Next, we consider the joint impacts of rollup rates and payout rates on the amount of guaranteed income the annuity can support. When it comes time to begin taking guaranteed withdrawals, it is worthwhile to investigate whether applying the contract value of the annuity assets to a higher payout rate possibly available from other annuities could result in more guaranteed income than applying a potentially lower payout rate to the annuity’s benefit base.
For instance, consider a variable annuity with a $1 million benefit base and a 4.5 percent payout rate at the current age. If a different annuity is offering a 5 percent payout at this age when the owner wishes to start income, then the owner would be better off exchanging to the other annuity if the contract value is greater than $900,000 (as that would guarantee more than $45,000 of annual income), but remain with the existing annuity if the contract value is less than $900,000 (as $45,000 is guaranteed from the benefit base).
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Moshe Milevsky has described the separate presentation of rollup rates and guaranteed withdrawal rates as telling consumers the temperature in Celsius when individuals can only make sense of temperatures provided in Fahrenheit. In this case, what a retiree will understand is the amount of income guaranteed by the annuity (Moshe does take the guaranteed income a step further and translates it into an equivalent investment return that can be more directly compared to the returns offered by other investment opportunities).
It may not be immediately obvious to someone whether an annuity with a 5 percent rollup rate and 5 percent withdrawal rate is better than an annuity with a 4 percent rollup rate and a 6 percent withdrawal rate. The answer also depends on how long the deferral period lasts before income begins, as longer deferral periods will increase the relative importance of the rollup rate and shorter deferral periods mean one should instead focus more on the withdrawal rate.
Exhibit 5.4 provides more clarity on how to better understand the intricacies of rollup rates and withdrawal rates for someone placing a $100,000 premium into a variable annuity and deferring for ten years before distributions begin. For instance, with the example in the previous paragraph, a 4 percent rollup and 6 percent withdrawal rate support $8,861 of guaranteed annual lifetime income, which is quite a bit more than the $8,144 provided by the 5 percent rollup and 5 percent withdrawal combination. The former provides more guaranteed income, which is the whole point of a lifetime income guarantee. To be clear, fees and investment opportunities also matter in determining upside potential, but for now we stick to only considering guaranteed income levels if no step-ups are ever realized.
Exhibit 5.4 Guaranteed Income Supported by a $100,000 Premium with a Ten-Year Deferral Period Before Income Begins
Retirement Researcher
Individuals considering variable annuities may tend to focus on the guaranteed rollup rate. They may even misunderstand it to mean a guaranteed return on their investment or contract value, rather than a guaranteed return on a hypothetical benefit base that is then used to calculate guaranteed income. This creates room to maneuver, as companies can raise the headline rollup rate that receives the attention while more subtly reducing the subsequent withdrawal rates attached to the benefit base. This avoids being on the hook to support a higher guaranteed income level that one might otherwise expect with a higher rollup rate.
Another example of this from the exhibit, for instance, is that a 6 percent rollup and 4.5 percent withdrawal combination provides less income ($8,059) than a 5 percent rollup and 5 percent withdrawal combination ($8,144). If consumers are confused and only focus on which annuity provides the higher rollup rate, then they may miss out on the opportunity to achieve the highest guaranteed income for their premium dollars.
At a more extreme level, it is also important to monitor whether the guaranteed rollup rate is presented as a compounding growth factor with growth also available on past growth, or whether it is a simple growth factor with growth only provided on the original premium. A simple 5 percent rollup rate on a $100,000 premium for ten years would grow the benefit base to $150,000, while a compounded growth rate would bring the benefit base to $162,890. This does make a difference. We can observe in Exhibit 5.4, for instance, that a 10 percent simple growth rate with a 4 percent withdrawal provides less income ($8,000) than a 6 percent compounded growth rate with a 4.5 percent withdrawal ($8,059). It is important to focus on the guaranteed income provided by the rollup and withdrawal factors, rather than trying to make some determination in isolation about which combination of factors sounds better.
Many consumers misinterpret the guaranteed growth rate on their benefit base as a guaranteed investment return, not realizing that it is the combination of a growth rate on the benefit base and the withdrawal rate applied to the benefit base that determine the level of guaranteed income. These two factors cannot be disentangled. A higher rollup rate combined with a lower payout rate does not necessarily leave consumers in a better position.
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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