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  A basic GMWB is structured as a guarantee of principal: a percentage of the original investment, typically 7%, can be withdrawn on an annual basis until the entire investment is recovered, regardless of actual account value.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.