Diving Into Those Guaranteed Variable Annuities
Investors steadily increased purchases of variable annuities with guaranteed benefits in recent years. These annuities clearly are striking the interest of a substantial number of investors. But they’re complicated, and I doubt most of the buyers fully understand them or know how to compare them to alternatives.
There are several versions of variable annuities with living benefits. But the most popular is generally called variable annuity with guaranteed minimum withdrawal benefits (VA-GMWB). It’s a cumbersome name, and each insurer uses its own brand name. But the contract offers a guaranteed minimum annual payout for life, and that payout might increase with investment performance. You also can terminate the annuity. If you die before exhausting the account balance, your heirs inherit the remaining value.
It’s easy to the attraction. Here’s a more detailed look at how the VA works and how to analyze it.
The contract actually is a variable annuity with a GMWB rider. The consumer purchases it with a lump sum. The account is invested in subaccounts (essentially mutual funds) selected by the consumer from among the choices offered by the insurer. The GMWB rider entitles the owner to receive a minimum percentage distribution of the initial investment from the annuity each year for life.
The guaranteed benefit depends on the owner’s age and how long he or she waits before beginning distributions. For example, a 60-year-old who begins distributions immediately will be guaranteed a 4.5% distribution in one popular version. A 55-year-old who doesn’t begin benefits until age 60 receives an initial payout of 5%, while a 50-year-old who waits for distributions until age 60 receives a 5.5% payout.
The guaranteed distribution also rises under most VAs if the owner waits until a later age to begin benefits. These percentages vary from policy to policy, of course, and will depend on interest rates at the time the VA is purchased.
Suppose a 60-year-old buyer begins distributions right after the purchase. As I said, he’s guaranteed to receive at least 4.5% of the original investment each year for life. The account balance initially is set at the investment amount. It’s reduced each year by the income distribution. It’s also reduced by fees. The annual fees are likely to total 3% or more of the account balance.
The account balance also is adjusted for the investment returns. If investment returns are high, the account balance can increase over time. Under most policies that higher balance resets the base amount that is used to compute the guaranteed annual distribution. You would receive 4.5% annually of the higher balance. So, there’s the potential for the distributions to increase over time with high investment returns. Also, the account balance can’t fall below zero no matter how long you receive payments.
The consumer can terminate the contract, though there might be a surrender fee, and would receive any remaining balance. If the consumer dies while the account balance is positive, the beneficiary receives the balance.
Though it’s possible for the account balance to rise and have that increase the annual distributions, that’s not a high probability event. The investment returns have to overcome the annual fees plus distributions. An owner of a VA-GMWB should invest the account as aggressively as allowed by the insurer. Because of the calculation of guaranteed benefits and the contract base, there’s no advantage to coordinating the asset allocation with the rest of your portfolio. You want to seek the maximum return to try to increase the contract base. You don’t have a downside to investment losses, because of the guarantee. For that reason the insurer might limit the account allocation to no more than 70% equities. The insurers also now offer primarily index funds, since those are easiest for the insurers to hedge against. In your personal asset allocation, you should consider the VA similar to a bond or an immediate annuity.
That is a generic explanation. There are many variations. There also are guaranteed minimum accumulation policies which are a little different. They guarantee your balance will increase by at least a certain amount each year before distributions begin.
The VA-GMWB policies and their variations are controversial. They’re complicated, so they’re tough to analyze. There recently was a war of research reports between Morningstar and its Ibbotson division on one side and AdvisorPerspectives.com on the other. Morningstar issued a positive research report on the contracts, while Robert Huebscher of Advisor Perspectives believed the study was misleading and incomplete.
The contracts are easier to analyze than many people realize. You don’t want to look at a contract in isolation, which is what many people do. You want to compare it with others things you could do with your money.
For example, you could take the money you would invest in the VA and instead put it into a diversified portfolio of index funds. This portfolio would pay annual fees much less than the 3% annual fees of the VA. Compare how long the two different strategies would last under different scenarios. Huebscher and some consultants did this and concluded that when distributions began at age 60 both strategies were almost certain to last through the owner’s early 70s. After that, the probability of outliving the non-annuity money begins to increase but not significantly. Even after age 90, Huebscher found there still was a 60% probability the non-VA portfolio would last.
You also could compare the VA-GMWB with a regular immediate annuity. The immediate annuity will pay more than the VA. It’s likely to pay over 6% annually when a VA-GMWB guarantees 4.5%. The immediate annuity, however, offers no benefits to heirs. There’s also no potential for the immediate annuity’s payout to increase, while the VA’s has a low probability for higher payouts. The immediate annuity also doesn’t allow you to terminate it or change your mind.
With VA-GMWB and other complicated insurance products, here’s all you really need to know. You’re transferring longevity risk (the probability of outliving your life expectancy and eventually your money) and market risk (earning lower returns than you need) to the insurance company. You’re paying for this in fees and probably in lower initial payouts. There also is an element of life insurance in these products when they guarantee a beneficiary will receive something under at least some conditions. If you don’t live to at least life expectancy or would have earned at least average long-term returns, then you probably would lose money by choosing the insurance product. But those who live a long time or would have earned mediocre investment returns will probably turn out to have done better with the VA-GMWB.
When you decide to transfer the longevity and market risks to an insurance company, then it’s a matter of shopping around to find the best deal on these types of products. Comparisons aren’t easy, because the policies don’t have standardized features.
Here are a few other points to review when considering these policies.
Examine the details of the language that guarantees payouts and minimum balances. You want to know how they’re determined. For example, some policies guarantee minimum growth in the account balance, and let you begin lifetime payments at some point using that guaranteed balance even if your account hasn’t earned enough to grow to that amount. But at least some of the policies take away some of that benefit by saying that your lifetime payments will be based on your age minus two or three years. You’ll receive the annuity of a younger person. In other words, you could probably have received at least the same payout by holding your money for a few years and buying an immediate annuity.
Since you’re buying an annuity, all distributions above your initial investment are taxed as ordinary income. Part of each distribution will be pro rated between tax-free return of principal and ordinary income. After your initial investment is returned, all of each subsequent distribution is fully taxable. When you invest the money yourself, at least some of the distributions could be long-term capital gains or other tax-advantaged income.
Your guaranteed distributions from the annuity don’t have inflation protection and are locked in at today’s low interest rates. Though there’s the potential for higher distributions from good investment returns, that’s not a high probability, given the fees.
The VA-GMWB can be a better deal if you invest earlier than age 60 and give the balance a chance to grow for a while. But try to compare this with the results from keeping your money and investing it for a few years, without losing the 3% or so in annual fees, and then buying an annuity.
Insurers also seem to be reducing their guaranteed benefits and investment choices. These policies could be less attractive in the future than they’ve been recently.
