In 1952, The Teachers Insurance and Annuity Association (TIAA) sold the first variable annuity (VA) developed by Harvard Ph.D. economist William Greenough to Brown University President Henry M. Wriston. Since then, over a million education employees have invested in VAs through the TIAA College Retirement Equities Fund (TIAA-CREF). The original VA was seen as a creative solution to the retirement income puzzle.
(Related: Revenge of the Variable Annuity)
The variable annuity concept as originally envisioned is remarkably simple. The initial purpose of the VA was to provide a higher income to retirees than fixed annuities, for the trade-off of removing the stronger guarantees that fixed annuities provide.
A VA invests in assets that are more volatile, but carry higher upside potential — namely, stocks. Greenough imagined that this would allow retirees an income that rose over time, counteracting the price inflation that reduces the purchasing power of a fixed annuity – and, in many cases, paying more over time.
In his research published in the Journal of Finance, Greenough mapped out the income from a VA purchased prior to the Great Depression; at first, the income fell below a fixed annuity, but by the 1940s, the income rose to the point that it was keeping pace with inflation, while a fixed annuity lost ground each year.
These benefits should translate into retirees flocking into variable annuities – however, the data doesn’t quite back that up.
According to a recent analysis, the percentage of TIAA participants choosing to take lifetime income fell from 54% in 2000 to just 19% in 2017; the drop in annuitization follows the decline in recent interest rates, which chipped away at the amount of income one can receive from an annuity.
Adding pressure to the mix is a general misunderstanding of annuities across the board; in a recent survey of retirement income literacy from The American College of Financial Services, only 19% of respondents correctly guessed that the payout on a single-premium immediate annuity (SPIA) to a 65-year old male was about 6%.
This lack of knowledge can prevent savers from selecting a product solution that is fairly priced and inhibit their understanding of the true value that these products can provide.
In a low-asset-return, low-interest rate environment where an ever-growing percentage of savers will not receive a defined benefit pension, retirement savers need all the help they can get to fund adequate spending from a portfolio of assets.
A variable annuity can help fill the gap by providing mortality credits and an equity risk premium, a combination that traditional assets can’t deliver. A basic investment portfolio, for example, gives retirees an equity risk premium but leaves mortality credits on the table, resulting in lower spending and greater risk.
In order to maximize the power of their mortality credits, it’s important that these products be illiquid in structure.