What Advisors Don’t Know About Variable Annuities: Market Conditions and VAs

As the graph above demonstrates, the account value of $100,000 (the investor’s money) drops even faster given the higher withdrawal amount that occurs when the account value and high-water mark start at the same level.

Under the circumstances where there is a large gap between the values, the hurdle for getting inflation-adjusted income is even higher. Assuming a constant inflation rate of 2.5%, the investor’s account will need to return at least 14% a year for the income to catch up to inflation by the end of the 10^th year. There is no mystery to this. It is simply the result of the basic mechanics of the GLWB. To get an increase in income payments you must set a new high-water mark. In our example, for this to happen the $100,000 actual value must rise to higher than $125,000 net of fees and net of the $6,250 withdrawal each year. In today’s markets, it is hard for anyone to imagine a portfolio having 10 consecutive years of 14%-plus returns.

For a GLIB a large gap between the guaranteed amount and the actual account value causes a slightly different problem. As noted in the last post, the annuity factor used to convert the high-water mark to an income annuity is offset a number of years from the current market annuity quote. The table below shows some calculations using current market quotes for a male purchasing a single premium immediate annuity.

If the investor has an actual account value of $100,000 and the annuity factor adjustment is 10 years (a 65-year-old converting the GLIB gets the annuity factor of a 55-year-old) the table below shows the high-water mark where the investor is just about break even between converting the high-water mark at a discount versus taking the actual account value and buying a market annuity. If the high-water mark is higher than this, then converting is a better deal. If the gap is smaller, then abandoning the guaranteed level is a better deal.

Professor Moshe Milevsky at York University in Toronto recently wrote an article for AdvisorOne’s sister publication, Research magazine, in which he posits that “if you own a GLB that is too good to last, then you should actually turn on the income as soon as possible.” The math of it gets a little too complicated to go into right here, but Milevsky makes a compelling case.

How Things Have Changed

The second area that advisors should be aware of is that the characteristics of products currently available in the marketplace have changed.

As a result of increased hedging costs and higher capital requirements, VA providers have dramatically readjusted their offerings. The VA policies currently being sold have much lower income guarantees or much higher prices, and sometimes both. For example, some underwriters have raised the total price of their VA GLWB policies to over 400 basis points. Others have dropped the guarantee level to 4%. In at least one case, major brokers have removed some of these products from their approved list. As always it is incumbent upon the advisor to know just what it is they are buying on behalf of their clients.

In our next and final column on this subject, we will be looking at how VAs can fit into an investor’s portfolio under current market conditions, especially considering the impact of these lower payouts and higher fees.