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Strategies For Existing Variable Annuities With GLWB Or GMIB Riders

Posted by Michael Kitces on Wednesday, April 10th, 11:03 am, 2013 in Annuities

While some advisors recommend annuities more often than others, virtually any advisor may have to deal with situations where clients have existing annuities. And because of the significant "living" and death benefit riders offered over the past decade, the reality is that the decision about what to do with an existing variable annuity is not as clear cut as it was in the past; in fact, failing to do proper due diligence before recommending a client cancel a variable annuity can land an advisor in more hot water than just selling one in the first place!

Unfortunately, the due diligence process is complicated by the fact that almost no two variable annuity riders work the same, with a broad range of GLWB and GMIB riders from one company to the next, each with their own unique features and benefits. As a result, there's more pressure than ever on advisors to read through the details of each and every contract, to try to make a good assessment of the situation and what the client should do next. On the plus side, though, a growing number of third-party providers are available to assist - including a notable new offering aptly titled "Annuity Review" - giving advisors the opportunity to gain outside expertise to help go through the details of contracts with which they may not be familiar.

Understanding GLWB And GMIB Riders

The first key to evaluating an existing variable annuity is simply to understand the income or "living benefit" rider on the contract and how it works. The two broad categories are a Guaranteed Lifetime Withdrawal Benefit (GLWB) and a Guaranteed Minimum Income Benefit (GMIB); the key distinction being the words in the middle, "lifetime withdrawal" versus "minimum income." Both riders rely on the use of a withdrawal or income benefit base, which is a phantom amount against which the lifetime withdrawal or minimum income guarantee applies. The benefit base typically grows every year by some guaranteed amount, ranging from 5% to 7% depending on the contract; in addition, the benefit base may also step up to a higher amount if the cash value exceeds it (i.e., the benefit base can step up or "ratchet" up to the high water mark set by the contract's cash value itself). The notable thing about the benefit base, though, is that it is not liquid; when a variable annuity states that it will grow by a guaranteed 5%, 6%, or 7%, it is not the liquid cash value that is growing, but the benefit base.

So what's the use of a benefit base if the annuity owner can't liquidate it? Depending on whether the contract is a GLWB or GMIB, the policyowner can either take withdrawals against the benefit base, or annuitize the benefit base.

For instance, if a variable annuity has $100,000 invested - and therefore starts out at a $100,000 benefit base as well - the benefit base may be guaranteed to grow at 5%/year. In addition, the annuity owner can withdraw 5%/year as a guaranteed lifetime withdrawal; this means the benefit base starts out at $100,000, grows to $105,000, and then has a $5,000 withdrawal against it, bringing it back down to $100,000. Accordingly, as long as the annuity owner stays within these parameters, the benefit base will remain at $100,000 for life (climbing to $105,000 and falling back again), thereby ensuring that the policy will provide $5,000/year for life (5% of the original contract value). If the policyowner takes no withdrawals for the year (or less than the maximum), the benefit base will be higher in the future, allowing 5% of a larger amount and a greater level of lifetime income. The guaranteed income benefit rider is similar; the difference, however, is that the policyowner can annuitize the $100,000 benefit base, receiving lifetime income base on his/her age at the time of annuitization, using a conservative - but guaranteed - annuitization factor. In either case, though, the whole point of the contracts is that while withdrawals (especially if market performance is poor) can deplete the cash value, the benefit base remains intact providing its (lifetime withdrawal or income) guarantee.

Notably, details vary significantly from contract to contract. Not all GMIB contracts use the same annuitization factors, and vary in their internal rate of return assumptions (in addition to the fact that some use an age setback provision to reduce the guaranteed payments). Some early GLWB riders don't actually guarantee payments for life, but only a more limited period of time. Most GMIB contracts (and the occasional withdrawal rider) require a holding period (where the benefit base grows) before withdrawals can begin, and/or the benefit base can be annuitized. Perhaps most important, contracts vary dramatically about the consequences of taking withdrawals in excess of the guaranteed growth amount of the benefit base; some are relatively favorable, while others may terminate the rider entirely for taking even $1 over the limit! To say the least, the devil is in the details, and it's crucial not to begin taking withdrawals or making decisions without getting an actual copy of the annuity contract and rider to read!

General Strategies For Existing Variable Annuities

Notwithstanding the important caveat that the details depend on the particular contract, there are a few general strategies for variable annuities with GLWB and GMIB contracts that are worth noting.

The first key point is to recognize that even if the planner wouldn't necessarily have recommended a variable annuity to the client today, contracts issued years ago may still have substantial value. This is especially for annuities purchased before 2008, when both the riders themselves were a lot less expensive and had more favorable provisions, and because policyowners who invested prior to the financial crisis may get value from the riders for the exact purpose for which they're intended: to protect a retiree against a severe market decline that occurs at the outset of retirement! Thus, for instance, an individual who put $300,000 into an annuity with a GLWB rider and started taking $15,000/year (5%) may find that the contract value is down to $200,000 (between ongoing withdrawals, the market decline, withdrawals that occurred while the market was down, and ongoing fees and costs of the annuity itself), which means the guarantee for $15,000/year may have been 5% of the original contract but represents a remarkably favorable 7.5% guaranteed lifetime withdrawal based on the current value! The bottom line: just because the annuity might not have been ideal in the first place doesn't mean it should be cancelled now, especially if the benefit base is in fact significantly higher than the current cash value; in fact, taking ongoing withdrawals from the benefit base may actually be the best course of action at this point!

A second related strategy, possible for GLWB riders but more popular for GMIB riders, is to take an ever larger withdrawal from the contract. Whether this is feasible or not depends greatly on the detailed language of the annuity contract, so be certain to read the fine print. What you're looking for is whether withdrawals in excess of the guaranteed growth amount are dollar-for-dollar or pro-rata. In the context of our prior example - where the benefit base is $300,000 but the cash value is only $200,000 - a pro-rata rule would stipulate that if the beneficiary took out $199,000, the contract value is reduced by $199,000 / $200,000 = 99.5%, which means the benefit base is also reduced by 99.5% down to $1,500 (which isn't terribly appealing or helpful). A dollar-for-dollar rule, however, would mean that a $199,000 withdrawal reduces both the cash value and the benefit base by $199,000, which means the client is left with a $1,000 cash value and a $101,000 benefit base. At this point, the client simply annuitizes the benefit base - which means the client essentially gets to keep almost all of the cash value, and annuitize the underlying loss that was being protected by the benefit base! Notably, this option is often only available for annuities issued prior to roughly 2005; after that point, the companies realized that this strategy may be a risk, and required all withdrawals to be pro-rata. In addition, this strategy is really only useful where the benefit base is materially higher than the cash value; if they're close, or the cash value itself is higher, than a large withdrawal - even on a dollar-for-dollar basis - will simply reduce the benefit base all the way to $0!

For contracts that are up - meaning the cash value is equal to or higher than the benefit base - or where the contract is still in the blackout period (where withdrawals or annuitization can't begin yet), there is often a decision about whether to begin withdrawals at all, or just get rid of the contract. If the annuity is down slightly - the benefit base is higher than the cash value, but only slightly - this question also arises, especially given the fact that these annuities often have significant ongoing costs while just "waiting" for the value to either decline enough to really utilize the guarantee, or rise enough to make it irrelevant. An interesting recent research piece by so-called "Retirement Quant" Moshe Milevsky, however, suggests that counterintuitively, the best strategy is to either liquidate the contract entirely, or begin withdrawals immediately - even if they're not needed yet - but not to just hold the contract and wait. In his paper "Optimal Initiation of a GLWB in a Variable Annuity: No Arbitrage Approach" Milevsky actually found that the annual increase in benefits - even with the guaranteed growth rate on the benefit base - is generally not enough to compensate for the risk of waiting. Instead, the optimal approach in most circumstances is to begin withdrawing as soon as allowed, even if the funds aren't needed (if they're not, they can simply be withdrawn and re-invested, or even 1035 exchanged on a tax-deferred basis to another annuity, or a hybrid LTC/annuity, or even a standalone long-term care insurance policy). In essence, Milevsky notes that if the value of the rider is to guarantee a floor while taking withdrawals, then the goal should be taking withdrawals to try to hit the floor... and the older the client, the better it works!

An Annuity Due Diligence Process

Having an effective process for due diligence on a (new or existing) client's existing annuities is required as part of a CFP certificant's Practice Standards, in addition to basic professional prudence. The starting point is to simply gather the underlying annuity contract itself, and read through the contract details and the associated riders. The reality is that because variable annuities companies were trying hard for the past 15 years to not be commoditized, each company deliberately designed its product to be different than all the competitors. The end result is truly that no two contracts work exactly the same (nor in some cases even the same contract from the same company issued in different years!). Just as the basic structure is the same but the devil is in the details with a client's Will or trust, requiring a detailed read-through to understand what's really going on underneath, so too is the situation for existing variable annuities.

The caveat, though, is that many practitioners - especially those who don't already use or aren't already familiar with variable annuities of the past decade - don't necessarily have the background necessary to evaluate contracts. Fortunately, though, a growing number of third-party services are available to help. A notable newer offering specialized in annuities is Mark Cortazzo's "Annuity Review" service, which has a deep expertise in the variable annuity living benefit riders issued for the past 15 years and how to appropriately evaluate them. Cortazzo's firm works specifically with fee-only firms (which tend not to have as much annuity experience and background) and will review up to the first 6 of your clients at no cost (just mentioned you heard about it from Nerd's Eye View!), and provide feedback and recommendations on the nuances and potential concerns or opportunities of the client's particular annuity contract. In addition, Cortazzo's firm is available to become the broker-of-record on the annuity contract, after signing a non-compete (crafted by Tom Giachetti from Stark & Stark!) for the rest of the client's business. This may be especially helpful for RIAs that don't maintain a broker license, and ensures the advisor can work with Annuity Review to get additional details or updated information about the annuity as well; furthermore, Cortazzo's firm will provide a monthly data file of client annuity information that RIAs can upload into their portfolio management software (whether for tracking, asset allocation management across the household, or even separate billing on assets under advisement if that's the firm's model), and if the client signs the appropriate forms then Cortazzo's firm can even accept trading instructions directly from the RIA firm to manage the annuity as part of the overall household. Notably, by becoming the broker of record, Cortazzo's firm will become eligible for any annuity trail fees, if there are any associated with the contract, which are already being paid either way but can at least be redirected to Annuity Review in exchange for their ongoing support and services.

Whether working with a firm like Cortazzo's Annuity Review or on your own, though, the bottom line is that with the complexity and stakes high for variable annuities, an effective process to perform due diligence on existing variable annuities and determine an appropriate strategy is crucial. For firms that don't have the expertise to do so, it's time to either get the educational resources necessary to be appropriately educated on annuities, or look at an outsourcing partner to assist in the process. Otherwise, the irony is that those at greatest risk for inappropriate new variable annuity recommendations may not be the agents who sell them, but the advisors who may inappropriate recommendations about what to do with the existing ones!

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