“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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