Have you heard of an investment that will guarantee a 5, 6, or even 7 percent return, and can return more if the market performs well? Actually, these claims are quite common in the variable annuity world. However, it is critical to realize that the guaranteed return is only half the story, and that the withdrawal rate attached to the annuity dramatically impacts the actual return achieved by the investment.
Moshe Milevsky has done some great work determining “the catch” of these investments. His entire report can be viewed here, but the following is a summary of his findings:
Growth Rates Aren’t The Whole Story
These products are called “guaranteed lifetime income benefit” variable annuities (GLIB VAs). The annual guaranteed growth rate, which is the rate touted by annuity firms to attract consumers, applies only to an income base. The income base is usually the equivalent of your original investment, plus the interest derived from the invested dollars at the annual guaranteed growth rate. This value is completely separate from the actual market value of the account, which fluctuates with the market. At set periods, an investor can choose to withdraw the actual market value from their account or annuitize the income base. If the investor decides he wants to annuitize the value of the income base rather than cash in the actual value of the account, he will receive a set dollar amount annually for the rest of his life. The dollar amount is determined by the withdrawal rate assigned to the contract. Withdrawal rates frequently range from 4 to 7 percent, and this figure is usually not made as clear and apparent as the annual guaranteed growth rate by insurance firms. Yet, it is crucial to understand that the withdrawal rate is different from the annual guaranteed growth rate, and every GLIB VA has both.
In order to take advantage of the annual guaranteed growth rate of as much as 7 percent, investors must first sacrifice the liquidity of their investment. After annuitizing, investors will never be able to access the lump sum of their investment — they will only receive annual payments for the rest of their life. Second, whether annuitizing is a good option depends on the withdrawal rate and how long the investor lives. If the withdrawal rate is low, which essentially limits the speed in which you can access your invested funds, the annuity’s actual return is lowered.
Not as Good as it Sounds
Let’s look at an example. Suppose a 55 year old invests $100,000 in a product offering a 7 percent guaranteed growth rate and annuitizes this product in ten years. The guarantee assures this investor he will have at least $196,715 by the age of 65. This number sounds great, but this is where the potential problem arises.
When you refinance your home, do you simply work with the bank that offers the lowest mortgage rate? Recently, banks started utilizing a trick where they offer obscenely low mortgage rates but charge a high amount of fees to process the loan. Homeowners are beginning to realize that when financing their home, they need to consider total costs, or a combination of the mortgage interest rate and the fees to generate the loan.
Similarly, a high annual guaranteed growth rate of return doesn’t do an investor any good if they are restricted by a low withdrawal rate. Suppose our hypothetical product stipulates a withdrawal rate of 5 percent. Thus, at age 65, the investor will receive 5 percent of $196,715, or $9,836 for the rest of his life. Again, this figure doesn’t sound too bad, but what rate of return is he actually achieving assuming he lives to his natural life expectancy? Following is a chart containing cash-equivalent returns for GLIB VAs with various guaranteed growth and withdrawal rates.
As you can see, our 65 year old investor whose annuity has grown 7 percent annually during the past ten years but is restricted to a 5 percent withdrawal rate will only earn 2.09 percent annually over the life of the investment. Don’t forget that these guaranteed income riders come with an additional cost – commonly 1 percent per year. Of course, this makes our actual achieved return even lower. Varying the investor’s age and the investment’s growth and withdrawal rates will produce a range of implied returns, but the actual return is always less than the growth rate highlighted in the policy. Why? As Mr. Milevsky puts it, “marketing materials speak the language of ‘investment Celsius’ to human beings who are hard-wired to understand ‘economic Fahrenheit.’ The numbers sound similar, but the scales are completely different.”
Do your homework when analyzing any annuity product. Speak to a fee-only financial planner who can provide you with objective advice. You may hear a different side of the story than what you hear from the commissioned sales agent promoting the product.