The High Cost of a Guaranteed Income

Fidelity Investments has joined the rush to “Living Benefits.” Partnering with Metropolitan Life, it now offers a variable annuity that guarantees 4 to 6 percent distributions from your original investment each year for life— regardless of what happens to the stock and bond markets.

It’s not surprising that living benefit variable annuity contracts now account for a majority of all variable annuity sales. If the market goes down, you get your income no matter how long you live, even if your original investment drops to zero. If the value of your investment goes up, your income will rise with it.

Unfortunately, living benefits aren’t as good as they seem. The basic problem is simple: high costs. While the sales force hints at higher income in your future, it is more likely that your account value will slowly disappear and your guaranteed monthly income will remain fixed until you die.

How can this be?

Part of the answer is basic arithmetic. Like many living benefit contracts, the Fidelity/MetLife product requires that you invest in a balanced portfolio. In this case the fund is committed to being 60 percent equities, 35 percent fixed-income and 5 percent cash. Over the 80 years from 1928 through 2007, the Ibbotson Associates data indicates that such a portfolio would have provided an annualized return of about 8 percent.

That return must cover all costs— both the cost of managing the portfolio and the distributions you receive. The Fidelity fund costs 0.84 percent a year. The cost of the insurance is an additional 1.90 percent for a single life or 2.05 percent for a joint life. The guaranteed distribution ranges from 4 percent to 6 percent of the original deposit, depending on your age. It is 5 percent for a 65-year-old.

So do the math. If the portfolio earns 8 percent, the effective annual expenses of just more than 3 percent and the 5 percent payment will cause the remaining amount to shrink slightly each year.

Fidelity’s online calculator shows just that. At an even 8 percent, an initial investment of $100,000 will be $84,706 at the end of 30 years. Your lifetime income will be fixed at $416 a month. The only way your income will rise is if Fidelity managers can earn more than the market return of 8 percent.

But that’s just the simple part. The Fidelity calculator ignores the same market ups and downs that make living benefits seem so wonderful. As a consequence, it materially overstates the amount that will be left in most accounts. The online calculator makes the same mistake that Peter Lynch made in 1995 when he wrote that you could have a 100 percent stock portfolio and safely withdraw 7 percent a year. Responding to that article, I demonstrated that you can’t. Real stock portfolios could run out of money under those circumstances.

The factor being ignored is “variance sink,” the nasty thing that happens when you make constant withdrawals in a volatile market. While a living benefits guarantee assures your income, nothing in a living benefits contract protects the underlying investment from market volatility.

So what happens when you consider market volatility?

Investors may die broke.

Using Firecalc, an online simulation calculator, I found that a $100,000 portfolio with an expected return of 8 percent, expenses of 3.1 percent (calculated using the methodology described on the Fidelity website), and a 5 percent of original investment withdrawal would often run out of money before 30 years.

How often? It depends, but under each scenario there was a significant chance of ending with zero.

Even if it is only a chance event, that’s a long way from the $84,706 shown so positively by the Fidelity online calculator. The important fact here is that any calculator that includes market volatility will reveal materially worse results than the static model Fidelity uses on its website because market volatility always has a cost.

Called for comment, a spokesperson for the Fidelity Annuities group said: “I wouldn’t disagree with any of your points. But I do think these products play a role in providing lifetime income.” The spokesperson also noted that the Fidelity/MetLife product had lower costs than typical living benefits contracts.

The significant probability of disappointing results isn’t unique to this particular living benefits product. In fact, the probability of disappointment rises with higher expenses.

Coming December 20, 2009: An alternative with lower costs and better results

On the web:

Sunday, November 2, 2007: An Alternative to Living Benefits

Sunday, October 8, 1995: Making the Lynch All Stock Strategy Work

Some Technical notes:

Adjustment of gross return for expenses:

Here is how Fidelity describes its method for calculating the “Adjusted Market Return”— the return credited to an investors’ account net of expenses:

“An annualized rate of return equal to the Market Return, as input by the user, adjusted for both Fund Expenses and the product Annual Annuity Charge. Refer to Our Assumptions for the Fund Expense and the Annual Annuity Charge applicable to the product.

Adjusted Market Return = (1 + Market Return) x (1 - Fund Expense) x (1 - Annual Annuity Charge) - 1

This Adjusted Market Return is used to project the Contract Value.

Example
Assume you input the following:
Current age = 51
Spouse's age = 55
Market Return = 7% (net of fund fees)

Fund Expense = 0.84%
Annual Annuity Charge = 2.05% based on two annuitants
Adjusted Market Return = (1 + .07) x (1 - 0.0084) x (1 - 0.0205) - 1 = 0.03926 = 3.926%”

Subtract the adjusted market return of 3.926 percent from the gross return of 7 percent and the imputed total cost of the product is 3.074 percent. Apply the same formula to an 8 percent gross return and the imputed total cost of the product is 3.10 percent.

Standard deviation assumption of 11 percent.

Using the Morningstar database I found that the average 10 year standard deviation of all moderate allocation funds was 11.27. Standard deviations were higher over the previous 5 and 3 year periods. Ibbotson Associates SBBI Yearbook for 2007 indicates an annual standard deviation (1926-2006) of 17.1 percent for a 70/30 equity/fixed income portfolio and a 15.3 percent standard deviation for a 50/50 equity/fixed income portfolio. In its 2008 Matrix Book, Dimensional Fund Advisors shows an 8.9 percent standard deviation for its more broadly diversified 60/40 portfolio for the period 1973-2007. Incorporating 2008 would increase the standard deviation somewhat.