The good news for baby boomers has been well documented and heavily publicized: Boomers are going to live for a long time, thanks to medical advances and lifestyle changes. However, this good news carries with it a fundamental challenge: How can boomers continue to increase and protect their lump-sum nest eggs throughout their retirement years without the fear of running out of money?
Insuring Retirement Assets Against Loss
While most people are comfortable insuring homes, cars, life, and income, they are not as comfortable with the concept of insuring retirement assets. The source of this discomfort lies in the type of vehicle that has been developed to address the long-term need of simultaneously increasing and protecting assets. The financial services industry has responded with an array of solutions packaged in a product that has long been maligned and misunderstood: the guaranteed variable annuity with living benefits. A variable annuity is a life insurance contract that provides future payments to the holder, usually at retirement, and usually for life. The payments are not a fixed amount; their size depends on the performance of the assets (usually stocks, bonds, or mutual funds) that the contract has invested in. Gains are not taxed until distributed to the annuitant (but are taxed as ordinary income under Secs. 61(a)(9) and 72(b)(2)). The “living benefits” are guaranteed minimum withdrawals each year, usually a percentage of the annual stepped-up basis. The annual increases are derived from the actual performance of the underlying separate accounts, which are invested aggressively because of the future guarantees. By locking in future annual stock market gains, the increasing guaranteed minimum withdrawals will act as a hedge against bear market cycles.
The Traditional Retirement Planning Paradigm
Most retirees cannot afford to lose capital during retirement because they do not have the time to make it up—e.g., a decline of 25% in value must be followed by a return of 33% to break even and recoup lost capital. Without any financial guarantees of principal or locking in future stock market gains, prudent financial planning would dictate that people become more conservative as they approach retirement and maintain this posture during their retirement years. This common approach translates into a reallocation of equities to bonds or a general strategy of rebalancing variable investments to fixed investments.
While this strategy for nonguaranteed retirement assets will work, it presupposes that the retiree has sufficient capital to stay ahead of inflation and maintain his or her present monthly living expenses. For many baby boomers who have not saved enough money to sustain their lifestyle in retirement, this is a dangerous assumption. According to Behavioral Economics and Annuitization 2006, a study published by the Life Insurance Marketing Research Association (LIMRA), 76% of baby boomers have no plan in place to convert their lump-sum retirement assets into a steady stream of predictable and sustainable income. How can this situation be improved?
Equity-Based Investments with Underlying Guarantees
If retirees had a choice, they would likely opt to stay aggressively invested in the stock market throughout their retirement years (to stay well ahead of inflation) and to insulate themselves from expected broad market declines in order to make retirement assets grow faster and last longer. From a long-term investment perspective, there is only one way to achieve this result: Retirees must stay invested in an equity-oriented asset allocation for the rest of their lives. That may sound good as long as the market continues to rise, but from a historical perspective it is not realistic. Retirees would also need protection from the precipitous bear cycles that are an inevitable part of the market. This is where guaranteed annuities with living benefits may be appropriate and suitable for a client’s needs.
By entering into an annuity contract with a highly rated carrier, retirees can pay an insurance fee and guarantee minimum withdrawals, even during a declining market. This additional fee is deducted from the performance of the assets that have been invested in an aggressive asset mix. Without the downside protection, these assets would have been invested in an otherwise conservative mix. The long-term performance of the guaranteed annuity, net of the insurance fees, has the potential, based on historical rates of return, to far exceed the returns realized from maintaining a conservative nonguaranteed investment mix. According to researchers at the University of Pennsylvania and Brigham Young University, individuals who use lifetime income annuities can fund a secure retirement with lump sums that are about 25%–40% smaller than they would need if they were using other types of investments (Babbel and Merrill, “Rational Decumulation” (Wharton Financial Institutions Center, July 2006), p. 8).
Guaranteed Variable Annuities with Living Benefits
While the guaranteed minimum withdrawals come at the price of higher annual fees, focusing solely on the expenses associated with the guarantees of lifetime income and the locking in of future stock market gains is shortsighted. The additional expenses of these living benefit riders are costs only if they do not provide quantifiable future value.
The focus should be on the value of the long-term economic benefits received from these additional costs. The cost may be worthwhile if it allows clients to guarantee the principal for the rest of their lives, prevents them from running out of money in their later years, allows them to stay aggressively invested throughout their retirement years, or gives retirees the confidence to start taking distributions. The additional costs for the guarantees may provide the peace of mind that the client wants. With the decline of the traditional defined-benefit plan, investing a portion of a client’s retirement assets in these vehicles may be appropriate. The program creates a guaranteed baseline income during the retirement years that used to be provided by a pension.
Most annuities contracts include surrender charges, which are designed to discourage early liquidation of a long-term integrated financial instrument. Although most annuities generally have free withdrawals of 10% annually, some retirees are preoccupied with surrender charges, which on average last seven years. If a retiree contemplates the liquidation of 100% of his or her retirement assets during the surrender period, he or she should not invest in a guaranteed annuity program. In many cases, surrender charges serve as a barrier to liquidation, preventing retirees from raiding their retirement accounts for other than retirement goals. Financial advisers should strenuously emphasize the impact of surrender charges on the early termination of the program.
Suitability and the Informed Client
It is essential that clients understand the nature of the guarantees and, most important, how they will access the benefits of those guarantees during declining stock markets. One of the most common guarantees is a guaranteed minimum withdrawal benefit. This component represents the underlying promise of an insurance company to provide baseline income for the rest of one’s life. What must be repeatedly communicated to clients is the window of available capital (e.g., 4%–7%) that they can access during a declining market; the retiree may not access the guaranteed value in the form of a lump-sum distribution. This is not a problem for most retirees because they are looking for an increasing future stream of income, not a single lump-sum payout. It is an issue only if the contract value (actual performance, net of fees) is less than the guaranteed value.
Protection Against a Sequence of Returns Risk
Is it possible to retire at the wrong time? A major provider of variable annuities compared the return rates of a 60% stock–40% bond mix over two different 30-year periods (1966–1995 and 1976–2005), starting with a single, initial investment of $500,000 and annual withdrawals of $25,000 (John Hancock Annuities, “Is It Possible to Retire at the Wrong Time?”). The results created two very different outcomes: One retiree exhausted the capital after 15 years, and the other had accumulated a substantial amount of capital. Which 30-year period will boomers live through? Given the level of uncertainty in the world markets, baby boomers should look for a way to securitize a portion of their assets against a possible sequence of return risk.
The Semantics of Annuities: Withdrawals Versus Annuitization
While guaranteed annuities with living benefits are developed on an annuity platform, the newer programs offer an annuity option but do not contemplate annuitization as part of the guaranteed benefit. Annuitizing the contract value is an available option, but it is rarely chosen because it would limit the retiree’s ability to participate in future stock market gains. So while the retirement assets reside in an annuity structure, the future value for the retiree is realizing a stream of potentially increasing income in the form of guaranteed withdrawals.
Facing an Uncertain Future with a Degree of Certainty
Knowing that Social Security benefits are likely to decrease in the future, baby boomers are looking for ways to secure their financial future. In concert with the demise of the defined-benefit pension plan, baby boomers must be empowered to manage their own form of a personal pension plan. They must closely examine their available options for managing their lump sums at retirement. The longevity risk once managed by pension departments has now been shifted to retirees. With this shift comes the responsibility to simultaneously increase and protect their retirement nest eggs. Achieving this financial goal at their own kitchen tables is an unlikely scenario.
What is feasible is to aggregate common investment and longevity risks in a pool of funds managed by top money managers and guaranteed by a highly rated insurance company. This form of risk sharing is no different from any other form of risk management, except that it involves one’s retirement assets. Given the level of uncertainty in the world today, the costs associated with a guaranteed annuity with living benefits may be well worth the future benefit. For tax practitioners, securitizing a portion of clients’ retirement assets to create a baseline retirement cashflow should be considered an integral part of building a secure retirement future.
Michael David Schulman, CPA/PFS Schulman CPA, An Accountancy Professional Corporation New York, NY