- Patrick J. Collins
Annuitization is one asset management strategy for retirees seeking to secure lifetime income. The US annuity marketplace offers a variety of annuity contracts, including single premium annuities, advanced life deferred annuities, variable annuities with lifetime income guarantee riders, and ruin contingent deferred annuities. Advisers seeking to provide guidance to clients in or near retirement can benefit by understanding (1) the arguments both for and against annuitization and (2) how a client’s interests might be best represented in the marketplace. Important annuity contract provisions are highlighted and briefly discussed so the adviser can become more familiar with retirement-planning options.
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1 The term beneficiary can mean a single individual or a beneficiary plus spouse. When the term encompasses two individuals, the lifespan measured is the joint lifespan. For purposes of expositional clarity, we assume that the annuitant, payer, and contract owner are the same.
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2 In the Middle Ages, merchants often traded personal wealth to local monasteries in exchange for the promise of lifetime support and protection for themselves and their families within the confines of the monastic institution. Many monasteries later found themselves in grave financial crisis because they failed to collect sufficient wealth to fund long-term obligations. The reverse annuity mortgage plans of the 1980s were initially privately insured. It was not until the early 1990s that the Federal Housing Administration initiated government involvement.
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3 To simplify the example, we describe the form of contract known as a tontine, which is illegal because it might encourage some participants to take steps to ensure the premature demise of other pool members. An insurance company, however, pools many individuals into contracts in which the death of any one member does not affect the payout promised to the remaining annuitants (i.e., there are no “death dividends” to reward the survivors). Moshe A. Milevsky provides an in-depth discussion of annuity-pricing principles in his monograph Life Annuities: An Optimal Product for Retirement Income (Charlottesville, VA: CFA Institute Research Foundation, 2013).
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4 Technically, profits and losses emerge over time as experience dictates whether the liability reserve for the annuity payments is conservative (profits) or inadequate (losses).
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5 It is misleading, however, to compare the annuity yield with the current yield paid by a bond or a CD. Bonds and CDs usually involve a return of principal, whereas the replicating portfolio for an annuity payout is a series of zero-coupon bonds with a 100% probability of eventual default. This is truly an oranges-to-apples comparison.
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6 In California, for example, the 2014 amount of contract “nonforfeiture” value that is covered under state guarantee fund provisions is 80% of the present value of annuity benefits, including net cash surrender and net cash withdrawal values up to a maximum of $250,000. The rules are complicated. Coverage may apply to each annuitant in a joint contract, benefits may be subject to interest rate adjustments, moving to another state may trigger different benefit levels, and so on. Although it is wise to diversify the annuity portfolio over several insurance companies unless the annuity is of a type that is segregated from creditor claims against the insurer, the California Life & Health Insurance Guarantee Association limits total coverage for any one individual to $300,000—assuming the annuitant owns contracts issued by multiple companies (see https://www.califega.org/FAQ). Independent rating firms upgraded the insurance industry outlook from “negative” to “neutral” following the recovery from the global recession. However, several carriers with a large share of the US annuity market have recently exited the marketplace because the financial guarantees embedded in annuity contracts threatened the carriers’ financial condition. In the 1990s, both Japan and Europe saw multiple carrier insolvencies as mispriced guarantees thrust insurance companies into dire financial straits.
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7 The tax regulations for inflation-adjusted annuities differ in important respects from those applicable to nominal payout annuities.
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8 It is cheaper to buy a lifetime income of x dollars at age 75 than at age 65, all else being equal. Generally speaking, the only investors who find SPIA contracts of interest are those who consider themselves to be in good health. If the investor does not expect to enjoy a long lifespan, longevity risk is a less important factor in lifetime income planning. A few carriers write SPIA contracts with high lifetime payouts for people in poor health. Actuaries call these contracts substandard annuities. When such annuities are customized to compensate people who have been awarded court judgments for life-impairing injuries, they are known as structured settlements. Structured settlements may also be available to people in good health who have won a lawsuit or lottery.
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9 Holding constant the premium deposit amounts, age, sex, and annuity underwriting pricing formulas, changes in interest rates over time generate a “time series of annuity payments.” For example, spending $100,000 to buy an annuity for a healthy 65-year-old female in 1995 buys a much higher lifetime income than a comparable annuity purchased for a 65-year-old in 2012.
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10 The SPDA’s lower premium cost does not imply that the SPDA has lower expenses. Indeed, compared with an SPIA, an SPDA’s load may be higher because the insurance company must protect itself against adverse selection—that is, only investors who expect to live a long time are likely to purchase a contract whose payout is contingent on living to an advanced age.
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11 The funds under management of outside investment companies may differ from the similarly named mutual funds offered to investors. For example, in some cases, the expense structure of the mutual funds may differ from that of the funds on the VA menu.
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12 The cost structure of VA contracts is complex and lies mainly outside the scope of this discussion. That said, cost matters—a lot. The prudent investor should thoroughly investigate the myriad of implicit and explicit costs associated with this product.
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13 The NAIC is the National Association of Insurance Commissioners. Insurance companies are regulated primarily at the state level, with the chief regulatory officer being the state insurance commissioner. The 50 state commissioners, in turn, belong to the NAIC, which acts as an advisory body regarding the need to keep or amend current regulatory standards.
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14 Recent events have seen such AAA rated firms as AIG Life and Hartford Life requiring federal bailout funds to survive the liabilities that emerged when their financial guarantees were suddenly in the money. Hartford Life, the company with the largest share of VA sales, exited the VA market.
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15 An estimated 75% of all VA contracts sold in 2005 included riders with supplemental financial guarantees. Before the recent recession, insurance carriers were in a race to offer more and more competitive products. Currently, they appear to have reversed direction and are now in a race to sell products with increased rider costs and/or decreased rider benefits.
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16 The death benefit is adjusted for aggregate withdrawals before death.
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17 Unfortunately, the names of the various riders have not become standardized across the industry. For example, the term GMWB is sometimes used to describe a GLWB. Companies often have proprietary trademarked designations for these riders, which further adds to the confusion.
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18 These observations are not criticisms of the insurance principles underlying the VA contract. Insurance policy buyers hope to receive no benefits whatsoever for the premium payments made to an automobile insurance company because they do not wish to be involved in an accident. However, if the company is charging an annual premium of $2,000 to insure a vehicle that is worth $1,500, most automobile owners would question the wisdom of continuing such an arrangement. Gaobo Pang and Mark J. Warshawsky have noted that modeling a VA with a GMWB is difficult because “the majority (approximately 70 percent) of the VA+GMWB providers . . . state in their prospectuses that, upon the automatic step-up or the investor-elected step-up of GIB [guaranteed income benefit], the contracts will increase, may increase, or reserve the right to increase the annual rider percentage charges, subject to the contract maximum rates. Changes in market conditions may also trigger such fee hikes” (p. 45). See Gaobo Pang and Mark J. Warshawsky, “Comparing Strategies for Retirement Wealth Management: Mutual Funds and Annuities,” Journal of Financial Planning, vol. 22, no. 8 (August 2009): 36–47.
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19 In 2014, a working committee of the NAIC recommended that the GLWB rider be reclassified as a “hybrid annuity.” If the recommendation is adopted, it is uncertain whether or how it would affect the taxation of benefits received under the rider.
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20 Vanguard Group, “Annuities Offered through Vanguard,” cited Morningstar, Inc., as of December 2014.
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21 According to the American Academy of Actuaries, “A CDA is essentially a stand-alone guaranteed living withdrawal benefit” (p. 2). Note that in this context, CDA means the same thing as RCDA. See Nancy Bennett, “An Overview of Contingent Deferred Annuities,” Life Insurance and Financial Planning Committee, National Conference of Insurance Legislators (25 February 2012).
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22 The insurer is part of the Aegon Americas group of companies. As of 1 June 2015, the A.M. Best Company rated Transamerica Life Insurance A+ with respect to financial strength and AA– with respect to its ability to meet its ongoing financial obligations. Aegon N.V. is an international life insurance, pension, and investment group based in The Hague, the Netherlands. The parent company or affiliates, however, may not back the guarantee according to disclosure information: “The guaranteed lifetime payments are backed by the claims-paying ability of Transamerica Advisors Life Insurance Company. They are not backed by any other entity.” Transamerica Advisors Life Insurance Company carries similar A.M. Best ratings. See provisions of the online prospectus for Aria RetireOne investment products at www.sec.gov/Archives/edgar/data/845091/000119312513456163/d635967dfwp.htm.
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23 Aria is an acronym for access to registered investment advisers. The SALB (stand-alone living benefit) program also refers to this product.
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24 Fees for the lifetime income guarantee are billed directly to the investor and, unlike in a VA contract, are not paid by liquidating investment positions within the covered account.
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25 Investors should study the RetireOne prospectus carefully to understand the contract provisions and options. These provisions include the ability to exercise options via step-up or ratcheting formulas, payout adjustments in the event of large interest rate moves, maximum future fee adjustments, and discounts for large portfolios. Although perhaps not as complex as VA contracts, RCDAs give investors an abundance of fine print to digest.
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26 The NAIC Working Committee recommends that GLWBs be classified as “hybrid income annuities” and that RCDAs be classified as “synthetic hybrid income annuities” (p. 2); see Contingent Deferred Annuity (A) Subgroup Conference Call Summary (16 February 2012).
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27 Private-letter rulings apply only to the specific taxpayers to whom they are issued.
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28 RetireOne marketing material states that “benefit payments to you are subject to ordinary income tax” if paid under the terms of the RCDA guarantee and that the annuity has “no cash value, surrender value or death benefit” (pp. 45, 1); see prospectus dated 15 May 2013 as amended and restated 15 May 2014.
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29 On 26 February 2015, the NAIC stated that a CDA contract “establishes a life insurer’s obligation to make periodic payments for the annuitant’s lifetime at the time designated investments, which are not held or owned by the insurer, are depleted to a contractually defined amount due to contractually permitted withdrawals, market performance, fees or other charges”. On 24 March 2015, the CDA Working Group addressed the issue of whether CDA contracts are fixed or variable annuities in its draft “Guidance for the Financial Solvency and Market Conduct Regulation of Insurers Who Offer Contingent Deferred Annuities,” stating that “because a CDA shares qualities of both a fixed and variable annuity, the Working Group concluded that a CDA should not be classified in either category but instead belongs in its own category” (www.naic.org/documents/committees_a_contingent_deferred_annuity_wg_exposure_cda_guidance_clean.pdf). A good recap of regulatory concerns about CDAs can be found in Leslie Scism, “New Annuity Guarantees Raise Questions,” Wall Street Journal (3 February 2013): https://www.wsj.com/articles/SB10001424127887323468604578247692560852924.
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30 For example, the investor might compare the current cost of an SPDA in which the payout is contingent on only survival with the present value of the yearly cost of an RCDA promising to pay a comparable income in which the payout is contingent on both survival and complete portfolio depletion.