Is the security of guaranteed minimum
withdrawal benefits worth the cost?
Guaranteed Minimum Withdrawal Benefit (GMWB)
features in variable annuities have grown steadily in popularity since
first introduced in 2002 by Hartford Life via their Principal Plus
benefit. Even as equity markets and the near-term economic outlook
falter, variable annuity sales continue to set new highs; mid-year
estimated sales were close to $80 billion, almost 23% higher than
mid-year 2005 sales. Historically, VA sales have correlated pretty
closely with U.S. equity returns and the economic outlook-so why are we
now observing a departure from historic trends?
The answer appears to lie in the appeal of living
benefits, particularly the GMWB, to the largest generation of retirees
in history. Trillions of dollars in retirement assets, fear of market
loss and the desire (one might even say need) to allocate assets into
asset classes with higher risk and higher potential returns to finance
retirement expectations are characteristics of this generation that,
for some, can put variable annuities in a new light. You may have read
about the use of GMWB features as an effective approach for getting
nervous investors comfortable with an asset allocation that is
appropriate for their goals and objectives, but what may be even more
powerful is the use of such features as a mechanism for helping
investors stay the course in the face of market losses
A basic GMWB is structured as a guarantee of
principal: a percentage of the original investment, typically 7%, can
be withdrawn on an annual basis until the entire investment is
recovered, regardless of actual account value. So a $100,000 investment
can be recovered through withdrawals of $7,000 per year over a little
more than 14 years, even if the actual value of the investment falls to
zero. Some recent innovations in this benefit include a "for life"
option, which guarantees payments for life, although generally at 5%
withdrawals; step-up features, which allow the investor to reset the
guaranteed amount at specified intervals, generally five years but as
frequently as annually; and spousal continuation, which permits
withdrawals for the life of the spouse after the contract owner dies.
Almost every large issuer of variable annuities offers a GMWB feature,
but are they worth the cost of the annuity and the added expense of the
rider, which together can add more than 2% a year on top of the
underlying investment option fees and expenses?
In this article we'll take a look at three
hypothetical investors-Mr. Steel, Mr. Cave and Mr. Cautious-and see how
their investment decisions play out in a simple scenario covering a
fixed period of time.
The Options
All three investors have a $500,000 nest egg in a
qualified plan on June 30, 2001, have access to the same investments
and fee structures, and have decided to invest 60% of their retirement
assets in U.S. Equities and 40% in a money market fund. They can either
invest in a mutual fund portfolio or in similar investment options in a
variable annuity with a GMWB rider. For simplicity, we'll assume that
their expenses at the investment option level (fund or VA subaccount)
are the same, and that the variable annuity adds 1.5% in mortality and
expense charges and .60% for the optional GMWB rider. All three will
set up their portfolios to rebalance on a quarterly basis.
Mr. Steel
Mr. Steel believes firmly that employing an asset
allocation appropriate to his risk tolerance and time horizon is
sufficient protection against market downturns, and decides that he
would rather not incur the additional expense of a variable annuity. He
isn't concerned about short-term losses, and reasons that he will
adjust his lifestyle if his wealth does not grow as expected.
Mr. Steel, like all of our hypothetical investors,
had the unfortunate timing to allocate his nest egg just prior to a
significant downturn in U.S. Equity returns, but by staying the course
he still managed to realize a gain.
Mr. Cave
Mr. Cave realizes he has not saved enough for
retirement to achieve the lifestyle he desires. Like our other
investors, he believes that the 60/40 allocation gives him the best
chance of achieving his goals and he decides on the same course of
action as Mr. Steel. Unlike Mr. Steel, however, Mr. Cave monitors his
investments closely and is unnerved by the impact of significant losses
early in his investment time frame. Terrified by the prospect of
continuing declines eating further into his nest egg, Mr. Cave decides
to move all of his assets into the money market fund at the end of 2002.
Mr. Cave not only experienced unfortunate timing
with his initial investment, he also did not participate in future
positive returns because he did not maintain his asset allocation
strategy.
Mr. Cautious
Mr. Cautious isn't quite sure what to do. He has
read about historic average returns in equity investments and would
like the opportunity to grow his nest egg substantially, but he has
experienced losses in the past and has taken his money out of equities,
only to miss out on future gains. Like our other investors, Mr.
Cautious decides to use a 60/40 allocation, but opts for investing in a
variable annuity with a GMWB feature, despite the added cost.
Mr. Cautious experiences much higher fee drag on his returns, so his
initial losses are greater than Mr. Cave's, but Mr. Cautious does not
reallocate away from equities because he knows that he can recover the
benefit base (the original $500,000 investment) in the variable annuity
through withdrawals. But the higher fees also mean that Mr. Cautious
significantly lags Mr. Steel.
A Solid Case For The GMWB?
That depends. In these very simplified
examples-using S&P 500 returns to represent the equity portion of a
portfolio, three-year constant maturity Treasury rates as a proxy for
money market returns and focusing on one five-year period-the case for
the GMWB seems pretty strong. All three of our hypothetical investors
were disadvantaged at the start due to the timing of their initial
allocation, but Mr. Cautious significantly outperformed Mr. Cave
because he had the GMWB to fall back on. However, Mr. Steel was still
the victor because he maintained his allocation discipline and
experienced much lower fee and expense drag on his returns. Choosing
the variable annuity for the GMWB feature is an exercise in
understanding the investor, and the investor understanding himself.
There are other factors, such as liquidity needs, to consider in
evaluating whether the variable annuity makes sense for the client.
Variable annuities can come with some pretty hefty surrender charges,
and if the investor needs to access more than the guarantee allows the
value of the benefit can be significantly impacted. There is also the
issue of the complexity of all living benefits; the onus is on both the
advisor and the investor to carefully evaluate the structure of the
benefit and ensure that all parties understand exactly what is
guaranteed and the potential impact of any limitations involved in the
election or exercise of the benefit. But if liquidity needs and other
considerations do not preclude the use of a variable annuity, the GMWB
can be a useful tool for giving nervous investors the safety net they
need to get invested and stay invested.
Frank O'Connor is the product manager for Institutional Variable Annuity Solutions at Morningstar Inc.