Retirement income is a growth industry, and the menu of products is expanding fast. Immediate annuities and variable annuities with living benefits are established products, while longevity insurance and standalone living benefits are more recent additions.
For many planners, this is a new and confusing world-particularly for those who have relied exclusively on systematic withdrawal strategies. So it's worth a closer look at the key features of the various options and their pluses and minuses.
Let's use a specific example to compare financial outcomes for the products-a 65-year-old retiree with the following financial profile:
* Social Security: $20,000 a year increasing with inflation;
* Expenses: $40,000 a year increasing with inflation; and
* Retirement savings: $450,000.
Our retiree, a woman, needs to generate an additional $20,000 each year, increasing with inflation. The numbers have been chosen to fall in a range where a variety of options might work. To keep this simple, the analysis is pretax.
Systematic withdrawal is the unguaranteed option. In this case, the initial withdrawal rate would be 4.44% ($20,000/$450,000). Based on an assumed asset mix and various economic assumptions, we can calculate probabilities of running out of money. I've assumed a stock/bond mix of 60%/40%, stock returns averaging 8% with 20% volatility, bond returns averaging 4% with 8% volatility and inflation of 2.5%.
The life expectancy for a 65-year-old woman is 20 years, and it turns out that the probability of running out of money before age 85 is 10%. Of course, 50% will exceed average life expectancy, so we should look at the probabilities for older ages. The likelihood of running out of money before age 95 is 30% so, in this case, it may be worth looking at products offering longevity protection.
The results from this example are more pessimistic than those produced by Bill Bengen, the California planner well-regarded for his research into sustainable withdrawals from retirement client portfolios. He used historical numbers to demonstrate the safety of an inflation-adjusted 4% withdrawal rate. I have assumed lower future stock and bond returns than the historical averages.
The most straightforward approach to funding lifetime expenses would be to purchase an inflation-adjusted immediate annuity. Most insurers only offer level-payment annuities, or annuities that increase by set amounts each year, but a few offer annuities that adjust for actual inflation. Vanguard offers immediate annuities sourced by Hueler Cos., providing quotes from multiple insurers.
Based on the Vanguard/Hueler rates, our retiree could purchase an inflation-adjusted annuity with an initial income of $20,000 for $411,777. Another possibility would be an annuity with fixed annual step-ups. We can measure expected inflation based on the rate spread between Treasury bonds and Treasury Inflation- Protected Securities; that spread was recently 2.5%. We could combine equal amounts of annuities with 2% and 3% step-ups to produce an average of 2.5%, and that would drop the cost to $345,652.
Such an annuity would hedge the risk of expected inflation, but not actual year-by-year inflation. However, a good strategy might be to purchase the less expensive step-up version, and hedge against higher-than-expected inflation by investing the remaining $104,348 of available money in equities that tilt toward real asset returns.
Disadvantages of the immediate annuity would include loss of control of a substantial portion of the $450,000 of retirement savings, losses to heirs in the event of an early death and some risk of insurer insolvency. An advantage is that leftover funds can be used freely; they do not have to be dedicated to a systematic withdrawal program.
This product, which has been on the market for about five years, is an immediate annuity with a long deferral period. For example, with longevity insurance from The Hartford, our retiree can invest $100,000 and, beginning at age 85, receive a level lifetime income of $53,747. The appeal of longevity insurance is that, for a relatively small upfront investment, an individual can purchase an income stream that begins at a set point in the future. The remaining savings only need to last for a fixed number of years, eliminating worries about longevity risk.
No companies offer this product with payments that adjust for actual inflation, but some companies do offer fixed step-ups. The woman would need to purchase longevity insurance that begins paying $32,772 in 20 years ($20,000 inflated for 20 years at 2.5%) with payments increasing by 2.5% each year thereafter. Based on current market rates, longevity insurance meeting these criteria would cost $62,987, leaving $387,013 to be used for 20 years of systematic withdrawals.
The risk with longevity insurance is that the savings will run out before 20 years are up. For this particular client, that probability is 20% if the woman lives to at least age 85. Note that this is a higher probability than running out of money within 20 years using pure systematic withdrawal (10%) because the starting base of savings is reduced by the $62,987 used to purchase longevity insurance.
This woman might be uncomfortable using longevity insurance because of the significant probability of running out of money. A more thorough investigation would involve searching for a better product fit by testing the pricing of longevity insurance at shorter durations than 20 years.
VAS AND SALBS
Variable annuities with guaranteed lifetime withdrawal benefits and standalone living benefits are similar products. An individual invests funds and receives guaranteed systematic withdrawals for life. Payouts come from the invested funds, and if the funds are depleted due to long life and/or poor investment returns, the guarantees kick in. Guaranteed lifetime withdrawal benefits use a variable annuity chassis, and standalone living benefits use mutual funds or managed accounts.
For a 65-year-old, a typical guarantee is level lifetime payments at 5% of the initial investment, with payments ratcheting up if account values increase over the initial investment amount. This ratcheting provides less than a full inflation hedge.
Fees for the guarantee may vary with the proportion of investments held in stocks; for a mix of 60% in stocks and 40% in bonds, a 1% annual fee is about average. Typically, the underlying funds are actively managed, so total fees run about 2% for the lowest cost products and may approach 4% for products that also include sales loads.
We can think of these products as akin to systematic withdrawal, but with a guarantee of not outliving assets. The investor maintains control over assets, but receives a lower rate of return (gross return less the fees). The key basis for evaluation is the impact of fees on account values.
COMPARING THE ALTERNATIVES
We can compare the alternatives two ways-by payment security and the expected amount of assets left to heirs. Regarding payment security, immediate annuities and products offering guaranteed lifetime withdrawal benefits and standalone living benefits provide uninterrupted payments for life, and immediate annuities can also provide explicit inflation protection. Unguaranteed systematic withdrawals entail a risk of running out of money, and that risk increases significantly at older ages. With longevity insurance, there is the gap risk that money runs out before the end of the deferral period.
The chart in "What's Left?" on page 116 compares expected asset amounts left to heirs (bequest values) under the different alternatives. It also shows expected present values, which may be a more useful evaluation tool at time of purchase. (The difference in present values versus systematic withdrawals represents the amount being paid for guarantees.)
The systematic withdrawal method produces the highest expected bequest values. That's because nothing is being paid for guarantees, so the initial $450,000 is available to earn full investment returns. For individuals with enough wealth not to have to worry about running out of money (not the case in our retiree's example), systematic withdrawal will be the likely choice.
Longevity insurance produces the highest expected bequest values for products with guarantees, because 85% of the $450,000 is left available for investing in the 60%/40% stock/bond mix. As with systematic withdrawal, this product carries some risk of running out of money.
Bequest values for immediate annuities are lower than for longevity insurance because such a large portion of savings is devoted to the annuity, which is a bond-like investment. (It could be argued that any remaining funds should be invested more aggressively, which would improve expected bequest values.)
The plus side of immediate annuities is that, for clients stretched financially, this product can produce the highest income per dollar of savings. In our example, investing the full $450,000 in an immediate annuity would have produced an initial annual income of $26,000, which would not have been feasible under the alternatives. The downside would be giving up any bequest value.
Two different sets of value are shown for guaranteed lifetime withdrawal benefit and standalone living benefit products-a low-cost option with a 2% annual fee and a high-cost version charging 4%. These two products provide less than full inflation protection so bequest values have been reduced to make results comparable to the other products. To benchmark the effect of fees, we can think of a hypothetical guaranteed or standalone benefit product with zero fees as represented by the systematic withdrawal numbers. The low-cost product slices present values by 43%, and the high-cost version chomps off 63%. Clearly, it's worth watching the fees when purchasing these products.
The example of our retiree was chosen because she falls in a wealth range where there is no clear choice between the product alternatives-the goal was to show the tradeoffs. Clients concerned primarily about income security can choose immediate annuities or guaranteed/standalone benefit products. Clients more concerned about bequest values may be willing to take income risk and opt for unguaranteed systematic withdrawals or longevity insurance.
Planners who wish to evaluate alternatives will realize quickly that they need software to do the job effectively. (Research for this article used makeshift Microsoft Excel Visual Basic for Application programs I wrote myself.) Most software planners work with is designed for evaluating systematic withdrawal strategies. There is work to be done on the software so it catches up to the available products.
There is also a need for low-cost products fee-based planners can use. There are plenty of low-cost investment products, for example, index funds and ETFs, but products with longevity guarantees tend to be more expensive. Such products typically carry higher expense charges in addition to the fees for the guarantees. To the extent that more low-cost products can be developed, that will help level the playing field in providing options for planners to recommend to income-loving clients.
Joseph A. Tomlinson, FSA, CFP, is a financial planner and actuary. He is managing director of Tomlinson Financial Planning in Greenville, Maine. He can be reached at firstname.lastname@example.org.