Quiz Question: Do Variable or Index Annuity GLWBs Produce Higher Income? Yes!
July 08, 2010 at 08:00 PM
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The quiz question was:
Based on average returns, variable annuities will be a better financial planning choice than indexed annuities if the next 10 years perform similarly to which two decades?
a) The 1960s and 1970s
b) The 1970s and 1980s
c) The 1980s and 1990s
d) The 1990s and 2000s
e) None of these combinations
Guaranteed lifetime withdrawal benefits (GLWBs) apply a predetermined withdrawal percentage to an annuity account value and guarantee the withdrawals will continue until death, even if the account runs out of money. As an example, if the account value was $100,000 and the percentage was 5% the annuity owner could take out $5,000 every year until death, guaranteed.
Today, many index annuities provide guaranteed compound income account growth of 7% to 8% a year. What this means is $100,000 could have an income producing value of $196,715 to 215,892 in 10 years. The result is a 5% percentage would guarantee lifetime withdrawals of $9,836 to $10,794 a year.
Today, although many variable annuities do not provide any guaranteed growth some do provide guaranteed simple income account growth of 5% to 6% a year. This means the variable annuity could have an income producing value of $100,000 to $160,000 in 10 years. Using the same 5% withdrawal percentage means $5,000 to $8,000 in guaranteed lifetime withdrawals is produced.
Based solely on the guarantees the index annuity generates a higher income due to more robust income account guarantees. However, with both index and variable annuities the withdrawal percentage is applied to the higher of actual account value or income account value. I decided to look back at ten year periods over the last half century and take a hypothetical look at income account balances.
I examined the annual returns of the S&P 500 with reinvested dividends over the last 50 calendar years. I also calculated the calendar year returns of a mix of bonds consisting of 50% Baa rated, 25% Aaa rated and 25% 10-yr U.S. Treasury Notes. I then calculated the annual returns of a portfolio made up of 80% S&P 500 and 20% bond returns. The reason for the 80/20 mix is every variable annuity with a GLWB requires a certain percentage of the money to be in bonds or a fixed account and 80/20 is the most aggressive mix I could find. From this 80/20 portfolio I then subtracted 3.2% each year reflecting the current average variable annuity with GLWB rider costs (1.40% for mortality & expenses, 0.75% subaccount fees, 1.06% GLWB rider fee). I next computed the annualized returns. These annualized returns were compounded and I concluded what a $100,000 premium was worth in my pseudo-VA model at the end of 10 year periods ending from 1969 through 2009.
Finally, I compared these variable annuity totals with a consistent ten year ending value of $200,000. The rationale for the $200,000 figure is several index annuities guarantee 10 year income account growth of greater than 7.18% (the compounded rate needed to double money in 10 years; equal to 10% simple interest). This chart compares the $200,000 guaranteed minimum income account growth of many index annuities with historical hypothetical growth of my pseudo variable annuities.
Of the 41 10-year periods since 1960, the index annuity guarantee won 20 times, the variable annuity won 20 times and there was 1 tie. If the next ten years resembles the 60s, 70s or 00s the index annuity should provide higher guaranteed income. If the decade looks similar to the 80s or 90s the variable annuity is the better choice. Indeed, assuming identical 5% payouts the variable annuity model produced at least 50% more income than the index annuity in seven periods.
This assumes a 5% payout, which is the typical individual payout at age 65 for most variable annuities and some index annuities. Although most index annuities have a payout percentage of 5.5% the difference had little effect on the results, but what about older ages?
At age 75 most variable annuities continue to have individual payout percentages of 5%, but individual index annuity payouts are 6% to 6.5%. A $200,000 account balance with a payout percentage of 6.5% translates into $13,000. At only a 5% payout the variable annuity would need a value of $260,000 to match it meaning the index annuity income would be higher in 27 of the 41 periods.
However, most index annuities cut the percentage by a half or full percent if a joint payout is selected, but many variable annuities do not. And some annuities offer slightly lower payouts but will substantially increase the payout if the annuityowner needs a nursing home. And this assumes you wait 10 years to begin withdrawals. My other research shows that, historically speaking, if you begin withdrawals immediately the variable annuity resulted in much more cash paid out to beneficiaries than the index annuities in most scenarios.
What I think it comes to down is if you expect the stock market in the future to look more like the 80s and 90s the variable annuity should give you greater upside while providing a guaranteed level of income. If you are afraid the previous decade might repeat and wish to guarantee the highest income the index annuity is a sure thing.