Retiring baby boomers are pouring their money into variable annuities with guaranteed lifetime withdrawal benefits. Variable annuity sales totaled $39.8 billion in the first quarter of 2011, up 24 percent from the first quarter of last year, according to LIMRA. Meanwhile, the election rate on variable annuity guaranteed living benefits was 86 percent, a rate that’s remained steady over the past three years. The problem is, these products have a number of hidden drawbacks. Financial advisors need to understand these drawbacks and keep clients informed.
Variable annuities with guaranteed lifetime withdrawal benefits offer investors guaranteed retirement income while allowing them to invest assets in stock funds. The guaranteed lifetime withdrawal benefit is a rider that lets the contract holder withdraw a specific percentage of a “benefit base” annually for life, regardless of the performance of underlying investments. The benefit base frequently equals the contract holder’s paid-up premiums.
Some research indicates that adding a variable annuity with a guaranteed lifetime withdrawal benefit to a retirement portfolio can decrease a client’s chance of running out of money and improve a portfolio’s return over time. The benefit helps increase total income by permitting a higher stock allocation, while lowering the income risk of the overall combined portfolios, according to an Ibbotson Associates study conducted in October 2007 and sponsored by Nationwide Financial.
The riders, though, don’t come for free. Morningstar Inc., Chicago, and the Insured Retirement Institute, Washington, D.C., say fees average 1.032 percent annually per $25,000 investment. The fee, IRI indicates, is on top of contract and mutual fund expenses, that averaged 2.49 percent in the fourth quarter of 2010.
Aside from the added cost, the amount that can be invested in stocks when there is a guaranteed lifetime withdrawal benefit may be limited by some insurers to little more than one-half of a portfolio.
More important, financial advisors need to make it clear that only their clients’ annual income is guaranteed—not the account balance in the variable annuity. So if your client cashed out, he or she would collect the market value of the account, not the principal value. There may also be surrender charges.
And if the policyholder withdraws more than the guaranteed payout in any year, the guaranteed amount can drop. Insurance companies also have the right to increase the cost of the withdrawal benefit, and they have. Five years ago the benefit cost as little as 60 basis points. Today the charge can be over 100 basis points. There also are concerns that inflation can work against fixed guaranteed withdrawal features.
Finally, although guaranteed lifetime withdrawal benefits are a popular annuity rider, many of those who have paid for it have not actually activated the feature. On the other hand, some policyholders began guaranteed withdrawals even though their contracts were under water. Milliman’s June 2011 annual Guaranteed Living Benefits (GLB) survey of leading U.S. variable annuity carriers shows that nearly 15 percent of eligible policies started withdrawals within the first year. About 6 percent began withdrawals 13 months to three years after becoming eligible, and 2 percent started withdrawals more than three years after becoming eligible.
Withdrawal benefit exercise rates also are significantly influenced by the degree to which the benefit is in-the-money. For purposes of the survey, in-the-money means the withdrawal benefit base exceeds the account value.
The survey found that the median benefit exercise rate for policyholders whose benefit bases were less than the account value or “out-of-the-money” was 13.2 percent. However, the median benefit exercise rate rose steadily the more policyholders’ withdrawal benefit base exceeded the account value. Withdrawal benefit exercise rates also rose with age.
A study released last year by Ruark Consulting, Simsbury, Conn., suggests that most policyholders are opting to grow their retirement nest eggs tax-deferred rather than take withdrawals.
The study found that among owners whose annuity included a guaranteed lifetime withdrawal benefit, only one in five is actually taking partial withdrawals.
“Guaranteed lifetime withdrawal benefits that provide lifetime income to the owner have been the most popular form of guarantee over the last few years,” says Peter Gourley, vice president of Ruark Consulting. “Owners have significant discretion when they will use the partial withdrawal benefits that they purchased. Because of the newness of these products, the insurance industry has relatively little experience to evaluate, until now.”
Other research questions whether the variable annuity with the guaranteed lifetime withdrawal benefit can deliver on its promise of income growth. A study by Advisor Perspectives (www.advisorperspectives.com), a financial planning research publisher, used a Monte Carlo simulation to compare the investment performance of a variable annuity with a guaranteed lifetime withdrawal benefit to that of a similarly allocated passive portfolio.
The key findings of the study:
· Over the average life expectancy of a 60 year old who invested in a variable annuity with a guaranteed lifetime withdrawal benefit, there is only a 9.5 percent probability that product would provide superior performance to a passive account.
· The median income from a variable annuity with a guaranteed lifetime withdrawal benefit increases at a rate of about 50 basis points annually, failing to keep pace with a 3 percent annual inflation.
· There is a 21 percent probability that income from a variable annuity with a guaranteed lifetime withdrawal benefit never will increase.
· Although the guaranteed lifetime withdrawal benefit offers the possibility of bequest, the median value of the potential of the bequest drops and is zero after age 88.
· For an investor whose sole goal is to maximize total lifetime income, the single premium immediate annuity is superior to the variable annuity with the guaranteed lifetime withdrawal benefit.