How Well Does the Next Generation of Guarantee Riders Protect Your Income? Part 2 - Starting the Inc
November 13, 2012
by Wade Pfau
This is part two of a three-part series of articles reviewing stand-alone income (SALB) guarantees. Part one of this series is available here.
Unlike traditional guaranteed lifetime withdrawal benefit riders on variable annuities (VA/GLWBs), the future payments from stand-alone income riders (SALBs) are tied to 10-year Treasury rates. That’s bad news for retirees, who may find their future benefits compromised if interest rates remain at historically low levels – regardless of how the stock market performs.
Part 2 in this series on income guarantee riders considers the point when a client locks in an income guarantee after a 10-year deferral period, picking up where Part 1 left off. (Part 1, linked above for those who missed it, focused on the deferral period.)
RetireOne’s SALB offers many attractive features relative to a VA/GLWB: it can be applied to stand-alone portfolios of mutual funds and ETFs, its costs can be reduced by choosing index funds, and the rider fee is charged on the remaining contract value rather than the typically larger benefit base.
Bob Veres, in his publication Inside Information (link, requires subscription), posed the fundamental question with respect to SALBs: What market scenarios does their guarantee hedge against, and how likely are those scenarios to occur?
To answer Veres’ question, we’ll explore more deeply the link between pre-retirement wealth accumulation – which is driven by equity-market performance – and interest rates at the retirement date, which will govern SALB payments post-retirement. As we’ll see, recent retirees can’t catch a break. Relative to historical outcomes, wealth accumulations from 10-year deferral periods ending currently are low, as are interest rates.
Ideally, wealth accumulations should relate inversely to interest rates. The most helpful income guarantee would provide downside protection, in the form of higher payout rates, against declines in the stock market – which for most investors will translate to disappointing accumulations of wealth.
Unfortunately the historical record does not show an inverse relationship between equity returns and interest rates. This means payout rates that are linked to current Treasury yields, as in the case of RetireOne’s SALB, are an unattractive feature for an income guarantee rider.
The key assumptions that drive performance
For anyone interested, part 1 of this series offered a complete run-down of the background and features for VA/GLWBs and SALBs, and I will not go into the same level of detail here. Very briefly, VA/GLWBs are designed to provide owners with downside protection, upside potential, and the opportunity to have remaining assets returned. These riders guarantee an income for life at a fixed withdrawal percentage of the initial assets. As long as the investor does not exceed the allowed withdrawal amounts, guaranteed withdrawals never decrease (in nominal terms, as opposed to inflation-adjusted or “real” terms) even if the account balance falls to zero. If the contract value of the underlying account increases enough in value (after accounting for any withdrawals and fees), a step-up feature will kick in to provide permanently higher withdrawal amounts.
Because these guarantees are not adjusted for inflation, however, the real value of future benefits will decline over time as cost of living increases.