This is the fourth in a series of blogs on what advisors don’t know, but should, about variable annuities.
Previous installments in the series have covered the mechanics of how Guaranteed Lifetime Withdrawal Benefits (GLWB) and work inside of variable annuities. In continuing our discussion, this installment will talk about VAs and how current market conditions impact their benefits.
On paper, VA contracts look like a win-win situation, but the last five years have created a lot of problems for both variable annuity holders and providers. With that in mind there are two areas that need to be taken into consideration.
When VA Accounts Fall Lower Than Their Guaranteed Value
First, there is the situation of many current variable annuity policyholders who find themselves with account values that are much lower than the guaranteed value of their policies. Second, there is the issue of changes in both fees and benefits for those looking to buy a VA as underwriters look to pare back their risk exposure.
Many policies, particularly those sold before 2008, now have an actual account value that is far lower than the guaranteed value. The problem with this situation is that the only way for an investor to access the higher guaranteed level is to begin taking income. While taking income based on the high-water mark is not a problem, having those payments ever keep up with inflation over their retirement years is. As explained earlier in the series, for these investors to ever achieve an increase in the payments they receive, their account values have to grow by huge, and in today’s markets, highly unrealistic amounts. Higher withdrawals based on the high-water mark are going to exhaust these accounts much faster, which, as recently pointed out by Moshe Milevsky, might in fact be a good thing.
To illustrate how this works, let us use an example with a GLWB that has an actual value of $100,000 and a high water mark of $125,000. If returns are 8% a year, and fees 3%, then the policyholder gets constant nominal income of $6,250, which is equal to 5% of the high-water mark.
As the graph above demonstrates, the account value of $100,000 (the investor’s money) drops even faster given the higher withdrawal amount that occurs when the account value and high-water mark start at the same level.
Under the circumstances where there is a large gap between the values, the hurdle for getting inflation-adjusted income is even higher. Assuming a constant inflation rate of 2.5%, the investor’s account will need to return at least 14% a year for the income to catch up to inflation by the end of the 10th year. There is no mystery to this. It is simply the result of the basic mechanics of the GLWB. To get an increase in income payments you must set a new high-water mark. In our example, for this to happen the $100,000 actual value must rise to higher than $125,000 net of fees and net of the $6,250 withdrawal each year. In today’s markets, it is hard for anyone to imagine a portfolio having 10 consecutive years of 14%-plus returns.
For a GLIB a large gap between the guaranteed amount and the actual account value causes a slightly different problem. As noted in the last post, the annuity factor used to convert the high-water mark to an income annuity is offset a number of years from the current market annuity quote. The table below shows some calculations using current market quotes for a male purchasing a single premium immediate annuity.