Managing Your "Tail-End" Risk -- Part 3: Variable Annuities and Guarantees

By Stephen Horan, PhD, CFA, CIPM

What’s in a name?

Lots, I’d say. Especially if we’re discussing asset classes.

We’ve spent some time talking about how an annuity can play a role in your long-term financial planning and secure an income stream for life. Now I’d like to discuss a popular category of annuities that trades under a misleading name: variable annuities.

I’m satisfied with the product’s first name, “variable,” but not necessarily with the second. That’s because variable annuities are typically equity-based, while standard fixed annuities are similar to fixed-income instruments. And, by calling a variable annuity an “annuity” at all, investors could be misled into thinking they are investing in a fixed-income type of asset.

Nomenclature aside, a variable annuity can be a useful tool for those interested in taking more risk in hopes of a higher total return, while still generating lifetime income.

Let’s begin our discussion with an immediate variable annuity. These products typically have a diversified equity portfolio that underlies the annuity contract. This means the money put into the annuity is invested in something akin to a mutual fund. The value of the mutual fund, which is exposed to market fluctuation, will in the end determine the amount of money that the annuitant gets for life.

Therefore, the investment risk of the mutual fund erodes some of the longevity protection – i.e. the reason you bought the annuity in the first place.

So, I’d say that if you’d like more equity exposure, you’re typically better off just going and getting your equity exposure through another investment vehicle. That’s because the cost of variable annuities gets steep quickly, and the assumed investment rate that is selected upfront will determine the initial payment of the annuity.

Accumulation and Payout Phases

If a variable annuity remains interesting to you, you’ll want to understand the accumulation and payout phases.

With an immediate variable annuity, there is no period of accumulation.  Payouts begin immediately.  Other variable annuities separate the two phases.

In a deferred variable annuity, your initial premium(s) is invested in something like a mutual fund that will go up and down in value.  Your investment may be made with a single premium payment or a series of payments over time.  More often than not, the term “deferred” is dropped from the name.

At the beginning of the payout phase, you can choose to receive the value of your account as a lump sum or as a stream of payments.  The size of either of these payments is based on whether and how much the mutual fund has increased or decreased in value.  Again, it’s “variable” nature erodes some of the longevity protection that that an annuity can provide (and therefore my qualms about the name).

Guaranteed Minimum Withdrawal and Income Benefits

Features of some variable annuities provide ways to take a measure of doubt out of the payout phase, through a guaranteed minimum withdrawal or guaranteed minimum income benefit (a GMWB or GMIB).

A GMWB entitles the annuitant to withdraw a minimum amount during the payout period – either as a lump sum or a stream of cash flows. The higher the floor, the more you’ll typically pay for the peace of mind that comes with the guarantee.

In some cases, insurance companies will take off some of the top-end growth that they might otherwise be able to achieve instead of charging a customer­ more for these floors. This feature, sometimes known as an “equity-linked annuity”, can help keep down the cost for the investor,

Three CFA charterholders wrote a paper about allocating assets to these vehicles entitled “Allocation to Deferred Variable Annuities with GMWB for life.” They concluded that implementing a target asset allocation with a mixture of traditional investment products and variable annuities with guaranteed minimum withdrawal benefits for life can create a “powerful retirement income solution that enables investors to participate in the potential upside of good markets and providing them with income for life in bad markets.”

A related feature is a guaranteed minimum income benefit (GMIB).  Rather than placing a floor on the amount that an annuitant can withdraw (either as a lump sum or as a stream of payments), the GMIB allows the annuitant to withdraw for life a minimum percentage based on the variable annuity’s value at the end of the accumulation period.

Although payments are guaranteed to continue for life and their percentage is fixed, the size of the payment depends on the value of the mutual fund at the end of the accumulation period.  Again, this investment risk may erode some of the longevity protection of the annuity.

In closing, I’d like to say that a variable annuity - with or without a guaranteed minimum withdrawal or income benefit - may be a good tool for some investors. I would encourage you to consider if the fees and costs outweigh the benefit of the longevity hedge in your specific case.

-With Rhea Wessel, a personal finance writer based in Frankfurt.