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May 01, 2010 at 04:00 AM
PRODUCT REVIEW
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.
Mechanics
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.
