How Should You Evaluate a Guaranteed Annual Withdrawal Rate Annuity?
Annuity products can offer guarantees such as on the rate of interest, death benefits, income streams and/or withdrawal rates during retirement. Here are a couple of things to consider before making a product purchase of an annuity with a Guaranteed Annual Withdrawal rate.
Withdrawals are Guaranteed -
One positive about a guaranteed withdrawal rate is that you will receive retirement income throughout the term of the annuity contract. This could be for your entire lifetime, as long as you and your spouse’s lifetime, or for a specified length of time. The payments are guaranteed by the issuer who may have a high credit rating from AM best. Current rates may be between 4-8% per year. This is a way of securing an income source which can be a great addition to your retirement plan and the risk of this investment is considered more conservative.
On the contrary, investment performance of your own portfolio that includes equities, bonds, etfs, mutual funds, CDs and money markets is not guaranteed. If you decide to invest in a combination of these assets, then you are accepting the risks of lower performance as compared to the built in rate of return on the annuity offering the guaranteed withdrawal rate.
How do you compare performance?
Rate of Return -
A guaranteed withdrawal rate is not the same as annual average rate of return. Comparing average annual returns of investments is an important step. An average annual return calculation should use how much you invest, the annual income amount, whether there is compounding, the number of the payments received and the remaining principal. This return rate is more easily compared to other available investments.
For example, an annuity product that guarantees to pay you 4.5% per year will be sending you payments using part of your principal with each payment rather than all earnings. The average annual return on this product is most likely lower than 4.5%.
Along the same concept the guaranteed withdrawal rate of 4.5% will translate into a lower simple interest rate. A simple interest rate indicates the amount of annual interest earned on your principal. The calculation does not account for any reinvestment of the interest.
A few numbers to illustrate -
Annual Withdrawal Rate :
$250,000 invested in a product that guarantees a 4.5% withdrawal rate means you will receive $11,250 per year; however, this payment will reduce your principal each year. Over a 30 year period the average annual return would be 2.06%. (with zero remaining principal or death benefit)
Simple Interest Rate :
$250,000 earning simple interest of 4.5% annually means you will receive an annual interest of $11,250 and your principal could be $261,250 after 12 months. The next year you end up with $273,006.25. If you withdraw or spend the interest, then you are left with your initial principal of $250,000 until the maturity or end of the time period. Simple interest earnings rates will vary with current rates available.
Average Annual Return :
In a portfolio of $250,000 with a 4.5% average annual return over 30 years compounded annually would end up being valued at $936,329.53. This assumes you do not withdraw anything and can reinvest earnings at 4.5%. If you were to withdraw $11,250 each year (4.5% of the principal) for those 30 years, then you will have remaining principal of $250,000.00. A 4.5% rate of return on your investments is not guaranteed.
Adding an annuity product with a guaranteed withdrawal rate can be effective for reducing market risk and/or adding a guaranteed income stream; however, you should work with an advisor who carefully reviews the other risks involved (See page 8 of the Firm Brochure for a list) and objectively considers alternatives outside of annuity products before making your purchase. How does your advisor define their success?
The important concept from these quick examples is that the financial planning process should include a step to evaluate alternative methods of reaching your financial goals. Using a fee only financial planning RIA who is an independent fiduciary can make having these conversations a bit easier. They may not be able to sell you the product, but they can offer you objective advice to help you decide whether you want or need the product or program.