Focus on guaranteed lifetime withdrawal benefits

(MoneyWatch) This post continues my look at guaranteed lifetime withdrawal benefit (GLWB) products, also referred to as guaranteed minimum withdrawal benefit (GMWB) products, offered by insurance companies and other financial institutions. If you haven't yet done so, you'll want to read my previous post as background for this one.

Here's an example of how this product works to help you assess whether it's worth it to pay for GLWB insurance during the period before retirement, while you're building your retirement savings.

Suppose you're 10 years away from retirement and you're considering whether to keep your retirement savings in a target date fund without any GLWB protection or to add the GLWB protection. As mentioned in my previous post, the best GLWB products typically charge about 1 percent of your income base each year for the downside protection on your retirement savings. In essence, your net return each year is about 1 percent less with the GLWB protection compared to without.

Retirement income review: GLWB/GMWB
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In this example, with the GLWB protection, your income base would be charged 1 percent each year for 10 years. So the income base with the GLWB protection at the end of the 10-year period would be a bit  more than 10 percent less than if you had simply invested in the target date fund without the GLWB protection. (Because of compounding and the exact application of the insurance guarantee, the difference could be a little different from 10 percent, but it's close enough for this example.) Remember, though, that your income base with the GLWB protection can never decrease during this period.

The following chart contains a simplified example that compares the total change in your account values with and without the GLWB protection for various rates of total appreciation or depreciation during the 10 years preceding your retirement.

Let's say the target date fund appreciates by about 20 percent over 10 years. Then your retirement savings would have grown by 20 percent with the unprotected account, but your income base would have grown by about 10 percent with the GLWB protection. But if your target date fund were to lose 20 percent of its value over 10 years, you'd be 20 percent poorer without the GLWB protection. That wouldn't be the case if you had GLWB protection -- your income base wouldn't drop.

Note, however, that your "surrender value" could drop under most GLWB products. The surrender value is the amount you can withdraw at any time if you don't convert the income base into retirement income. This is an important feature to understand. If you want the downside protection on your retirement savings, eventually you'll need to convert your income base into retirement income under the terms of the GLWB product.

Also note that the above chart is a simplified example that ignores the order of the years in which you earn your gains or losses. Some GLWB products lock in accumulated gains each year, so it's possible that the difference between accumulations with and without GLWB protection could be different than shown in the above example. Nevertheless, this simplified example shows you how GLWBs provide downside protection and that the price is forgoing some upside potential.

Many financial advisors claim that the odds are low that you'll ever need this protection, and they may have extensive analyses to support their position. A blog post by economist and retirement expert Wade Pfau, "GLWBs: Retiree Protection or Money Illusion?," is an excellent example of such an analysis.

But let's dig a little deeper and consider the behavioral finance aspects. People who were invested in target date or balanced funds just before the 2008-2009 meltdown experienced 20-30 percent declines in their retirement savings in less than a year. This devastated many people who were close to retirement, and many people had to postpone their retirement plans.

Even worse, many people bailed out of their target date or balanced funds because they were afraid the values would keep dropping. Would it have been worth it for these people to avoid these declines by giving up some upside potential with the GLWB protection? It's easy to imagine many people answering "yes" to this question.

On the other hand, by the fall of 2011 -- three years after the crash -- many balanced portfolios had recovered all their losses. So if you had had the stomach to maintain your asset allocation, in this example, you might have had to postpone your retirement by up to three years.

It turns out that the real losers from the 2008-2009 downturn were the people who bailed out of their target date or balanced funds and moved all their assets into "safe" CDs or money market funds, which are now earning a piddly amount of interest. They missed the significant stock market rally following the crash. If they had only stayed invested, they most likely would have recouped their losses by now.

And this illustrates the value offered by GLWB products during the final years of the accumulation phase: If they give you the peace of mind and the confidence to stay invested in target date or balanced funds, it might be worth paying the price of the GLWB guarantees. On the other hand, if you have the stomach to ride out stock market declines or are able to postpone your retirement by a few years if there's a stock market crash, then you might not need to pay for GLWB protection.

If you decide that you like GLWB protection, the example of the 2008-2009 crash suggests that you might not need the GLWB protection until about five years before your retirement, since the odds are very good that you could ride out a stock market drop that's more than five years prior to your expected retirement. This would allow you to forgo five years of paying GLWB fees, and your benefits value would then be about five percent higher when you eventually retire, compared with electing the GLWB coverage for 10 years. Another strategy would be to start paying the guarantee fee after the market has run up, to "lock in" your account value.

If your head is spinning by now, don't give up. It's worth it to spend the time to assess whether these sophisticated products are appropriate for your situation and your tolerance for investment risk. Stay tuned for my next posts that examine GLWBs and their advantages in the retirement phase.