Income Annuities versus GLWBs: A Product Comparison
Here is the first in what will be a monthly column by Joe Tomlinson on topics related to retirement investing strategies.
The variable annuity with a guaranteed lifetime withdrawal benefit (VA/GLWB) has become the most popular form of annuity, as retirees seek income protection and equity-market participation. But VA/GLWBs are often costly, and the typical purchaser has few tools with which to assess the costs. Investors need a straightforward way to gauge the fees for VA/GLWBs versus other retirement income alternatives.
The income annuity is another type of retirement income product, which, at first blush, might seem quite different from the VA/GLWB. It is a bond-like investment that provides payments that last for life, whereas the VA/GLWB allows individuals to invest the bulk of funds in equities and take systematic withdrawals with lifetime guarantees. But when examined more closely, there are in fact more similarities than differences. The purpose of this article will be to compare these two products, including real-world examples, with a goal of providing information that will help advisors and clients make product choices.
A comparison of these two products begins with a simple example. Let's say that a 65-year-old individual has dedicated a portion of his or her retirement savings to provide regular monthly payments equal to 5% of the initial fund balance, with the payments increasing each year for inflation. One alternative would be to invest the funds in an inflation-adjusted immediate annuity. A check of current market rates from Income Solutions®1 – which offers income annuities from a number of different insurance companies – indicates that a 65-year-old could purchase an inflation-adjusted annuity with a payout rate a bit over 5%, so this strategy could provide the needed income and eliminate the risk of outliving one’s savings. Downsides of this approach include inability to control one’s funds, lack of liquidity and flexibility, and the elimination of a possible bequest to one’s heirs.
Another alternative would be a VA/GLWB, which would guarantee a base level of lifetime withdrawals. Unlike the income annuity, the VA/GLWB would allow the purchaser to retain control over funds, invest in equities, and have liquidity and flexibility. However, current VA/GLWBs do not offer inflation guarantees. A typical guarantee for a 65-year-old is a flat 5%. The products do provide for increases in guaranteed payments if account values increase (i.e., if returns more than offset withdrawals), but such increases are likely to fall short of inflation. An Ibbotson study in 2007 estimated that such increases would average 1.35%, compared to historical average inflation of 3%. (For a more extensive treatment of this issue, see Wade Pfau's article GLWBs: Retiree Protection or Money Illusion? in the December 13, 2011 issue of Advisor Perspectives, which provided an in-depth analysis of GLWBs and highlighted the lack of inflation protection.)
The VA/GLWB is a more popular product than the income annuity, and it is often touted as providing stock market participation with downside protection, like "having your cake and eating it too." This is largely a mischaracterization, because the fees one pays to obtain the GLWB’s guarantees take a substantial bite out of the equity returns. Given the dictates of financial markets, it is not reasonable to expect to both hedge downside risk and enjoy equity-like returns.