Living benefit riders have become an inescapable part of buying a variable annuity. These options are often touted as the seat belts that make these annuities safe during periods of stock market decline.
But are they? Often, the answer is no.
Riders are optional add-ons that annuity buyers can choose, usually at an extra cost. Two popular types of variable annuity living benefit riders—guaranteed minimum withdrawal benefits (GMWB) and guaranteed minimum income benefits (GMIB)—will only recover their costs in very specific circumstances.
- Riders are optional add-ons that annuity buyers can choose, usually at an extra cost.
- The cost of guaranteed minimum withdrawal benefit riders can continue to be incurred even if there is no chance the riders will ever pay off.
- Payouts are continually changing based on interest rates, company mortality experience, and how hungry companies are to attract business.
Understanding these circumstances can be difficult. Despite all the fine print in a variable annuity prospectus, there is rarely a clear explanation that describes when a guaranteed minimum withdrawal benefits (GMWB) or guaranteed minimum income benefits (GMIB) rider will pay off.
Disregard the hype often used to sell these riders. They are often sold with this logic: "When you add a seat-belt feature to your annuity, you can participate in the stock market without risking your retirement security. If the market declines, rest assured that your living benefit rider will rescue you from losses."
Such a claim can be misleading because the seat belt analogy is full of holes. Only particular 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 are advised to be skeptical and do their own research.
Also, much can change during retirement years. If one's health declines several years from now, the cost of these riders may be wasted. Opportunities can also crop up that make exchanging or cashing in a variable annuity contract advisable.
For the riders to make sense, you should plan on holding a variable annuity for at least 20 years with a guaranteed minimum withdrawal benefits (GMWB) rider, or for the required waiting period (perhaps 10 years) with a guaranteed minimum income benefits (GMIB) rider. These riders should also be compatible with income tax planning needs.
Guaranteed Minimum Withdrawal Benefits (GMWB) Overview
A GMWB is guaranteed to return 100% of the premium paid into the contract, regardless of an investment's performance, through a series of annual withdrawals. The withdrawals covered by this rider are limited to a percentage of premiums, typically 5% to 7% per year. If the annual limit is 5%, for example, an annuity owner would need to receive 20 annual withdrawals to recover 100% of premiums.
A GMWB usually must be elected when the contract is issued. Sometimes, they cannot be canceled, which means the costs incurred 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 40 to 75 basis points.
Suppose the stock market tumbles and annuity investment performance is terrible? When will a GMWB recover its cost? Several factors determine the answer.
Each year, over a continuous period of many years, the contract holder is required to take withdrawals up to the maximum percentage covered by the GMWB. Deferring the start of withdrawals, skipping withdrawals, or just 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 variable annuity, the GMWB will have little chance to pay off. The annuity's guaranteed minimum death benefit may pay off in this case. However, that is a separate contract feature that may be automatically included.
The opportunity to earn tax-deferred earnings is a significant selling point of variable annuities. However, a GMWB does not make much sense for buyers who are older than 65 and want tax deferral. Such buyers should start taking immediate and continuous annual withdrawals if they expect the rider to pay off during their lifetime. Unfortunately, annuity withdrawals in the early years of contract ownership are 100% taxable in most cases.
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).
GMWBs can be useful for those who plan to invest their variable annuity in risky stocks. In this case, the insurance protection could pay off if the contract holder suffered a severe loss in a drastic market downturn, such as the Nasdaq crash of 2000-2002. Some insurers might not allow buyers who select living benefits to access the riskiest investment choices in their variable annuity menus. On the other hand, investing in a GMWB doesn't make very much sense for conservative investors who choose a balanced mix of blue-chip stocks and bonds.
Also, the contract holder should not plan to exchange or surrender the contract for many years.
Finally, 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, suppose that an annuity purchased for $50,000 is worth $60,000 five years later. At that time, the contract holder elects to step up the GMWB protection. In this case, the contract holder would be guaranteed to receive at least $60,000 through a series of annual withdrawals (starting after the step-up date). Keep in mind that this step-up feature can permanently increase the cost of the GMWB in some cases.
Guaranteed Minimum Income Benefits (GMIB) Overview
At a continuing cost, ranging from 50 to 75 basis points of the contract value, a GMIB rider guarantees the right to annuitize a contract into a payout program. The payout offers a specified minimum periodic income after a waiting period, regardless of the variable annuity's investment performance.
For example, a GMIB might guarantee that the contract holder can annuitize a $50,000 annuity contract into monthly payments of at least $420. That establishes a floor of future retirement income. The payments could start whenever the holder chooses after waiting for a predetermined number of years.
Under what circumstances will this floor help the GMIB pay off? The contract holder will have to live long enough (and hold the contract long enough) to be able to use the annuitizing option. Typically, a 10-year waiting period after the purchase of the variable annuity is required.
Later in retirement, the contract holder may decide that annuitizing is a better choice than continuing to accumulate money in the contract or cashing it in. In this regard, some contracts limit GMIBs to annuitization methods that include a lifetime payout. For people who experience poor health during retirement, a lifetime payout may not be attractive.
Most importantly, the GMIB will only pay off if it guarantees more periodic income than can be obtained from a comparable insurance carrier at the time of annuitization. Today's immediate annuity industry is highly competitive. Quotes can easily be obtained from many companies. Payouts are constantly changing based on prevailing interest rates, company mortality experience, and how hungry carriers are to attract business.
Riders to annuities can only repay their cost under specific circumstances that may depend more on the buyer's needs and situation than on stock market performance.
A financial professional can help to convert any annuity quote into an equivalent interest rate. For example, suppose a 65-year-old wants to annuitize a variable annuity worth $100,000 into a lifetime income of $640 per month. If a standard mortality table indicates that this person's life expectancy is 19.2 more years, the internal rate of return of this payout over this life expectancy is 4.3%.
Generally, if a variety of different variable annuity contracts are analyzed at once, it becomes clear that:
- Among insurance companies with comparable financial strength, interest rate quotes on annuity payouts commonly vary from 1% to 2%.
- The floor rates built into GMIBs often do not offer the most attractive payouts available in a competitive market.
The GMIB can only recover its cost if the contract holder is willing to give up the right to shop around and take the payout plan guaranteed long in advance.
The Bottom Line
Variable annuity living benefit riders are not necessarily seat belts. They involve separate purchase decisions (apart from the annuity itself) that should make sense based on their own merits. The purchase of a GMWB or a GMIB always generates extra costs that continue over time. They can only repay this cost many years in the future under specific circumstances that may depend more on the buyer's needs and situation than on stock market performance.