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Variable Annuity with a 5.5% Guaranteed Growth Rate?

A reader writes in, asking:

“Several friends have purchased the Prudential Defined Income Variable Annuity. The illustration we were given shows a guaranteed 5.5% growth rate, meaning $100,000 invested for 12 years would be almost $200,000. But everything I read says to stay away from variable annuities. Have you published anything that explains why this isn’t a good deal?”

Typically, what’s going on with illustrations like the one mentioned is that the illustrated value (e.g., $200,000 after 12 years) isn’t exactly real money. That is, it’s not the same as having $200,000 in mutual funds, stocks, bonds, CDs, or cash.

Generally speaking:

  • If you were to cash in the annuity all at once, you wouldn’t get the full $200,000, and
  • If you instead choose to turn on the income stream, it would typically pay out at a rate significantly below what you could get with an ordinary fixed lifetime annuity. (That is, it doesn’t buy $200,000-worth of annuitized income either.)

A reading of the actual prospectus for the Prudential Defined Income Variable Annuity shows that this is indeed what’s going on here. In this particular case, there are two important terms to understand:

  1. The annuity’s “account value” and
  2. What’s referred to in the annuity’s promotional literature as the “protected withdrawal value.”

What Do You Get if You Cash It In?

The account value is the amount that you would receive if you were to cash in the annuity. (Although if you cash it in within the first 7 years, you will actually get somewhat less because a “contingent deferred sales charge” will apply.)

The account value does not grow at a guaranteed 5.5% per year. Instead, the account value grows (or fails to grow) based on the performance of the underlying “sub-account.” In the case of this annuity, the sub-account invests in a bond fund (Advanced Series Trust AST Long Duration Bond Portfolio) with a 0.83% expense ratio, to which an annual insurance cost of 1.9% is added.

Suffice to say, a bond fund facing annual costs of 2.73% is likely to grow at a rate much slower than 5.5% per year. (In fact, with rates as low as they are, I would be surprised to see any noticeable growth over the next several years from a bond fund with such high expenses.)

How Much Income Can You Get?

The amount that is growing at a guaranteed 5.5% annual rate is the “protected withdrawal value.” This is the amount upon which the lifetime income benefit is based. That is, if/when you turn on the stream of guaranteed lifetime income, the amount you’re guaranteed to receive per year is the protected withdrawal value multiplied by a rate that’s based on your age.

But, as it turns out, that age-based rate is not anything to write home about. For example, a 65-year old would receive a 5% payout (regardless of gender). In contrast, by shopping around online, a 65-year old female could get a fixed lifetime annuity paying 6%, and a 65-year old male could get an annuity paying 6.54%.**

In addition, the age-based rate is based on your age as of the date the annuity was issued (i.e., when you first bought it) as opposed to your age when you decide to begin taking income from the annuity.

Let’s look at an example.

Sue is 65 years old. She puts $100,000 into this annuity, then waits 5 years (until age 70), at which point she begins taking withdrawals per the defined income benefit. Her “protected withdrawal value” has grown at the guaranteed 5.5% annual rate, from $100,000 to $130,696. Sue’s guaranteed annual lifetime income will be calculated as her “protected withdrawal value” of $130,696, multiplied by the 5% payout ratio for somebody age 65 (i.e., her age when she purchased the annuity). Result: She’s guaranteed to receive $6,535 per year for the rest of her life.

But guess what? Given her age of 70, if she went online and searched for annuity quotes, she would find that she could get a fixed lifetime annuity paying 6.65% per year.** In other words, she could get that $6,535 of guaranteed lifetime income for just $98,271 using a fixed lifetime annuity.

In short, the enticing 5.5% guaranteed growth rate isn’t anything like a guaranteed 5.5% rate of return. The “protected withdrawal value” that’s guaranteed to grow at that 5.5% rate cannot be cashed out, and the income it provides is worth less than it appears to be worth once you actually compare it to simple fixed lifetime annuities available elsewhere.

**These annuity quotes are for fixed lifetime annuities with a 10-year period certain guarantee, because the Prudential annuity’s defined income benefit comes with such a guarantee. If you have no interest in such a guarantee, you could find higher-paying quotes for simple fixed lifetime annuities.

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If you want to discuss this article, I recommend starting a conversation over at the Bogleheads investing forum.
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