The sales pitch sounds great, especially given the stock market's recent woes: Invest in stocks using a popular retirement savings vehicle and, for an extra layer of fees, you'll get protection from market declines and a guaranteed pension-like income for life. And you won't give up the ability to profit when stocks recover. | With baby boomers nearing retirement and corporations scaling back defined-benefit pension plans, the insurance industry is adding guarantees called living benefits to the plain old variable annuity. The over-50 set is snapping them up. Since 2005, VA sales have risen 18%, after stagnating earlier this decade. "Living benefits have been the primary driver," says Michael DeGeorge, general counsel at the National Association for Variable Annuities (NAVA). Insurers say more than 80% of VA contracts now offer the new breed of benefit.
But there are serious downsides to these benefits. The fees can raise the already high cost of VAs to over 3% of assets per year. And the fine print in many of the contracts may reduce the value of the guarantees. Moreover, there are cheaper ways to get similar results.
Annuities, which allow you to convert a payment into a monthly income for life, come in many varieties. Fixed annuities establish an income stream at the time of purchase. But with a variable annuity, you won't know exactly what you'll end up getting, since your account value will fluctuate with the markets. Much like a 401(k) or Individual Retirement Account, these allow you to invest in stocks, while deferring taxes on gains. Of course, VAs also give you the option of turning the pot of accumulated money into a stream of payments for life—in other words, into an annuity.
The basic transaction is simple. You give the insurer money in a lump sum or installments and choose between an array of stock and bond funds. You can transform whatever has built up into an annuity, or, after age 59 1/2, withdraw it without penalty. Of course, if the market tanks, the value of your assets—along with the payment stream you'll derive—will, too.
Living benefits promise to protect against that. The insurer guarantees your account won't fall below the sum you invested. Often, these contracts deliver more—a 5% annual return is typical, plus an inheritance for heirs. And if stocks soar, you won't miss out: Under certain circumstances, the insurer will base your payments on your account's actual appreciated value, instead of your investment.
The appeal of a guarantee is obvious. But in the fine print are arrangements designed to protect insurers that may reduce the value of your benefit. Examples include provisions that limit investment options and expose you to a greater hit from fees, and the risk of missing a market recovery. Then there's the expense: Adding a living benefit typically raises the hefty fees VAs charge—2.44%, on average—by 0.5 to 1.5 percentage points. In contrast, the average stock fund charges 1.4%. "Investors need to evaluate whether the guarantee is worth what they'll pay, not only in fees but in the drag some of these arrangements will create on returns," says Frank O'Connor, a variable annuity specialist at Morningstar. (MORN) David Odenath, president of Prudential Annuities, says that without the guarantees, retirees might skip stocks entirely, missing out on the potential for higher returns.
The products, with names like guaranteed minimum income benefit (GMIB) and guaranteed minimum withdrawal benefit (GMWB), fall into two categories. One lets you begin getting guaranteed payouts quickly. The other may provide slightly higher payments, but before you can receive a guaranteed income there's a multiyear wait. And once payments kick in, you can no longer touch the nest egg. To see how the guarantees work, BusinessWeek examined the prospectus for the Prudential Premier Series Annuity, a variable annuity offering both kinds of guarantees.
With the GMIB, an investor opens an account and transfers a one-time sum or builds up savings over years. Before lifetime income payments can begin, Prudential imposes a seven-year waiting period. It guarantees an annual 5% rate of return, so a $100,000 investment would produce $140,708 seven years later. But if your investments appreciate by more than the guaranteed 5%, you can step up the value of your account and lock in the guarantee on the actual worth. The 5% return then kicks in on that amount. You can do this twice; each time restarts the waiting period.
After seven years, you're free to start receiving lifetime payments. To calculate the minimum you'll get, Prudential takes your account's guaranteed value—$140,708, in the above example. Then it factors in an annual growth rate for the assets and divides by your life expectancy. But you'll pay about 2% a year in fees to get that 5% guaranteed return. And when calculating lifetime payouts, Prudential adds five years to your expected time on this earth. That cuts the payments since it spreads that $140,708 over more years.
Moreover, some provisions in the fine print protect Prudential from incurring losses—at your expense. Say the value of your account falls below the amount you invested, to $80,000 from $100,000. Prudential will assess its 2% fee on the full $100,000. So you'd pay $2,000, or 2.5% of the actual $80,000 balance.
The second living benefit—the GMWB—guarantees you can withdraw up to 5% of the amount invested for the rest of your life, starting any time. Again, Prudential assures a 5% return. If the market surges, there are ways to reset your account value so you won't miss out. In one Prudential version, Highest Daily Lifetime Five (HDLF), you can do this daily.
Once you begin withdrawals, the 5% bump-ups stop, though you can still periodically lock in market gains. To reduce odds of a loss, Prudential makes you use one of 11 diversified investments. If the market tanks, it can move money in an HDLF account from stocks to more conservative assets. But when stocks recover, less of the portfolio will take part in the rally.
This form of benefit is tax-inefficient. As with a 401(k), you pay ordinary income tax of up to 35% on profits you withdraw from a GMWB. The same goes for a GMIB. But the tax hit is spread over time, since a portion of the payments, deemed a return of principal, is tax-exempt. With a GMWB, the IRS assumes you withdraw profits first. Until you spend down profits, you'll pay tax on all money you take out.
Shop around for living benefits. Fidelity and Old Mutual have recently introduced lower-cost versions. "We've tried to keep our product fairly straightforward," says Patrick Ferrer, Vice President of Variable Products at Old Mutual. "Clients are buying these things without digesting them." New York Life takes a different tack. It recommends pairing mutual funds with a fixed annuity. For the same investment, these produce a far higher income. Among potential downsides: Unless you buy a death benefit, the insurer can keep what's in your account when you die.