By Charles E.F. Millard
Lifetime income solutions make a lot of promises: guaranteed payouts; liquidity; portability; simplicity; maximizing asset growth. But do they all deliver on these promises to their full capacity?
In evaluating lifetime income solutions, we need to examine each of those promises —with growth opportunity as one of the most critical considerations. This article is a brief guide to looking at how these solutions do (or do not) maximize the growth of a participant’s assets.
Sacrificing growth for income won’t drive adoption
For decades, the financial services industry has offered lifetime income solutions that lack participant adoption. The principal reason: Participants want their assets to grow, and they want that growth to be to their benefit. They want lifetime income, but they don’t want to sacrifice growth. They work hard for their money, and they want their money to work hard for them.
This poses a challenge for most lifetime income products. The usual annuity standard is that you give your money to the insurance company and get a guaranteed income in return. The insurance company invests in strategies designed to ensure that it can pay the income stream. Any upside in the investment of your assets is kept by the insurer. This may seem like a fair arrangement, but people don’t agree to it because they don’t want to give up growth in their own assets.
Some lifetime income solutions have tried to address this challenge, but most have failed. Here’s why:
1. Insurance carriers require conservative investing
In working with an insurance carrier to fund the guarantee, asset managers are often restricted by certain rules they may not otherwise need to consider. For example, a variable annuity promises a certain payout to the participant and includes full participation in the upside potential of the account. That seems appealing and appears to address the issue of participation in the growth of the participant’s assets.
However, to ensure consistent and predictable returns and to limit risk exposure, the insurer restricts the underlying allocations to relatively conservative strategies. This means the participant can participate in growth, but that growth is unlikely to be as substantial as it otherwise might be.
2. Wrap fees drag down performance
Another solution in the market today promises a specific income, as a percentage of one’s savings, for life. These kinds of “percentage income for life” arrangements sound attractive but are structured based on old thinking. They take the defined contribution plan and “wrap” it with an annuity. That wrapper has a cost—usually about 1.5 percentage points a year. That is a drag on growth.
For example, let’s take two accounts that make the same contributions of $6,000 per year for 30 years with the same exact investments, but one has a wrap fee of 1.5% and one does not. At the end of 30 years, the account without a wrap fee would total $606,438, assuming a 7% annual return. The account with the wrap fee would total $458,517 with the same 7% annual return minus the 1.5% wrap fee. So, if a product promised 5% a year as the payout, which would you rather have: 5% on $606,438 ($30,322 annually) or 5% on $458,517 ($22,926 annually)?
3. Limited growth in return for longevity insurance
With a deferred income annuity (DIA), the individual pays a certain amount, either once in a lump sum or in a series of premium payments spread out over time, to the insurer for a deferred annuity that provides a stream of guaranteed income payments. In a typical scenario, payments to the insurer are concluded by the time the participant is, let’s say, age 60. But the payments to the insured are deferred and do not start until the person is, for example, 80 years old.
Unlike a variable or indexed annuity, which provides growth opportunity tied to the performance of underlying assets, a DIA provides a simple interest rate. To fund the guarantee, the participant is required to take a portion of their assets out of their traditional investments and allocate it to an annuity with limited to no growth potential. Taking the assets out of the market before starting retirement will have a significant impact on future growth opportunity.
There are some valid arguments for purchasing a DIA, especially as a form of longevity insurance. But if we are trying to solve the problem that participants do not want to sacrifice growth of their assets to receive guaranteed income, the DIA is not an effective or viable solution.
How to Maintain Growth – AND Provide Lifetime Guarantees
Lifetime income solutions that use a fixed indexed annuity (FIA) can provide better growth potential, because the FIA is a better fixed-income alternative. The performance of the assets in an FIA is linked to the performance of an underlying index, and the index has a component that includes exposure to equities, with a guarantee from the insurer.
At Annexus Retirement Solutions, we transformed the traditional FIA into an investment vehicle, creating Lifetime Income Builder, our patent-pending solution.
That means that at retirement, Lifetime Income Builder pays 6% income on the high-water mark1 of the entire target date fund and, should the account ever run out of money, a 4.5% guarantee for as long as the participant lives.2
Participants want lifetime income, but they do not want to sacrifice growth. Plan sponsors are looking for QDIA-eligible solutions that provide the best value for their participants. Understanding how growth works in each solution is key to a fiduciary decision.
Charles E.F. Millard is Senior Advisor at Annexus Retirement Solutions and the former Director of the United States Pension Benefit Guaranty Corporation. This article is part of a series on the Five Fundamental Elements of Lifetime Income Solutions. Follow us on LinkedIn for the latest posts.
1 The value of the Target Date Fund account is measured on the last business day of each calendar quarter and on the last date that contributions may be made to the Fund, and then the highest measured value is locked in. The high water mark is not measured until the Fund begins to allocate to the Fixed Indexed Annuity or Lifetime Income Builder.
2 6% annual income is the amount targeted at income activation. If the value of equities and fixed-income holdings reaches zero at or after income activation, annual income is adjusted to a guaranteed percentage that is the cumulative of all insurance company guarantees. 4.5% annual income is targeted for the guarantee. However, both actual percentage rates are dependent on economic factors and may be more or less than what is targeted. Insurance contract guarantees are also subject to the claims paying ability of each insurance company.