If you play backgammon, you know how annoying it is when a novice makes the wrong move, gets lucky, and then thinks that he knows how to play. Some variable annuity owners are even more annoying. They have actually lost, but they think that they’ve won.
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Variable annuities with guaranteed living benefits, especially guaranteed lifetime withdrawal benefits (GLWBs), have been popular for several years. Most annuity contracts have been issued with at least one of these benefits.
Annuity advocates believe that the recent financial crisis shows that annuity critics have focused too much on expenses and have overlooked the valuable benefits of these products. I am not convinced that recent history teaches this lesson at all.
Let’s look at the situation in October 2007 before stock prices fell. Suppose you had invested $100,000 with a 50% equity/50% bond allocation as follows:
25% Vanguard Total Stock Market Index
25% Vanguard Total International Stock Index
50% Vanguard Total Bond Market Index
Using Morningstar performance data and ignoring income taxes, here are the portfolio values at 3/31/2010:
$98,250 — without rebalancing
$101,200 — with rebalancing at end of each calendar year
Now suppose you invested $100,000 in October 2007 in John Hancock’s Venture III variable annuity. According to the Morningstar Annuity Research Center (as reported in National Underwriter), that product was ranked #4 for nine-month sales through September 2007.
If you elected to buy Venture III’s guaranteed lifetime withdrawal benefit rider, called Income Plus for Life, you had a limited menu of investment choices. Assume that you made a 100% allocation to JHT Lifestyle Growth Series II. According to Morningstar, that subaccount had the highest total assets as of 12/31/09, and it had a 69% allocation to equities (U.S. and international) as of 1/31/10.
The Venture III prospectus dated April 28, 2008 provides details of the contract fees and features. The Income Plus for Life rider guarantees that you can withdraw 5% of the Benefit Base each year for life. When you buy the annuity, the Benefit Base equals your premium. At the end of each of the first 10 years, the Benefit Base is increased by 7% of your premiums if you take no withdrawals in that year. (The Benefit Base can also be reset due to favorable investment performance, but that doesn’t apply here.)
Therefore, if you bought the Venture III annuity in October 2007, paid no additional premiums and took no withdrawals, the Benefit Base in March 2010 would be $114,000, and the guaranteed annual withdrawal amount would be $5,700 (i.e., 5% of $114,000), or 5.7% of the original investment.
The Venture III surrender charge is a percentage of premium payments, based on the date of receipt of each payment. The schedule by year is 6%, 5%, 4%, 0%.
The Venture III asset-based fees are 1.65% for mortality and expense risk, administration and distribution. The subaccount expense for JHT Lifestyle Growth Series II is 1.08%. Therefore, the total asset-based fees are 2.73%.
The cost of the Income Plus for Life rider is more complicated. The current cost is 0.60% of the Adjusted Benefit Base, which is the “Benefit Base that was available on the prior Contract Anniversary (including any Step-up applied on that prior Anniversary) increased by any additional Purchase Payments that we applied to the Benefit Base during the Contract Year prior to the current Contract Anniversary).” The guaranteed cost is 1.20%, but that applies only if you accept a step-up. (The current cost for new contracts is 0.90%.)
Unlike the other contract charges, the rider cost is not a percentage of the subaccount assets. When the Adjusted Benefit Base is greater than the subaccount assets, the rider cost will exceed 0.60% of the subaccount assets.
The prospectus states that “We charge an additional fee on each Contract Anniversary for a guaranteed minimum withdrawal benefit Rider, and reserve the right to increase the fee on the effective date of each Step-up in the benefits under that Rider.” This seems to say that the rider charge is deducted at the end of each contract year based on the Adjusted Benefit Base as of the end of the prior contract year.
Using performance data for JHT Lifestyle Growth Series II from Morningstar Principia and deducting the Income Plus for Life fee each year, the contract value at 3/31/2010 would be about $81,000.
So who is in the better position going forward: the Venture III owner with a $5,700 annual lifetime withdrawal, an $81,000 contract value, a 4% surrender charge (until October 2010), high ongoing expenses and a short menu of investment choices; or the diversified investor who has almost all of his original capital available and the entire world of investment opportunities to choose from?
It's not obvious to me that the annuity owner has anything to brag about. And here are a few more questions:
- How are you going to figure out the optimal exercise strategy for your in-the-money Income Plus for Life benefit? (Hint: Start by reading Min Dai, Yue Kuen Kwok and Jianping Zong, “Guaranteed Minimum Withdrawal Benefit in Variable Annuities,” Mathematical Finance, October 2008.)
- Where will you get third-party information about your investment choices?
- What is the tax treatment of your annuity? The withdrawals should be taxed as ordinary income to the extent of any gains, so you miss out on lower capital gains tax rates on gains and on loss-harvesting opportunities on losses.
The Venture III prospectus also warns: “At present, the IRS has not provided guidance as to the tax treatment of charges for optional benefits to an annuity contract. The IRS might take the position that each charge associated with these optional benefits is deemed a withdrawal from the contract subject to current income tax to the extent of any gains and, if applicable, the 10% penalty tax for premature withdrawals. We do not currently report charges for optional benefits as partial withdrawals, but we may do so in the future if we believe that the IRS would require us to report them as such. You should consult a tax adviser for information on any optional benefit riders.”
- What value do you place on the flexibility that you have had to give up with the annuity? For more discussion on this point, look at my 4/1/2010 interview