With the powerful new financial planning tools that are now available, advisors can measure the planning value of insurance and annuity products to clients.
What practitioners intuited all along–that such tools would be of great added value–is being proven true. Now, they can quantify.
Combined with modern financial engineering calculations, industry professionals also can see the difference between the client’s value and Wall Street’s manufacturing cost. This is the “planning value added,” which can be shared among clients, the distribution system and product manufacturers. Knowing this spread can be of great help in effective product design.
Let’s define the terms:
Planning value: This refers to the liquid general investments a client would need to meet financial planning objectives, minus the amount needed if the life or annuity policy or other instrument is in place. This is calculated using financial planning software that takes probabilities for investment and longevity risk into account. The value will vary from client to client, according to financial condition and objective.
Pure manufacturing cost: This is the cost to fund the policy benefits, net of premiums, on a risk-free investment basis. It excludes expenses, distribution costs, cost of capital to absorb risk and profit. It is calculated using modern financial theory. It does not depend on the client or the insurance company.
Planning value added: This refers to the “planning value” less the “pure manufacturing cost.” It’s available for expenses, distribution, cost of capital, profit to insurer and financial planning benefit to client, as determined by market forces.
Value ratio: This is the “planning value” divided by “pure manufacturing cost.”
As an example, look at the much touted but much underused immediate annuity.
Take a male age 62, wanting an income of $60,000 per year that keeps up with inflation, with $22,000 in Social Security. He wants a 1% or less probability that he will run out of money. He is considering an immediate annuity with $25,000 in annual income. He can meet his planning objectives with $1,580,000 in general investments.
Now, let’s look at what might happen if he includes an immediate annuity in the planning. The following are examples with three different types of immediate annuities:
1) Buy a fixed immediate annuity: He needs $700,000 less in investments to achieve his goal if he buys the annuity (planning value). The pure manufacturing cost for this is only $365,000. In today’s market, one can buy the annuity for about $337,000.
The value ratio is 189%. The advisor can be proud of the annuity’s great planning value.
2) Cost of living indexed annuity: This is an immediate annuity (if you could buy it) where the income payments go up with the cost of living. The planning value is $1,030,000. The pure manufacturing cost for this is only $473,000.
The value ratio is 217%.
This solution costs more than the fixed annuity, of course, but the added cost has an added planning value of $330,000 for $118,000 of manufacturing cost. The value ratio for the added cost is 280%! The product is not generally available. But look what an advantage it would bring. Professionals can hope new offerings are on the way.
3) Variable annuity. In this case, the planning value is unattractive, as the worst case 1% long-term return on equities is rather low. Note: The planning objective is conservative and looks only at avoiding financial ruin. Less conservative objectives, paying attention to long-range average returns would yield a different conclusion.
My attraction to this subject is immediate: I am approaching age 65 and winding down my actuarial practice progressively. Retirement planning is now very real for my wife and me. So, I did our own plan in detail.
It became obvious to me that cost of living indexed tools would have great added value in meeting our objectives. Alas, the cost of living annuity is not generally available. However, United States Treasury instruments indexed to the consumer price index are available. My solution was Plan B: Buy indexed bonds now, then go for an immediate annuity (hopefully indexed) later on, when the income pickup from the mortality feature of the immediate annuity is bigger.
The hurdles for gradual early retirement are yet another subject.
New planning tools lead to new insights. Agents and home offices should explore the possibilities.
G. Thomas Mitchell, FSA, MAAA, is president of Aurora Consulting, Inc., St. Louis, Mo. His e-mail address is Mitchell.firstname.lastname@example.org.