After the market turbulence which began when the tech bubble burst in 2000, annuities offering certain guaranteed benefits experienced a surge in popularity. Many offer a guaranteed minimum income benefit rider, or GMIB. Are these benefits as good as they appear? In this article, we’ll look at what they are, how they work and discuss a few lesser known but very important details surrounding these annuity riders.
If you are a proponent of them let me be clear. My goal is not to dissuade anyone from investing in one of these annuities. To the contrary, my goal is to help advisors gain a better understanding of often ignored but highly relevant information which should be considered before choosing this product. Additionally, if you have a client who is invested in an annuity with a GMIB, we’ll examine their choices (i.e.; stay in or get out), factoring in all applicable taxes.
Note: This is assumed to be a non-qualified annuity and the word annuitant is used in lieu of client.
Now, let’s take a look Under the Hood.
How They Work
These annuities have two separate account values. The first is the actual market value which is derived from the performance of the underlying mutual funds. The second is the GMIB account. It should be noted that the GMIB value only applies when the contract is annuitized. As such, it is used to calculate the amount of income the annuitant will receive.
The guaranteed percentage is the annual interest rate credited to the GMIB account each year until the annuitant reaches a certain age, at which point its value is frozen. Regardless, at some future date, if the annuitant decides to trigger the income option (i.e.; annuitize the contract), the income he receives will be calculated based on the greater of:
the market value of the annuity
the value of the GMIB account.
To clarify, consider the following example:
Initial Investment: $100,000
GMIB Annual Return: 7.0%
Actual Annual Return: 5.0%
Period of Years Until Income Option Is Triggered: 10
GMIB Account Value at End of Year 10: $196,715
Market Value at End of Year 10: $162,889
In this example, the annuitant’s income will be based on the value of the GMIB account since it’s higher than its market value. The GMIB essentially provides a minimum return which is credited each year, and again, if this value is greater than the actual market value when annuitized, the GMIB will be used to calculate the income. Now let’s look at how the income is determined. Determining the Income
When the annuitant decides to annuitize the contract and selects a payout option, there are two basic steps, which are:
1) Calculate the number of 1,000s in the greater of the GMIB or actual market value; and
2) Multiply #1 by the appropriate annuity factor.
For example, using an actual annuity contract I viewed recently, the annuity factor for a 20-year payout is 5.53. Therefore, the calculation would be as follows:
Step 1) 196,715 / 1000 = 196.7
Step 2) 196.7 x 5.53 = $1,087.85 per month or $13,053 per year.
Now that we have determined the amount of income and the term of years, we have one final step before deciding if this is a good product for the annuitant. That step is calculating the internal rate of return (IRR) needed on the lump sum to provide this income for the 20-year period.
In other words, what annual rate of return does the insurance company need to earn to generate this amount of income?
However, there is one additional wrinkle. The insurance company doesn’t actually have the $196,715 (the GMIB value). Rather, the lump sum the insurer has to work with is the account’s market value of $162,889. Therefore, the question becomes: What average annual rate of return is required on $162,889 to generate the promised income for the 20-year period?
Fortunately, this is a simple time value of money calculation, and the answer is 5.14%. This now becomes the insurance company’s hurdle or breakeven rate.
But what if the annuitant doesn’t want to remain in the annuity? Does it make sense to get out? On the surface, it would seem foolish to cash it in, especially since the GMIB is so much greater than its market value and taxes would be due. Let’s look at this issue in detail.
The Annuitant’s Choices
If the annuitant wanted out of the annuity, assuming the surrender period has expired, he should list the options and give careful consideration to each. Here are his choices:
1) Do nothing and maintain the annuity;
2) Annuitize the contract and begin receiving an income; or
3) Cash in the annuity, pay tax on the gain and invest the net proceeds in a taxable account.