Understanding annuity guaranteed withdrawal riders
Let’s dig into and demystify one of the most confusing and misunderstood features of any financial product; guaranteed lifetime withdrawal riders attached to deferred annuities.
Did I lose you yet??? Stick with me, I’ll break it all down.
First, I should start by saying there are LOTS of different kinds of annuities. Each could look and function very differently from one another. With that said, put aside whatever existing experiences or understandings you have of annuities and pretend like you’re starting from scratch with you knowledge of them.
For purposes of this article, I will be focusing on the “deferred” type of annuity (as opposed to “immediate” type).
However, the real focus of this article is to explain the function of a common rider; a Guaranteed Lifetime Withdrawal Benefit, or “GLWB,” rider (where “rider” is just insurance speak for an extra option or feature that’s tacked onto the product).
For the sake of making a comparison to a more simple and easy to understand form of annuity, let me start be explaining what a Single Premium Immediate Annuity, or “SPIA,” is.
In the most plain vanilla straightforward version of a SPIA, you give the insurance company a lump sum of money and, in return, they agree to give you a fixed guaranteed monthly income payment for the rest of your life.
For example, as of current rates, a 65 year-old female could get a lifetime SPIA payout of approximately 7.2%. That means if a 65 year-old female were to give $100,000 to a life insurance company to buy a SPIA whose payments start immediately, she could expect to receive about 7.2% of $100,000 – or about $7,200 – per year in guaranteed payments for the rest of her life. On a monthly basis, this would be approximately $7,200 / 12 = $600 per month of guaranteed lifetime payments.
This example and payout assumes the annuity buyer selects a “Life” payout. This means that the $600 per month will last as long as she lives, even if she lives to 120 year sold.
However, the Life payout also means the annuity has no sort of residual value, If she were to die three months after buying the annuity, payments would stop upon her death and there would be nothing left to go to heirs.
In other words, this annuity was “annuitized,” which means the $100,000 used to buy the annuity was irrevocably handed over to the insurance company such that the annuity buyer no longer owns that $100,000 and no longer has any rights to it. Instead, the annuity buyer simply has an IOU from the insurance company to receive $600 per month for the rest of their life, however long (or short) that may be.
Logically, many people aren’t comfortable with the idea of irrevocably handing over so much money and running the risk of dying prematurely and not getting back enough in payments to cover what they paid into the annuity. This is especially true when someone has heirs they want or need to leave money to if they were to die young.
Realizing many people will never be comfortable with the risk of handing over a lump sum of money to the insurance company and only getting back a portion of it if they die early, insurance companies offer many tweaks and different forms of annuities that help address that concern.
One potential solution is to select for the SPIA a payment form other than Life. For example, if the person is married, they can instead select a “Joint Life & Survivor” payment option. This means the payments will last as long as the person is alive. And if that person dies before their spouse, the payments will continue on for the life of the spouse. If/when the spouse eventually dies, then the payments will stop.
A payment like this is more valuable than just the Life option, as the payments will most likely last longer. As such, the amount of payment you get will be smaller; there is no free lunch with insurance products (nor should there be).
As an example, again assume a 65 year-old female uses $100,000 to buy a SPIA. Now also assume she has a 65 year-old spouse and wants to select a Joint Life & Survivor payout option. Under this payment option, at current rates, the payout rate decreases to about 6.5% from 7.2% (i.e. the annual payment would be about $6,500, or about $540 per month).
However, even with a Joint Life & Survivor payment option on the SPIA, the annuity is still “annuitized” such that after the second spouse dies, there is nothing left to go to their heirs. For example, if both spouses were to unfortunately die in an accident at age 68, they would have only received about $19,500 in payments for the $100,000 purchase of the annuity, yet there would be no payout or remainder for any heirs.
There are other SPIA payment options to help better address the fear/risk of dying early and not having anything left for heirs. For example, there are “Period Certain” payment options, such as a “Life with 10 Year Period Certain.” This means the payments will last for the life of the annuity buyer, or 10 years, whichever is greater. But if the person dies in the 11th year, payments will stop and there will be nothing left for heirs.
Even with the various payment options available on SPIAs, people are still generally reluctant to annuitize their annuities and give up ownership and control of their money. Yet they often still want the benefit of having a guaranteed income as long as they live.
This is where deferred annuities with income riders come into play.
Unlike a immediate annuity, a “deferred” annuity does not immediately (if ever) annuitize. Which means the money someone puts into it remains theirs; they still own it, they can take money out of it in part or in full (potentially subject to early surrender charges, however), they can roll or exchange it to a different annuity, etc.
However, because a deferred annuity typically does not get annuitized, there generally wouldn’t be guaranteed lifetime income from it. At least not without buying an income rider of some sort. Hold that thought for now…
In this sense, a deferred annuity is functionally not much different from an investment account: if you have $100,000 in a traditional investment account and you take it all out, there is nothing left. In other words, there isn’t any guaranteed lifetime income from it.
So, while deferred annuities avoid the risk of people losing access to and ownership of their money, they don’t provide guaranteed lifetime income. At least now without 1) eventually annuitizing it or 2) buying an income rider.
I think you all probably have a good enough understanding of option 1 by now. Option 2 is the focus of the rest of this article.
There are various forms of riders that can be bought and tacked onto a deferred annuity. One form is a rider that guarantees you can get a certain amount of payments or withdrawals for the rest of your life, even if/when the deferred annuity contract value depletes down to zero. I want to focus specifically on one of the most common forms of income riders, the Guaranteed Lifetime Withdrawal Benefit, or GLWB, rider.
With a GLWB rider, you never actually annuitize your deferred annuity. Instead, the rider allows you to take out a certain amount of withdrawals from the annuity every year/month/etc. for the rest of your life.
At first, these withdrawals function like taking money out of a normal investment account: if you have $100,000 in an investment account and take $2,000 out, you now only have $98,000 left. That account can also go up or go down, based on what it’s invested in. And there may be fees that get deducted from the account, too. But, those things aside, every time you take a withdrawal, the account value will go down by the amount of the withdrawal.
Eventually, if you only have $2,000 left in your investment account and you take it out, your account is depleted and there is nothing more take out.
This is where deferred annuities with GLWB riders differ. While there is still some non-zero value to the contract, that value will decrease every time you take a withdrawal under the rider. BUT, even if/when the contract value fully depletes to zero, the rider guarantees the insurance company will continue paying you the same amount of withdrawal every month/year/etc. for the rest of your life. In that sense, it then functions like an annuitized annuity.
For example, assume you took $70,000 and bought a deferred annuity 10 years ago, and you also bought a GLWB rider that lets you start taking guaranteed withdrawals from the annuity in 10 years (i.e. now). Further assume the rider stipulates you can withdraw $12,000 per year, or $1,000 per month, for life. And also assume the contract’s value is currently $120,000 (i.e. the $70,000 you put in has since grown to $120,000).
To keep the example simple, let’s for now assume your contract gets zero growth or interest going forward, and it has no fees. If you take out $12,000 per year in monthly payments, your contract value will deplete down to zero in exactly 10 years (i.e. $120,000 current value - 10 years of withdrawals of $12,000). BUT, even if/when that happens, the rider guarantees the insurance company will continue to send you $1,000 per month as long as you live.
Along the way between now and when the contract value eventually depletes, there will still be some positive amount of contract value that you own and can take, or leave behind for heirs if you die early.
For example, let’s continue with this same example; currently $120,000 of contract value and you’re about to start withdrawing $1,000 per month from it under your GLWB rider. And we’re still assuming there is zero growth or interest, and no fees.
Four years from now, you will have taken out $48,000 of withdrawals under the rider (i.e. $1,000 per month * 48 months). At that point, the contract value of the annuity will be $72,000 (i.e. $120,000 of contract value when you started the rider withdrawals - $48,000 of cumulative withdrawals).
If you were to die after four years, the remaining contract value of $72,000 would be left for your heirs.
Alternatively, if you decide after four years that you no longer want the annuity, you can take the remaining $72,000 of contract value and walk away. If you do that, however, your guaranteed withdrawals also go away. But you can nonetheless get out of the contract and take whatever is left at any point.
In reality, your contract value will get some earnings and interest even after you start taking withdrawals. As such, your contract value isn’t likely to deplete as fast as what I assumed above. I kept the example oversimplified to try to make the math easy.
There is a lot more to deferred annuities with GLWB riders than what I touched on here, such as how your contract is credited interest along the way. You can have a fixed, indexed or variable annuity, each of which credits interest in a different way. Take a look at our February 2023 newsletter for more info.
Also, the way in which the guaranteed withdrawal amount under a GLWB rider is calculated is often convoluted and involves a separate calculation of a phantom account value often called things such as a “benefit base” or “protected income value.”
Unlike the annuity’s contract value, which is the value of what you actually own and can walk away with, the phantom benefit base or protected income value isn’t something you actually own. It’s simply an accounting figure on which the amount of guaranteed withdrawals you can take under the GLWB rider are calculated.
The complexities of understanding how these phantom benefit bases work are beyond the scope of this article. However, if you’d like to learn more and see one in action, check out this video I did: What is a Fixed Indexed Annuity with Income Rider?
I hope you found this explanation helpful. If you’re looking for guaranteed lifetime income but don’t want to irrevocably give up ownership and use of your money in return, a deferred annuity with GLWB rider could potentially be a good solution for you.