GLWBs: Retiree Protection or Money Illusion?
One of the most popular variable annuity riders is the guaranteed lifetime withdrawal benefit (GLWB), which offers downside protection through lifetime income, upside potential with step-ups based on market performance, and minimal surrender penalties. But, examining historical data, I have found that those riders carry a cost that will not be readily apparent to retirees: their cash flows rapidly decrease on an inflation-adjusted basis.
Moreover, GLWB riders, which are also known as guaranteed minimum withdrawal benefits (GMWBs), compare unfavorably to the cash flows a retiree would obtain using a systematic withdrawal plan.
Vanguard made headlines recently with its offering of a GLWB rider that costs less than nearly all of its competitors. This product is attracting lots of attention as retirees seek guaranteed income sources in the face of market turbulence. Vanguard is marketing it on behalf of two insurers, and the retiree is still exposed to the credit risk of those insurers. The rider for its variable annuities guarantees an income for life at a fixed withdrawal percentage of the initial contracted assets. As long as one does not exceed the allowed withdrawal amounts, guaranteed withdrawals never decrease (in nominal terms) even if the account balance falls to zero. In this regard, GLWBs share similarities with immediate annuities, though a GLWB contract can be terminated and remaining assets can be returned. Additionally, if the contract value of the underlying account increases enough in value after accounting for any withdrawals and fees, a step-up feature may kick in to provide permanently higher withdrawal amounts.
For Vanguard’s recent offering, the GLWB rider has an annual fee of 0.95% of the total withdrawal base (this is the amount used to calculate the guaranteed withdrawals and may often be more than the contract value of remaining assets) on top of the 0.59% fees on the underlying assets held in a Vanguard variable annuity.
But do these products provide guarantees of any real value to their users? I won’t attempt to evaluate the actuarially fair cost for the GLWB guarantee to determine if they are over- or underpriced. Others have done important work in that area, such as Advisor Perspectives’ analysis and a rather heated discussion with Morningstar that ensued. I acknowledge such disagreements about the actuarial value of the guarantees, and that such products’ values are difficult to objectively quantify.
Those issues aside, I remain concerned that prospective retirees may be overvaluing the guarantees in their mind because they are not properly considering how inflation will erode their real value over time. In behavioral economics, this bias is known as money illusion. People can logically understand the effects of inflation, but their emotional responses and decisions remain attached to nominal values.
The guarantees are not inflation-adjusted and would have been worth little in rolling periods of U.S. historical data. Moreover, it would have been rather easy to replicate the GLWB guaranteed withdrawal amounts using a systematic withdrawal plan that is not guaranteed and does not require a rider. Benefiting from GLWB guarantees would require worse circumstances than any historical stretch so far. It’s important to note, however, that U.S. financial market history has been very kind to retirees. A new worst-case scenario could await those of us for whom retirement lies in the uncertain future. But these guarantees depend on the insurance company’s ability to pay, which could be at risk if the overall financial landscape gets bleaker.
Data and modeling approach
I used Ibbotson Associates' Stocks, Bonds, Bills, and Inflation (SBBI) data on total returns for U.S. financial markets since 1926. For the purposes of my inquiry, I used the U.S. S&P 500 index to represent the stock market and the intermediate-term U.S. government bond index to represent the bond market. In all cases, returns are calculated on an annual basis with withdrawals taken at the beginning of each year, fees taken at the end of each year and annual rebalancing. I investigated performance over rolling 30-year periods taken from the historical data. This covers 56 rolling periods between 1926 and 1981.
For the GLWB, I used Vanguard’s offering as the basis for many assumptions, though I did not model it exactly. For instance, I used annual instead of quarterly data, and I used index returns rather than the returns from Vanguard’s specific underlying variable annuity. My GLWB has a 0.59% annual fee on the contract value of the remaining assets in the variable annuity, and it has an annual rider of 0.95% of the total withdrawal base. That base is always at least as large as the remaining contract value, which is used to calculate the annual withdrawal amount. When GWLB assets reach zero, fees stop, but the guaranteed withdrawals continue. To simplify the scenario, I assumed the GLWB was purchased for a single male on his 65th birthday. It provides a 5% withdrawal amount of the initial assets and steps up if and when the total withdrawal base increases. The GLWB owner withdraws precisely the maximum allowable amount each year within the terms of the contract to maintain the guarantee. The GLWB asset allocation is 65/35 for stocks/bonds, as using the highest possible stock allocation gives the best chance for step-ups, and Vanguard’s Balanced Portfolio variable annuity is the most aggressive option, with approximately this allocation.