Pros and Cons of Guaranteed Income Streams

To manage longevity risk, investors and advisors must weigh an incredible number of factors, including, ultimately, one that is unknowable: how long a person is going to live. Meanwhile, the financial industry, has been rolling out more and more products and innovations that offer new ways to guarantee investors a steady stream of retirement income. But sorting through and understanding all these options has become its own challenge.

In the fall of 2010, I sat down with three leading experts in the field to get a handle on longevity risk and the best ways to control it. Moshe Milevsky is a finance professor at the Schulich School of Business at York University in Toronto and author of Are You a Stock or a Bond? Create Your Own Pension Plan for a Secure Financial Future (FT Press, 2008). John Ameriks is a leading researcher at Vanguard, where he heads the firm's Investment Counseling & Research group. Thomas Idzorek is chief investment officer and director of research at Ibbotson Associates.

Excerpts from that interview, which was originally published in the December 2010/January 2011 issue of Morningstar Advisor magazine, are below.

Christine Benz: I'd like to start by talking about what you think belongs in investors' toolkits when it comes to managing the risk that retirees will outlive their assets.

John Ameriks: I think standard asset classes are going to serve people well throughout both accumulation and distribution. Once people get a little older, once they stop thinking about how much life insurance they need and begin to worry about outliving their money, then they need to think about what kind of instruments might be appropriate.

I want to point out that most people start off in retirement with a pretty big annuitized chunk of wealth in the form of Social Security. So it's not really about needing to do things that are new. It's just thinking about what you have, and whether it's sufficient to meet your needs, and then trying to decide whether additional longevity protection--an immediate annuity or a company pension plan--is something that makes sense in your situation.

Moshe Milevsky: The effect of Social Security really depends on what wealth decile you're in. At the lowest decile, 95% of people's wealth is in Social Security. In some sense, they're overannuitized. In the top decile, only about 10% of people's wealth is in Social Security. So you really have to slice it depending on people's level of wealth. If you just look at the average, I'd agree--a lot people are overannuitized. But if the typical advisor is advising someone who has $500,000 to $1 million in net worth, you're not looking at the average anymore.

Ameriks: That's a really important point, and it gets missed in the policymaking discussion about annuitization. A lot of the discussion focuses on people who are in the lower lifetime income categories. For them, there's already a significant amount of annuitization. The interesting financial planning issues, and the place where most guidance is needed, is in that group of folks that Moshe mentions--$500,000 to maybe $1.5 million. They have been wealthy enough to accumulate a substantial amount of money and they've had an affluent lifestyle. Social Security, yes, will provide a backstop and floor for them, but it may be well below what they've become accustomed to. It's in these circumstances where the idea of needing additional protection of the downside comes into play.

But I also think that it just changes the nature of the debate. This is not a starving-in-the-street kind of phenomenon. Social Security is there. I think my latest statement said it would pay 76% of what I'm scheduled to get--if nothing is done. So it'll keep me from going hungry. But will Social Security provide what I am accustomed to, and how much risk do I want to take around that? Those are the big questions. �

What's difficult about the retirement-income phase is that it's at the point when you try to articulate exactly what you need it for. The answer is going to dictate the approach. I'm not so sure that we need fancier products and technical engineering. What we need is a better appreciation that there are tools that are far better at achieving certain outcomes than others. There's a lot more that needs to be learned about exactly what someone's trying to achieve before a portfolio can be put together.

Milevsky: [Financial advisors] have to ask ... clients different questions in retirement-income planning as well. Your typical questionnaire about risk tolerance in the accumulation phase looks very different. In retirement, you have to ask questions like, how much do you love your kids? That's part of the risk tolerance. Is a bequest or legacy a big part of your portfolio? That's going to make a difference on product allocation. How healthy are you? Are you healthier than average or not? That's part of asset allocation.

Ameriks: Or how much do your kids love you?

Milevsky: Exactly. Are they going to backstop your retirement if something goes wrong? Are you moving in with them? These are very uncomfortable questions to have for a stockbroker who's used to asking about stocks and bond mixes.

 

Benz: All of you have done research that point to some form of annuity as being beneficial to retirees' portfolios. Which types of products do you think make the most sense within this framework?

Thomas Idzorek: The problem with talking about annuities is that there are so many different flavors. There are indexed-linked annuities. There are immediate annuities in both the fixed and variable flavor. Then, there's the deferred variable annuity, now typically with a guaranteed minimum withdrawal benefit for life on top of it. And there's the pure longevity insurance, which I never know what to call--some people refer to it as a deferred immediate annuity or an advanced life deferred annuity.

We think that immediate annuities, deferred variable annuities with the GMWB for life, and the pure longevity insurance all could play an important role in a retirement-income solution. The one area that we're not particularly fans of would be the equity-linked indexed annuities.

Benz: Why?

Idzorek: The goal of creating a retirement-income solution is to have longevity insurance. Equity-linked indexed annuities do not have that component.

Milevsky: I've gone beyond labels and names. I think that the word "annuity" is almost meaningless. You have to do a DNA analysis on an annuity before you even consider it. "GLWB" may sound good, but if they're promising 3% for life and they're charging you 400 basis points a year, I don't think it belongs in an optimal portfolio.

So the term "annuity" is a very broad term and misunderstood. What we need is some sort of nutritional disclosure of what the annuity really contains, so that we can eliminate some of this confusion. I would like to see a DNA analysis done of any annuity product before it's given to the public. Then, we can understand how many mortality credits there are, what's the fixed-income component, how much downside protection we're getting. Are we really getting inflation protection if we need the market to step up?

It's a very broad universe, and a lot of these annuity products definitely do not belong on the shelf. Just because a lawyer or a state regulator called it an annuity doesn't necessarily mean an economist will.

Benz: Let's back up and talk about how an advisor would go about matching an investor with the right type of product. How do you figure out which type of annuity is appropriate?

Idzorek: John and Moshe have brought up some of the key, difficult questions ... How healthy are you? Do you expect to live long and, therefore, face longevity risk? Do you care more about your own income for life or leaving the maximum value to your heirs? I suspect most people would rather guarantee their own income than that of their children. But not everybody will make that decision the same way. What is important when making these product-allocation decisions is to really understand how that each individual investor drives utility.

Ameriks: The key question is, is a retiree fundamentally comfortable with the idea of giving up access and liquidity to a portion of what they've saved in exchange for a guaranteed flow of income, no matter how long they or their spouse lives? ... That's really the crux of things. For some people, it's a deal that makes sense, and for some, it doesn't.

A lot of people have missed the boat on annuities because they had a very hard time giving up liquidity and making this "bet" that they'll live a long time. I think some conversations need to be had with the children of these individuals, because in many cases they are going to be on the hook if a parent doesn't manage to successfully finance their retirement. This is what makes it hard. ... They're questions that may involve other people who need to be involved in the conversation.

 

Benz: The behavioral aspect of this is really valuable terrain to mine. It does seem that despite all the academic literature advisors and individuals have an aversion to the concept of an annuity of any type.

Ameriks: Moshe, I love this notion that "annuity" doesn't mean much anymore. It's lost its meaning because there's so many different flavors of it. And people don't react well to that kind of uncertainty. They don't react well to commitment. We're going to spend a lot more time studying some of these behavioral aspects, because there's no question that when you look at the choices that people are making, they do not seem to be predisposed to annuitize. But we have to focus on both sides. There are plenty of rational reasons why people avoid annuitization.

Milevsky: Just because I'm in favor of annuities doesn't necessarily mean I'm in favor of every single annuity, which is where I think the confusion around annuities has to be clarified. I wish they were called "personal pensions," or something that's a little bit more favorable. Who's against pensions? It's like apple pie and mother's milk. Why would you not want a pension? But with annuities, you have all this emotional baggage because of the many years of negative press that you almost have to play defense from the beginning.

Benz: How should you do due diligence on insurance providers?

Ameriks: It can be very difficult. Analyzing the books of insurance providers is a full-time job for a lot of very-well-paid people. One of the big problems is that immediate annuities are generally one of the many claims on the general account of a diversified insurer. So it's not just looking at their ability to meet their promises on their book of annuity business, but it could be a problem in another part of the business that really represents the biggest threat. From a consumer standpoint, there's some information provided by the rating agencies. You also have to rely on the fact that there are state regulators whose job it is to make sure that the companies operating in the state are able to meet their obligations.

Milevsky: There's a lot to be said for just making sure you stay under the state guaranty limits. It's like telling people stay under the FDIC limits. Diversify your CDs and term deposits and make sure that any financial institution doesn't have more than that limit. The same thing applies to insurance providers. I would not tell people to become CFAs just so that they can read the financial statements of the insurance company because I can tell you, despite as much training as you get in accounting, finance, and economics, some of them are impenetrable.

Ameriks: That goes both for individual clients as well as most financial advisors. Get up to speed on what those guaranty association provisions are state by state and what applies to your client, because they do vary a lot by state.

Milevsky: Another thing I would add is that personally I would select a mutual company versus a publicly traded company simply because of what we've seen in the financial crisis. I think that the mutual companies have held up a lot better than the publicly traded ones.

Benz: I have a feeling the answer to this question is going to be a big "it depends." What percentage of a person's portfolio that should go into an annuity product?

Milevsky: Yes, and I guess the word "depends" isn't going to cut it. Using reasonable parameters, I've seen numbers such as 30% to 35% at the standard retirement age. If you're older, more mortality credits, so it would be higher. If you're younger, it would be lower. � That's the farthest I would go in terms of suggesting a percentage. It's not zero. It's definitely not 100%. If you have strong bequest motives, it would be zero. If all you care about is sustainability, it would be higher. But I don't mind 30%-35% being the beginning of the conversation, in the same spirit that 60/40 comes up over and over again in stock/bond mixes.

Ameriks: It is a very difficult to say, because situations vary so much. The key question for people is, what do I need if the worst happens? The markets are poor, I run through my assets, and I don't get what I expect from my other sources of finance. What is that bottom-line level of spending that I need every year? Then you just have to back into it. If that number is too big for your portfolio, if you start getting uncomfortable that you won't have enough leftover to deal with emergencies and everything else, then something's got to give. You have to have a discussion around what's discretionary and what's not. A lot more stuff may be discretionary than people expect--which goes back to a lot of research that's been done on consumption changes at the point of retirement.

Idzorek: I, too, am in the "it depends" category. � How wealthy is somebody and how does that compare with their retirement income? What are their existing sources of guaranteed income? Do they have a pension? What fraction of their total annual income need is that going to cover? Again, how do they make that critical tradeoff between whether they want to guarantee their own income or whether they want to leave the maximum bequest to their heirs? These are all critical elements to trying to figure out what is that appropriate retirement-income solution.

 

Benz: Are there any other annuities that you think in general just don't add up for consumers?

Ameriks: It comes down to the numbers. We just put out a research report that looks at different ways for people to generate an income stream. We looked at immediate annuities, managed-payout funds, guaranteed minimum withdrawal benefits of a particular flavor. As drawdown approaches, it comes down to the price and what is the benefit that they're providing.

The one area of caution that I would give on annuities and GMWBs, in particular, is that these things are advertised as if you get liquidity and you get a guarantee. But when push comes to shove, you don't get both. You have one or the other. If someone is in the money with their guarantee and looking to exercise the option to take whatever remains of their assets, well, they would have to give up the guarantees. So one scenario I worry about with that structure is that if somebody is advanced in age and there have been bad markets and their guarantees are in effect and they're looking at a care event where they need $10,000 or $20,000, that's going to extinguish 30% or 40% or 50% of what they've got left on that contract. When they do that, their future income is going to drop, as well. I am never 100% sure that investors understand this.

Idzorek: That's a great point. When we developed what we refer to as "retirement-income solution questionnaires," we really tried to hone in on what is the likelihood of that investor being able to meet the conditions of that contract and stay in the contract.

Milevsky: The answer to, "should I GMWB or not? and how much to GMWB?" very much depends on the fees involved. About a month ago, I purchased my first VA, which sounds crazy for somebody who's 42 and has a pretty decent pension. I bought a VA with a GMWB because I thought that they were being ridiculously priced by the company. I think that they had made a mistake. They did not price it high enough, and they were giving a guarantee that was simply too good. I purchased it not because the optimal allocation for me at 42 was x% of this annuity. I just think this was being mispriced. So I purchased it almost as an arbitrage. I could see the exact same thing happening in the other direction, where you look and you say, "Theoretically, I really like the idea of downside protection and liquidity and longevity. But I just can't pay 400 basis points for this."

Benz: That seems to be a likely scenario right now. A lot of annuities were too cheaply priced in the past, and now it seems like insurers are compensating for that.

Milevsky: Some of them are withdrawing from the market entirely. They just have so much of this liability on their books that they don't want to sell anymore. Others are definitely ratcheting up the fees, watering down the benefits, reducing the asset allocation that you can have. The pendulum has now swung in the other direction.

When I talk about asset allocation and product allocation for retirement, I like to discuss strategic product allocation versus tactical product allocation. Tactically, I like GMWBs. Tactically, I like annuities. Strategically, it depends on what your circumstances are and your bequest motives. You can say, "This is a really good product. It may not be strategically what I need for my portfolio, but it's mispriced."

Ameriks: It's a very important point. Pricing will change around an awful lot. I hope it's one thing a lot more people will appreciate post-crisis; the costs of these guarantees and the price of providing insurance against the equity markets can change radically.

Milevsky: If I could summarize, annuities and anything with the "A" in it are part of the retirement-income discussion. They're part of the retirement-income portfolio. It's not the main component, and it's certainly not the only component. I think it's important not to lose sight of the fact that there's a nutritional triangle. Everybody has to have a whole bunch of things for breakfast. One of them is eggs, and one of them is milk, and one happens to be zinc. We happen to be experts on zinc. You don't want to have too much of it, but you don't want to have nothing. ... The perception is that annuities are what retirement is really all about. Should I or shouldn't I? But annuities are really just a small component. Long-term care and nursing homes, what will my family do, will I be able to make financial decisions? These are such big parts of retirement-income planning that it almost swamps the annuity-or-not-annuity discussion.

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