A Gauranteed Life Withdrawal Benefit (GLWB) is an extra-cost rider you can add to a Variable Annuity that guarantees the payment of a fixed (i.e, not inflation adjusted) benefit to the purchaser during his lifetime even if the value of the investments in the variable annuity drop to zero. If the value of the portfolio increases by its anniversary date, a new, higher gauranteed withdrawal base (GWB) is established and you have the option to base the annual withdrawal on that higher value. If there is any money remaining in the portfolio when you die, it is paid to your beneficiary.
These insurance products are offered to retirees worried about outliving their savings and those spooked by wild gyrations in the value of their retirement assets. This article will examine the GLWBs offered by Fidelity and Vanguard and compare them to taking a similar withdrawal from a low-cost balanced 60% stock/40% fixed income portfolio.
How much can you withdraw?
The permissible annual withdrawal varies with age from 4.00% for a 59-year old to 6.50% for those over 80 years of age in the Vanguard program. The tables below list the ages and withdrawals for both the Vanguard and Fidelity programs.
What are the fees and costs of this arrangement?
For readers familar with low-cost index funds, the fees and costs associated with a GLWB are large enough to choke a crocodile. Back in September, Retire Early showed that you can put togther a $1 million stock/bond portfolio for less than $1,000 in annual fees and costs -- including the hidden trading costs and brokerage commissions that are not included in a mutual fund's expense ratio. The portfolio below is an example.
Vanguard's GLWB offers three investment options within their variable annuity; a balanced fund that mimics their highly regarded Wellington Fund, a Conservative fund, and a Moderate fund. The table below illustrates the total annual cost using the Balanced fund.
Fidelity's GLWB requires you to invest in its VIP FundsManager® 60% Portfolio, a mix of over 30 high-turnover sector funds. Adding to the high cost of the GLWB rider, brokerage commissions and trading costs run more than 48 times that of a low-cost index fund. While the total annual cost of the Fidelity product is more the double Vanguard's, the damage doesn't stop there. To add insult to injury, Fidelity extracts a 2% surrender fee from hapless purchasers on any excess withdrawals during the first 5 years of the annuity contract.
What are the odds that the insurance company will have to pay out on the contract?
There are three factors that govern whether or not the insurance company will have to pay out on the contract; 1) how long you live, 2) how fast the portfolio fails, and 3) whether the insurer is still solvent when the time comes to pay.
According to the latest mortality table from the Social Security Administration, a 60-year-old male has about a 10% chance of living to age 92 while a 60-year-old woman has a 10% chance of reaching 95. There's roughly a 1% chance either sex will reach 100. The table below summarizes these results.
Since the insurance company is not guaranting an inflation-protected withdrawal, there is actually very little chance the portfolio will run dry based on historical returns if you keep costs low. Indeed, a 4% fixed withdrawal survived every 50-year pay out period from 1871-2002 using Shiller's database.
Adding the expense of the GLWB rider with Vanguard's level of fees and expenses causes the portfolio to fail in the 36th year. (Note: In this analysis the annual withdrawal is not stepped up if the portfolio value has increased by the anniversary date. That didn't make any difference in the worst case period starting in 1929 since the portfolio never recovered to its starting value. For those periods where the portolio value increased by its starting value, the lack of a step-up meant that the ending portfolio values were higher.
A portfolio under the annual assault of a nearly 3.5% fee is driven to failure much more quickly. A portfolio with Fidelity's level of costs and fees failed in only 19 years under the worst case scenario (i.e., a 50-year pay out period beginning in 1929.)
The three charts above don't adequately represent what happens to a portfolio when its balance falls below the Gauranteed Withdrawal Base (GWB). Since the rider fee is based on the GWB and not the current asset value of the portfolio, the rider fee rises as a percent of assets as the portfolio loses value -- thus driving the portfolio to exhaustion even faster. The chart below illustrates the worst case results for the three portfolios examined under a withdrawal of 4%.
The table below summarizes these results for the three portfolios examined at various levels of fixed annual withdrawals .
The other remarkable observation is what happens if there is no portfolio failure. With the portfolio invested in a low-cost fund, the balance at the end of 50 years of withdrawals for the 91 overlapping payout periods examined ranged from a high of $84 million to a low of $0.7 million with a median value of $20 million. The cost of the Vanguard GLWB drops the median result to $6 million, while the Fidelity GLWB with fees that are double Vanguard's leaves the retiree with a median value of a bit less than $1 million. That's an awful lot of wealth being transferred from the annuity purchaser to the insurance company through fees. These results are summarized in the table below.
The last concern is will the insurance company be around to pay off on a claim when your retirement fund hits zero? So far, insurance companies and the state guarantee funds that backstop their operations have a very good record, but there's no guaranty of the future. During the 2008 financial collapse many insurance companies received Federal bailouts -- AAA-rated American International Group (AIG) the largest of the group. (Note: AIG happened to be Vanguard's annuity provider at the time.) Will taxpayers stand for another round of Wall Street bailouts during the next collapse? Your answer to that question should inform your decision on whether or not to trust the purchase of an insurance product to secure your future. Whether you manage your own retirement assets and make annual withdrawals from the pot, or turn it over to an insurance company, you're both investing in the same stock and bond markets and incuring similar systemic investment risks. The only difference is that an insurer is skimming big fees from your portfolio making it more likely to fail, and you more dependent on the solvency of the insurer.
A combined look at Portfolio Exhaustion and Longevity
The chart below illustrates the relationship between portfolio exhaustion and male longevity. The solid blue line is the 90th percentile for the life expectancy for the attained ages of 59 to 80. The dashed blue line is the median life expectancy for males that have attained those same ages.
The green line is the first failure point for a fixed withdrawal from a low-cost stock/bond portfolio under the worst case scenario in history (i.e., a payout period commencing in 1929.) The yellow line marks the same failure points for the Vanguard GLWB while the red line traces the same values for the Fidelity GLWB.
Historically, a 4% fixed withdrawal has a considerable margin of safety against portfolio exhaustion. Higher withdrawal rates cause the portfolio to fail more quickly, with failure point below the 90th percentile of longevity. Adding the high fees of a GLWB puts further pressure on portfolio survival. The Fidelity GLWB with fees and cost twice as high as Vanguard's has failure point below the median life expectancy in most cases examined.
What to conclude from these results?
A Gauranteed Life Withdrawal Benefit (GLWB) is very expensive insurance for the protection it provides. For someone taking a 4% withdrawal from a $1 million portfolio (i.e., $40,000/year), the $16,000 added annual cost for the Vanguard GLWB rider vs. a low-cost stock/bond portfolio amounts to 40% of the $40,000 annual withdrawal. It's much worse for the Fidelity GLWB. The $34,720 in fees and costs are more than 85% of the $40,000 withdrawal. Yet despite the very high fees, the guaranteed benefit is not adjusted for inflation, so annuitants will likely suffer considerable erosion in their spending power.
What are the alternatives?
An inflation-adjusted single premium annuity is likely a better choice than a GLWB if you believe you have the longevity to "beat" the insurance company's mortality tables. The costs are in the same range, plus you get inflation protection on the annual benefit. The only downside is that buying a single-premium annuity is an irrevocable decision while you can cancel the GLWB rider arrangement at any time. The TIAA-CREF Research Institute published an excellent report on the subject in 2008 that's well worth reading.
And, of course, if you are considering the purchase of an inflation-adjusted annuity, the cheapest place to buy one is from the Social Security Administration. Delaying taking Social Security until age 70 increases your monthy benefit by about 72% vs. starting benefits at age 62. Think of it as buying an inflation adjusted annuity on the installment plan. As this analysis shows for someone getting the maximum Social Security benefit, there's about a $50,000 savings for a male and $80,000 for a female versus buying the same benefit from a commercial insurer.
Resources for more information
An Analysis of the Guaranteed Withdrawal Benefits for Life Option Premal Shahy and Dimitris Bertsimas, MIT
Retirement Portfolio and Variable Annuity with Guaranteed Minimum Withdrawal Benefit (VA+GMWB) Ibbotson Associates, Inc. October 2007
THE 5% GUARANTEED MINIMUM WITHDRAWAL BENEFIT: PAYING SOMETHING FOR NOTHING? TIAA-CREF INSTITUTE April 2008
Vanguard’s GLWB: Credit to Vanguard for delivering on the promise Peter Benedek, CFA
GLWBs: Retiree Protection or Money Illusion? Wade Pfau, PhD
Longevity Insurance: Buying Down the Risks of Living Too Long New York Times, June 28, 2011.
Income Security in Your 80s, Bought in Your 60s New York Times, November 4, 2010
Longevity Insurance Bad Money Advice Blog
A Blood Test Offers Clues to Longevity New York Times, May 18, 2011
Differential Mortality by Income and Social Security Progressivity Gopi Shah Goda, John B. Shoven , Stanford University; Sita Nataraj Slavov, Occidental College, May 2009
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Copyright © 2012 John P. Greaney, All rights reserved.