This year’s Wharton Pension Research Council conference theme was about reimagining pensions over the next 40 years. What did the brightest minds in the world come up with? Traditional pensions should look more like variable annuities. And defined contribution plans should look more like variable annuities too. Is it time to prepare ourselves for a variable annuity (VA) revolution?
Not if you look at VA sales numbers. VA sales peaked at $184 billion in 2007 and have been over 20% below that high water mark over the last two years. Many insurers got out of the business after going a little crazy on guarantees, and the percentage of consumers with a favorable opinion of annuities hovers in the same range as Congress or venereal disease.
This lack of popularity is happening at the same time the largest cohort of new retirees in the history of mankind is looking for something to do with their $6.5 trillion of IRA assets. How about a single investment that lets them take a reasonable amount of investment risk while protecting against outliving assets? Baby boomers should be knocking down doors to shift their assets into a variable annuity.
How are variable annuities not the most popular financial product in IRAs? It should be noted that the $145 billion of VA purchases in 2013 overestimates their popularity as a retirement tool since many are bought by really rich people using them as a tax shelter of last resort. As we know, a VA in an IRA takes away any sheltering bonus so the product needs to hold its own against increasingly cheap mutual funds and ETFs. VAs need to be lean and easy for a consumer to understand, they need to capture a risk premium and be immune to firm-specific default, and they need to provide actual income that a retiree can spend.
This was pretty much what economist William Greenough envisioned when he came up with the VA concept for TIAA-CREF. The big problem with traditional immediate life annuities is that they invest in safe assets that tend to be suboptimal over a long retirement. A single premium immediate annuity (SPIA) will gradually lose purchasing power over time, and the amount you can spend each year will be calculated based on market bond rates the day you buy it. Recent research shows that most retirees should optimally accept quite a bit of investment risk in retirement, and a SPIA forces them to put a big chunk of their portfolio in a bond-like asset.
The perfect annuity would allow retirees to accept a certain amount of investment risk. What does investment risk really mean in retirement? It means that their income could go up or down depending on the market. A variable annuity shouldn’t mean that the pre-annuitization savings is variable—it should mean that the income received after retirement is variable.
The Hidden Variable
A lot of insurance companies want to take the variability away from a variable annuity by providing stable income guarantees and a springing option of potentially higher income in the future. When any entity guarantees an income for retirees, this creates an important problem for the institution (which may be an insurance company, corporation or government agency). If markets don’t cooperate, then the institution is on the hook to make payments and must scrounge for money from other revenue sources to make up the difference.
This is the transfer of investment risk from the annuitant to the institution. It can make sense, but this transfer is costly (for an institution to accept that risk, it should mean a lower annuity payment on average) and it puts the institution at risk of going out of business and not paying any annuitants.
In a fascinating and important presentation at the Wharton conference, pension expert David S. Blitzstein (who negotiates pensions for the United Food & Commercial Workers International Union) argued for a mechanism to allow greater risk sharing in pensions by providing variable incomes tied to market returns. Let me just say that one more time—a union pension expert argued that it is in the best interest of employees to encourage employers to transfer investment risk from their own balance sheet to union employees.
Why? Because it’s too, well, risky for employers to be forced to dig into their own assets to make up for guaranteed income promises when markets fall (or stagnate). This could mean that no employees get pensions if employers go bankrupt, and you’d rather that employees deal with slightly varying income than no income at all.
This also helps explain why insurance companies shouldn’t necessarily be the ones bearing the investment risk from income guarantees. The other problem is that, in the case of a pension or a mutual insurance company, the other participants lose out when promised guarantees are overly generous—creating a wealth transfer from one group to another.
In the worst case, an insurance company could go belly up in a market crisis. The risk of insurer default can be impossible for a retiree to hedge outside of state guarantee associations that provide as little as $100,000 of protection and may not be rock solid if multiple firms fail. Risk sharing is probably the most efficient way to deal with unknown future investment returns.
A Product Problem?
Why are variable annuities the optimal retirement income tool? In theory (with giant air quotes), variable annuities are all about giving retirees two very important things they don’t get with traditional fund investments. Unlike withdrawing money from a mutual fund, a variable annuity will allow a retiree to spend more each year from pooling longevity risk and will provide protection against running out of money.
In the absence of a variable annuity, a retiree must figure out how much to withdraw each year from an investment account. This requires some difficult calculus that even the experts can’t agree on. Take out too much or live too long and you’ll run out of money. Take out too little and you’ll have a lot less fun in retirement. Instead of retaining the risk of not knowing how long you’re going to live, it is far more efficient to pool this risk. Keep the investment risk that balanced mutual funds provide, but pool the longevity risk.
Linked to the Market
A variable income annuity linked to market performance promises both. In many ways, variable annuities after retirement are like lifecycle funds before retirement. They are an optimal retirement investment instrument. Sure, employees could rebalance their own portfolios regularly and select the right mix of stocks and bonds, but we know that nobody actually does that (even financial planning professors).
The most popular investment in the Thrift Savings Plan, largely considered the most efficient DC plan, is a T-bill-based fund that’s paid about 2% over the last five years. Making it easy for employees to default into lifecycle funds gave millions of workers access to a more appropriate investment portfolio and a chance to share in the risk premium to meet retirement goals.
Variable annuities could do the same thing for retirees. Opting a part of retiree assets into a VA would “theoretically” improve their average investment portfolio performance while protecting against the risk of running out of money. In a perfect world, employers could add a VA to a DC plan without fear of being sued by employees for a fiduciary breach. Greater availability of VA products could enhance industry competition and reduce fees. Sounds like a terrific idea. In “theory.”
At this point, if you’re an advocate of existing VA products and have high blood pressure you may want to stop reading. Because the problem with VAs is that the products often don’t look like an optimal retirement income tool. Most of them really look like one of two things—a tax sheltering device for the rich, and a complex financial instrument that resembles a structured product with features that make it more attractive in a sales pitch.