The Cost Of Variable Annuity Guarantees

By George D. Lambert AAA

We're retiring earlier and living longer. According to the Bureau of Labor Statistics, the average retirement age dropped from about 67 years old in 1950 to 62 in 2000. Over that same period, life expectancies increased from 68 to 77. In other words, the time span between retirement and death is getting longer. The number of workers with pension benefits has changed, too. Major corporations are looking for ways to cut costs. As a result, many have discontinued their pensions in favor of 401(k)s or other employee contribution plans. In light of these trends, it looks like future retirees may need to seek out additional ways to save for a comfortable retirement. A deferred variable annuity can supplement other income sources after you retire or make up for the pensions you may have lost, as well as provide the advantage of guaranteed benefits. But are these guarantees worth the price? Here we go over several common guarantees offered by annuity companies and provide an estimate of the degree to which these guarantees will affect your returns.

Guaranteed Benefits
Annuity companies understand that guarantees are critical to the sale of variable products. As a result, some are offering richer benefits in an attempt to outdo their competitors. Here are some of the common available benefits:

Guaranteed Death Benefit
If you die before your annuity begins paying out benefits, your beneficiary, as named in the contract, will receive a death benefit. The method used to determine the death benefit varies among companies and contracts. The general concept, however, is to make sure that your beneficiary will receive either the amount you had invested or the contract's value on the most recent policy anniversary statement, whichever is higher.

The guaranteed death benefit feature can give you the peace of mind that comes from knowing that your beneficiary will not lose out if you happen to die when the markets are off and your account value is down.

Additional cost of investment: 15-35 basis points (Note: the figures provided are estimates based on a 2004 study by Towers Perrin Inc.)

Guaranteed Earning Increase Death Benefit
This option will guarantee that your beneficiary will receive the higher of your account's value or the amount of your investment, plus a predetermined annual increase at your death.

Additional cost of investment: 10-40 basis points

Guaranteed Minimum Income Benefit (GMIB)
The GMIB guarantees a minimum payment when the annuity is annuitized, regardless of how the stock and bond markets perform. The guaranteed future payment is calculated by compounding your investment by a predetermined rate. The company may require that the owner hold the contract for a specified time before using the benefit. (To learn more, see Selecting The Payout On Your Annuity.)

For example, an annuity company's GMIB might guarantee that if the contract owner chooses annuitization, the income will be based on the greater of the account value or the GMIB benefit base, which is equal to your investment accumulated at 5% annually. The GMIB has no effect on how the variable annuity operates, and for investors who do not annuitize, the GMIB does not provide any benefit for the account owner or beneficiaries.

Additional cost of investment: 50-75 basis points

Guaranteed Minimum Withdrawal Benefit (GMWB)
The idea behind the GMWB is to allow you to withdraw a maximum percentage of your total investment each year for a set number of years, regardless of market performance, until you have recovered 100% of your investment. The company might also have provisions that lock in any growth in your contract, extending your withdrawals and increasing your benefit amount. Some companies will increase the percentage of your total investment that you can take out if you don't take withdrawals during the first years that you own the contract.

A GMWB can give you downside income protection, the potential for market growth and a guarantee of return on your investment. However, if you do not intend to take withdrawals from your variable annuity, this option is probably not for you. (To learn more, read Taking The Bite Out Of Annuity Losses.)

Additional cost of investment: 40-65 basis points

Guaranteed Lifetime Withdrawal Benefit (GLWB)
The GLWB guarantees that you can withdraw a minimum amount throughout your lifetime - regardless of the subaccounts' performance - and you don't have to annuitize your contract. The guarantee is a set percentage of your investment, which increases the longer you delay taking payments. For example, the company might agree to pay you 5% at age 55. But if you wait until you are 70 to begin taking income, the company might increase that to 5.5%. At age 80, it could be 6%.

It's possible that your payout can rise over time because the value of your account is recalculated at set intervals, such as every five years, allowing you to benefit if your account goes up. However, because of the guarantee, you will avoid suffering if the markets are weak. As a result, you could stay invested in stocks without worrying that a market crash might damage your income.

This option can be a good idea if you need a guaranteed income but don't like the idea of giving up the control over your money that annuitization provides. However, if you do not intend to take withdrawals from your variable annuity, this option may not be worth buying.

Additional cost of investment: 50-60 basis points

Guaranteed Minimum Accumulation Benefit (GMAB)
The GMAB allows investors to protect their principal by either locking in growth or accepting the annuity company's guaranteed return during a set term, such as 10 years. At the end of that term, the account value will be either the contract's value or the GMAB's value, whichever is greater. This could give you the comfort of knowing that no matter what happens in the markets, your investment is protected for at least the GMAB's term.

Additional cost of investment: 25-75 basis points

Conclusion: Buy Smart
Variable annuities can help many investors meet their retirement savings and income needs, but you need to shop around and ask questions. Find out exactly what each benefit will cost - if a company or agent can't or won't tell you, go to another one. Weighing the benefits of a variable annuity and determining whether it is worthwhile is all about figuring out how much that expense will cut into your annual returns. Now that you're familiar with some of the guarantees that are used to sell variable annuities, you are well on your way to determining which one could be a good fit for your portfolio.

For further reading, check out An Overview Of Annuities and Getting The Whole Story On Variable Annuities.

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