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SOct 29, 2008

The Problem With ‘Living Benefits’

Scott Burns

Retiring is easy. The hard part is having a steady income from your investments. Many who retired in 1999, for instance, regretted it as the stock market fell in the next three years. Today, after a year of spectacular declines for stocks around the world, millions of soon-to-retire boomers are wondering what to do.

Enter the allure of living benefits.

These were rare as recently as 2000, and now the National Association for Variable Annuities says that at least 85 percent of all VA contracts now have some form of living benefit option.

Until this innovation, a variable annuity had just two benefits: tax-deferral of all gains and a death benefit. The contract guaranteed that your heirs would receive at least as much as your original investment -- but you had to die first.

Living benefits are a whole new deal. They contractually guarantee that you can receive an income for life, regardless of the value of your underlying account. The contracts call this provision a "guaranteed minimum withdrawal benefit" (GMWB). They can be further sweetened by another benefit, the "guaranteed minimum accumulation benefit" (GMAB). This guarantees that no matter what the markets have done, your account will grow at a certain percentage rate (usually 5 to 7 percent) for a period of time. Better still, your guaranteed minimum withdrawal benefit can be based on that guarantee.

Sounds like a great deal, right? A guaranteed minimum return and a guaranteed payout, plus lots of upside potential if the markets happen to soar. What's not to like?

Plenty.

Here's an example. You're 65, just retired, and you like the idea of a guaranteed 5 percent for life. You invest $100,000 in a typical contract. You start drawing $5,000 a year. You'll have that income for life regardless of what the markets do.

In fact, you can buy the same promise -- $5,000 a year for life -- for only $61,778.

How? Just purchase another insurance product, an immediate life annuity. By choosing the living benefits option, you have effectively given the insurance company 38 percent of your money. To put the loss in some perspective, it's like volunteering for a loss that is about the same size as the decline in the S&P 500 over the last year.

But what about all that upside potential?

Well, it's just that: potential. The 38 percent of your money that you lost is here, now and real. With typical contract costs of about 3 percent a year, you will enjoy account growth only when your gross return exceeds 8 percent a year. In other words, contract fees and your withdrawals are likely to devour most of the upside potential.

Now let's see if living benefits are a better deal if they are combined with a guaranteed minimum accumulation benefit. Suppose you are 55 years old. You intend to retire at 65. You will leave your investment untouched for 10 years. If you invest $100,000 today and get a guaranteed minimum accumulation benefit (GMAB) as well as a guaranteed minimum withdrawal benefit for life (GMWB), what happens?

With a guaranteed return of 5 percent, compounded, your $100,000 investment will grow to an account value of $162,889 in 10 years. That value cannot be withdrawn in a lump sum. It is only the basis for calculating the annual income you can withdraw for life. At 5 percent, that's $8,144 a year, or $679 a month.

So, how much would it cost to have the same lifetime income guarantee in an immediate life annuity? Answer: About $100,593.

Fortunately, you don't have to have that amount today. You just need it 10 years from now. If you invest only $61,755 today in a CD-like fixed-income annuity with a yield of 5 percent, you'll have the $100,593 when you need it. Recently, I found 17 contracts with yields over 5 percent on www.annuityadvantage.com.

Again, if you choose living benefits rather than alternative insurance products, you have effectively gifted the insurance company 38 percent of your money. The enthusiastic, high-commission salesperson who likes living benefits so much has turned your cash into his gold.

Why does it turn out so badly?

Simple. The guaranteed withdrawal rates are much lower than the percentage payouts on life annuities. While a 65-year-old man can withdraw at only 5 percent in a typical living benefits contract, a life annuity would pay at 8.1 percent a year.

Big difference.

Sidebar
How to find the value of what you are being offered

Want some fun? Ask your friendly living benefits salesman to calculate the present value of his living benefits product offer. Some won't understand present value; some will. But here's an easy way to do it. Whatever the guaranteed lifetime income is, go to www.immediateannuity.com and find out how much it would cost to buy a life annuity that delivered the same income.

If the income is promised at a future date, you'll need to do a two-step analysis. First, find the cost of the life annuity that would deliver the promised income. Second, use a financial calculator to find out how much you would have to invest, today, to have that sum in the future.

On The Web

"An Alternative to Living Benefits" (11/2/2007):

National Association of Variable Annuities press release on Living Benefits:


Web site with data on fixed income, CD type annuities:

Web site with online estimates of life annuity rates:

Wikipedia: Three-card Monte:

Filed Under: Q&A (from print)