The Next Generation of Income Guarantee Riders: Part 1 - The Deferral Phase

Another important difference is the way RetireOne’s guaranteed payout rate is calculated: It depends both on the age at which benefits begin and on the current yield on 10-year Treasury bonds. For a 65-year old single person who wishes to begin his or her guaranteed withdrawals, the payout rate is 4% if the Treasury yield is less than 4.5%, but it increases to 6% if the Treasury yield exceeds 7%. 

After the guaranteed income begins, the benefit base no longer determines the withdrawal amount. Step-ups in withdrawals occur if the revised payout rate based on new Treasury yields multiplied by the remaining account balance exceeds the previous guaranteed withdrawal. Though this can be a difficult hurdle to pass after income-drawdown begins, rising Treasury yields do offer greater hope for a benefit increase, and benefits do not decrease after yields fall.

A final important issue to consider is taxes, even though the complications of individual clients’ cases make it difficult to generalize about outcomes. A VA/GLWB defers taxation, though all gains and income are taxed at the marginal income tax rates, while the SALB is generally taxed like a mutual fund. Joseph Tomlinson recently provided a deeper analysis of the tax concerns when comparing annuities and systematic withdrawals.

Data and modeling approach, and a caution
 
To simulate performance of these different approaches, I used Ibbotson Associates' Stocks, Bonds, Bills, and Inflation (SBBI) data on total returns for U.S. financial markets since 1926. I used the U.S. S&P 500 index to represent the stock market and the intermediate-term U.S. government bond index to represent the bond market. In all cases, returns were calculated on an annual basis, with withdrawals taken at the beginning of each year, fees taken at the end of each year, and annual rebalancing.

Simulations for a 10-year deferral period based on this historical data show how well these guarantees would have protected the benefit base in past markets, specifically examining rolling 10-year periods for retirement dates between 1936 and 2011. A complete collection of outcomes can be found in table 2, an appendix to this article.

Consider an investment of $100, made by a couple when both spouses are 55. The simulation shows the portfolio wealth and benefit base, in real terms, that this couple enjoys 10 years later, when both are 65 and preparing to retire. Though their initial wealth is $100, the benefit base can be less than $100, since it is expressed in real terms, while the guarantee is nominal. (Though analyzing the guaranteed income phase will be left for part 2 in this series, the guaranteed payout rates for the couple, given their decision to retire at 65, for both the VA/GLWB and RetireOne SALB are also shown in table 2.)

For the mutual funds, I assumed an annual expense ratio of 0.2% of remaining assets. For the VA/GLWB and SALB, assumptions are mostly based on the Vanguard and Aria offerings, except that I assumed an annual step-up feature for each, rather than their actual, quarterly step-up. Though this simplification could cause the benefit base to occasionally fall lower than otherwise might be possible, such differences will be consistent for the purposes of comparing the two products.

For SALB, the rider amount is calculated as a percentage of remaining assets; it is 1% for the 40/60 allocation, 1.35% for the 70/30 allocation, and 1.75% for the 80/20 allocation.

A note on historical simulations such as this one: It is important to realize that the history of the U.S. financial markets has been very kind to retirees. A new, previously unrealized worst-case scenario could well await those for whom retirement lies in the uncertain future, and – again – these guarantees depend on the insurance company’s ability to pay, which could be at risk if the overall financial landscape gets bleaker.

Another caveat to consider is that the terms of the VA/GLWB and SALB were set under current market conditions; if these products had existed in the past, they may have offered different terms than at present.

Comparing unguaranteed and guaranteed mutual funds

For the deferral period, on which we focus today, comparing the VA/GLWB to RetireOne would not be a meaningful exercise, so I’ll dispense with that aspect of the analysis quickly. The small differences between the two products seen in table 2 are attributable only to their differing fees, which mean that RetireOne can gain a slight edge in scenarios that cause the account value to trail the benefit base. The differences between these products will be more evident in the next article, which will focus on the income phase.

Rather, what is interesting now is to compare the role of a guarantee in supporting a benefit base and reducing risk for prospective retirees at a time of life when wealth accumulations may be the largest, but when they are also most sensitive to losses. This returns us to the fundamental question asked by Bob Veres: What are guarantees designed to insure against?

To study the role of the guarantee, we have to find suitable comparison groups.  What asset allocation would a client use for an unguaranteed portfolio, and what would they choose for a guaranteed portfolio?

Figure 1, below, compares the performance of a mutual fund account, with 80% stocks and 20% bonds, against the performance of the RetireOne guaranteed benefit base with the same 80/20 asset allocation. (Admittedly, this may be an unlikely case, since it implies a rather aggressive allocation for the unguaranteed portfolio.)

Points above the 45-degree line indicate better performance with RetireOne, while points below the line favor the unguaranteed mutual funds. Vertical red lines show cases where RetireOne users’ account value would differ from the benefit base, and the line reaches down to the real value of remaining assets in those cases. These points show the outcomes for all the rolling historical periods.

As expected, in most cases the unguaranteed portfolio provided more wealth, given the lack of rider fees. Occasionally, however, a drop in the markets shortly before retirement did cause the guaranteed benefit base to be higher. For instance, for a deferral period ending at the start of 2009, the mutual funds provided real wealth of $82, while RetireOne supported a real benefit base of $96 and a contract value for remaining assets of $69. The $13 difference between $82 and $69 represents the cumulative impact of the rider fee. But hypothetical SALB owners might have appreciated their decision, especially if it helped them to stay the course and maintain high stock allocations going into 2009.  (As a point of comparison, in nominal terms the mutual fund portfolio was $105, the RetireOne benefit base was $123, and the contract value of RetireOne was $88.)

If these were the asset allocation choices, would it be worth the expense to add the guarantee rider? There’s no clear answer, and it depends in large part on client preferences, but one important point to consider is that the downside protection is only relative. We could consider a decline in real wealth after 10 years to be a rather bad outcome, but the rider does not protect well against that outcome, as the real value of protected wealth does occasionally fall below the initial $100 at age 55.

Historically, there has never been a case in which the unguaranteed value of the mutual funds fell below $100, while the rider maintained a real benefit base above $100. And most of the bad-luck cases still favored the unguaranteed approach. Nonetheless, the rider was quite helpful in a minority of scenarios (the benefit base was larger than the mutual fund assets in eight of the 76 rolling historical periods), such as the aforementioned 2009 retiree, or a 1975 retiree, whose unguaranteed wealth would have dropped to the lowest level observed historically ($74). The rider would have supported a benefit base of $90 and a contract value of $62.

Next, consider figure 2, which may feature a more realistic example – a more conservative client, who chooses a 40/60 allocation for unguaranteed mutual funds, but who is persuaded to use a more aggressive 70/30 allocation with the RetireOne guarantee. This is a very interesting case to examine, showing how RetireOne supports greater upside while providing less impressive performance on the downside. When real wealth is less than $100, the guaranteed benefit base is slightly greater than the unguaranteed mutual fund balance in a few cases, but, generally, the more conservative asset allocation from the unguaranteed funds supports greater wealth. Based on these historical simulations, it would be difficult to justify paying the rider fees and making the asset allocation more aggressive for clients who worry more about downside protection than upside potential.

The bottom line

Unfortunately, I cannot draw any categorical conclusions for you; individual clients’ views and concerns need to be a part of deciding whether to apply RetireOne to an investment portfolio. Nonetheless, table 2 and the figures in this article illustrate the role of a rider during the deferral phase – the surprise is that riders do not typically support a higher benefit base to protect from downside risk in the historical simulations.

Clients seeking to protect against a sequence of bad returns just before retirement will find that the guarantee still leaves them worse off in inflation-adjusted terms, especially as the rider fees hamper the ability of the contracted assets to grow faster than the unguaranteed alternative.

There is much to consider when deciding whether to use RetireOne during a deferral period. In part 2, I will provide further comparisons between the VA/GLWB and RetireOne to see how they stack up in the post-retirement income phase.

Wade Pfau, Ph.D., CFA, is an associate professor of economics at the National Graduate Institute for Policy Studies (GRIPS) in Tokyo, Japan. He maintains a blog about retirement planning research at wpfau.blogspot.com

Wade wishes to thank Bob Veres and Joseph Tomlinson for providing valuable feedback and insights.

Read more articles by Wade Pfau