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November 04, 2015 at 12:13 PM
A 65-year old American male has a 10 percent chance of living to the age of 96. Let’s say he wants to fund $100,000 of spending during his 96th year of life. Since he values spending certainty, he’ll put the money in a diversified portfolio of long duration bonds.
Assuming today’s long-term 4 percent rate on 30-year corporate bonds and a 1 percent advisor fee, he’ll have to set aside $41,200 today to cover the desired $100,000 in spending at age 96.
The problem, of course, is that 90 percent of the time our new retiree won’t make it to age 96. He’ll live to 76, or 86, or 90. But he can’t ignore the 10 percent chance that he’ll be around to spend the money in 31 years. If he doesn’t set the money aside, he’d better be OK with living on Social Security.
Now, let’s say he has nine friends who are each in this predicament. Each one plans to invest $41,200 today to fund the $100,000 in future spending. Since only one of them is going to be around by age 96, why not pool these funds together for the one remaining retiree lucky enough to be alive in 31 years? They can call it a long life income club. Instead of setting aside $41,200, they can set aside $4,120.
Even better, they can hire a third party to manage the investments and make sure the payment is made in 31 years. Maybe they can each chip in $5,000 to cover expenses — still a lot cheaper than the $41,200 they’d have to pay without the long life income club.
As the reader knows, we don’t have to start creating long life income clubs. We already have them in the form of insurance companies that sell annuities that pool retirees together to provide a stream of future income. The most popular types of annuities are those that blend features of an investment with a lifetime income option. But they aren’t necessarily the most efficient way to create retirement income, and figuring out which one makes sense isn’t easy. So let’s take a quick look at the options.
Variable Annuities
Variable annuities are consistently listed as a top source of consumer complaints by FINRA. Personal finance gurus can’t get enough of bashing VAs. It can be more than a little difficult for consumers to understand the costs and features of many products (or for those who sell them or even for personal finance professors).
They are often expensive, have big commissions, and are not necessarily sold to those who would benefit the most from a VA. But VAs may be what some investors are looking for, and the best products can provide value (and many products issued a decade ago provided arguably too much value). They are a complex mix of investments, income guarantees, financial options and tax sheltering.
On the surface, a variable annuity can provide everything a retiree wants in a financial product that he or she can’t get from a fixed annuity. First, VAs have a contract value that can be withdrawn to provide liquidity. Of course, this contract value often falls through early retirement, especially in a low asset return environment. Nonetheless, this contract value can provide valuable protection against unexpected health expenses or other spending shocks.
Second, a VA can provide exposure to a risk premium. If investments held within the VA perform well, the contract value can rise and push up a retiree’s income allowing it to grow as inflation eats up a larger share of their budget. All retirees should accept some risk within their investment portfolio, and VAs provide exposure to this risk while simultaneously providing downside protection. Again, the criticism of accepting investment risk within a VA is that the income benefit from VA equity investments should be compared to the equivalent income benefit from accepting risk outside of a VA.
Holding risky assets in an investment account may provide better protection against inflation later in life since fees will eat away at growth in VA assets over time. Investments held outside of a VA may also be invested in less expensive funds. Oh, and risky investments will push up income in a VA only in a bull market when retirees who hold risk assets outside of a VA don’t really need the boost as much.
Third, income from a VA can provide a paycheck in retirement that lasts forever. Even after the value of investments within the contract no longer have value, the VA will continue to make payments. Although research finds that the income in most retirement simulations will be a little less than a retiree could get from a single premium immediate annuity (SPIA), the protection against outliving assets makes annuitized retirees significantly better off than retirees who don’t pool long life income risk.
I’m a big advocate of VAs that are easier for consumers to compare, and that are structured in ways that will provide the greatest value to retirees. Sheltering savings for the purpose of buying income, providing competitive investment options, and creating a pathway to annuitize these assets with some optional downside protection shouldn’t be that complicated.
I don’t fault companies for developing products that consumers will buy and agents will sell. But a little bit of clarity in disclosure and, more importantly, standardization in product features would go a long way toward increasing confidence in the product. Today’s imperfect market has limited demand for what could be the target date fund of the decumulation stage.
Fixed index annuities have become an increasingly popular hybrid option that provides some liquidity benefit like a VA with more limited upside potential and more generous income guarantees. Moshe Milevsky, writing in Research magazine’s July 2013 issue, provided a generally positive evaluation of a fixed index product as an alternative to a plain vanilla fixed annuity.
In a conversation I had with Brian Kroll, senior vice president of annuity solutions at Lincoln Financial Group, he noted that “a fixed indexed annuity will generally provide a better floor guarantee (or minimum income level) than a variable annuity,” but will sacrifice the upside potential that a variable annuity provides from uncapped participation in the market.
Deferred Income
Let’s return to our 65-year old retiree who cut his cost of funding retirement income at age 96 by 90 percent by pooling assets with nine other retirees. I cheated a little bit by choosing 96, an age that really makes annuitization look good. If I’d chosen 100, it would have made annuities an even better deal. If I’d chosen age 70, annuitization wouldn’t have looked so great.
