Income Guarantees, Risk Capacity, Upside Potential, And Asset Allocation
If one maintains the same asset allocation both inside and outside of the variable annuity, then the additional fees for a variable annuity can be expected to deplete the underlying value of the assets more quickly than if they were held in an unprotected investment account with lower fees.
However, this outcome changes if one accepts the notion that having an income guarantee in place can support using a higher stock allocation within a variable annuity. In this case, when markets do well in retirement, the additional exposure to the risk premium can more than offset the higher costs of the variable annuity to allow for greater overall growth in assets. If markets perform poorly in retirement, the additional costs within the variable annuity could cause it to deplete assets sooner than otherwise. But with poor returns, the investments-only portfolio will be on track to depletion shortly thereafter.
With the variable annuity assets, at least, the income guarantee continues to support spending after the contract value depletes. With investments-only, spending power ends. Over time, variable annuities with income guarantees could have lower remaining wealth (due to fees) or higher remaining wealth if the guarantee moves someone to accept a higher stock allocation and stocks perform well.
The assumptions made about asset allocation for guaranteed funds and unguaranteed funds are incredibly important. It is natural that retirees with income guarantees will feel more comfortable accepting a more aggressive asset allocation, and ideally one should compare approaches using the asset allocations a retiree would choose for both a guaranteed and unguaranteed approach. This will be individual specific. Moshe Milevsky and Vladyslav Kyrychenko have provided research based on over one-million variable annuity policy holders showing that those with optional income guarantees were willing to have about a 5 percent to 30 percent higher stock allocation than those without guarantees on their variable annuities. For instance, someone willing to hold 40 percent stocks without a guarantee may increase their stock allocation to between 45 percent and 70 percent (if allowed) with an income guarantee in place.
Having the income guarantee supported with actuarial bonds increases the risk capacity of retirees, as their retirement standard of living is less vulnerable to a market downturn. This can provide the capacity to use a higher stock allocation when a guarantee is in place, both inside and outside of a variable annuity. Inside because the income guarantee protects income on the downside while still offering upside potential. Outside because the income guarantee reduces the harm created if portfolio assets are depleted. Risk capacity is greater.
A retiree may be willing to invest more aggressively within the variable annuity than with an investments-only strategy. The variable annuity owner has the upside potential to grow the asset base and increase guaranteed income with a higher stock allocation, while knowing at the retirement income is protected and sustainable even if the market is performing poorly in the pivotal early years of retirement.
The income riders on variable annuities provide the ability to receive mortality credits, which can reduce the asset base required to support a lifetime spending goal. The rider fees paid for the income guarantee provide insurance that the spending will be protected in case someone experiences a combination of either living too long or experiencing sufficiently poor market returns that they outlive their underlying investment assets and cannot sustain an income for life.
A higher variable annuity fee may provide stronger protections, or it may provide more upside potential. Retirees seek to evaluate variable annuities along the tradeoff between what can provide the most certainty for the least cost to potential upside opportunities.
In evaluating a variable annuity guarantee, it is important to first start with the level of guaranteed income it provides if no upside is ever achieved. This can be compared with the guaranteed income from an income annuity offering a cash refund, since this is the most comparable to the standard death benefit for variable annuities. The difference in payouts between the two better relates to the cost of upside and liquidity while alive. Most frequently, the variable annuity guaranteed withdrawal rate will be less than an income annuity. The differential reflects the guaranteed income one would give up to receive the upside potential and liquidity in the contract.
With the investment options and annuity features, how likely is it that the contract value can grow, and how important is it to the retiree to maintain the liquidity provided by the contract for those assets? About liquidity, we must remember that it may not be true liquidity if those assets are earmarked for income because excess distributions beyond the guaranteed amount will reduce the subsequent amount of guaranteed income provided. But if a retiree values this liquidity nonetheless, then comparing the amount of guaranteed income lost to provide the liquidity (and upside) help to quantify the tradeoff for the decision between income annuities and deferred variable annuities with income guarantees.
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This is an excerpt from Wade Pfau’s book, Safety-First Retirement Planning: An Integrated Approach for a Worry-Free Retirement. (The Retirement Researcher’s Guide Series), available now on Amazon AMZN .