Living benefit riders have become an inescapable part of the variable annuity (VA) buying experience. These options are often touted as the "seat belts" that make VAs safe during periods of stock market decline. But are they?
Unfortunately, more often than not, the answer is "no".
Riders are optional add-ons that annuity buyers can choose, usually at extra cost. Two popular types of VA living benefit riders - guaranteed minimum withdrawal benefits (GMWBs) and guaranteed minimum income benefits (GMIBs) - will only recover their costs in very specific circumstances.
For annuity buyers, understanding these circumstances can be difficult. For all the fine print written into a VA prospectus, rarely will you find a clear explanation that describes when a GMWB or GMIB will pay off in dollars and cents. In this article we'll help you understand how these riders work so you can make an informed decision before the salesperson straps you in. (For details on how these riders work, see The Cost Of Variable Annuity Guarantees.)
First, a Warning
Let's begin with a caveat, which is to disregard the sales hype often used to sell these riders. It goes like this: "When you add a seat-belt feature to your VA, you can participate in the stock market without risking your retirement security. If the market declines, rest assured that your GMWB (or GMIB) will rescue you from losses."
Such a claim can be misleading. As we'll later explain in detail, the seat belt analogy is full of holes as only very specific situations will allow buyers to gain such a high level of protection. Because sales of living benefit riders are profitable for insurance companies and generate commissions for agents, consumers should try to dig deeper and learn the truth.
Guaranteed Minimum Withdrawal Benefits (GMWB)
A GMWB guarantees to return 100% of the premium paid into the contract, regardless of your investment's performance, through a series of annual withdrawals. The withdrawals covered by this rider are limited to a percentage of premiums, typically 5-7% per year. If the annual limit is 5%, for example, you would need to receive 20 annual withdrawals to recover 100% of premiums.
GMWBs usually must be elected when the contract is issued, and in some cases they are non-cancelable, which means their costs continue even if there is no chance they will ever pay off. The cost is charged annually as a percentage of separate account assets, generally from 40 to 75 basis points.
Suppose the stock market tumbles and VA investment performance is terrible. In this case, when will a GMWB recover its cost?
- Each year, over a continuous period of many years, the contract holder must need and request withdrawals up to the maximum percentage covered by the GMWB. Deferring the start of withdrawals, skipping withdrawals or just plain forgetting to take them won't help the rider pay off.
- The contract holder must live long enough to take the required series of withdrawals. For example, if the holder dies 15 years after buying the VA, the GMWB will have had little chance of paying off. (The VA's guaranteed minimum death benefit may pay off in this case, but that is a separate contract feature, which may be automatically included.)
- The opportunity to earn tax-deferred earnings is a major selling point of VAs, but GMWBs don't make much sense for buyers who are over age 65 and want tax deferral. Such buyers should start taking immediate and continuous annual withdrawals if they expect the rider to pay off in their lifetimes. However, in most cases, annuity withdrawals in the early years of contract ownership are 100% taxable.
- The contract holder should not plan to exchange or surrender the contract for many years. If a better VA contract comes along, or if a large amount of cash is needed for an unexpected reason, receiving the GMWB may not have been a great idea.
While the GMWB can protect 100% of premiums paid into the contract, it doesn't offer any inflation protection for retirement income. On a present value basis, taking into account the time value of money, a GMWB actually guarantees to return only about 62% of premium value (assuming a 5% discount rate and 20-year withdrawal period) (To learn about limiting the effects of inflation in your investments, see Curbing The Effects Of Inflation and Inflation-Protected Annuities: Part Of A Solid Financial Plan.)
- GMWBs can be useful if you plan to invest your VA in somewhat risky stocks. In this case, the insurance protection could pay off if you suffered a severe loss such as in the Nasdaq crash of 2000-2002. However, for buyers who select living benefits, some insurance companies may not allow access to the most risky investment choices in their VA menus. Thus, investing in GMWBs makes little sense for conservative investors who choose a balanced mix of blue chip stocks and bonds.
One final word of caution: In some contracts, the amount protected under the GMWB can "step up" to a higher contract value after the contract is issued. If investment performance is good in the early years, this type of GMWB can protect more than 100% of premiums. For example, you purchase a VA for $50,000 and five years later it is worth $60,000, at which time you elect to step up your GMWB protection. In this case, you would be guaranteed to receive at least $60,000 through a series of annual withdrawals (starting after the step-up date). Just keep in mind that exercising this step-up feature can (in some cases) permanently increase the cost of the GMWB.
Guaranteed Minimum Income Benefits (GMIBs)
At a continuing cost that ranges from 50 to 75 basis points of contract value, a GMIB rider guarantees the right to annuitize your contract into a payout program with a specified minimum periodic income, after a waiting period, regardless of VA investment performance. For example, you put $50,000 into a contract, and the GMIB guarantees that you can annuitize it into monthly payments of at least $420 per month, with these payments starting at a time of your choosing after 10 years. This establishes a "floor" of future retirement income into which the contract can convert at the holder's option. But under what circumstances will this floor help the GMIB pay off?
- You will have to live long enough (and hold your contract long enough) to be able to use the annuitization option. Typically, a 10-year waiting period after VA purchase is required.
- Later in retirement, you may decide that annuitization is a better choice than continuing to accumulate money in the contract or cashing it in. In this regard, some contracts include a catch-22 because they limit GMIBs to annuitization methods that include a lifetime payout. Yet, for people who experience poor health during retirement, a lifetime payout may not be attractive.
Most importantly, for the GMIB to pay off, it should guarantee more periodic income than can be obtained (at the time of annuitization) from a comparable insurance carrier. Today's immediate annuity industry is highly competitive. Quotes can easily be obtained from many companies and payouts are constantly changing based on prevailing interest rates, company mortality experience, and how hungry companies are to attract business.
A competent financial professional can help to convert any annuity quote into an equivalent interest rate. For example, suppose a person wants to annuitize a VA account balance of $100,000 into a lifetime income of $640 per month at age 65. If a standard mortality table indicates that this person's life expectancy is 19.2 years, the internal rate of return of this payout over this life expectancy is 4.3%.
Generally, if a variety of different VA contracts are analyzed at once, it becomes clear that:
- Among insurance companies with comparable financial strength, interest rate quotes on annuity payouts commonly can vary by 1-2%.
- The floor rates built into GMIBs often do not offer the most attractive payouts available in a competitive market.
The bottom line of annuitization is that it pays to shop around. The GMIB can only recover its cost if you are willing to give up your right to shop and take the payout plan guaranteed (long in advance) by your VA carrier.
The Bottom Line
VA living benefit riders are not necessarily "seat belts". They involve separate purchase decisions (apart from the VA itself) that should make sense based on their own merits. GMWBs and GMIBs always generate extra continuing costs, and they can only repay this cost many years in the future, under specific circumstances that may depend more on the buyer's needs and circumstances than on stock market performance.
Much can change during retirement years. If your health declines several years from now, or if you have opportunities that make exchanging or cashing in a VA contract advisable, all of the cost of these riders may be wasted.
For the riders to make sense, you should plan to hold your VA:
- for at least 20 years with a GMWB, or
- for the required waiting period (e.g. 10 years) with a GMIB.
These riders also should be compatible with your income tax planning needs.
Don't accept the argument that these riders will help you sleep better, even if they don't pay off. If losing sleep is an issue, choose investments (inside or outside a VA) that will help you slumber in peace. None of the basic benefits of a VA - including access to professionally managed investment portfolios, tax-deferral and a guaranteed minimum death benefit - are compromised if you take a pass on these riders.