In our previous white paper Defined Benefit Plans are disappearing: Are variable annuities the answer? we made the case that a retiree is exposed to a significant risk when deciding on how to invest a retirement fund. To illustrate the basic idea of how a Variable Annuity can mitigate this risk, we will first examine a very simple product: a Guaranteed Minimum Withdrawal Benefit (GMWB).
Suppose that the investor pays $100,000 to an insurance company, which is invested in a stock market index. Make the assumption that the contract runs for 10 years, and that the guaranteed withdrawal rate is $10,000 per year. Each year, the investor can withdraw $10,000 per year, which is subtracted from the amount invested in the stock market account. At the end of ten years, the retiree can withdraw anything left in the account. The interesting aspect of this contract is that the insurance company guarantees that the retiree can withdraw $10,000 each year, even if the actual amount in the stock market account is zero.