The great debate of our time -- or at least within the halls of economics departments around the country -- is whether the U.S. (and possibly the entire world) is headed toward uncontrollable inflation. On one hand there are the pessimists, who worry that trillion-dollar deficits and near-zero interest rates can only beget hyper-inflation. On the other side are the optimists, who believe that we are nowhere near conditions in Zimbabwe, unemployment rates of 10 percent can't create wage pressure, and that Paul Volcker -- giant consultant to the president -- is lurking in the background, ready to slay the inflation dragon if he dare emerge from his 30-year hiatus.
Whatever your position, you must admit there is a substantial amount of uncertainty in the U.S. economy in general, and with regards to inflation in particular. To be sure, financial advisors have long recognized "inflation risk" as one of the major threats to retirement income and there are a number of ways in which to hedge inflation risk using conventional instruments such as TIPS and their derivatives. This month I will focus on a particular variable annuity that addresses inflation risk head-on.
Penn Mutual's Purchasing Power Protector (PPP) Benefit, available as an optional rider on a number of the company's variable annuities, is unique in that it promises a real inflation-adjusted income as opposed to the nominal variety offered by most other companies in the VA universe. In other words, if inflation spirals out of control your client's retirement is insured.
Here is how Penn's PPP rider works. First of all, it is built on the standard VA + GLWB chassis. Your client deposits an initial premium sum into the VA and selects from a large variety of stock and bond sub-accounts in hopes of tax-deferred growth over time. So first and foremost this is an investment. Then, when the client is ready to turn on the "retirement income spigot," the insurance company takes a snapshot of the account history and crystallizes what they call the guaranteed withdrawal base (GWB). This base is used to determine allowable withdrawals, which in Penn's PPP case are 5 percent for life provided your client starts at or after age 65.
Here's an example: If the GWB and the account value on the retirement (i.e., income start) date is $100,000, your client can withdraw $5,000 that year -- and this amount is guaranteed to continue for life. The following year (on the policy anniversary date, to be precise) if the account value has gone from $100,000 to $110,000 (which means the GWB increased by 10 percent), he can withdraw 5 percent of $110,000, which is $5,500 per year -- a corresponding 10 percent increase in income. Now it is true that a bear market may push the account value below the GWB when retirement starts, but this is a mere technicality.
So far I haven't described anything particularly novel or clever. Most VA + GLWBs have exactly the same structure. In fact, the 5 percent promised by Penn is lower than the 6 percent or perhaps 7 percent older retirees can obtain from some of the more aggressive products.
But -- and here is my key point -- the 5 percent you get from Penn's PPP is much more valuable than the 6 percent, 7 percent or even 8 percent you might get from company ABC, and this is exactly where things get exciting. Most products adjust the GWB upward on a periodic basis -- some as frequently as daily -- but only if the underlying subaccounts have increased in nominal value. In other words, if the underlying investments have grown sufficiently to cover their management and insurance fees, your client gets a raise. If the subaccounts shrink or collapse, no GWB growth equals zero raise. All measurements are in nominal terms.
However, in the case of Penn's PPP, the GWB increases every year based on the increase in the consumer price index (CPI-U), which is guaranteed during bull and bear markets. So, if inflation spikes or markets collapse -- or both -- the GWB stays the same in real (remember: inflation-adjusted) terms even though every other product around will decline in real terms.
How does this work in practice? If the GWB is $100,000 on the first anniversary date and the guaranteed income is $5,000 per year, and next year the change in the CPI-U is 3 percent, then the base increases from $100,000 to $103,000 and the income will increase from $5,000 to $5,150. Of course, in real terms the income has not increased, but all the clients with competitors who are offering nominal payouts have just experienced a 3 percent decline in real income.
This is true inflation protection, not a hope or an expectation that the income will increase in line with the underlying portfolio or investments. Sure, if the sub-account blows past the above-mentioned 3 percent then everyone's GLWBs will increase, but insurance is about protection when your dreams aren't realized -- not a rising tide that lifts all boats.
In fact, looking at the underlying portfolio, with this product you can actually allocate 100 percent of your investments to equities, via a passive index fund or actively-managed subaccounts, and you can diversify internationally. The all-in cost for Penn's PPP is approximately 3 percent per year for the joint life version, which is as low as you can get for this type of product. Sure, you can find a low-cost annuity that charges an all-in cost of 2 percent or maybe even 1 percent, but none that offers an inflation-adjusted income for life.
Now, this particular rider doesn't offer a guaranteed roll-up on the GWB, or daily step-ups, or enhanced living benefits...or a free toaster if you sign up before Wednesday. But from where I sit, if you grant me inflation protection, I don't care much for all the other bells and whistles. See the table below for more details about the product.
Today, if your 65-year-old client were to purchase an inflation-adjusted annuity, he would probably get a payout of $5,500 per year per $100,000 premium -- which is only a little bit more than what Penn's PPP is promising. However, PPP has upside potential and a liquidity feature, notwithstanding the surrender charge period of a few years. So, you can do the actuarial math in your head: The earlier you start the income, the more valuable the 5 percent inflation-adjusted payout for life. Moreover, if your clients deposit more than $50,000 on day one, they will be entitled to a 4 percent "enhanced credit" bonus which means that the 5 percent for life is applied to the original premium times 1.04.
Now normally when I see something that sounds too good to be true I worry about the financial viability of the issuer. But Penn Mutual has been around for over 160 years, has AA3 ratings from Moody's and as a mutual company is immune to the often distorting pressures of shareholder-value maximization. In fact, I actually spent some time on the phone with an unknowing Penn Mutual customer service representative (I said I was shopping for my mother -- not entirely untrue) who managed to answer most of my questions about these rather complicated issues, and quite competently to boot. (Although the rep did get just a tad suspicious when I asked whether the delta-hedging strategy was based on a Q-measure or the P-measure valuation.)
So if anything, I worry that this product is mispriced and is perhaps being cross-subsidized by other, more expensive variable annuity riders offered by Penn Mutual. I wondered: Am I missing something? I actually asked Thomas Hamlin and Glenn Daily, two experienced annuity and insurance practitioners I know and trust, who are in the trenches (as opposed to the Ivory Tower) and they confirmed that I had my facts straight.
Alas, perhaps Penn Mutual will wake up to the deal they are offering relative to the marketplace and impose some asset allocation restrictions, or weasel out of the CPI adjustments under force majeure clauses. Granted, I am a rather paranoid and pessimistic sort by nature; but I have seen crisis in action and have learned to fear the worst.
If a financial advisor were to recommend Penn Mutual's variable annuity with a PPP to my mother, I would be very impressed and very happy. Every retiree should have some source of guaranteed lifetime income; this product provides it. I will take the company's word that they have no intention of shutting the PPP benefit down. So, whether or not you believe inflation to be a threat, there is much value to be had from inflation-protected income. I am not talking about allocating 100 percent, 75 percent or even 50 percent of a portfolio (even my mother's) to this or any other annuity product. But I am talking about some non-zero allocation for your client's credit-risk-diversified nest egg. Bottom line: I grade the Penn Mutual PPP Benefit a 9/10 -- and I am known as a very strict grader!
Moshe A. Milevsky, Ph.D. is a professor at York University in Toronto, Executive Director of the non-profit IFID Centre at the Fields Institute and CEO of the QWeMA Group (www.qwema.ca). His latest book, entitled Your Money Milestones: a Guide to Making the 9 Most Important Financial Decisions in Your Life, was just published by FT/Pearson.