December 13, 2011
The second part of figure 4 shows how, in real terms, the contract value of the GLWB stabilizes at about 35% of the initial value after about year 15, but this is primarily because the value of the GLWB withdrawals are so low by this point. In fact, the black curve is the path of remaining wealth for a systematic withdrawal plan (with a 65/35 asset allocation as well), replicating these lower GLWB withdrawal amounts without paying a rider; 71% of initial assets remain after 30 years in real terms, and in nominal terms this is a factor of 3.33 times retirement date wealth.The difference between the black and red curves is explained solely by the compounding impact of the 0.95% GLWB rider on the total withdrawal base.
The last part of the figure shows that for the 1966 retiree, the first step up does not occur until the 20th year of retirement. These step ups are what help to keep the real withdrawal amount stabilized at about 30% of its initial value in subsequent years.
The bottom line
Retirees may find “peace of mind” from the guarantees a GLWB provides. Perhaps the guarantee would stop retirees from panicking and selling stocks after a market drop. Moreover, if retirees do have a tendency to reduce their spending as they age, it may not be necessary for them to maintain a fully inflation-adjusted income. GLWB guarantees may also come in handy if people live beyond a 30-year retirement horizon. Perhaps most importantly, I have conducted research that suggests that withdrawal rates may fall dramatically below 4% for recent retirees. Should that prove to be the case, retirees could possibly benefit from the guarantees.
Nevertheless, there are several important points that advisors and their clients should consider when evaluating GLWBs. For one thing, the nominal withdrawal amount guaranteed by a GLWB can become quite small in real terms, and money illusion biases may prevent clients from properly appreciating this drawback. What’s more, GLWBs rarely provide inflation protection, and they are least likely to do so during inflationary periods or periods with poor equity returns. In the event that someone replicating GLWB withdrawals on his or her own runs out of wealth, an outcome that no investor has faced historically, then GLWB owners will surely worry about the risk of default for the insurer. And it’s important to note that the GLWB considered here is a best-case scenario for GLWBs with relatively low fees. Higher fees would erode the account balance more quickly, allowing for fewer step ups, more exposure to inflation, and making it even easier for systematic withdrawals to match GLWB withdrawal amounts.
It is possible that purchasing a fixed single-premium immediate annuity (SPIA) would generally enable retirees to obtain a guaranteed income source more cheaply. Financial planner Joe Tomlinson refers to GLWBs as “actuaries gone wild,” due to their complex combination of downside protection and upside potential. It may be more straightforward to treat these important needs separately, which is a proposition I plan to examine in a future article.
Wade Pfau, Ph.D., CFA, is an associate professor of economics at the National Graduate Institute for Policy Studies (GRIPS) in Tokyo, Japan. He maintains a blog about retirement planning research at wpfau.blogspot.com
Wade wishes to thank Peter Benedik, CFA, Jason Branning, CFP®, Robert P. Seawright, J.D., and Joseph Tomlinson, FSA, CFP®, for providing him with helpful feedback on an earlier draft of this article.
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