Retirement income review: GLWB/GMWB

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(MoneyWatch) Several insurance companies and a few mutual fund companies now offer hybrid products that combine the best features of managed payouts with the guarantee of a lifetime retirement income. These products are known as a "guaranteed lifetime withdrawal benefit" or "guaranteed minimum withdrawal benefit," but for simplicity's sake let's refer to them as GLWB plans. 

Prudential's IncomeFlex annuity is one example of a GLWB  now being offered in 401(k) plans, and Vanguard's Variable Annuity with a GLWB rider is available in both IRAs and regular investment accounts. In addition, you might find other GLWB products in your employer's 401(k) or other defined contribution plan.

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GLWBs offer the potential for growth in your retirement savings and retirement income if the stock market does well, while guaranteeing that your savings or income won't decrease if the stock market crashes. And if you invest in these products, you can withdraw the remaining part of your retirement savings at any time, even after your retirement income starts, unlike conventional immediate annuities.

Sound too good to be true? Should you consider using a GWLB for your retirement savings and generating retirement income?

There's usually a price to pay for having your cake and eating it, too, but in this case many people might find the cost easy to swallow. (Because of the complexities of these products, it will take me a few posts to explain their pros and cons and answer these questions.)

GLWBs and their guarantees can be used both for accumulating savings before retirement and to generate a lifetime paycheck during retirement. Most GLWB products have basic features in common that operate during these two phases. This post and my next one will look at how GLWBs work during the accumulation phase, while subsequent posts will look at the retirement phase.

Accumulation before retirement

If you decide to invest in a GLWB, you'll typically invest your retirement savings in one of a handful of portfolios with different allocations among stocks and bonds. The funds are often target date funds, in which the asset allocation to stocks starts at levels ranging from 70-90 percent and declines to 50-60 percent as you approach retirement.

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The insurance company accumulates something typically called the "income base," "benefit value," "guaranteed value," or "withdrawal value"; again, for the sake of simplification, I'll use the term income base. The income base is the amount that's eventually used to generate a lifetime paycheck when you retire. This value is increased by the amount of your contributions and the earnings on your investments, and it's decreased by all the expenses on the product, including investment management expenses and the insurance company's charge for the guarantees.

Typically the insurance company guarantees that the income base will never drop below the value of your accumulated contributions, or the value when you elect to start the GLWB guarantees. In addition, many policies (including the Prudential and Vanguard products) will also lock in accumulated investment gains. Each product offers different income base guarantees, which are described in the policy's fine print. I strongly advise that you read and understand the entire policy, but especially the income base guarantees before you invest.

In the accumulation phase, you typically don't start using the GLWB guarantees and paying for their charges until five to 10 years before you expect to retire. The assumption is that in the years leading up to your retirement, you'll value the protection against downside risk for your account. If you're 10 or more years away from retirement, the assumption is that you'll have enough time to recover from a stock market downturn, so you don't need to pay for the downside protection on your account.

Watch out for surrender value charges

The "surrender value" is the amount that you can withdraw at any time; with many GLWB products, the surrender value doesn't necessarily equal the income base, and often it is less. The surrender value may not be subject to the same guarantees as the income base, or there may be a surrender charge that's deducted from the income base to determine your surrender value (Again, the method of calculating the surrender value is spelled out in the policy's fine print.)

These products are often sold with the convincing pitch that "you can always withdraw your money if you change your mind." However, these guarantees won't mean much if the fine print shows that the surrender value is much less than the income base. Take the time to learn how the surrender value is calculated and whether it's likely to be much less than the income base.

Learn about the guarantees

During the accumulation phase and while the insurance company's guarantees are in place, GLWBs offer you protection against the value of your retirement savings declining in the years approaching your retirement due to a stock market decline or a rise in interest rates. During this period, they also offer upside potential if stock and bond markets do well.

The most cost-effective GLWB products charge about 1 percent of the benefit value each year for the guarantee. I recommend that you only use GLWB products that assess insurance charges at or below 1 percent and avoid products that have significantly higher charges. Note that I'm only talking about the insurance guarantee; you'll also be paying investment management expenses on top of the insurance fee, and you'll also want to minimize those fees.

Is it worth paying for the GLWB insurance charges? Stay tuned for my next post, which will provide a concrete example that can help you evaluate the potential risks and returns of these 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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