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The Right Fit: Annuities in Allocation Models

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This is the fifth in a series of articles that will be published on the annuity space.

Introduction and overview

It’s no secret that baby boomers are rapidly entering retirement. Even for those who plan to stay in the workforce past their normal retirement age, the question of retirement income is top of mind. Most advisors do not currently receive adequate support from their firms relating specifically to retirement income planning, although this is starting to change. There are many organizations that are starting to develop more sophisticated and scalable tools to understand and evaluate the ability of individuals to meet their retirement goals—including income, wealth transfer and a contingency fund for health care or other unexpected expenses.

As a general product type, the features of annuities line up very well to meet many of the new risks that are present in retirement—specifically, longevity and uncertain market performance. However, these products are often sold as stand-alone options without an understanding of how or why they are a better fit than other, lower-cost options, such as mutual funds. While there are a number of strategies devised that incorporate annuities, this article will focus on product allocation models—packaging annuities with investment solutions that provide advisors with a more effective way to help their clients meet their retirement goals.

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Evaluation framework

Before looking at the impact of including annuities into a retirement plan, the evaluation framework needs to be considered. As individuals transition from the accumulation phase to the distribution phase of retirement, they are exposed to many new risks in addition to the new goals and objectives found in Table 1. In order to adequately evaluate any retirement income product or strategy, all of the risks and goals need to be taken into consideration. An approach that focuses on the outcomes during retirement provides a more direct way of comparing products and solutions that have traditionally been difficult to compare.

For example, comparing the results of a traditional systematic withdrawal plan to a plan that includes 30 percent into a single premium immediate annuity is not as straightforward. What age do you assume the individuals live to? What is the value of having an income floor? Does annuitizing 30 percent of the portfolio reduce the chance of meeting the estate goal? These are all difficult questions to answer using a traditional risk-return optimization framework. An outcome or goals-based approach can directly compare these and any other products and strategies to provide the individuals with information to understand their trade-offs.

A quick example of an outcome based framework is found below in Table 2. The real, after-tax and after insurance premium consumption amount is calculated such that 90 percent of the scenarios end with the objectives being met using a full risk framework. The first column has the sole objective of meeting an income goal, and the second column has a goal of leaving the starting assets behind upon death. The results were analyzed using Retirement Analytics™ with a full risk framework that had long-term care expenses, Monte Carlo mortality, variable inflation and stochastic fund returns.

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The impact of different products and strategies are evident by these results. For the no-wealth transfer objective, adding longevity insurance instead of a SPIA is the best option to maximize your consumption. With a wealth transfer goal, the importance of purchasing life insurance to efficiently deal with that objective can be used since the highest income amounts result from a fully insured solution.

Allocation models

Asset allocation models have become standard for nearly all investors looking to invest in a diversified portfolio. These models combine different asset classes to help manage the overall volatility of a portfolio, and provide a portfolio that has the best possible trade-off of return and risk. By extension, product allocation represents the combination of traditional investment solutions, insurance, annuity and other income-focused investments that will allow for improved outcomes throughout the retirement income phase of life.

The key factors that differentiate the objectives used to set up the optimal asset allocation models are typically risk tolerance and time-horizon. By using these two factors, an analysis is performed that selects the proper combination of investments that will best meet the stated objectives. Similarly, product allocation models in retirement can be calculated given key factors about the individual’s plan. However, unlike asset allocation models, product allocation models need substantially more inputs. As stated previously, there are new risks and objectives in retirement that all go into the ideal product allocation. In addition, the current demographic and financial situation of the individual can have a large impact on the optimal portfolio. For example, when trying to meet a specific retirement income level, the level of existing Social Security or pension income will lead to a different combination of products. Similarly, different product allocation models will be optimal for an individual who wants to leave substantial assets to their heirs, compared with individuals who are comfortable spending their entire nest egg. 

One of the key differentiators of a holistic product allocation model is the inclusion of other products that don’t fit into the traditional pie chart depiction. For example, purchasing a long-term care policy is something that is critical for most individuals at retirement—but doesn’t fit into the traditional “X percent” of their portfolios. An example of product allocation model can be found in Table 3.


There are many benefits to including annuity and insurance products within a product allocation portfolio for retirement income, including, but not limited to:

  • Higher “safe” consumption levels
  • Less exposure to market volatility and recalibration
  • Floor of income that limits potential downside income risk
  • Leveraging most efficient products for specific income, bequest and insurance needs

The access to these types of solutions should continue to grow as home offices catch up with new approaches and develop scalable solutions available to their advisors. Also, with the increased importance of retirement income in the advisor community, there is going to be an increased demand for solutions and strategies from consumers. Packaging traditional investment solutions with annuities and insurance products can help retirees achieve their desired outcomes.

The views expressed herein are those of the authors and do not necessarily reflect the views of Ernst & Young LLP.

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