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December 01, 2009 at 02:00 AM
Most readers of this column know that the annuity is one of the most misunderstood — and often abused — terms in the lexicon of retirement income planning. Financial services companies currently offer variable annuities, fixed annuities, deferred annuities, income annuities, immediate annuities, longevity annuities and equity-indexed annuities, to name just a few; each comes with its own distinct and difficult-to-compare features.
This is extremely confusing to the end-user (i.e., your client) who has little or no background in actuarial science or advanced derivatives valuation. Even financial advisors themselves have a hard time distinguishing between the steak and the sizzle in the newer financially engineered products with guaranteed living income benefits (GLIB).
To make things worse, many of the retirement products I come across, christened and marketed as annuities, have little to do with the antique Roman concept of periodic income. Some offer no mortality credits whatsoever. (Remember, mortality credits capitalize on the concept of risk sharing and dictate that survivors within the pool must inherit some assets from the deceased.)
The no-free-lunch dictum applies here as well. Once you allow retirement income products to have ample liquidity, enhanced death benefits and on-demand refunds, you could be left with an expensive bond or fixed-income portfolio, perhaps with a thin veneer of life insurance. In my view that’s not an annuity, regardless of what it says on the packaging.
In other words, if an “annuity” company promises to pay you whether you live or you die, that’s a bond. The only way to pay you more if you live — as annuities are supposed to do — is to pay you less if you die. For anyone “worried” about living, it is worth giving up the death benefits.
Just as an example, a so-called income (a.k.a. immediate) life annuity sold to a 70-year-old male but with a 25-year period-certain guarantee — which might be a safe and appealing investment from a psychological perspective — contains very few mortality credits. It is effectively a collection of staggered and stripped bonds. Likewise, a variable annuity with a nominal 5 percent guaranteed lifetime withdrawal benefit (GLWB) for a single life, and a conservative asset mix, provides only a negligible amount of longevity insurance or protection against a market crash and negative early sequence of returns.
And so, to bring structure to this rapidly evolving market, I think it is time for insurance companies and other product manufacturers to start reporting the nutritional content of their creations in a limited and standardized format. This is akin to the labels on your favorite cereal, yogurt or granola bars which disclose the amount of vitamins, minerals and nutrients. The financial labels should disclose the amount of longevity insurance, mortality credits, stock market crash protection, and other factors contained within any and all annuity products.
I call this process Retirement Income Product (RIP) DNA Extraction.
In this context, though, instead of breaking open cells, removing membranes and dousing proteins in ethanol, the laboratory of choice is a fast computer that can simulate thousands of potential market scenarios. The extraction algorithm counts the percentage of cases in which various product features pay off and the cases in which they expire worthless, all discounted to account for the present value of money.
So, for example, if the annuity product doesn’t offer any lifetime income, then its discounted payoff will be quite low for those scenarios in which retirees exceed their life expectancy. Likewise, if the product offers no inflation protection, its discounted payoff will be low in high-inflation scenarios. In the language of statistics the properly scaled “regression coefficients” would be the weights which should add up to one. The total is the sum of its parts. All of this is presented for a hypothetical case in the nearby table.
For example, such a DNA extraction algorithm confirms that a low cost S&P 500 index fund (or ETF) contains 100 percent basic market exposure with a 0 percent factor loading in all other six categories listed in the table. But, in contrast, a generic (low cost) 5 percent-for-life variable annuity with a Guaranteed Lifetime Withdrawal Benefit (GLWB) sold to a 65-year-old with a 60/40 equity/bond asset allocation consists of 90 percent basic market exposure and only 10 percent longevity insurance. And, if you increase the allowable equity exposure by 10 percentage points the longevity insurance component grows to 15 percent.
