FIAs also frequently offer optional lifetime income guarantee benefits in the same manner as variable annuities (VAs). These guaranteed lifetime withdrawal benefits (GLWBs) are what can make FIAs particularly valuable in a retirement income plan. Though the names for different pieces may vary, the discussion from the previous chapter still applies in terms of rollup rates, the potential for step-ups, guaranteed withdrawal rates, and so on. The lifetime guaranteed rates vary by age and are also available for joint contracts at a reduced level or a higher fee. These aspects are all designed to work in similar ways as with a VA. As well, FIAs are deferred annuities. Receiving lifetime income through the optional rider does not formally annuitize the contract while a positive contract value remains.
With these optional income benefits, it is important to emphasize that principal protection for an FIA is on a gross basis and would not apply net of the fees for included optional riders. Principal would be protected in terms of zero interest being credited when the index lost value, but the optional benefit charge would then reduce the value of the principal.
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In practical terms, one difference from VAs is that upside potential for step-ups with FIAs may be more limited. The interest crediting method might even prevent the possibility of a step-up during the accumulation period. This could happen when a cap on credited interest is less than the rollup rate, especially when the optional rider fee would reduce the net cap applied. With the distribution phase as well, the capped gains could be less than the guaranteed withdrawal amount plus the rider fee, preventing the possibility for step-ups.
For this reason, greater focus with FIAs should be on the guaranteed income to be generated without necessarily thinking that step-ups will provide much chance to increase this amount, except there are a number of FIAs that automatically increase income over time with a cost-of-living adjustment that does not require a step-up. Certain variable annuities and possibly FIAs that use participation rates instead of caps could provide more upside potential in strong market environments, but caps would limit the ability to benefit from upside.
Some find the idea of using a lifetime income guarantee benefit on an FIA as a bit puzzling. The three reasons to use an income benefit include that one expects to take income from the annuity, there is a possibility of significant decreases in the portfolio value, and there is a possibility of outliving the portfolio. For these three reasons, the second does not apply with an FIA because principal is protected. In the absence of upside, one can calculate with certainty how long the underlying asset base will last with distributions. This is different from a variable annuity in which a market drop could significantly reduce the contract value of the annuity assets and create greater uncertainty about when the contract value may deplete. In this regard, the FIA income protection is more about pure management of longevity risk, not the joint impact of longevity and market risk. The FIA could be viewed as an income annuity that also provides liquidity for the underlying assets.
This naturally leads the comparison of an FIA with an income benefit to an income annuity. The tradeoff is that the FIA should be expected to offer a lower payout rate than an income annuity because it provides liquidity for the asset base and some upside exposure.
However, it is the case that FIA payout rates for their income benefits do occasionally exceed the payout rates on income annuities. Moshe Milevsky wrote a column about this anomaly in 2013 at Research Magazine. He found that especially for females, and for long deferral periods before income begins, the FIA payout can beat an income annuity payout. Reasons include that FIA payouts are gender neutral, while females receive a lower payout rate on income annuities since they live longer. As well, with a long deferral period, the insurance company can expect that some FIA owners will lapse and not take the guaranteed distributions from the FIA despite paying for the income rider. This takes the insurance company off the hook for making good on its guarantee, and through competitive pricing some of this benefit is returned to the other owners in the risk pool. With an income annuity, ending the contract is not possible and so there will be no lapsation.
This is an excerpt from Wade Pfau’s book, Safety-First Retirement Planning: An Integrated Approach for a Worry-Free Retirement. (The Retirement Researcher’s Guide Series), available now on Amazon
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