By Douglas Wolff
Before 2007, whenever Americans were asked about their retirement goals, the most common responses boiled down to “retiring early” and “accumulating as much wealth as possible.” Pose the same question today, however, and the dominant answers are more likely to be “dealing with health care expenses” and “not outliving my income.” As an industry, we have a great opportunity to respond to this attitudinal shift by developing a new and improved game plan for helping clients generate retirement income.
New approaches combining traditional vehicles with innovative income guarantees can reduce the risk of failure and improve the odds of creating a successful income-generating strategy. More specifically, retirement income plans using mutual fund systematic drawdowns and an indexed annuity (IA) with guaranteed lifetime withdrawal benefits (GLWB) may be a great addition to an advisor’s playbook.
Variable Annuities and Mutual Funds Not Fully Up to the Task
Americans are concerned about health care expenses, the volatile equity markets and the thought of living 30 to 40 years in retirement. In fact, a substantial percentage of your pre-retiree and retiree clients – roughly one third to one half, according to recent surveys by major organizations – said they are no longer focused exclusively on the size of their retirement accounts. Instead, their chief concerns are safety of principal and achieving a lifetime income stream. This new emphasis on safety of principal, along with providers’ de-risking and re-pricing, has made variable annuities (VAs) less attractive to aging baby boomers. Today’s income-oriented retirement portfolios demand a different balance of growth and security than VAs, even those with lifetime benefits, can provide effectively.
Investors’ caution with regard to VAs as retirement income tools is well-deserved. A leading independent actuarial consulting firm studied the effectiveness of three popular investment strategies in creating a sustainable retirement income for various joint and single life retirement scenarios. Success was defined as annually meeting the needs of an inflation-adjusted income. The study assumed a $1 million investment, an initial withdrawal rate of 4.5 percent and annual inflation adjustment every year until death. The base case analyzed systematic withdrawals from hypothetical mutual fund portfolios comprising a combination of equity and fixed income. Next, the mutual fund portfolio was paired with an annuity providing a GLWB. Using a Monte Carlo analysis, the study sought to determine the best allocations to optimize chances for success in each case. The resulting portfolios from the study were graphed to create an efficient frontier representing those points with optimal risk/return trade-offs. Risk was defined as the probability of running out of money while still alive. Return was defined as the average amount of remaining assets upon death.
Mutual Fund Spend-Down Strategy
The results were consistent among the joint and single life scenarios, and for this article, we will use the results of the joint life study to illustrate the point. Not surprisingly, a balanced portfolio of 60 percent equities and 40 percent fixed income provided a maximum probability of success (82 percent) when using a mutual fund-only investment strategy. In short, the best-case scenario for a mutual fund-only strategy suggested that one in five retirees could run out of retirement income prior to death.
Mutual Fund Spend-Down Strategy + Variable Annuity
Combining the mutual fund strategy and a VA with GLWB revealed that a 45 percent allocation to the VA and, for the remaining 55 percent of assets, a fund portfolio of 55 percent equities and 45 percent fixed income would be the most effective or optimal mix. However, the likelihood of success increased by just 3 percent to 85 percent. Withdrawals from the mutual fund portfolio would provide income during the first 10 years. Thereafter, lifetime benefit withdrawals from the VA combined with withdrawals from the mutual fund portfolio would fund the income stream. While there is improvement over the mutual fund spend down alone, there is still a one out of six failure rate – meaning a one in six chance that your clients could outlive their retirement income.
Today’s IAs Enhance Odds of Success to 97.5 Percent
Finally, the study examined mutual fund systematic withdrawals paired with a contemporary IA with GLWB. The probability of success was greatly enhanced, to 97.5 percent, when a 50 percent allocation to the IA was combined with a mutual fund mix of 25 percent equities and 75 percent fixed income. As with the VA/mutual fund strategy, mutual funds would provide income for 10 years before lifetime withdrawals from the IA were initiated. With clients seeking retirement income, this strategy provides the greatest probability for success, moving from a one in five or one in six failure rate to a one in 40 failure rate. That is a significant improvement as compared to the VA with GLWB strategy.
A Well-Timed Solution
The more attractive results for the IA/mutual fund combination are no accident. In recent years, IAs have been re-engineered to provide the combination that aging boomers moving from asset accumulation to asset decumulation need most: guaranteed future payout over time coupled with liquidity and upside opportunity. Increases in account values are achieved via crediting options linked to performance of a stock or bond market index but, in most cases, there is no downside risk to the investor from market movements.
The bulk of the premiums are invested in the insurer’s general account, which gives the insurer greater control over the assets and makes account values less volatile. The insurer’s hedging efforts are centered more on longevity risk, which is predictable with a fair degree of accuracy, and less on market risk, which can be highly unpredictable and volatile. Traditionally estimated by actuaries, longevity risk is less costly to manage, and the cost savings can be passed along to consumers in the form of more attractive and/or lower cost benefits, including specific future payout levels that (generally) are higher than those guaranteed by today’s VAs. Simply put, IAs offer retirees the best of several worlds: a guarantee of principal, the potential of market-linked growth with no market-related risk of principal loss and the ability to generate retirement income without having to annuitize.
More Options for Tailoring the Strategy to the Client
Providing well-reasoned, compelling retirement income options is critical, as clients require a “game-changing approach.” Investors are demanding a smarter balance of growth and security to achieve their retirement goals effectively and to create a sustainable stream of lifetime income. As IAs continue to gain share, the popularity of guaranteed income riders
attached to IA products is increasing. Our research demonstrates that the highest probability of success in creating sustainable income throughout retirement results from combining a mutual fund drawdown and an IA with a GLWB. At its highest probability of success, a 97.5 percent success rate was achieved, which translates to a failure rate of one out of 40. That compares to a one out of five failure rate for mutual funds alone and a one out of six failure rate for a mutual fund drawdown plus a VA with a GLWB.
The significant improvement in the probability of success should capture the attention of pre- and post-retirees. Positioning clients for little to no market risk, a guarantee of principal, potential for portfolio growth and retirement income requires a series of well-executed plays. Improved retirement outcomes, flexibility to respond to a variety of needs and market conditions, and retaining control of the assets are driving today’s retirement game. All these goals are achievable by combining the mutual fund drawdown strategy with a contemporary IA with GLWB.
Douglas Wolff is president of Security Benefit Life, overseeing product development, pricing and operations. He brings 25 years of experience in investments, financial consulting, actuarial pricing, product development, marketing and strategy formulation to his role. Contact him at [email protected]