)