Retirement income (RI) planning is becoming more important and relevant to an aging American population. The well-documented bulge of accumulated savings held by the baby boomers, estimated to be between $10 trillion and $15 trillion, will be moving into its RI phase over the next 10 years. Because of its investment and mortality guarantees, the Fixed Immediate Annuity (FIA) is a product that, in many cases, is uniquely qualified to satisfy RI needs. Insurers and advisors need to demonstrate its value clearly to clients.
In fact, the current methods for evaluating the impact of incorporating annuities into a RI plan including the use of pre-set allocation percentages and approaches that treat FIAs like an asset classsuch as a stock or a bond fundare misguided and ignore the fundamental advantages and disadvantages of FIAs.
The RI planning dialogue needs to move beyond this simplistic view to address the true value of an FIA and when it will work best for a client. The impact of an FIA on retirement goals can be easily demonstrated when one considers how it performs under a range of possible retirement scenarios. When these scenarios test both random market returns and mortality, the FIAs value becomes clear. As such approaches become commonplace, the product will explode in popularity as its unique advantages are recognized.
RI Phase Requires Incremental Risk Analysis and Control
The principal need in retirement is to use savings to generate income levels that have a high probability of meeting needs. The chance of failure must be low, because in the RI phase of life, the flow of new savings from employment dries up and consumers no longer have the risk-taking flexibility they had in the accumulation phase. In many cases, what the retiree has in terms of financial resources today is all he or she will ever have. Therefore, retiree risk must be analyzed and controlled.
Unfortunately, the software tools used to evaluate RI risks are still in their infancy. Most of the current RI software attempts to apply the approaches used in the accumulation/savings phase to RI, but the two phases have such different requirements that accumulation planning approaches simply do not work well when applied to the RI phase. RI planning tools should educate retirees and near-retirees regarding the risks and limitations they face in this new phase of their financial life.
It is clear that future retirees will be far less able to depend on generous defined benefit plans (and perhaps even Social Security) and will instead need to rely primarily on defined contribution plans and savings. Since most research indicates that savings fall well short of goals, we know that RI planning solutions must revolve around tradeoffs, compromises and adjustmentsthat is, probabilistic illustrations of outcomes created under a range of reasonable future circumstances. Effective RI planning software can demonstrate the usefulness of immediate annuity products for many retirement plans based on their unique ability to provide assurance of meeting needs in many cases.
Addressing Longevity Key to Accurate Planning
Even though mortality risk exists in virtually all RI plans, it is not carefully considered. While this may be an acceptable simplification for the “accumulation stage,” for RI planning purposes, longevity risk (the chance of outliving ones assets) and death related events (changes in pensions, Social Security and needs) must be considered. Planning to a fixed age does not provide an appropriate picture of RI risks and opportunitiesthis type of planning creates the risk of either over- or underspending in retirement.
Since death is even more certain than taxes, and many key planning variables depend on mortality assessment, ignoring mortality is a significant and glaring oversight, especially in an industry that can provide the products to manage this very risk.
Challenging the treatment of FIAs as an Investment
A common view during planning is that an FIA is an investment and should be evaluated against other potential investments using traditional techniques. In reality, an FIA should not be viewed as an investment, because its objective is neither to maximize returns, grow value nor guarantee returns. It is, however, intended to provide a form of guaranteed income.
Because of the fundamental difference in the objectives of FIAs vs. investment products, the real challenge is to find the appropriate technique to measure the value of an FIA to a retiree. Our research has shown the most appropriate method available is to examine the level of success a retiree can achieve meeting retirement needs with and without the benefit of an FIA. These levels of success are called “success rates.”
We have observed some attempts to put the FIA on a level playing field with other investments, and although some of those approaches may have advantages and disadvantages, we feel they miss the key benchmark in retirement planning, which is the level of success. For example, comparison of an FIA and an investment vehicle over a fixed planning horizon misses the impact of longevity risk, which is a key risk addressed by an FIA.
Annuities and RI SuccessCreating a Clear Picture
How many products in retirement provide a guaranteed return that the retiree cannot outlive? Since an individual cannot increase pension and Social Security incomethe primary sources of guaranteed returnsthere are actually very few ways to guarantee cash flow. CDs and bank accounts can guarantee against loss of principal, but do they guarantee returns? Obviously not, as their declining earnings rates over the past several years have demonstrated. Reverse mortgages have some potential, but they are not well understood and only minimally used. Most retirees face a known gap between basic needs and stable income that they need to fill.
Despite the natural ability of FIAs to fill this gap, annuity writers and advisors have lacked the ability to demonstrate their unique capability. With stochastic analyses that show how an FIA improves the likelihood of success in meeting retirement needs, a clearer picture can be painted for consumers.
Of course there are some commonly encountered objections to the purchase of an FIA contract such as:
The monies required to purchase an FIA contract are tied up forever.
FIA contracts do not protect against inflation risk.
FIA contracts limit the ability to accumulate wealth.
Sales compensation has been an issue.
There are, however, products now appearing on the market that address these issues. Additionally, a planning tool that demonstrates true FIA value would allay the concerns created by at least three of these “top 4″ objections. Using such a tool, our research has identified an “annuity frontier,” a situation in which the purchase of any amount of annuity product will improve the individuals chances of RI plan success.
Table 1, developed using Ernst & Youngs Retirement Analytics value demonstration model, illustrates the “annuity frontier” concept. Assuming a retiree has annual income needs of $45,000 and total savings of $650,000, this table displays the chances of the retiree meeting those needs over time.
Without an annuity, the likelihood of the retiree meeting his Basic Income Needs decreases as the planning horizon increasesillustrating the risk of longevity. However, with an FIA paying $45,000 (priced at current market, with taxes considered), the retiree will be able to meet the needs, regardless of how long he lives. Even a smaller annuity purchase improves chances of success.
While the annuity protects the retiree against longevity risk, there is a cost related to obtaining such guarantee. This cost is the annuitys impact on potential wealth accumulation. This classic RI tradeoff decisionincome maintenance vs. wealthis illustrated in Table 2. This table shows a distribution of wealth at death for the same retiree. Unless the needs are 100% secured with guaranteed income, we see there is some chance of running out of money and having no wealth at deaththe two bars on the far left show these probabilities, which are the complement to the final success rates shown in the graph.
The annuity that meets 100% of the retirees need ensures that there will be at least some wealth at death and thus there is no green bar at the far left. Likewise, the annuity provides sufficient safety that it gives a higher chance of wealth up to about $100,000 for this particular plan. Purchasing no annuity or a smaller amount of annuity creates the opportunity for much greater wealth, although the chances of “lottery” scenarios (legacies of over $1 million or even over $5 million) are very small. It depends on personal goals and priorities, but for many retirees income assurance takes precedence over legacy building, and an FIA can play an important role in meeting that priority goal. This example represents a critical FIA tradeoff question, “Am I willing to sacrifice upside potential to achieve downside protection?”
A planning tool that accounts for longevity risk and uses mortality and investment variability to test plan viability can potentially define the situations where an FIA may be an appropriate solution for a retiree. It can not only propose an initial deployment of assets to purchase an annuity, but if the purchase of an annuity is sub-optimal today, it can profile future circumstances where such a purchase would be more appropriate.
Since the “annuity frontier” expands as both age and investment returns increase and consumers tend to update their retirement plans infrequently, it is crucial to map out points in the future when FIA purchasing should be revisited. Once an individual enters the “frontier,” the purchase of any amount of annuity could improve the chances of RI successmaking this an important zone on the retirement income planning radar screen. New, stochastic value demonstration tools will enable advisors to show this unique FIA capability.
Jack Ladley, is a Senior Actuarial Advisor in the Philadelphia office of Ernst & Youngs Insurance and Actuarial Advisory Services Practice. His e-mail address is: email@example.com.
Joseph Weiss is an Actuarial Advisor in the Hartford, Conn., office. His e-mail address is: Joseph.Weiss@ey.com.
Reproduced from National Underwriter Edition, February 25, 2005. Copyright 2005 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.