Paclean & Sweep Investment

Over the years the debate over the relative safety of mutual funds versus variable annuities has come and gone with nothing in the way of any real consensus winner. They both came on the scene at roughly the same time, surged in popularity together during the raging stock markets of the 80’ and 90’s, and proliferated to the point of saturation well into the early 2000’s. All things being equal, they both offer investors the opportunity to participate in the markets with relative safety and equal potential for upside growth. In either case, investors can achieve a level of diversification within professionally managed portfolios that can reduce the risk of stock market investing. In that regard, can one actually be safer than another?  In a word, yes.

If, by “safer”, we are referring to the possibility of principal loss, both types of investments entail market risk. Both invest in portfolios of securities that can either appreciate or decline in value. But, if you consider a standard variable annuity contract, there is at least one safety feature that you won’t find in a mutual fund and that is the guaranteed death benefit.  The death benefit affords the variable annuity investor one layer of protection that the mutual fund doesn’t offer and that is the guaranteed return of the investor’s principal investment.  While some variable annuity critics may try to belittle that benefit as inconsequential, they might ask those mutual fund investors who were unfortunate enough to die during the worst of the market decline in 2008.  At the very least, variable annuity investors can assure their surviving families of greater financial security even in the face severe market declines.

It has only been in recent years that variable annuity providers have upped the ante for investment safety by adding rider options that go even further to protect the principal as well as the gains in the account value.  And, for the increasing number of people who are concerned with outliving their income sources, the riders will also guarantee their income from a variable annuity.  Practically speaking, it doesn’t get much safer than that. While they do come at a cost, these riders provide the ultimate peace-of-mind that one doesn’t usually find in investments that also allow for unlimited upside growth.

All Gain and No Pain

The guaranteed account value rider (GAV) enables variable annuity investors to enjoy the gains in their account values while riding out the market swings.  Essentially, the rider guarantees a minimum amount of growth of the principal amount regardless of market declines. And, if the account values do appreciate over time, the rider provides a “step-up” that enables the investor to reset the principal amount to the higher account value.

No Account Gain? No Problem

The guaranteed minimum income benefit (GMIB) addresses any concern an investor might have over the possibility of having to take a smaller income as a result of declining market values.  The rider ensures that, during the accumulation phase, the account values will achieve a minimum amount of growth. And, at the time of annuitization, the income payment will be based on the greater of the minimum accumulation amount, the actual account value, or the highest account value level at previous anniversary date.

No Account Balance? No Problem

The living withdrawal benefit (LWB) essentially turns a variable annuity into a bottomless pit of withdrawals regardless of whether or not there are funds left in the account. When the rider is exercised, the withdrawal rate is set based on a percentage of the account value which can be the actual value or a guaranteed account value based on a minimum growth, whichever is higher.  Even after withdrawals begin, the account value can be “stepped up” if, as a result of market growth, it increases above the base account value. This would result in an upward adjustment of the withdrawal amount based on the same percentage applied to the higher account value.

Summary

The addition of these variable annuity riders essentially shuts the door on the “safer” debate. It’s not even a fair fight. However, they don’t come without a cost.  To add one of these riders an additional fee in the range of .5% to 1.2% will be deducted annually from the account values.  This on top of the average annual fees of 1.5% to 2% for standard variable annuity contracts. So, for the absolute peace-of-mind that can be attained alongside the upside growth potential, an investor will pay as much 3% of account values each year.  With over 60% of Baby Boomers lying awake wondering if they will outlive their income, these types of guarantees may be priceless.

One important caveat: Guarantees are only as solid as the companies that back them. If you are guaranteed a minimum income for a lifetime that may last 30 years, it would be extremely important to make sure you are working with a company that will be around at least as long. Life insurance companies are considered to be the strongest and most stable of financial institutions, but, with so much at stake, why not work with the strongest? Companies that have earned the highest ratings (A+ or better from A.M. Best or AAA from Standard & Poor’s) are deemed to have the capability of weathering even the most treacherous economic storms. If you really want peace-of-mind, stick with quality.

Over the years variable annuities have had a somewhat spotted history. During the high tax and bull market environment of the 1980’s they became the darlings of financial advisors and investors looking to capitalize on rising stock prices while reducing their taxes. As the proliferation of variable annuity products hit a peak in the 1990’s they came under close scrutiny for their high expenses and their suitability for some investors. In recent years, especially in the aftermath of the recent financial crisis, variable annuities are getting a fresh look as much for the renewed concerns about outliving retirement income as for the availability of new riders that have enhanced their standing as a solid investment vehicle. Here we explore the most important variable annuity riders.

Guaranteed Minimum Income Benefit (GMIB)

The GMIB arrived at a time when variable annuity investors began to feel the pinch of the wild market gyrations on their annuity income payments. While the advantage of variable annuity income stream is the potential for increased payment amounts during rising markets, investors may not have been prepared for the steep drops in market values that they saw in the 2000 decade. The GMIB was introduced to allay the fears of those kinds of market swings by providing a minimum income guarantee regardless of declining market values.

The income guarantee is typically based on the greater of the actual market value of the annuity contract at the time of annuitization, or a fixed rate of interest compounded annually over the accumulation period, or the highest market value of the contract during the accumulation phase. The GMIB provisions vary from one contract to the next, but most of them require that the annuity be in effect at least 10 years (or some specified period) before it can be exercised. They also require that the whole contract be annuitized versus only a partial annuitization. Not all variable annuity providers offer a GMIB, but those that do usually offer them on all of their different variable annuity contracts, except no-load contracts.

Living Withdrawal Benefit (LWB)

The LWB is another rider that investors can purchase if they are concerned with the impact of market declines on their future withdrawals. The LWB ensures that you will receive a minimum withdrawal – monthly, quarterly or annually- for life, even if your account balance falls to zero. The amount of income is typically based on a withdrawal percentage using a minimum compounded interest rate such as 6% or 7%. To determine the guaranteed withdrawal amount, the percentage is based on the higher of the actual account value or the amount the account value would have grown to using the minimum interest rate. Some contracts allow you to “step up” the account value to the highest value attained during the exercise period of the rider. In all cases, once the withdrawals begin, they are guaranteed to continue for life.

Guaranteed Minimum Withdrawal Benefit (GMWB)

The GMWB is similar to the LWB except that it doesn’t provide a lifetime guarantee of withdrawals. The GMWB does guarantee that you can never lose any of your principal and that you will receive a minimum withdrawal payment based on a percentage of your principal balance until you have used up all of your principal and accumulated interest. If the market performs well and you account value increases, even while you are receiving withdrawals, you may have the option of “stepping up” the principal payments to reflect the higher account value. This means that, if your initial payments were based on a $100,000 investment, and your account value grew to $150,000 over a 10 year period, you could increase your withdrawal payment based on a percent of the stepped up account value of $150,000. You would choose a GMWB over a LWB if you preferred that you receive all of your principal and interest within a specified period of time as opposed to over your lifetime. In this regard, the GMWB can generate much higher withdrawal payments.

Guaranteed Account Value (GAV)

The GAV rider guarantees your account value so that it doesn’t drop below the principal balance. It also enables you to lock in a minimum growth rate. In some cases, the GAV will also allow you to step up your account value to lock in market gains. All future withdrawals are then based on the stepped-up account value regardless of whether the market declines. In this regard, a variable annuity with a GAV acts very similar to an indexed annuity, but with greater upside potential.

Weigh the Costs and Benefits

These are very powerful riders, and on their face, they turn an ordinary variable annuity into an extraordinary investment vehicle. But, they do come at a cost. The fees for adding these riders range from .30% to 1.0% of the account value and are deducted annually. For anyone who experienced the market roller coaster of the 2000 decade, they may be well worth the cost. When comparing variable annuity products, it is important to compare the cost of these riders as well as their provisions. For example, each annuity provider will have their own provisions that establish when the riders can be exercised, or how often step-ups can occur, or the minimum holding period before withdrawals can begin. Each rider has specific provisions that should be fully explored and their costs weighed against the benefits they provide.