Annuities can be a good way to build funds and guarantee income for your retirement years. But there are many different types with different characteristics. Some annuities focus on growing your money, whereas others focus on providing you guaranteed income for life.
Some growth-oriented annuities offer, at an additional cost, an optional rider — typically called a guaranteed lifetime withdrawal benefit (GLWB) — that can provide a level of guaranteed income for life, even if the market drops significantly.
To understand the pros and cons of a GLWB, it’s important to know the underlying basics of annuities.
An annuity is a contract with an insurance company that can protect you from the risk of outliving your savings in retirement. It is purchased in a lump sum or series of payments.
Typically, annuities fall into one of two categories:
- Income annuities, which are designed to provide a guaranteed stream of income, either immediately or at a specific date in the future.
- Deferred annuities, which are designed to help you accumulate funds for a long-term goal, particularly retirement, upon which they can provide a guaranteed income stream.
The performance of certain kinds of deferred annuities — specifically variable annuities, registered index-linked annuities, and fixed index annuities — are tied to investment options outlined by the insurance carrier.
- Fixed index annuities provide a return related to the performance of a market index, such as the S&P 500. It is important to note that it is not a direct investment in an index, but simply a crediting calculation based in part on the index’s performance. Through the crediting mechanism, the fixed index annuity can reflect the designated index’s positive performance subject to participation limitations and/or caps. If the benchmark index has negative performance, then the annuity doesn’t get credited any interest, but the principal is protected, limiting downside risk.
- Registered index-linked annuities, also called structured index annuities, are annuity contracts where, like fixed index annuities, the rate of interest credited is linked to the return of an index. There is typically a higher cap on positive returns, but there is less protection from market loss.
- Variable annuities typically offer a range of market-based investment options that an annuity owner can choose from. This can offer more upside potential than other annuities should the market gain, but doesn't offer any level of protection from market loss.
Market risk and the GLWB
Because the funds in variable, registered index-linked annuities, and fixed index annuities are tied to market performance, there is a risk of limited or no growth, which would impact the level of assets available for retirement. And, iin the face of a market downturn, variable annuities and index-linked annuities can lose money.
This is where a guaranteed lifetime withdrawal benefit (GLWB) rider can be beneficial. Elected at the time of purchase, the rider shifts the focus of the annuity from tax-deferred growth to providing predictable income.
How that works as a benefit depends on the type of annuity.
“In the case of variable annuities, the real benefit of the GLWB is that you can stay invested in the market and have a guaranteed income stream for life,” said Phil Michalowski, MassMutual’s head of annuities. “The insurance carrier is taking on the risk of allowing you to be invested in the market and providing a specific guaranteed amount of income if your account balance goes to $0. That is the real benefit.”
For fixed index annuities, the GLWB rider is more of a guard against eventually outliving the returns provided by original investment as withdrawals are made over the years.
“The GLWB rider on a fixed index annuity is more of a longevity protection, since your principal is already protected by the function of the base contract,” said Michalowski. “But on the variable annuity, the GLWB allows you to take on market risk, which can provide a lot more upside than the fixed index annuity, but also exposes you to the downside. That is where the GLWB rider provides protection.”
The GLWB rider can also allow the owner more flexibility to take withdrawals from an annuity on a regular or occasional basis, depending on the terms of the rider. Of course, withdrawals can affect the overall investment performance of an annuity, depending on the timing.
Advantages versus cost of a GLWB rider
For those who want to stay invested in the market yet fear what a downturn could do to their retirement income, a GLWB rider can offer some peace of mind. Additionally, depending on its terms, the size of withdrawals available may increase if certain investment options within the annuity rise.
It should be noted that, unless the contract value falls to $0 based on permitted withdrawals and/or market performance, the value of the rider will not be realized. Some may consider that a drawback. However, many investors feel that paying the cost of the rider is worth the security of knowing that their income is protected regardless of future market performance.
Also, in conjunction with the GLWB rider, an insurance company may direct that invested funds have to be dedicated to specific investment options offered within the annuity.
The particular requirements and terms of a GLWB will differ depending on the type of annuity involved and the insurance carrier. Annuity contracts that offer a GLWB rider will also have terms outlining what amount of invested funds will serve as a base for benefits and what will determine the overall value of the annuity, which can affect the level of withdrawals available without penalty.
Many people interested in such a rider, or even annuities in general, turn to a financial professional for advice on what may be most appropriate for their specific situation.
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This article was originally published in July 2021. It has been updated.