GMWBs are a big part of the "living benefit" trend that has helped to revive VA sales after the bear market of 2000-02. They are widely considered to be similar to two other living benefits: Guaranteed Minimum Income Benefits (GMIBs) and Guaranteed Minimum Accumulation Benefits (GMABs). In fact, they are very different from these other types of living benefits – both of which offer an opportunity to accumulate tax-deferred assets for a number of years before income begins.

The basic GMWB offers to return 100% of the client's premium payments through annual withdrawals, up to a specified percentage of those payments each year, typically 5% to 7%. For example, if a client withdraws 5% of premiums each year, all premium would be returned (and the GMWB guarantee would be exhausted) after 20 years. Withdrawals above the specified percentage can have negative consequences.

The typical cost of a GMWB is .35% to .75% of separate account assets per year. An extra feature of some GMWBs is the opportunity to reset the guaranteed withdrawal amount to contract value at specified future intervals. This benefit effectively restarts the GMWB at a higher value, but it also can result in an increase in rider costs, in some cases.

An Example

An example can be helpful to show the cost-benefit tradeoff of a GMWB. The example assumes the following: A client puts $100,000 into a VA at age 60. Not needing retirement income right away, the client waits five years to begin annual withdrawals at the maximum rate allowed by the GMWB, which is 5%. In the first five years, the client has good investment performance, netting 7% per year (after fees). The VA grows in value to $140,255 after five years, at which time the GMWB "steps-up" to this amount (without an increase in cost).

Starting in the sixth year, the client then takes annual withdrawals of $7,013 (5% of $140,255) for the next 20 years. We have assumed a -1.0% annualized net investment return over this 20-year period, reflecting the poor performance a GMWB is designed to protect against. The table below summarizes hypothetical results.

* Calculated as 0.50% of account value at the start of the year.

** Calculated as if each year?s annual rider cost is compounded at 5%.

Does the GMWB pay off? Yes, because the VA account value is depleted shortly after the end of the 23rd contract year. The last $19,020 is paid under the GMWB guarantee, after the contract value goes to zero.

But what does the GMWB cost over 25 years? The answer is $9,396. If each year's rider cost were invested at 5% compound interest, the opportunity cost of the rider over time would be $22,203.

Most people would consider earning a -1% annualized net return over 20 years to be a realistic example of poor investment performance. Yet, even in this example, the GMWB ultimately does not repay its cost, if you assume cost is reinvested at a reasonable rate of return.

Three Bets in One

As this example shows, a big problem with GMWBs is that their payoff usually occurs many years in the future, and then in dollars that will be worth only a fraction of today's purchasing power. Any number of things could happen before the guarantee pays off, including contract surrender or the owner's death. In the example above, the owner would have to live to age 84 to receive the $19,020 value of the GMWB. So, buying a GMWB actually involves three bets rolled into one: 1) investment performance will be bad; 2) the contract will survive until the end of the guarantee period; and 3) the client will live until the end of the period.

Here are guidelines for how GMWBs should be used, if at all:

1. The VA owner should need current retirement income and begin taking steady income withdrawals as soon as possible after the rider is purchased. The owner then should take the maximum withdrawal allowed each year. Delays in starting withdrawals (or withdrawals of less than the maximum specified percentage) add to the cost of the rider without increasing its benefit.

2. The GMWB should allow withdrawal of at least 6% per year and cost not more than about .50% of separate account assets.
3. Taking steady GMWB withdrawals should meet the client's tax needs.
4. The client should plan on living until the end of the guaranteed withdrawal period and maintaining the contract under any reasonable circumstances.

Potential Problems with GMWBs

Financial professionals should heed these caveats before recommending GMWBs:

1. GMWBs can negate variable annuity death benefits – VA clients pay an ongoing charge to purchase death benefit protection. A GMWB adds an additional charge on top of the death benefit. Yet, it is hard to imagine a situation in which both the GMWB and death benefit would pay off. A client who is steadily withdrawing VA account value is steadily losing death benefit protection. If the VA contract value ever goes to zero while GMWB payments continue (as in the last two years of the example above) and the VA owner then dies, the beneficiary usually is not entitled to any payments after death. (The GMWB is a living benefit.)
2. Skipping withdrawals isn't a benefit – Some insurance companies have tried to turn the ability to skip a GMWB withdrawal into a benefit. For example, for income flexibility or tax planning purposes, a client may not want to take the maximum withdrawal allowed in a given year. However, this just stretches out the principal-return period, which adds to the GMWB's cost without increasing the benefit. Clients should understand that a GMWB has the best chance of providing cost-effective protection against bad investment performance when the maximum withdrawal is taken each year.
3. Income tax consequences can be negative – Annuity withdrawals can be one of the most inefficient forms of retirement income, for tax planning purposes. LIFO treatment means that earnings are withdrawn before premium. In the early years of withdrawals, up to 100% of withdrawals could be included in a VA owner's taxable income. In alternative retirement income programs (outside retirement plans) such as systematic withdrawal plans and immediate annuities, a portion of each income payment usually is tax-free return of principal.
4. GMWBs can be impossible to cancel – Imagine that you have guided a successful VA investment program that has produced a 10% net annualized return over several years. Meanwhile, the client has been withdrawing just 5% per year under a GMWB. Now, this client says: "I have done so well with investing that I don't need the rider and don't want to pay for it." Unfortunately, in some VA contracts, GMWBs are non-cancelable for the life of the contract. The only way to escape them is to cash out the VA.
5. GMWBs decrease liquidity – After the VA surrender charge has run its course, most VA owners want the opportunity to take large withdrawals, if needed. But if you're paying for a GMWB, taking withdrawals above the specified maximum percentage generally isn't a good idea. The explanation of how GMWBs are impacted by large withdrawals is so complex that many financial advisors don't understand it.
6. Minimum distributions may not work – Given modestly good investment performance in a qualified VA, taking the required minimum distribution can easily exceed the specified GMWB percentage at older ages. Financial advisors should not recommend GMWBs in qualified VAs unless they clearly understand the potential impact minimum distributions will have on the guaranteed payout, at all ages.
7. Step-ups can be almost impossible to analyze – Consider this situation. A client with a GMWB has enjoyed strong investment performance. After a few years, the contract allows a step-up of 15% in the GMWB guaranteed amount. But if the step-up is elected, the rider's cost will increase from .40% to .70%. Is stepping-up a good deal? Few financial advisors know how to perform the analysis. If you offer GMWBs and can find a Monte Carlo simulation program capable of performing this analysis, buy it.
8. Investment choices can be limited – Modern VAs offer a variety of attractive investment choices. Yet, when GMWBs are added, many insurance companies constrain investment choices to those with modest risk. The whole point of GMWBs is to insure against loss in risky investments. When financial professionals insist that every VA sale include a GMWB, they may take potentially attractive investment choices off the table. This is a case of the tail (a rider) wagging the dog – the VA and all its attractive investment choices.
9. Investment strategy can lack discipline – For GMWBs to have value, it usually takes a period of dismal investment performance or a series of investment mistakes. When this happens, most investors instinctively "pull in their horns" to protect principal. With the help of a financial advisor, they reduce risk or correct mistakes. But imagine that you are advising a client who has already lost 50% of VA contract value in a short time, with a GMWB in place. The only hope for obtaining more future value than the GMWB guarantees may be to increase investment risk. Under suitability guidelines, financial professionals should never advise clients to take more risk than is comfortable just because insurance guarantees are in place. (The client could lose even more money and then die, in which case the GMWB might offer no protection.)
10. Inertia and orphans – Unlike other types of "living benefits," the profit that insurance companies earn on GMWBs is inertia-driven. Unless clients request withdrawals every year, the rider is not likely to have benefit. When VA contracts become "orphaned" because the advisor is no longer connected, clients may forget that they should continue taking withdrawals. With age, they may become sick, disabled, or incapacitated. Meanwhile, rider costs continue as long as the contract remains in force, even into old age.
11. Lack of purchasing power protection – Most retired people need a way to generate a steadily rising income that can protect purchasing power, but most GMWBs don't provide it. A new type of GMWBs offers an income for life if the owner outlives the return-of-principal, but these lifetime payments usually do not increase over time. If the GMWB pays off at all, its income probably will not be what retirees will need to cope with future inflation.

How to Help People with GMWBs

What can you do to help VA owners who have purchased GMWBs?

1. Recognize the difference between GMWBs and other living benefits. GMIBs and GMABs can have future value even if they are not used now. To have value, GMWBs must be used every year – i.e., annual withdrawals should be taken up to the maximum allowed. Unfortunately, many GMWBs have been sold as future benefits. They lie dormant year after year, costing money while their potential benefit dwindles with life expectancy. Start by encouraging people with GMWBs to "use them or lose them."
2. Describe GMWBs accurately. GMWBs are not, as often described, a guarantee that principal will be returned through annual withdrawals. They are: "A guarantee that principal will be returned through annual withdrawals provided that: 1) you request these withdrawals; 2) you do not surrender your policy until receiving a return of principal; and 3) you remain alive until receiving a return of principal."
3. Help GMWB owners evaluate their options to step-up to a higher guaranteed amount. In general, this option should be accepted unless it will trigger a higher rider charge. If a higher charge applies on a step-up, develop a sound method for evaluating the tradeoff between long-term cost and potential benefit.
4. In contracts that allow GMWBs to be cancelled, make the owner aware of this option and its consequences. In contracts that do not allow cancellation, you can evaluate the total contract benefits and costs and then determine whether it would be feasible to transfer into another annuity (without GMWB) after the surrender charge period. Of course, whenever VAs are transferred, GMWBs almost never pay off.
5. Become aware of more effective solutions for generating current retirement income with acceptable stock market risk. For example, you could urge clients to take regular annual withdrawals from an equity indexed annuity. Or, you could become familiar with a new generation of immediate variable annuities that offer retirement income linked to the stock market, with a "floor" guarantee on each income payment regardless of market performance. In general, immediate variable annuities are more efficient retirement income solutions than VAs + GMWBs. They are more cost-efficient, can guarantee lifetime income, and can protect purchasing power by linking each income payment to investment performance. They also can have tax impact that is less costly and more predictable.

GMWBs were never a great idea, and they may one day become obsolete. Help your clients participate in the best ideas of the future, not dubious ideas of the past.