9. Annuities Are Personal Pensions
“...Annuities are bad investments because they are expensive, confusing and sold by shady insurance salesmen....”
—Myth #9
Annuities are likely one of the most misunderstood and confusing investments in the financial universe. The word annuity itself can describe many different instruments, which can be very different from each other. Annuities have received an unbelievable amount of bad press and publicity—some of it justified, some not—yet few people realize that these products are implicitly contained within every single defined benefit (DB) pension plan as well as Social Security. They are the underlying ingredients of retirement plans around the world. Hopefully, this chapter can help clear up some of the confusion and help answer some questions, or at least give you some questions to ask your own financial advisor. But first let me start by telling you an interesting story and review some history of my limited role and involvement in the annuity industry’s bad publicity.
In the mid-1990s, I conducted and subsequently published a widely cited research study, together with a risk analyst from Goldman Sachs, on the nature and magnitude of fees and expenses charged within variable annuities (VA). The basic chassis of a generic variable annuity is quite similar to a mutual fund but it is classified as an insurance product because of various explicit and implicit insurance guarantees. Hence, annuities also benefit from a more favorable tax treatment by having all investment gains within the policy sheltered from taxes until the policy is surrendered. I’ll get to the details of my research study a little bit later in the chapter, but the bottom line is that my early verdict wasn’t very kind to VAs. They didn’t make much sense to me.
In general, an annuity is best viewed as a process as opposed to just a product. Think of it as having a life cycle of its own that starts at birth, grows over time, and finally matures. The early part of the process consists of a pay-in stage. Here the policyholder or investor contributes money (either in one lump sum or over time) with the funds allocated among a number of subaccounts that move up and down in value over time. The goal of this process, like any other investment, is to grow the account by receiving dividends, capital gains, and interest.
This growth phase will come to an end in one of three different ways. The policyholder may do one of the following:
• Decide to surrender (also known as lapse) the policy by withdrawing the entire sum of money
• Die, which would result in a guaranteed minimum death benefit (GMDB) to a beneficiary
• Opt to receive slow and periodic income payments (called the pay-out stage). The slow and periodic income payments can be guaranteed for life, for a fixed period of time, or until the money runs out.
So, these are basically the three exit strategies (if you can call dying a strategy) for terminating an annuity policy. Each of these exit points is important in their own right, because there might be guarantees associated with each of these triggering events. Also, obviously, the more guarantees that are included within the basic annuity structure, the more that including them in your investment portfolio might make sense. If you are considering one of these, whether inside a 401(k) or IRA, or outside of a tax shelter, make sure you understand exactly how these events will impact the value of your account and the amount of money you can withdraw.
Now let me get back to my statistical study of the late 1990s. At the time we conducted our research, most VA policies were only offering a basic guaranteed return-of-premium (RoP) death benefit, which meant that at the market’s worst you got your money back, and only if you died. These guaranteed minimum death benefits, or GMDBs as they are abbreviated, were the only relevant guaranteed features that distinguished VA policies from their mutual fund cousins.
Yes, during the mid-1990s some insurance companies started offering variable annuities with more lucrative minimum investment returns or maximum anniversary guarantees. These enhanced GMDBs promised that in the event of death, beneficiaries would be guaranteed at least the premium deposit, grown by up to 7% per annum, or a death benefit equal to the best historical anniversary value. But then again, you had to die to get these benefits and many policies were surrendered and lapsed well before the policyholder ever died. More importantly, at the time of our analysis the bulk of VA assets—and especially the policies inside tax-sheltered qualified plans such as 401(k) or IRA accounts—only offered a plain vanilla (RoP) GMDB.
To conduct the study, we examined a comprehensive database that Morningstar graciously provided to us, which at the time included more than 400 VA policies and 7,000 investment subaccounts. That was then. Now, more than 1,400 different policies and a mindnumbing 66,000 different investment subaccounts are available to choose from. (Talk about inflation for retirees!) We compared the pure insurance charges, called the mortality and expense (M&E) fee—which ranged from 7 to more than 140 basis points (or 0.07% to 1.40%) per annum—to theoretical model values, which approximated the costs of replicating these guarantees in the capital markets. Think of it as comparing retail prices to wholesale prices for a pair of shoes, to calculate the markup.
This might sound like an odd type of project to do as a hobby in your spare time, but it was pure intellectual curiosity that motivated us to investigate whether consumers were getting their money’s worth on the guarantees offered within variable annuities.
Nowadays, the question of whether the costs and fees charged within a variable annuity contract are “too high” or “too low” or “just about right” relative to some baseline economic valuation model is not just a theoretical exercise in abstract pricing theory. This topic is relevant to more than just the cost-conscious investors or consumer advocates who want to make sure they are getting fair value for their money. In fact, no less authority than the U.S. Department of Labor has recently issued regulations that pertain to the fiduciary responsibilities of trustees in defined contribution (DC) pension plans. The DOL regulates these plans and has a critical voice in deciding what investments should be allowed into DC plans. Their recent regulations explicitly mention the importance and centrality of the costs and fees of annuities within DC plans. According to the DOL, those who are tasked with the responsibility of selecting annuities as a form of accumulation or distribution within a DC plan “...must consider the costs of an annuity contract in relation to the benefits and administrative services provided.”
As far as the original study was concerned, the embedded guarantees promised at death were quite similar to equity put options, which are contracts that grant the holder a right but not an obligation to sell an underlying portfolio at a fixed price on a given date. These options are traded on financial exchanges all over the world and have readily available market prices. In the VA case, instead of the option maturing at a fixed date such as three weeks, months, or years in the future, the maturity date of the option was random; namely a date of death. Partially tongue in cheek, we called these securities, Titanic options.
Alas, our main research conclusion was that, if the extra added insurance fee was only meant to cover true risk, the typical VA policyholder was being grossly overcharged for the protection and peace of mind. We found that the basic RoP guarantee (that is, you get your money back at death) was worth no more than 5 to 10 basis points (or 0.05% to 0.10%) of assets per annum. Now, this obviously depended on the exact age of the policyholder, because older investors are more likely to die and hence cash in on the guarantee. Table 9.1 displays the theoretical model values of the death benefit guarantees for policy holders age 30 through 65.
Table 9.1. Capital Market Cost of a GMDB: RoP Guarantee
Assumptions: Equity: expected returns = 6%, volatility = 20%
Source: M. Milevsky and S. Posner, “The Titanic Option: Valuation of the Guaranteed Minimum Death Benefit in Variable Annuities and Mutual Funds.” Journal of Risk and Insurance, 2001.
For example, consider a 60-year-old female who invests her nest egg of $100,000 among various equity mutual funds and wants to purchase a guarantee that would return the entire initial $100,000 sum to her beneficiary upon her death. According to Table 9.1, she would need to pay 5.0 basis points (which is 0.05%) of her account value per year. Assume for a moment that the account grows to $110,000 by the end of the first year and the guarantee fee is charged at the end of each year. This means that she would pay 0.05%×$110,000= $55 for this protection for the first year.
I don’t want to get caught up in the mathematical details here, but these are model values, because purchasing capital market guarantees with maturities that are 40 to 50 years into the future is very difficult. Yet, the mathematical models tell us that they are worth no more than a few basis points because they can theoretically be replicated for this cost. In plain English, just get some token life insurance. It will be cheaper.
Once again, an RoP guarantee essentially promises that at death you will get no less than your money back. That is the lower bound or worst-case scenario. There are some products and companies that offer a better worst-case scenario return, often called death benefits with look-back or ratchet guarantees, and those are worth a bit more, as illustrated in Table 9.2. The word ratchet refers to the fact that every time the account value within the variable annuity moves up (or ratchets) to a higher level, the death benefit is reset.
Table 9.2. Capital Market Cost of a GMDB: Look-Back (Ratchet) Guarantee
Assumptions: Equity: expected returns = 6%, volatility = 20%
Source: M. Milevsky and S. Posner, “The Titanic Option: Valuation of the Guaranteed Minimum Death Benefit in Variable Annuities and Mutual Funds.” Journal of Risk and Insurance, 2001.
I don’t want to get lost in the details of these various life insurance guarantees, but for the most part, their “replicating costs” or “hedging costs” are quite low. Stated differently, Tables 9.1 and 9.2 give a rough sense of the wholesale cost the insurance company would have to pay to insure themselves against the same risks they are insuring you against—otherwise described as the amounts it would cost the insurance company that is offering the guarantee to hedge its exposure to this risk. Even the more lucrative (although at that time rare) death benefits guarantees that promised more than just your original investment were worth no more than 60 basis points (or 0.60%) at most. The high estimate applied only if you were male, old enough to be close to death, risk tolerant enough to invest aggressively, and persistent enough not to surrender (also known in the tax jargon as an IRC section 1035 exchange) your policy prior to death.
In addition to these results, our research study reported on a number of other peculiarities in the VA market. As you can see from the tables, we found that older (unhealthy) males who invested more aggressively were receiving a guarantee that was much more valuable to them relative to younger (healthy) females who invested conservatively. This was because the odds of dying during a bear market, which was the only way the insurance guarantee would pay off, were much higher for the former group compared to the latter. Yet both groups were paying the exact same level of insurance fees. It was akin to traditional life insurance that is sold to young and old, healthy and sick, for exactly the same premium. Likewise, the extra insurance fees were being charged independently of the actual asset allocation of the underlying subaccounts, even though the chances of a bond fund or money market fund being underwater at a random time of death was close to zero. We couldn’t help but wonder: Why weren’t subaccount risk fees being prorated by the true risk? Anyway, none of this made much sense to us at the time, especially given our training as financial economists where markets and prices are supposed to reflect costs and benefits. So, we threw our hands up and declared, “Why would anyone buy this?”
These findings were eventually published in the prestigious Journal of Risk and Insurance in 2001 and subsequently quoted in publications ranging from the Wall Street Journal and Newsweek to Reader’s Digest. Our findings were seized upon by investor advocates, financial commentators, regulators, and plaintiff lawyers as evidence that variable annuities were overpriced, oversold, and unsuitable. At the time, I was quite surprised at the attention this report garnered, because the article was full of equations and regressions, which normally don’t travel beyond the ivory tower.
In fact, I actually ended up taking the witness stand in a number of related lawsuits and regulatory actions to opine that a promise of getting your money back when you die was “kind of pointless” and at the very least could be replicated using cheaper forms of life insurance.
Indeed, I still stand behind those results, even if it means that I occasionally come face-to-face with disgruntled insurance industry executives who believe that our results were misguided. Remember, I never said that variable annuities were evil, dangerous, or unsuitable. Our basic position was that for many investors, a similar financial outcome could be achieved at a lower cost.
Times and Products Are Changing
However, in the last few years that I have been observing this industry, I am seeing a titanic shift in the way VA policies are being designed, priced, and marketed to the public. Namely, right now a much greater focus is being placed on the “pay-out” stage of the annuity life cycle and the concept of annuitization. Either way, it is now time for me to update my official position on these instruments. But first things first, let’s get a better understanding of the pay-out phase and how exactly a pension annuity really works.
What Exactly Is Annuitization?
Traditionally, when an annuity policyholder ends the pay-in phase by electing to receive a guaranteed income benefit, he is said to annuitize the account or to purchase an immediate or pay-out annuity. This “A” word strikes fear into the hearts and wallets of investors because it involves irreversibly handing over a lump sum of money—to an insurance company, no less. In exchange for the lump sum, the company promises to slowly return this money until the day of the retiree’s death. This irreversibility also creates the concern that the value of the account is lost to the family and loved ones because in the event of death, and if no guarantee period is selected, the insurance company retains any remaining unpaid portion.
Given the permanence of this action, this transaction might rightfully feel like financial suicide to many retirees. Ironically, as I mentioned earlier in the chapter, the loathed process of annuitization is at the core of defined benefit (DB) pensions—a steady generator of retirement income, which is cherished by retired civil servants around the world. In fact, the income from Social Security is also based on a type of annuitization process. You can’t securitize, cash in, or monetize your income stream, although it definitely lasts for the rest of your life. And, aside from providing longevity insurance, annuitization offers a substantial benefit to the retiree in the form of mortality credits. I’ll explain more about this in a minute.
So which one is it then? Is annuitization odious or perhaps is it the foundation of a well-balanced retirement income plan and hedging strategy? In an attempt to address the fog of confusion surrounding the financial benefits of annuities, allow me to digress a bit and provide a closer look at the pros and the cons. Indeed, if you are going to accept annuitization as a partial solution for your retirement income, then you should understand the mechanics of how they work. And, if you plan to bypass them as viable solutions, then talking intelligently about their shortcomings makes sense.
The Pros of Annuitization
An immediate annuity provides lifetime income that cannot be outlived, making it an invaluable hedging tool against longevity risk, which I discussed in past chapters. Recall, this is the risk of unexpected improvement in mortality and/or that a retiree lives far beyond any average life expectancy. Think of it as the equivalent of systematic/economic risk versus individual risk, which I explained in Chapter 3, “Diversification over Space and Time.”
Immediate annuities thus provide a mechanism for pooling, sharing, and hedging longevity risk over a large population, which leads to a higher yield for annuitants. Finally, they provide stable and predictable income that is not subject to the vagaries of the stock market. It’s a fixed-income bond product together with a longevity coupon “kicker.”
To get a better understanding on how this works, Table 9.3 provides some real-world data and displays sample quotes for single premium immediate annuities (SPIAs as they are often abbreviated) in May 2012. Each column contains the best five quotes for the given starting age and gender. These numbers are provided by a company called CANNEX Financial Exchanges, which is attempting to provide the equivalent of a stock exchange quoting system for retirement income products.
Table 9.3. What Does $100,000 Buy You? Monthly Income for Life
Source: CANNEX Financial Exchanges, May 2012.
Here is how to read the numbers in Table 9.3. For example, if a 65-year-old female invests or allocates $100,000 into a SPIA, then the upper range for lifetime income that she will receive is $522 to $548 per month, depending on which insurance carrier is selected. Note that this income stream will completely cease upon death. If she dies ten, five, or even one year into the annuitization period, everything is lost. Naturally, many people select a guarantee period for their SPIA, at the expense of a slightly lower income stream. For example, as shown in the same table, if the 65-year-old female selects a 10-year payment certain (PC, as they are often called), the upper income range is now lower; the best offer is $539 per month and the lowest offer is $511. A 65-year-old male gets slightly more. His numbers range from $541 to $556 if he selects a 10-year period certain and $561 to $568 if he does not.
On a slightly more technical level, if you divide the annual income generated by the SPIA by the initial premium of $100,000, you arrive at the important annuity yield. For example, using payouts from Table 9.3 at age 65, with zero years of certain payments, the yield ranges from 6.73% (=561×12/100,000) to 6.82% for males and 6.26% to 6.58% for females.
Indeed, these annuity yields have been steadily declining over the last few years as a result of both lower long-term interest rates as well as increasing longevity. The effect of the financial crisis has especially had an impact on these yields, and interest rates are at an all-time low because of the Fed’s monetary policy.
In fact, five years ago, annuity yields were much higher, with female yields exceeding 8% and male yields exceeding 7.5%. As a result, retirees are now faced with lower rates of return, further adding to the economic-crisis induced inflation, longevity, and sequence of returns risks discussed in the previous chapters.
Figure 9.1 illustrates the monthly evolution of the annuity yield over the last few years. I have plotted the average of the top five annuity yields, for both males and females, offered by insurance companies in the U.S., as well as the yield on a 10-year government bond.
Source: The IFID Centre / CANNEX Financial Exchanges, May 2012; IFID Centre calculations.
Figure 9.1. Immediate annuities always yield more than bonds.
A number of important insights can be gleaned from this chart. First, notice that the yield, which once again is the annualized income stream divided by the initial premium, is much greater than the yield on a government bond. The reason for this is because your income is an integrated blend of three distinct cash flows:
• You are getting a type of interest coupon on your money.
• You are getting a portion of your premium back.
• And the main benefit derived from the annuity—you are getting some of other people’s money.
What do I mean by “other people’s money”? This is what I earlier referred to as mortality credits, and here is a simple tale that can illustrate this concept, as well as the benefits of annuitization and longevity insurance.
A Digression—The Tontine
Imagine a group of five healthy 95-year-old females, all coincidentally celebrating their 95th birthday on the same day. To bring some excitement to the party, they decide to engage in an odd gamble. Each of the five women agrees to contribute $100 to a pool. The funds will be frozen for a year, they decide. “Whoever survives to the end of the year gets to split the $500; whoever doesn’t make it, forfeits the money.” This type of arrangement is known as a tontine, and is named after Lorenzo Tonti, an Italian banker who first promoted the concept to King Louis XIV of France around the year 1650.
While they wait for the next year to determine the winners and losers from the tontine, the five of them decide to put the money in a local bank’s one-year certificate of deposit (CD) paying 5% interest for the year. The CD will mature at $525 at year end, just in time for their 96th birthday.
So what exactly will happen next year? Who will survive? How much will they get? Well, according to statistics compiled by actuaries at the U.S. Social Security administration, there is roughly a 20% chance that any given 95-year-old will die during the next year. This, in turn, implies an 80% chance of survival for any one of them. These odds imply that we expect four out of five women to survive and make it to their 96th birthday to split the $525 pot at year-end.
Note that each survivor will get $131.25 as her total return on the original investment of $100. The 31.25% investment return contains 5% of the bank’s money and a healthy 26.25% of something we call “mortality credits.” These credits represent the capital and interest “lost” by the deceased and “gained” by the survivors.
The catch, of course, is that the average nonsurvivor forfeited her claim to the funds. Plus, while the beneficiaries of the nonsurvivor might be frustrated with the outcome, the survivors get a superior investment return. Personally, I find no other financial product that guarantees such high rates of return, conditional on survival.
More importantly, they all get to manage their lifetime income risk in advance, without having to worry about what the future will bring. This is the essence of the benefit from immediate annuities.
In fact, this story can be taken one step further. What if the group decided to invest the $500 in the stock market, or some risky NASDAQ high-tech fund, for the next year? Moreover, what happens if this fund or subaccount collapses in value during the next year and falls 20% in value to $400? How much will the surviving members lose? Well, if you are thinking “nothing,” that is absolutely the correct answer. They divide the $400 among the surviving four and get their original $100 back.
Such is the power of mortality credits. They subsidize losses on the downside and enhance gains on the upside. In fact, I would go so far as to say that after you wrap true longevity insurance around a diversified portfolio, the annuitant can actually afford and tolerate more financial risk.
Of course, real live annuity contracts do not work in the way described previously. The group’s “tontine” contract is renewable each year and the surviving 96-year-olds have the option to take their mortality credits and go home. In practice, annuity contracts are for life and these credits are spread and amortized over many years of retirement. The annuitant receives a constant periodic check that blends all of these varying components. But the basic insurance economics underlying the contract are exactly as described earlier.
Although this life-roulette game would not yield such high returns at younger ages—and one might be better off managing the money oneself with a systematic withdrawal plan—by the mid-1980s beating the implied return offered by immediate annuities becomes virtually impossible. To put it crudely, too many people are dying.
Back to Real-World Immediate Annuities
The spread between the highest/lowest quotes, that is, what the most competitive versus least competitive insurance company is offering, appears to be shrinking over time. In other words, the gains from shopping or the dispersion between companies is on the decline.
My personal theory is that the declining spread between the highest and lowest quotes reflects a market that is becoming more commoditized and more competitive. Plus, although insurance companies might not welcome this trend, the end user can only benefit. In fact, the availability of the Internet—and the CANNEX Financial Exchange, which provides a transparent platform for users to see quotes in real time—helps accelerate this trend.
The Cons of Annuitization
A number of legitimate criticisms are often leveled against SPIAs and other annuitization-based products. I have already mentioned one of the major concerns, and that is the almost complete irreversibility of the decision after the policy has been funded and the product is acquired. Unlike almost any other financial instrument, like a stock, bond, or mutual fund, one cannot redeem, cash in, or even sell a SPIA in the secondary market. In many cases you completely cede any estate value when you annuitize.
To be honest, although this irreversibility is frustrating, it is perfectly understandable and justifiable. Imagine what would happen if individuals who are in poor health, or are perhaps even on their death bed, were allowed to “return” their SPIA certificate to the insurance company and then ask for a refund against all the payments they had not yet received. Obviously, everyone would do this and the insurance companies would completely lose their ability to diversify longevity risk across a large pool of annuitants. This is another example of adverse selection, which I discussed in Chapter 2, “Insurance Is a Hedge for Human Capital,” and is one of the great justifiable fears for insurance actuaries. Remember, the reason you are getting the yield above and beyond what is available in the fixed-income bond market is because the insurance company can internally subsidize longevity.
Some companies have responded to the lack of liquidity concern by offering cleverly engineered SPIAs that provide partial-liquidity, refunds, and death benefits. And although these solutions might alleviate retirees’ concerns about annuitization, they come at the expense of the aforementioned longevity credits.
Second, inflation is a concern, and specifically how it impacts retirement income, a topic I tackled in Chapter 5, “Personal Inflation and the Retirement Cost of Living.” Remember that most currently sold SPIA products provide nominal payments that decay in real terms over time. The purchasing power of that income might decline by more than 60% by the time you are halfway through your retirement. Of course, you can purchase inflation-linked or cost of living adjusted (COLA) life annuities, but the price you pay is greatly reduced upfront payments.
A third quite legitimate concern is credit risk—the risk that the insurance company is unable to meet its payment obligations to the annuitant sometime in the future. Right now the best-rated insurance company in the U.S. offering SPIA products has a rating of Aa1 according to Moody’s Investor Services, while the lowest in our sample was rated A1. Although these ratings are at the upper-end of Moody’s scale, many buyers are concerned about the possibility of downgrades and eventual defaults over long horizons. The reassurance that is offered to these buyers is that insurance company defaults are rare and that state guaranteed funds do exist to protect policyholders up to a limit. However one easy solution would be to diversify across companies and, hence, reduce some risk that way.
In sum, immediate annuities provide a very unique and peculiar kind of insurance. It is virtually the only insurance policy that people acquire during the course of their life but actually hope to use! While we are all willing to pay for home insurance, disability insurance, or car insurance, we never actually want to exercise or use the policy. After all, who wants their house to burn down, leg to break, or car to crash? Yet, the “insurable event” underlying pension annuities is living a long and prosperous life.
Back to My Research on Variable Annuities
So, after spending quite a bit of time poring over some of the more recent designs of variable annuities as well as talking to actuaries, regulators, and advisors, I’m not even sure these instruments and riders deserve the old (maligned) variable annuity name.
Regardless of what you want to call these increasingly heterogeneous products, it seems the relative value pendulum has swung in the opposite direction. I can no longer claim that you are being overcharged for their guarantees or that you can achieve similar goals at a lower cost.
Nowadays, VA policies are not being manufactured as an investment to die for but as an investment to live for because they are increasingly focused on generating a lifetime of income that is guaranteed. They certainly are not being marketed as a primary tax shelter. Increasingly cheaper term life insurance and lower capital gains tax rates have rightfully taken the wind out of those sails. Currently the main story is about protection against the sequence of returns risk, which I discussed in Chapter 6, “Sequence of Investment Returns,” and a sustainable retirement income that will last a lifetime and beyond, without the scary irreversibility of annuitization. Alas, the variable annuity has finally returned to its roots I tried to explain earlier. It is providing longevity insurance; and creating a “living benefit” in a do-it-yourself manner would be very difficult and expensive.
Indeed, when you take into account the new living benefit riders being attached to variable annuities, such as Guaranteed Minimum Withdrawal Benefits (GMWBs), Guaranteed Minimum Accumulation Benefits (GMABs), and Guaranteed Minimum Income Benefits (GMIBs), these “FinSurance” products are creating a different type of protection. The characteristics of these elected riders are summarized in Table 9.4 and despite the odd-sounding acronyms, all of them include equity put options on the capital market. They protect the owner in the event that something goes awfully wrong during the early part of their retirement or when they start generating income. Plus, after the market meltdown earlier this decade, the sequence of returns risk might not be as remote as during the euphoria of the late ’90s. Indeed, markets don’t have to go down and stay down to ruin your retirement. All you need is a bear market at the wrong time, and the sustainability of your income can be cut in half.
Table 9.4. The Increasing Galaxy of Annuity Riders
Source: Moshe Milevsky and the IFID Centre, 2012.
Are the Fees (Still) Too High?
This heading leads me to my main point, which is that I’m now getting the impression that the latest guarantees and riders offered with variable annuities are actually worth much more than what some insurance companies are charging in pure insurance fees.
Yes, this sounds like an odd thing to say given the position of my earlier study. However, when I analyze the extra rider fees charged in the name of these living benefit guarantees, I can’t help but wonder why Wall Street’s investment bankers charge so much more for the same type of derivative security (essentially long-term put options) when they are purchased on a stand-alone basis. To review, put options are contracts that offer the purchaser a right but not the obligation to sell an asset at a predetermined “strike” price. Plus, when I obtained some pricey quotes for buying stand-alone put options to protect a hypothetical retiree’s lifetime income, I first thought it was the derivatives dealers and option market makers who were overcharging.
However, after some careful analysis, the same mathematical models that told us a decade ago that basic death benefit guarantees were overpriced were now telling us that many living benefits, for the most part, were underpriced.
As an example, I recently conducted a follow-up study with a colleague of mine at York University demonstrating that the basic GMWB rider, which charges an extra 30 to 50 b.p. in practice, might actually cost between 75 and 160 b.p. to hedge in the capital markets. That number does not even include any insurance company profit margins, commissions, and transaction costs. Indeed, the options exchange, which is the only other place an investor can buy similar investment crash protection, often charges five to ten times that number during periods of market stress (volatility).
As I mentioned earlier in this chapter, in addition to offering a hedge against the sequence of returns in retirement, innovative riders such as the GMWB for life and GMIB can implicitly serve as longevity insurance. This represents a solution for those retirees who are not comfortable with the irreversibility of annuitization and for those affected by the gradual “extinction” of defined benefit pension plans. Of course, this represents a challenge to the insurance companies offering the guarantee given that they are assuming more longevity risk—a risk that most defined benefit pension plans are running away from in droves.
In sum, more than two trillion dollars is sitting in VA policies. Many are still old-style VA policies whose guarantees are (still) worth no more than a few basis points of assets. But the rest of this money is allocated to VA policies with valuable living benefit options that might end up presenting a challenge to their issuers for many years to come. Note that I am not necessarily advocating that insurance companies act in tandem to increase the fees on these riders, and I don’t think the U.S. Justice Department would take lightly to such a suggestion either. Rather, that in this living benefits arms race, it will become more important than ever before for these issuers to implement adequate hedging strategies in the case that interest rates decline or longevity increases far more than expected. This will directly impact their ability to honor their promises and guarantees down the road. One thing is for sure: This type of insurance is worthwhile.
As you approach retirement, annuities can play an important role in protecting your personal balance sheet. In fact, after your human capital has run out, you are left with only financial capital, which is sensitive to inflation and sequence of returns risk. Longevity risk is also a concern because a chance always exists that you might outlive your financial capital. To combat these risks, different types of annuities can be used. Whether they are variable annuities or single premium immediate annuities, each offers its own distinct advantages. Choosing between these different financial products will be the topic of the next chapter. The bottom line is that when you no longer have human capital, protecting your financial capital to sustain your successful retirement is crucial.
Summary
• Annuities have been around for thousands of years and are the foundation of defined benefit (DB) pension plans as well as the U.S. Social Security system. Nothing is inherently wrong or problematic with annuities. They are risk management instruments, and you ignore them at your own risk.
• Think of a variable annuity as a mutual fund with a selection of different investment options, together with a number of implicit and explicit guarantees.
• Some of these guarantees are quite valuable and some are not as valuable. For the most part and, in general, the new generation of guaranteed living income benefits (abbreviated GLiBs) are very different compared to the old-style death-benefit guarantees. These GLiBs will provide fair value to the consumer and, therefore, make more sense to me as appropriate for funding one’s retirement.
• Annuities can help mitigate some of the risks to your financial capital, allowing you to potentially increase the sustainability of your retirement income.
Endnotes
This chapter draws heavily from and is inspired by the original research that I published with Steven Posner in the Journal of Risk and Insurance (2001) and the follow-up research I published with Thomas Salisbury in Insurance: Mathematics and Economics (2006). Please see Milevsky’s The Calculus of Retirement Income (2006) for additional background and references. As of mid-summer of 2012, a substantial number of insurance companies have suspended or stopped sales of Guaranteed Living Withdrawal Benefits (GLWB) because of the risks they pose, and the large cost of hedging these long-dated guarantees. So at this point the puzzle has been resolved. Many of these products were poorly designed, and the insurance companies who made these fundamental mistakes are now paying for their pricing sins.