Do variable annuities belong in a retirement plan?
A VA invests in assets that are more volatile, but carry higher upside potential.
In 1952, The Teachers Insurance and Annuity Association (TIAA) sold the first variable annuity (VA) developed by Harvard Ph.D. economist William Greenough to Brown University President Henry M. Wriston. Since then, over a million education employees have invested in VAs through the TIAA College Retirement Equities Fund (TIAA-CREF). The original VA was seen as a creative solution to the retirement income puzzle.
The variable annuity concept as originally envisioned is remarkably simple. The initial purpose of the VA was to provide a higher income to retirees than fixed annuities, for the trade-off of removing the stronger guarantees that fixed annuities provide.
A VA invests in assets that are more volatile, but carry higher upside potential – namely, stocks. Greenough imagined that this would allow retirees an income that rose over time, counteracting the price inflation that reduces the purchasing power of a fixed annuity – and, in many cases, paying more over time.
In his research published in the Journal of Finance, Greenough mapped out the income from a VA purchased prior to the Great Depression; at first, the income fell below a fixed annuity, but by the 1940s, the income rose to the point that it was keeping pace with inflation, while a fixed annuity lost ground each year.
These benefits should translate into retirees flocking into variable annuities – however, the data doesn’t quite back that up.
According to a recent analysis, the percentage of TIAA participants choosing to take lifetime income fell from 54% in 2000 to just 19% in 2017; the drop in annuitization follows the decline in recent interest rates, which chipped away at the amount of income one can receive from an annuity.
Adding pressure to the mix is a general misunderstanding of annuities across the board; in a recent survey of retirement income literacy from The American College of Financial Services, only 19% of respondents correctly guessed that the payout on a single-premium immediate annuity (SPIA) to a 65-year old male was about 6%.
This lack of knowledge can prevent savers from selecting a product solution that is fairly priced and inhibit their understanding of the true value that these products can provide.
In a low-asset-return, low-interest rate environment where an ever-growing percentage of savers will not receive a defined benefit pension, retirement savers need all the help they can get to fund adequate spending from a portfolio of assets.
A variable annuity can help fill the gap by providing mortality credits and an equity risk premium, a combination that traditional assets can’t deliver. A basic investment portfolio, for example, gives retirees an equity risk premium but leaves mortality credits on the table, resulting in lower spending and greater risk.
In order to maximize the power of their mortality credits, it’s important that these products be illiquid in structure.
Why? Think of an annuity as a long-life income club – when the club is formed, all members pitch in dollars, which will be distributed to whoever is still alive, and those who don’t live as long subsidize those who live a long time. If the shorter-lived savers pulled their money out of the club, there wouldn’t be enough to pay for the members who reach their 100th birthday.
Still, many savers will need some flexibility.
One possible solution is a guaranteed minimum withdrawal benefit (GMWB). This preserves some access to an equity risk premium, lifetime income protection and mortality credits because the minimum lifestyle guarantee is preserved even after the account balance runs out, along with the flexibility to withdraw assets if an emergency arises or the retiree doesn’t live a long time.
While the expected lifetime income will never be as high as a pure variable income annuity, many may find that the trade-offs are worth the cost.
Another method is to blend risky assets with fixed annuities. This allows employees to capture higher returns from equities while benefiting from mortality credits from annuitization.
My recent research with Morningstar’s David Blanchett found that fixed annuities should be substituted directly for bonds within a retirement portfolio allocation to benefit from the mortality credits without losing out on stock returns. The retiree can then trade liquidity for mortality credits by deciding when and how much to annuitize.
Additionally, since mortality credits are higher for annuitized income later in life, one can also buy a deferred income annuity (DIA) or a qualified longevity annuity contract (QLAC), which provides tax benefits by shielding up to $135,000 from required minimum withdrawals between age 72 and 85.
Ultimately, retirement planning can be simplified by focusing on the only two possible outcomes: income and legacy. How much does a retiree spend, how much does a retiree pass on after death, how much do they pay in expenses, and how variable are both the income and expenses?
If the goal is to maximize income, the optimal solution is a lean variable annuity. The amount of risk within that VA should be determined by the retiree’s willingness to adjust spending so that they can potentially spend more if stocks outperform bonds. Other options may increase expected legacy and liquidity, but any gain in legacy or liquidity will come at the expense of lifestyle.
At the end of the day, there’s no question that variable annuities can be complex to navigate. Some are expensive, and there is history of abusive sales practices within the industry. However, the SECURE Act gives plan sponsors a clearer avenue than ever before to incorporate low-cost, transparent annuitization products for the benefit of participants.
This has the potential to give savers the clarity and security they need to effectively turn their nest egg into income, and in a world where perhaps the only thing certain is uncertainty, that goes a long way for building a safer retirement.
