More than half of investors in this country are worried they will outlive their savings in retirement, according to a 2013 Gallup poll. And only 13 percent of American workers are very confident that they will have enough money for a comfortable retirement according to the latest report from the Employee Benefit Research Institute.
These fears are exacerbated by the fact that Americans are living longer. Today a person reaching age 65 can expect to live, on average, another 20 years, according to the Social Security Administration. Roughly one out of every four 65-year-olds today will live past age 90 and one out of 10 will live past age 95. And the number of Americans age 100 or older has increased almost 66 percent over the past 20 years, according to Census Bureau data, growing at twice the rate of the population overall.
And to make matters worse, there are increasing concerns that Social Security benefits will not be sufficient to fund future retirees’ expenses. Today, Americans who have reached the full retirement age of 66 currently receive a maximum payout of $2,642 per month. Those willing to postpone withdrawals until age 70 currently receive a maximum payout of $3,425 per month. But Social Security’s 2013 Trust Fund Report projects that the combined retirement and disability fund will be exhausted in 20 years. If Congress doesn’t agree on a plan of action to close the funding gap, benefits would need to be reduced.
Advisors acknowledge their clients’ concerns—and recognize the additional complexities. According to Jefferson National’s Retirement Income Solutions survey, more than two-thirds (71 percent) of advisors say the biggest challenge to generating sufficient retirement income for their clients is caused by a combination of three key factors: 1) a low yield environment, 2) maintaining adequate equity exposure and 3) managing volatility. This triple threat demands a new approach to the retirement income challenge.
Guarantees: The changing landscape
The landscape for guaranteed income products has evolved significantly. Variable annuities (VAs) were introduced in the mid-50s. Four decades later, VA premiums reached more than $70 billion per year, according to the Committee of Annuity Insurers. As the market boomed and returns consistently hit double digits, the VA industry thrived.
By the late 90’s products evolved to include an expanding range of enriched insurance benefits and income guarantees. Their appeal to investors was tremendous, a combination of downside protection, upside potential and guaranteed income stream in one product. And by 2000, VAs had become a trillion dollar industry.
But since the crash of 2008, historic low yields and ongoing market volatility have made it increasingly challenging for insurers to manage the risk on their balance sheet, making guarantees more costly to provide. In recent years, many companies have been forced to cut benefits, raise fees, restrict allocations, re-tool products and renegotiate guarantees. Others have been forced to retreat from the industry altogether. Still, 51 percent of advisors surveyed say variable annuities with income guarantees continue to be the most popular products to generate retirement income. Yet, close to 70 percent of these advisors and their clients who use VAs cite rising fees and declining benefits as a cause for dissatisfaction. The demand for a new approach has increased.
Investment-only VAs: The next generation
A great advantage of variable annuities — and one often overshadowed by the industry’s escalating focus on insurance guarantees — is the power of tax deferral. According to Jefferson National’s The Power of Tax Deferral survey, 96 percent of financial advisors say tax deferral is important to confront today’s triple threat, and 86 percent of advisors expect that tax deferral will be more important in the future.
With studies showing that tax deferral can add 100-200 basis point (bps) of alpha, the question is why aren’t traditional variable annuities used more frequently for tax-advantaged investing? And the answer is that most traditional VAs, with layers of asset-based fees for basic Mortality & Expense, income benefits, and other insurance guarantees, can easily charge 300 bps or more — effectively wiping out the value of tax deferral.
A VA must be low cost to maximize the value of tax deferral, which has led to a strong push in the industry to develop a new generation of Investment Only Variable Annuities (IOVAs), designed expressly to be used as a low-cost tax-advantaged investing solution. IOVAs have low or no commissions, eliminate costly insurance riders and feature significantly reduced asset-based fees or flat-fees, to help advisors optimize performance and help clients to build more long-term wealth. Likewise, as more advisors shift towards the fee-for-service model, IOVAs help meet the unique needs of the growing number of RIAs and fee-based advisors.
And moving beyond the restrictions of traditional VAs, most IOVAs are built to include a broad range of underlying funds to achieve maximum diversification. This includes more non-correlated asset classes, hybrid investments, and liquid alternative funds that employ strategies for managing volatility like those favored by hedge funds and elite institutional investors. Having the right mix of funds to implement more proactive risk controls can give advisors and clients the confidence to maintain a more aggressive allocation to assets with greater growth potential, essential for keeping pace with inflation and maximizing long-term performance.
Guaranteed VAs vs. IOVAs: A new approach
To provide the best solutions to the retirement income challenge, advisors need to evaluate both traditional guaranteed variable annuities and this new generation of Investment-Only Vas — two dramatically different products. By understanding the risks and benefits of each, advisors will be able to make the most educated, informed and unbiased decisions to better meet their clients’ unique needs.
According to a new whitepaper by Wade Pfau of The American College titled, “A New Approach to Retirement Income: Next-Gen vs. Traditional VAs,” the primary advantage to the variable annuity structure is the power of tax deferral. It further concludes that just as the power of tax-deferred compounding can grow wealth, its corollary is that the drag of compounding fees can reduce wealth. In turn, Pfau’s research determines that this new generation of low-cost IOVAs may have the potential to provide more efficient ways for clients to generate income, obtain upside potential and provide downside protection.
Pfau’s research is based on a proprietary model, running 5,000 Monte Carlo Simulations, using more than eight decades of market data, to test a variety of investor scenarios to simulate how often a VA with an insurance guarantee might be useful, and what the true value of that rider would be.
Laurence Greenberg is president of Jefferson National.