Having a lifetime income guarantee at age 85 may be fine, but having a retirement savings principal protection guarantee in place at age 67 is just too expensive, four economists say.
Vanya Horneff and three other economists analyze the value of principal protection in a new working paper posted on the website of the National Bureau of Economic Research (NBER).
A working paper is a preview version of a research paper. It may not have gone through the full academic peer review process.
Horneff and her colleagues assessed principal protection guarantee costs and benefits by analyzing data from Germany’s “Riester program.”
Here are five facts about the paper, for life insurance agents and other financial professionals with an interest in the U.S. annuity market.
1. The paper’s authors are a big deal.
Horneff, an economist at Goethe University Frankfurt, previously co-authored an influential paper on the effects of persistent low returns on retirement savings.
The list of co-authors also includes Olivia Mitchell of the University of Pennsylvania’s Wharton School, who has written dozens of influential papers about retirement savings.
2. The authors give details about how IRAs work in Germany.
Germany’s Riester program offers workers a way to save money in tax-qualified individual retirement accounts that, in some ways, resemble U.S. IRAs.
Managers of the Riester program divide life between an accumulation period, when a worker is building up IRA savings, and a decumulation period, when a retired worker starts pulling money from the IRA.
German pays annual subsidies of up top 175 euros per worker, or about $192 per worker, to workers who contribute up to 4% of pre-tax labor income to their IRAs.
Life insurers hold about 65% of the Riester contracts, and asset managers hold just 20% of the contracts.
German IRA holders can start taking money out at age 62. They can withdrawal up to 30% of the accumulated assets in the form of one big lump sum. A German IRA holder is supposed to take the rest of the assets out in the form of a lifelong stream of non-decreasing, guaranteed benefits, Horneff and her colleagues write.
A German IRA holder must annuitize any assets remaining at age 85, at the latest.
“Usually, to fulfill the last requirement, IRA providers devote a share of their IRA balances at age 67 to buy deferred annuities that pay benefits from age 85,” the economists write.
When the worker shifts from the accumulation phase to the decumulation phase, the German IRA provider must provide principal protection in the form of a money-back guarantee. The guarantee applies to the money the worker paid in during the accumulation phase.
3. The authors give details about a huge new European Union IRA program.
While the United Kingdom has been obsessed with a planned Brexit, or exit from the European Union, the European Commission — the entity in charge of the European Union — has been creating a Pan-European Personal Pension Product (PEPP) program.
The PEPP program could create a huge retirement plan sales opportunity for the financial services companies that have the ability to sell PEPPs in Europe.
The PEPP program will create a standardized, tax-qualified, funded defined contribution plan, Horneff and her colleagues write.
Life insurers, asset managers and banks will all be eligible to sell PEPP plans. Officials are estimating that about 220 million EU workers will be eligible to buy PEPPs.
Workers who move from one EU country to another will be able to take their PEPPs with them.
During the accumulation phase, the provider can impose charges equal to 1% of the PEPP capital.
For workers who do not say how they want their money invested, the provider must provide a default option, or Basic PEPP option, that provides a money-back guarantee for the worker’s contributions, or some equivalent provision that protects the worker’s principal.
4. The authors believe that a money-back guarantee cuts consumption for about 80% of retirees, and especially for lower earners.
The authors used information about the German tax system, German social welfare programs, and past investment performance, and Monte Carlo simulation techniques, to see how IRAs with and without principal protection guarantees might perform in many different scenarios.
“During what we call ‘historically normal’ capital market periods, money-back guarantees have only a modest effect on consumption prior to retirement, but they reduce post-retirement consumption for about 80% of retirees by an average of 2.3% per year,” the economists write
The 2.3% reduction amounts to the equivalent of about $400 per year.
The impact of the guarantees “means that eliminating these money-back guarantees would boost old-age consumption for most elderly,” the economists write.
5. The authors say they did consider how a guarantee might work in a period of persistent low interest rates.
“On the one hand, many people do benefit from the guarantee protection: the shortfall probability of losing money at age 67 without the guarantee is 18.1%, compared to 6.5% in the ‘normal’ capital market environment,” the economists write. “Yet the costs of protection are so high that 82% of retirees end up with far lower old-age consumption, by an average of 10% (or 950 euros per year).”
A 950 euro reduction is the equivalent of a $1,045 spending cut.
Managing risk by putting IRA holders’ money in a target-date default fund, or “lifecycle fund,” that invests too heavily in bonds could make the affected savers even worse off than they would be with an IRA with a money-back guarantee, but putting the IRA holders’ money in a target-date fund with enough stock in it could make them better off than if they had simply relied on a money-back guarantee,” the economists write.
The analysis should be of interest to policymakers who are developing or updating other account-based retirement programs with default investment options, such as the U.S. 401(k) program, the economist write.
“Regulators and consumers will need to better understand the opportunity costs associated with money-back guarantees and other risk mitigation techniques such as life cycle funds,” the economists conclude.
If the principal protection paper gets widespread attention, some clients may still want the kind of principal protection provided by fixed annuities or non-variable indexed annuities, or the kinds of guarantees available inside variable annuities, no matter what a bunch of professors say.
Principal protection is a form of insurance. Insurance makes people a little worse off most of the time to protect the insureds against dire, but rare, catastrophes. Many retirement savers may want to insure their retirement savings, even if the risk of market meltdowns cutting into principal appears to be low.
But the spread of the views expressed in the paper could also increase interest in variable annuities, and indexed annuities filed as variable contracts, that come without built-in principal protection, by providing support for the idea that most retirement savers can get by without money-back guarantees.
A copy of the Horneff team’s paper is available, behind a paywall, here.
— Read 5 New Things Finance Professors Are Saying About Your Prospects, on ThinkAdvisor.