Can GLWB products protect retirement income?

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(MoneyWatch) This post is the fourth in a series examining guaranteed lifetime withdrawal benefit products (GLWB) offered by insurance companies and other financial institutions. These hybrid products (also known as "guaranteed minimum withdrawal benefit" products) combine the features of both managed payouts and immediate annuities in an attempt to offer the advantages of each method of generating retirement income.

Today we'll look at an example of how GLWB products can protect your retirement income during retirement. You'll want to read my previous three posts on GLWBs as background for this latest piece.

Retirement income review: GLWB/GMWB
Focus on guaranteed lifetime withdrawal benefits
Retirement income review: GLWB in retirement

Even though GLWB products appear to provide the potential for upside growth in your retirement income if your investments do well, I wouldn't count on it. To understand why, you'll need to understand the impact of insurance fees on your investment and the mechanism of adjusting the maximum withdrawal amount.

Let's first take a look at how your retirement paycheck might be adjusted after you start withdrawing your income. For purposes of this example, we'll assume you're married and that you and your spouse are both 65 years old.

Now let's suppose your income base is $100,000 when you start your retirement paycheck and that you're invested in Prudential's IncomeFlex product. In this case, you've locked in a maximum withdrawal percentage of 4.5 percent (My previous post shows the withdrawal percentages at various retirement ages.) That means that the most you can withdraw in the first year of your retirement is $4,500 (4.5 percent applied to your income base of $100,000). This amount, along with the charges for investment management and insurance guarantees, would be deducted from your income base.

Now let's suppose that the total charges for your investment management expenses and the insurance guarantee are 159 basis points, or 1.59 percent (My previous postalso shows the total charges for the Prudential IncomeFlex product.) In this case, that means that about $1,590 would also be deducted from your income base.

Before adding back your investment earnings, your income base by the end of the first year of your retirement would be $93,910 (that's $100,000 - $4,500 - $1,590). For your income base to increase by the end of the first year, your investment earnings would need to exceed $6,090 by year-end in order to get your investment base back up to $100,000. That's a rate of return of a little over 6 percent just to break even. If your investments earn less than this amount, your new income base won't be any higher than your previous income base, and you won't get an increase in your retirement paycheck.

But suppose you earn a rate of return a little over 7 percent. In that case, your income base at year-end would be about $101,000 (I've simplified this example, since actual crediting of investment earnings and account values is more complicated.) If you apply your maximum withdrawal rate of 4.5 percent to this new income base, your annual maximum guaranteed withdrawal amount is now $4,545 per year, for an increase of about 1 percent over the initial amount of $4,500.

To achieve only a 1 percent increase in your retirement income, your investments would need to earn a little over 7 percent each year. And while it's possible to earn 7 percent with a portfolio balanced between stocks and bonds, it would be difficult to consistently earn that much over the course of many years by any meaningful amount.

Not only that, but if you experience investment losses instead of investment gains, you've dug a hole that's hard to get out of. Let me show you why.

Suppose in the first year you lose about 6 percent instead of gaining 6 percent. In this case, that means your income base is $6,000 less than when you started. Your total year-end income base would then be about $87,910 ($100,000 - $4,500 - $1,590 - $6,000). Now you're down by $12,090, and future investment gains will need to make up all of this loss, plus more for you to have a chance to see an increase in your income base. To do that, your investments would need to earn a rate of return of more than 13 percent in the following year.

This example shows why you're unlikely to achieve significant increases in your retirement income, unless your portfolio consistently earns well over 7 percent per year for many years and it doesn't experience losses in the early years of your retirement. While your portfolio very well could earn these amounts, it's also possible it won't.

Do GLWBs add value in your retirement years? They can, if the situation is right, so stay tuned for my last post in this series, which answers this question in detail and provides some shopping tips if you're interested in GLWB products.

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    Steve Vernon helped large employers design and manage their retirement programs for more than 35 years as a consulting actuary. Now he's a research scholar for the Stanford Center on Longevity, where he helps collect, direct and disseminate research that will improve the financial security of seniors. He's also president of Rest-of-Life Communications, delivers retirement planning workshops and authored Money for Life: Turn Your IRA and 401(k) Into a Lifetime Retirement Paycheck and Recession-Proof Your Retirement Years.

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