In the quest for guaranteed retirement income, annuities are receiving increased attention. One type in particular is a variable annuity with a Guaranteed Lifetime Withdrawal Benefit rider (GLWB), which is commonly referred to as a Guaranteed Minimum Withdrawal Benefit (GMWB).

This rider has a variety of features that make it popular: it provides guaranteed lifetime income, it allows the annuitant to pass on his remaining contract account balance to a beneficiary at death, and it allows the guaranteed lifetime income payment to potentially increase if the markets perform well.

But these types of annuities are becoming increasingly complex and advisors need to know how they work and where they work best for retirees.

GLWB Annuities 101
Variable annuities with a Guaranteed Lifetime Withdrawal Benefit rider are designed to provide guaranteed income for life.

The person receives an income stream based on a set percentage of her invested assets, or the "benefit base." This percentage, also known as the lifetime distribution factor, is determined by the age of the person when she starts receiving benefits.

The distribution factor for a couple is based on the age of the younger member when benefits are first claimed. It's lower than it would be for a single person because income is guaranteed as long as either member of the couple is still living. Distribution factors vary across providers, but 5% is common for a 65-year-old single individual (male or female), and 4.5% for a couple if the younger member is 65.

The actual income received by the annuitant is determined by multiplying the distribution factor by the benefit base at its highest point.

For example, if a 65-year-old retiree invested $100,000 in a GLWB annuity and received a lifetime distribution factor of 5%, he would be guaranteed income of at least $5,000 per year for life. The distribution factor will not increase, although the income received may increase if the benefit base rises. For example, say the annuity contract value were to increase to $110,000 on the second anniversary date (based on healthy market returns), the benefit base would "step up" to $110,000. The guaranteed lifetime income amount would then be based on this increased benefit amount, so the payment would be $5,500 (5% of $110,000) going forward.

If the portfolio value were to fall to $90,000 the following year and never again exceed $110,000 in value, the guaranteed withdrawal amount would still be based on the high-water mark value for the annuity, which was $110,000.

Therefore, the annual income generated from the GLWB annuity would remain at $5,500 until the annuitant passes away.

Even if the value of the GLWB annuity portfolio drops to zero during the annuitant's lifetime, she is still guaranteed lifetime income. The on-going benefit (after the contract value goes to zero) is funded by the rider fee, one of three different general types of fees associated with GLWB annuities, along with the general administrative (or M&E) fees and the investment fees.

Each of the different fee components will vary, although the GLWB rider fee tends to be the most consistent and typically ranges between 90 and 110 basis points.

The all-in cost of the annuity is likely to range from 150 basis points to 300 or more.

It is important to note that just because one GLWB product is more expensive than another, it's not necessarily better or worse. Different products have different features that affect the cost. So the features of each product need to be reviewed in their entirety to determine the overall quality of a given product.

Do You Feel Lucky?
Research on the potential benefits of GLWB annuities has been mixed. Since an annuity is a form of insurance, and insurance companies tend to be relatively good at pricing risk, the average person should not necessarily expect to be better off with an annuity than if he were to try and fund retirement income from a pool of assets.

So the key to whether a GLWB annuity is a good product for a retiree is to determine whether the benefits received are worth the cost, which means you should also look at the potential income received from a portfolio without an embedded guarantee.

Research shows the annuitant only actually receives a benefit from the GLWB rider (i.e., the GLWB only really ever "pays off") if two things happen.

First, the underlying portfolio within the variable annuity must no longer be able to sustain the withdrawal.

Second, the annuitant (or annuitants) must still be alive when the portfolio runs out. While the probability of actually needing the GLWB rider is relatively small, the cost of the GLWB rider is relatively small as well.

One thing that tends to reduce the relative cost of a GLWB annuity is that it allows the annuitant to take on more market risk than he or she may have taken had the guarantee not been available. Since the GLWB rider guarantees some minimum level of income, retirees tend to be more comfortable investing in equities within the variable annuity when a GLWB is present.

Indeed, Moshe Milevsky, a professor at York University in Toronto, has noted that annuitants who are age 65 and older with income guarantees have equity allocations that are approximately 20% higher than those without.

An important note about investing within a GLWB annuity is that the GLWB rider is essentially a lifetime put option on guaranteed income, since it guarantees some minimum level of income for life.

Since the GLWB rider fees do not typically vary by equity allocation, an annuitant is generally best served investing in the most aggressive portfolio available. Insurance companies that offer GLWB annuities have recognized this, though, and typically cap the equity allocation in the 60% to 70% range, and many require the annuitant to select only among managed portfolio options once the income rider has been activated.

Where GLWBs Work
There are other things that should be reviewed before purchasing a GLWB annuity, in addition to the fees.

Many GLWB annuities contain surrender penalties, and therefore the annuitant may have trouble accessing the funds without penalty.

Additionally, if an insurance company were to go out of business there are a number of negative implications that could result.

They are complex products and it is critically important that a potential client understands the product (as best as possible) before purchasing to help ensure it is an optimal solution within a retirement income strategy.

Variable annuities with GLWB riders are a relatively new way to create income for retirees.

Although they are complex products, they offer an innovative way to provide guaranteed income and may be attractive to some clients.

Determining whether or not a GLWB annuity is best for a retiree is a complex decision. But it's a worthwhile exercise, especially for retirees looking to annuitize some of their wealth.

David Blanchett is head of retirement research for the Morningstar Investment Management division

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