“Lifetime withdrawal benefits” are very popular these days; most of the indexed or variable deferred annuities sold today are bought by consumers who paid extra for this “rider”. Regrettably, all too many of those buyers believe that, for that extra cost, they will* *earn a *guaranteed* “investment return equal to the “rollup rate” of the annuity. They won’t. They will get a guaranteed amount of income, but that’s not the same thing.

Let’s define our terms. A “Guaranteed Lifetime Withdrawal Rider” (usually abbreviated as GLWB) guarantees the buyer the right to take an income for life. The amount of the annual benefit is stated as a percentage of a “benefit base” and this “payout percentage” typically increases with the age at which payout is elected. Once elected, that percentage usually remains the same, as does the amount of the annual income. The “benefit base”, which exists *solely *for the purpose of determining the GLWB income amount and which may *never *be taken as a lump sum, is typically the amount of the buyer’s initial investment (perhaps increased by a first-year “bonus” percentage) in the first year. It will increase each year by a certain percentage (usually called the “rollup rate”) for a set number of years (typically, 10 years) or until payout under this rider is elected, if earlier. When payout is elected, the insurance company will pay, each year, the payout percentage for the buyer’s then current age multiplied by the then current value of the benefit base. Once payments commence, they are guaranteed for life and may never be decreased. (Some newer contracts provide for an *increasing *benefit, but most GLWBs do not).

Here’s an example:

Joe buys an indexed deferred annuity for $100,000 when he’s 55 years old. He wants to *guarantee *a *minimum *income from that purchase, commencing when he retires at age 65. The contract *guarantees* a 5% payout at age 65 from a benefit base which is *guaranteed* to increase each year by 7.2% compounded (which, over 10 years, is the same as a simple interest rate of 10%). At his age 65, that benefit base will be roughly $200,000. He will take 5% of that benefit base as an income that will remain constant for the rest of his life.

Many agents tout that “rollup rate” of 7.2% as a “return on investment”. *It’s not. *Others point to the guaranteed payout percentage (in this case, 5%) and call that an investment return (“This policy will pay you 5% for year, guaranteed for life”). *That’s not true either. *

Why not? Well, it’s because “investment return” means the amount of profit, before taxes, from an investment made, expressed as a percentage of the amount invested. (Example: A invests $100. One year later, his investment is worth $108; his investment return is 8%). The “rollup rate” of 7.2% on Joe’s benefit base isn’t a return on investment because Joe cannot take that benefit base in a lump sum. It’s not “his money”, except to the extent that he is guaranteed the right to take 5% of it as income, via withdrawals from the annuity. And that 5% payout percentage isn’t a return on investment either, because it’s not a return *on* principal* *(Joe’s initial investment), but, rather, a return *of *that principal, with interest. If Joe lives long enough that the cumulative value of his annual withdrawals exceeds his original investment *plus *all interest earned (at which point the annuity contract value has fallen to zero), he may continue to take annual withdrawals (of the same amount ) until his death (at which point, the annuity contract will expire, with no remaining value).

Here are “Joe’s numbers”:

At his age 65, the *benefit base *has grown from $100,000 to $200,423. At that point, Joe takes annual withdrawals of $10,021 (5% of $200,423). If his annuity earns 3% per year, it will run out of money in the 28th year (when Joe is age 83). But Joe will continue taking withdrawals for his remaining lifetime. At that point, the “Internal Rate of Return” (IRR) on those 20 years of income payments will be 3.30%.

If his contract earns 4% each year, it will not run out of money until year 33, when Joe is 88. At that point, the IRR of this annuity would be 4.06%. Not 7.2% or even 5%.

If his contract earns 5% each year, it will not run out of money until Joe’s age 99, at which point the IRR will be 5.06% – more than the 5% payout percentage, but nothing like the 7.2% “rollup rate”.

Does this mean that the GLWB is a “bad deal “for Joe? Not necessarily. If the annuity Joe bought was a *variable *one, he would not have any guarantee of principal. His annuity might run out of money much sooner (because it does not not guarantee either a minimum rate of interest or safety of principal), so that his GLWB payments might exceed his cumulative investment (plus interest) much earlier. Even with an index annuity (which guarantees both minimum of interest and safety of principal if it’s not surrendered early), he might not get 5% per year or even 3%. But the amount of his annual withdrawals will still be $10,021 because they are a *guaranteed* percentage of a *guaranteed* benefit base.

A Guaranteed Lifetime Withdrawal Benefit is not an *investment *feature. Its value (a set percentage of a benefit base that is guaranteed to increase at a set rate for 10 years or until he begins withdrawals) is an *insurance *feature. And *insurance *features don’t perform like *investments* – because they’re not. *No *insurance feature, of any policy on the planet, will *ever *“pay off” *on average. *If the average buyer of an insurance policy *profits *from buying it, the insurance company will soon go broke. The true value of an insurance feature is not its IRR (or ROI, or any investment measure), but the fact that it *guarantees *an outcome, *no matter what. *

So, what does all this mean? It means that the “rollup rate” and the “payout percentage” of an annuity with a lifetime income benefit is *not *an investment return and the buyer *will not *get that percentage, *plus his original principal. * Those rates are simply factors producing an *insurance *benefit (in this case, the sure and certain income to Joe of over $10,000 per year, one tenth of his original investment, *even if everything goes wrong.*

For some consumers, this guarantee will not be worth the cost (which can run anywhere from 0.3% to over 1.3% of the benefit base each year; for others, it will. But in any case, *no *buyer should expect to get a “return on principal” equal to the “rollup rate”, or even the “payout percentage”.

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Great article! How would you frame the GWLB feature when your talking to a client. I understand this article, but not well enough to explain it to another client. All I see out there is advisors talking in terms you have described above, so when a prospect/client comes to you to ask about the IRR or return on investment, and you say…

Justin,

I begin by explaining that this guranteed income benefit is not an investment feature, but a pure insurance feature. You, Mr. Client, are TRANSFERRING risk to the insurance company. That risk is that you might outlive your income. When the insurance company assumes that risk (by guaranteeing you that the income will last as long as you do, no matter what), it charges for that insurance, because it's on the hook to pay you that 5% of that guaranteed MINIMUM benefit base every year, even if your annuity account balance falls to zero.

If your account balance never falls to zero, because the annuity earned enough interest to cover those 5% withdrawals every year, then this rider will never pay off. If the account balance does fall to zero, the rider does pay off, starting when the cash value hits zero and continuing for as long as you live.

Think of it as you do your homeowner's insurance. If your home burns down, the policy will pay to rebuild it. If your home doesn't burn down (or lose a roof, or any of the other things that the policy insures against), the policy doesn't pay.

Thought of as "an investment", that would be a terrible deal. But it's not, because it's not an investment. It's insurance.

So is this rider. If you're completely confident that you'll earn interest enough interest in this annuity to pay for that lifetime income, then you shouldn't buy this rider. If you need a guarantee that the income will last as long as you do, then you probably need this insurance. What do you think?

John:

This is an excellent explanation of these products. The important thing to keep in mind is that not all clients (probably most retiring Americans) have the luxury of being able to “invest” enough capital to support themselves in retirement with any degree of predictability that they will be able to sustain their lifestyle to the end of their life by taking more than about 3.5% per year.

There is no question that the most efficient way to distribute retirement savings is to use all of it and write the last check from your account the day that you die. Investment return will determine how much you spent, but spend all of it.

Unfortunately, that is not a good plan to try on your own, because you don’t know how long you will live. The insurance company takes that uncertainty off the table because they know mathematically how long that will be. This is why annuities make such good sense for so many people. The GLWB adds an extra feature that allows the client the satisfaction of receiving a relatively high monthly income while knowing that if he is one of those who die early, at least some of his money will pass to his heirs….at a cost, of course, but that should be his choice.

One more thing. For many it should not be about “annuity or no annuity”. A well designed retirement portfolio allocates a portion of the assets to some form of annuity to guarantee a lifetime income base. The remainder is in invested for returns that will provide inflation options and other liquidity needs.

GP

Are you an investment advisor. Be careful about offering investment advise.

It should obviously be explained that GMWBs are an insurance feature that protects you from ever depleting the portfolio after explaining how the actual account values grows. The rollup simply only increases the insurance benefit during the deferral period. GMWBs on VAs and IAs are not totally the same… IAs will never see an upword reset due to cap rates falling under the rollup amount.

Now explain a VA that has both a GMWB and a return of premium DB… Its more like a lifetime coupon bond that's guaranteed not to mature before you die, and its value fluctuates based on market performance.

most importantly, you should identify the purpose for the account; income growth or preservation? If income is not the ultimate goal, there should be no reason to include the GMWB.

Highland, I could not agree more that if income is not your ultimate goal, a GLWB is a waste of money.

As to "offering investment advice", I am no longer a Registered Investment Advisor or Registered Representative, so I don't give advice about variable annuities. That said, I believe that what I said in an earlier email about how to explain an income rider on an index annuity (because I don't say give advice about securities) is perfectly acceptable. It's literally "insurance advice". And I believe that ANY agent who gives advice about these income riders has an obligation to explain that they're INSURANCE features and that they will NEVER produce ANY economic benefit unless and until the annuiity value falls to zero. That makes their utility on a fixed annuity (including an indexed one) somewhat problematic. On the negative side, they cannot experience capital loss except through withdrawal; on the positive side, these riderss provide the assurance that withdrawals of the guaranteed amount will last for life.