The Suitability of an Annuity Recommendation
Your client, Lisa, age 58, has $500,000 in a variable annuity (VA) with a guaranteed minimum income benefit (GMIB) rider. The VA has an annual fee of 2.5% (including the rider). She is considering surrendering the VA to invest in a lower-cost portfolio of index funds (estimated 0.20% expense ratio). The surrender charge is currently 5% and decreases by 1% each year until it disappears in 5 years. The GMIB guarantees a minimum income of $30,000 per year starting at age 65. Lisa is in good health and has other assets of $300,000. She is concerned about fees and wants to reduce costs. She asks you whether she should surrender the VA now.
1. What factors should you consider in evaluating whether Lisa should surrender the VA?
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Key factors:
- Surrender charge: 5% of $500,000 = $25,000. If she surrenders now, she loses $25,000. Waiting 5 years eliminates the charge.
- Fees: The VA costs 2.5% annually ($12,500 per year) versus 0.20% for index funds ($1,000 per year). The difference is $11,500 per year. Over 5 years, the extra fees total $57,500, which is more than the surrender charge. However, the GMIB rider provides a guaranteed income floor.
- Guaranteed income: The GMIB guarantees $30,000 per year starting at 65. If she surrenders, she loses this guarantee. She would need to generate similar income from the index funds, which is not guaranteed.
- Health and longevity: Lisa is in good health, so she may live long and value the guarantee.
- Other assets: $300,000 provides some flexibility, but the VA is a significant portion of her retirement assets.
- Investment options: The VA may have limited investment options; index funds offer broad diversification at low cost.
- Taxes: Surrender value above basis is taxed as ordinary income. Need to know basis.
You should compare the cost of the guarantee versus the cost savings, considering her risk tolerance and need for guaranteed income.
2. What analysis would you perform to compare the options?
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Perform a quantitative analysis:
- Calculate the net surrender value: $500,000 - 5% = $475,000.
- Project the VA value over 5 years with 2.5% fees and assumed returns, versus the index portfolio with 0.20% fees. Use reasonable return assumptions (e.g., 5% gross).
- Compare the income at 65: The GMIB guarantees $30,000. For the index portfolio, calculate a safe withdrawal rate (e.g., 4%) on the projected value at 65. If the index portfolio grows to, say, $600,000, 4% = $24,000, which is less than $30,000. The guarantee may be valuable.
- Consider the breakeven: How long would it take for the fee savings to outweigh the surrender charge and lost guarantee? If she waits 5 years, she avoids the surrender charge but pays $57,500 in extra fees. However, the guarantee may be worth more than that.
- Scenario analysis: Consider poor market returns; the GMIB provides a floor.
Present the analysis to Lisa, emphasizing that the decision depends on her need for guaranteed income and risk tolerance.