Annuities and Retirement Income Planning

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.

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.

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).

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).

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.

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.

⁷ The tax regulations for inflation-adjusted annuities differ in
important respects from those applicable to nominal payout annuities.

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.

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.

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.

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.

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.

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.

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.

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.

¹⁶ The death benefit is adjusted for aggregate withdrawals before
death.

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.

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.

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.

²⁰ Vanguard Group, “Annuities Offered through
Vanguard,” cited Morningstar, Inc., as of December 2014.

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).

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.

²³ Aria is an acronym for access to registered investment advisers.
The SALB (stand-alone living benefit) program also refers to this product.

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.

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.

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).

²⁷ Private-letter rulings apply only to the specific taxpayers to
whom they are issued.

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.

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.

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.