Vanguard made waves in late 2011 by introducing a budget-priced Guaranteed Lifetime Withdrawal Benefit (GLWB) rider on its variable annuity. I knew I would be in the market for guaranteed lifetime income at some point. And, though I didn’t know much about the option then, I felt better knowing Vanguard offered one. Plus, there seemed to be at least murmurs of approval in the personal finance world….
So it came as a bit of a shock to learn that, effective this coming May 1st, Vanguard would be raising its rider fee (from 0.95% to 1.2%) and reducing its benefit (by 0.5% for certain ages) on GLWBs. Whether or not they are a good deal now, they are clearly going to be a worse deal going forward! Was I about to see the opportunity of a lifetime (or a retirement), slip away? Like any shopper faced with a limited-time offer, I swung into action….
I spent a good part of my free time this past week studying up on GLWBs. I’m not an academic, just an engineer going shopping for lifetime income, so I relied heavily on the analyses performed by others. I read about a dozen articles, and poured over many simulations of GLWBs against past history and future projections of current market conditions. I also called Vanguard and spent some time quizzing one of their annuity sales team members.
Before we get into my conclusions, let’s review annuities in general and GLWBs in particular….
The Holy Grail of retirement security is guaranteed, lifetime, inflation-adjusted income. Most of us will get some of that — though not enough — in the form of Social Security. A few will get the balance of what they need in the form of pensions. But the rest of us will have a shortfall between our living expenses and our guaranteed income. We could try to fill that gap by managing our investment assets to support systematic withdrawals indefinitely in retirement. But the insurance industry has what sounds, at least on the surface, like a simpler, safer idea: an annuity….
In its most essential form an annuity exchanges something of value (such as a career, or a lump sum of money) for a stream of payments — an income. Annuities can potentially help to ensure comfort and peace of mind in retirement. Unfortunately, more often than not, annuities, especially the complex variable annuity, have become a quagmire of pushy salesmen, hidden expenses, and dizzying complexity.
With annuities, as for investment products, we can greatly simplify our lives by sticking with the offerings from the most highly trusted, consumer-oriented companies. Let’s start with Vanguard. If you go to their landing page for annuities you’ll see they offer essentially three products for retirement income: (1) an immediate fixed annuity (SPIA), (2) an immediate variable annuity, and (3) a deferred variable annuity with Guaranteed Lifetime Withdrawal Benefit (GLWB).
Immediate annuities, where you buy a constant income stream over a certain period for a lump sum, are a relatively simple and well-known offering. They pool your lifetime risk with that of others to make your money go farther. I’ve discussed them elsewhere, and will surely be returning to the subject again.
Variable annuities remain at the eye of the retirement income hurricane. They are both the most popular, and the most despised, products. I have yet to see any independent, trustworthy source whole-heartedly recommend one. When I click on Vanguard’s link it takes me to an underwhelming page from American General Life that primarily touts the product’s many options, with no hard data on why I’d choose one. I remain unsold on variable annuities, in general.
That leaves one unexplored option at Vanguard: the GLWB (which is actually a rider or option for a variable annuity). Are GLWBs a viable alternative to immediate annuities? Let’s talk about what they are, and how they stack up against the alternatives.
GLWBs sound almost too good to be true. (Danger ahead.) They promise downside protection, lifetime income, upside potential, and the flexibility to cancel and withdraw your assets at any time. They seem like the perfect retirement income solution, until you start taking a hard look at the details….
A GLWB is an extra-cost rider that you purchase on top of a variable annuity. It guarantees that some fixed percentage of your assets can be withdrawn each year for lifetime. That amount will never decrease in nominal terms (not adjusted for inflation). The actual percentage you can withdraw is based on your age at the time of the first withdrawal, and whether you choose a single or joint life option, to cover your and your spouse’s lifetime. (The current withdrawal percentage at Vanguard for a couple age 59 is 4%.)
In theory, annual withdrawals from a GLWB might increase in rising markets, as your paper Total Withdrawal Base (a high water mark) ratchets up, for potential upside. But, if regular withdrawals, fees, or market declines take a toll on the real Contract Value of your underlying investments, then the Total Withdrawal Base will never ratchet up. However, if the Contract Value goes to zero, then the insurance will kick in and continue to make your guaranteed payments for life.
Costs vary by company and by feature, but figure the insurance company will collect about 1% minimum per year on your Total Withdrawal Base. (Note how that supercharges the fees, drawing your Contract Value down even quicker, since the Total Withdrawal Base will likely be much higher than your Contract Value over time.) Add to that any additional management expenses for the underlying funds. Even frugal Vanguard, with its suite of dirt cheap mutual funds and ETFs, seems to incur an extra 0.5% or so in expenses when managing those as part of a variable annuity. Other companies are much worse — with total expenses for a variable annuity with GLWB running around 3% annually in many cases.
Pros: Short List
Let’s start with the few clear positives for GLWBs:
- A GLWB does promise lifetime income. Assuming the insurance company stays in business, that could be a great comfort in your later years. According to Wade Pfau, current economic and market conditions could be creating a climate where the guarantees will be “in the money.” But, if the times are so far out of the historical norms, and all our annuities run dry at once and must be backstopped by the insurance provisions, will the insurance companies really be able to pay? And just how much will they be paying? That guarantee in nominal dollars at your retirement date could be woefully inadequate 30 or 40 years into retirement, depending on the effects of inflation. (More below.)
- GLWBs do let you change your mind. You can pull your assets out of the variable annuity at any time without punishing penalties. This is a good thing. Though you will have been paying additional fees and your assets will have been exposed to market risk, so there is no guarantee of getting all your original money back. The flexibility to change your mind costs you while you’re waiting. And there are other, simpler ways to keep your options open — for example splitting your assets between stocks and bonds in an investment portfolio, where you could withdraw principal if necessary.
Unfortunately, GLWBs come with a long list of real-world negatives, nearly all of which are surprising, given the sales spiel. Let’s start with perhaps the most surprising:
GLWBs do not protect against inflation. How can that be? Since the underlying annuity investments nearly always contain an equity component, why wouldn’t those stocks offer the traditional defense against inflation, growing along with other real world assets in at least nominal dollar terms? In a nutshell, it’s because the relentless rider and investment fees eat away at the growth that would have warded off inflation.
All of my trusted experts concur on this point. Jim Otar, in his book Unveiling the Retirement Myth, writes that guarantees like the GLWB convert longevity and market risk to inflation risk, which “is not handled well.” Joe Tomlinson agrees.
And Wade Pfau backs them up with his own extensive research, noting that GLWB guarantees are not inflation-adjusted and would not have been worth much in rolling periods of history. In another paper Pfau observes that inflation takes a “stark toll” on GLWBs and similar products, noting the steady decline in probability that the guaranteed income will keep up with inflation.
Con: Where’s the Upside?
Perhaps it’s not so surprising, now that we know the GLWB inflation protection is largely illusory, to learn that its “upside” is shaky as well. It sounds good on paper that you can keep some of your money in the market, through the underlying variable annuity, and participate in market upside. That’s the theory. But, in practice, it rarely works out:
Otar reports, for one of his historical analyses, that in every year between 1900 and 1938 portfolios ran out of money and the guarantees were activated. That’s a long time to go without any upside.
Pfau reports, for one of his studies based on current poor market conditions, that “After 25 years, the contract value for the VA/GLWB falls to zero in more than half of the cases.” And he notes, under normal market conditions, a typical 50/50 retirement portfolio may not even need a GLWB-style guarantee, since the failure rate would only be 1.4%, and the wealth after 30 years would match the initial wealth in real, inflation-adjusted terms.
Again, Tomlinson reminds us of the reason for this: costs, at least in more expensive variable annuity/GLWB products, eat up 50-100% of the equity premium — the growth advantage that stocks should have given us.
Ok, so maybe the GLWBs’ promised upside and hoped for inflation protection aren’t what they’re cracked up to be. But at least we can count on the downside protection, the guaranteed income, right? Well that downside protection may be partly an illusion as well:
For starters, there may be a realistic possibility of insurer insolvency. Pfau notes “In the event that someone replicating GLWB withdrawals on his or her own runs out of wealth, an outcome that no investor has faced historically, then GLWB owners will surely worry about the risk of default for the insurer.” And Otar, writing in 2009, thinks rider fees are unsustainable. What happens if insurers realize that too late?
Let’s dig deeper into that “guarantee” behind a GLWB. It’s really only as good as the company standing behind it, and any insurers standing behind that company. Pfau observes that “rider guarantees may not be protected by state guarantee associations.” So exercise due diligence on both insurance company ratings, and the state guarantees behind them, if any, before signing up for any GLWB!
Lastly, GLWB withdrawal maximums are actually quite minimal, once adjusted for inflation. Pfau found that GLWB withdrawal amounts met or exceeded their initial levels in real (inflation-adjusted) terms in only about 5% of the many 30-year periods he analyzed. In many cases, the guaranteed spending after those long time spans may be only 20-30% of the original level, in real terms.
What kind of “guarantee” requires you to give away virtually all of your upside while promising only 20-30% on the dollar? You’re giving away higher income in the majority of cases, to gain the dubious certainty of keeping one-third of your money over the long haul.
So, much of the certainty promised by GLWBs melts away when examined more closely. But one aspect of these products is a definite: They are among the most complex financial instruments ever devised for ordinary consumers.
I’ve just spent several days pouring over research papers from some of the brightest minds around, documenting reams of simulations with these products. Still their behavior isn’t clear. The only thing I’m confident about is that there is no way vague claims such as “guaranteed,” “upside potential,” or “downside protection” can really be taken at face value.
Pfau, one of the leading experts working today, says that there are continuing “disagreements about the actuarial value of the guarantees” and that the products’ values are “difficult to objectively quantify.” If the experts can’t accurately value them given unlimited time and resources, how can the rest of us do it given a few hours for retirement planning?
Well, maybe the friendly annuity salesman can simplify things for us. I spent about 30 minutes recently talking to a pleasant, helpful, and confident-sounding Vanguard rep. Unfortunately he disagreed with Vanguard’s online variable annuity kit on at least two key terms of the GLWB contract. Was he right, or was the online information right? Or did I just misunderstand something?
However that question is answered, it’s more proof, if you need it, that these things are highly complex. Better find a sales rep or advisor you can literally trust with your financial life, or shop for simpler products….
Thanks, But No Thanks
As we’ve seen, a GLWB is a complicated attempt at providing downside protection with upside potential for retirement income. But for financial products, as for physical products (think appliances), it may be best to unbundle the desired features so you have access to simpler, more reliable solutions in each department.
At its core, the GLWB attempts to offer two benefits:
- Lifetime income. But an immediate annuity offers the same feature, while keeping the principal of customers who die earlier, so it will be cheaper for the same benefit. All other things being equal, a SPIA will maximize your income vs. a variable annuity product. (In one scenario I evaluated for a 65-year old single male, the SPIA would pay out 1.6% more of the premium annually.) Conclusion: you’ll get more downside protection for the same amount of premium with an immediate annuity.
- Market upside. But insurance companies have access to the same markets as the rest of us, with no theoretical advantage over any other seasoned investor. And the kinds of ‘black swan’ market events that you might need protection from, are the same kinds of events that are likely to threaten an insurance company’s solvency anyway. The withdrawals for a GLWB are artificially low in most cases and could be duplicated by a systematic withdrawal plan from an investment portfolio, with much more upside potential. (Note: that systematic withdrawal plan may tilt payments toward earlier years, when a retiree is most likely to be alive to enjoy them, at more risk of depletion later. But the total value being delivered is probably the same in either case, before fees.) Conclusion: a systematic withdrawal plan from an investment portfolio is superior to a GLWB for capturing market upside.
The unpleasant probability with any kind of annuity product is that, over time, the insurance company will take all your money and the payouts won’t keep up with inflation. Further, if the markets do average or well, you will have left money on the table. And if the markets do poorly, you will be hoping your insurance company doesn’t go out of business. In the end, what you’re really paying for, is peace of mind, and money management. As we’ve seen, that peace of mind is probably not warranted, and you can do the money management yourself, if so inclined.
In the final analysis, a GLWB is like paying for a gatekeeper who forces you to take lower withdrawals from your nest egg — the same level of withdrawals that would allow a cheaper systematic withdrawal plan to be sustainable. Or it’s like buying fast food — settling for the lowest-common-denominator in order to get certainty, a meal that you can count on being mediocre. Or it’s like asteroid insurance. In spite of recent events, it’s unlikely that there will be a major asteroid strike in our lifetimes. And, if that does happen, it’s likely that nobody will be around to pay the claim….