Retirement income is in the news and several companies have responded to the increasingly visible shift from investment accumulation to income distribution by announcing new products, including:o The addition of principal protection and/or payout features to investment productso The availability of income guarantees as optional riders in variable insurance contractso The extension of traditional advice processes to include income projections, ladders and systematic withdrawal plans.
These products and enhancements are a great start. But what other products might be in our future?
Bodie, Merton and Cleeton, in their text book Financial Economics, seek to explain finance through its functions rather than its institutions, concentrating on the three pillars of finance: optimization over time, asset valuation and risk management. The transfer of risk through hedges, the pooling of risks with insurance, and the diversification of risk with investments are identified as three dimensions of risk management. Financial advisors may find it natural to add a fourth dimension, decision-making processes about risk with advice to create a framework (Chart 1) to help us understand and perhaps even forecast the evolution of retirement income products.
Ernst & Young tracks retirement income products in their Retirement Income Knowledge Bank, an online database that compares the various features, costs and benefits of retirement income products.
Traditional In-Silo AccumulationApplying this framework to the traditional in-silo accumulation and past history of the financial industry, we see that familiar products can be shown on Chart 2.
While financial advisors are not in need of definitions for mutual funds, annuities or advice processes, it may be useful to define hedges and selected types of derivatives available to retail investors in the accumulation phase.
Derivatives have been widely available for decades in the institutional markets including: options, forwards, swaps and swaptions. Derivatives have also been available in the retail markets, including call options, put options and commodity futures.
Accumulation-focused retail investors can use a derivatives strategy to protect against unexpected downturns in their investment portfolio during the accumulation phase. Two common strategies involve purchasing a put option and covered call writing.
Let’s move beyond definitions and towards observations. While traditional, retail accumulation products have tended to be in-silo developments, there are at least two examples of successful cross-silo developments in the accumulation-focused history of the financial industry: Target-date funds, also known as target- maturity funds, and separately managed accounts that both offer varied degrees of investments and advice as shown on Chart 3.
There may be an interesting lesson to be learned from the competition between target-date funds and separately managed accounts. Both are accumulation-focused, cross-silo innovations that combine investment and advice. However, the packaging of target-date funds is closer to an investment product than an advice process, whereas the packaging of separately managed accounts is closer to an advice process than an investment product. Which of these two seems to be more successful in your marketplace, the product-packaged combination or the process-packaged combination? Which of these two seems to be amplified into a greater success, in your practice or in your market, as measured by assets under management?
Cross-Silo Retirement Income GenerationSome recent retirement income-focused innovations, such as income funds, payout funds, systematic withdrawal plans and laddering processes, have been in-silo innovations as shown on Chart 4.
However, and as demonstrated by the rapid growth of the Retirement Income Industry Association (RIIA), many industry participants believe that retirement income products will require new, cross-silo developments.
Using our framework systematically, we can identify 11 potential cross-silo retirement income-focused innovations. These include six pair-wise combinations (e.g. insurance/hedges, insurance/advice, insurance/investment, etc.), four triple combinations (e.g., insurance/hedges/advice, etc.), and one combination including all categories. Which of these 11 combinations are likely to be successfully selected by the market?
Will the product-packaged vs. process-packaged distinction of the accumulation-focused target-date vs. separately managed account prove to be an important differentiator for market success in the retirement income space? Would we then be facing 22 possible combinations? To make matters even more interesting and in addition to the product vs. process packaging dimension, Sri Reddy (head of retirement income strategies, ING U.S. Financial Services) suggests that the ability to package the offering at a reasonable retail-level cost may be another key determinant for successful cross-silo combinations. For instance, combining hedging-only investment options with advice may be too expensive as a packaged option at the retail level.
Cross-Silo Innovations in the Insurance IndustryWhile we cannot answer these questions at this point because the market has yet to speak on the matter, we can take a look at some early developments that have taken place in the insurance industry.
One of these cross-silo developments is the addition of living benefit riders to variable annuities as shown on Chart 5. The living benefits include: o GMIB. A “Guaranteed Minimum Income Benefit” provides a minimum accumulation value, typically premiums paid with interest or the contract’s maximum anniversary value, assuming no withdrawals have been made. o GMWB. A “Guaranteed Minimum Withdrawal Benefit” guarantees the return of principal through withdrawals of a fixed percentage of principal during a fixed period of time until the amount of the original investment has been withdrawn. Now, most GMWBs offer a withdrawal guarantee for life. Other GMWB features include step-up provisions, bonuses for delaying withdrawals and extension of the “for life” benefit to cover a spouse. o GMAB. A “Guaranteed Minimum Accumulation Benefit” guarantees the return of the initial investment, regardless of actual market performance, provided the contract is held for a minimum number of years and the contract owner makes no withdrawals during that time.
As one decomposes the embedded investment vehicles, risk-poolings and risk-transfer options in such income riders, one could argue that some are actually a three-way cross-silo combination including investments, insurance and hedges.
There are also some variable annuity benefits that incorporate the four dimensions of risk management outlined above. These products often include features that provide exposure to market performance while offering protection against undesirable outcomes by combining elements of investments, hedges, insurance and advice.
A good example of a three-way, cross-silo combination is a variable annuity with a GMIB rider. This product allows individuals to participate in market performance by investing in equities while at the same time protecting the individual from downside risk by providing a guaranteed roll-up feature. The product also gives the individual the option to annuitize on guaranteed terms in order to create a secured stream of income for life.
Financially, the features of a GMIB can be broken down into being long an equity portfolio, owning a put on that equity portfolio, owning a call on the annuitization terms, and using insurance to benefit from the pooling of mortality when annuitizing and protecting against longevity. This protects the individuals from volatile markets as well as movements in interest rates, while still allowing market participation and providing a lifetime insurance guarantee.
The typical GMWB product offers similar benefits to that of the GMIB, with the exception of the interest guarantee on the annuity rate and the insurance pooling mechanism, resulting in a two-way, cross-silo combination. GMWB riders typically allow for participation in positive market performance while protecting the individual from downside risk. At the same time, withdrawals are guaranteed for life if certain restrictions are met (e.g., can’t take out more than the guaranteed amount). They provide a more limited insurance benefit when compared to the GMIB as they do not pool mortality risk, but do incorporate the same hedging and investment approaches to managing risk that are present in the GMIB.
The GMAB product combines the participation of the investment with protection from downside. However, this product does not contain a hedge against future interest-rate variation or any insurance-pooling benefits.
Interestingly, such cross-silo combinations may create new risks and possibilities for moral hazards that will need to be analyzed carefully. For example, a product that guarantees a minimum income level for the investor creates an incentive for the provider of the guarantee to minimize the variance of the underlying portfolio. On the other hand, the investor may be interested in taking the maximum risk possible, hoping for a higher return, since the guarantee provides a floor. Under such circumstances, who should be allowed to control the portfolio mix? Should the portfolio mix be restricted to traditionally benchmarked index investing or should it allow active investing in un-restricted asset classes?
A financial advisor should ask the traditional suitability questions as well as some new questions about these cross-silo products including: What are the specific risks (old and new) that a particular cross-silo combination seeks to address (or creates) and is the investor exposed (or should be exposed) to those risks?
The risk matrix introduced in our February article, as extended nearby, is a good checklist to develop such questions.
Francois Gadenne is president of Retirement Engineering Inc., a Boston-based R&D company that designs insurance and investment products for retirement-income needs (www.IncomeAtRisk.com); he is a co-founder of the Retirement Income Industry Association