As published in the Journal of Pension Benefits Summer 2021
By Jeffery A. Acheson
Jeffery A. Acheson, CPWA®, CFP®, CPFA, AIF®, CEPA®, has 40+ years in the financial services and retirement plan industries, creating a value proposition that is an exceptional and diversified integration of credentialed education, experience-based knowledge, and industry leadership. His fiduciary based business model focuses on enhancing his ability to be a trusted advisor to high net-worth individuals, families, businesses and their mission critical employees, retirement plan sponsors and their participants through his private practice, Advanced Strategies Group. Mr. Acheson also serves as the Chief Business Development Officer for Independent Financial Partners headquartered in Tampa, Florida. He also volunteers within the National Association of Plan Advisors having served as the Chair of the Government Affairs Committee, a member of its Leadership Council and as President of the organization. He currently is an active member of the American Retirement Association’s Board of Directors and is Chairman of NAPA’s nonqualified plan certificate program and annual conference.
There is an old saying..
Espoused at times by someone getting along in years that goes, “If I knew I was going to live this long, I would have taken better care of myself.” The saying could apply to both physical and fiscal health. A related conundrum occurs within retirement income planning as one cannot precisely pinpoint “how long” income will be needed, as no crystal ball exists to provide one’s mortality date. This leads to the dueling anxieties of Fear of Missing Out (FOMO) and Fear of Running Out (FORO). FOMO is the concern of suppressed lifestyle spending early in retirement to preserve income producing capital for the future, only to die prematurely (compared to assumed life expectancy), leaving “too” much behind after sacrificing that capital’s personal utilization and enjoyment. FORO is the concern of spending too much too early in retirement, leaving inadequate resources available late in retirement, and becoming dependent on others for financial support. This column will explore how annuities are being positioned as a source of guaranteed lifetime income to help address some of the uncertainties of retirement income planning and the pros and cons of their inclusion.
Do You Feel Lucky? If You Do, Just Know It’s Expensive
Retirement planning has become markedly more complex over the last 80+ years since the advent of Social Security. A great deal of the complexity is rooted in longevity advancements. In 1940, there were approximately nine million Americans over age 65. At that time, mortality tables generally indicated a life expectancy at age 65 of 12.7 years for males and 14.7 years for females. [ssa.gov/history/lifeexpect.html] Those longevity statistics have since progressed to nearly 18 years for males and 21 years for females [www. statista.com/statistics/266657] for the fifty million+ Americans currently over age 65. [The Administration for Community Living—2019 Profile of Older Americans, Publication Date: May 2020] Further complicating the longevity assessment are the life expectancy variances evident when factoring beyond just gender and including career history (i.e., white collar vs. blue collar vs. no collar), ethnicity, genetics, and individualized morbidity factors.
In the retirement income planning process, it is important to understand the math behind the calculation inherent in the term “life expectancy.” After all, everybody knows somebody who has lived well into their 80s, 90s, and even 100s and “beat the odds.” For clarity, life expectancy by definition means that, for any analyzed cohort (e.g., females age 65), 50 percent will live beyond life expectancy and 50 percent will predecease life expectancy. To paraphrase Harry Callahan in the 1970s movie Dirty Harry, the question becomes: “Do you feel lucky? Well do ya’?” It certainly applies to planning for retirement income with a 50/50 probability of needing income beyond your current actuarially calculated life expectancy. Apparently, most Americans do feel lucky—well kind of, as we will explore next.
The Expectation and Cost of Longevity
According to Nationwide’s sixth annual Advisor Authority study powered by the Nationwide Retirement Institute, nearly two-thirds (63 percent) of investors surveyed expect to live 20 to 30 years in retirement (i.e., lucky beyond life expectancy) but less than half (47 percent) believe they can live off their savings for that long. [Nationwide Retirement Institute—Advisory Authority Study, March 1, 2021] This longevity challenge has both systemic and individual consequences. As opposed to years past, when families and thus family caregivers were more clustered and available to provide care, today’s family units are increasingly more geographically dispersed, thus requiring more expensive third-party provided care before even considering the rising cost of late-stage life healthcare. A whitepaper collaboration between The Longevity Project and Principal Financial Group quoted statistics by the Employee Benefit Research Institute (EBRI), which projected that Americans are collectively $3.825 trillion short of adequately funding their retirement. Americans with the longest life expectancies account for the largest portion of that shortfall, and are thus exposed to the greatest amount of longevity risk. [Principal Financial Group—FINANCING LONGER LIFE—Retirement Innovation and the New Age of Longevity, September 2020] It is this cohort that would likely benefit most from the features and benefits annuities might offer as a risk management tool.
Quick Annuity Refresher
In its simplest form, an annuity is an insurance product designed to pay the policyholder a periodic, predictable, and guaranteed income benefit for as long as the policy’s annuitant lives (typically the policyowner and annuitant are one and the same), in exchange for a premium deposit or series of premium payments. The insurance company selling the annuity then pools the actuarially calculated annuity premium deposits paid by the policyholders into a larger pool of annuitants to spread the longevity risk to the insurance company over many lives with diversified statistics (e.g., gender, age, ethnicity, morbidity factors). Annuities come in many flavors (e.g., immediate, deferred, fixed, variable, indexed), all available with a myriad of features and benefits too numerous to detail in this column, so we’ll stick to the basics for sample utilization purposes.
Risk Management Strategies
Risk management generally falls into four basic strategies regardless of the type of risk involved. For the context of this column specific to longevity risk, let’s consider four possible approaches with and with- out the inclusion of an annuity.
- “Accept the Risk” Strategy: This approach involves withdrawing from retirement savings a certain dollar amount or annual percentage rate, determined at the inception of retirement to be realistic for rate-of-return, expenses, and inflation fac- tors, and hoping all assumptions hold over assumed life expectancy. In this scenario, lifestyle expenses typically drive regular income and unscheduled withdrawals and carries the highest FORO anxiety as the backside risk of exhausted capital beyond life expectancy is borne by the retiree.
- “Manage the Risk” Strategy: Withdrawal amounts with this approach are driven by a periodic reassessment of prior assumption tracking combined with future planning assumptions, leading to corresponding adjustments of annual withdrawals to compensate for any changes in rate-of-return expectations, inflation, and expenses, as well as health-related factors that might impact life expectancy. In this scenario, income withdrawals drive lifestyle adjustments in an effort to preserve near-term capital and carries the highest FOMO anxiety, especially if principal is deemed untouchable as a source of current income.
- “Hedge the Risk” Strategy: This hybrid approach involves purchasing a Qualified Longevity Annuity Contract (QLAC) with a deferred income benefit beginning at assumed life expectancy or later to integrate with options 1 or 2 so that all remaining retirement income producing assets left after the QLAC purchase have a targeted “exhaustion date” (i.e., assumed life expectancy). If longevity extends beyond life expectancy, the QLAC income benefits kick in to replace the lost income generated by the now exhausted income generating assets. QLACs can be designed to include a return of premium benefit if the annuitant dies before realizing the benefits of the annuity reasonably commensurate with the amount deposited.
- “Transfer the Risk” Strategy: With this approach, the retirement plan participant buys a life annuity which typically guarantees a monthly income benefit for the life of the annuitant (i.e., plan participant), which begins at or near the onset of retirement. The annuity can contain features and benefits that address early mortality, inflation, and spousal support, but the main focus is guar- anteed income for the life of the plan participant. The key goal and benefit of this annuity design is to provide predictable lifetime income for the participant and transfer the longevity risk to the insurance company. Interestingly, a 2012 study by Towers Watson found that “retirees with similar wealth and health characteristics, those with annuitized incomes are the happiest,” so annuities can trigger emotional benefits within the planning process. [Principal Financial Group— FINANCING LONGER LIFE—Retirement Innovation and the New Age of Longevity, September 2020] What’s not to love, right?
Beauty Is in the Eye of the Beholder
As with most things in life, annuities have supporters and detractors in the analysis of their inherent cost, transparency, and complexity versus benefits and guarantees provided. A March 2021 Financial Planning magazine article [Financial Planning—Secure Act May Boost Annuities. Are Advisors Ready?, March 2021] on this topic quoted one Advisor’s perspective worthy of consideration:
The cost of annuities would have to come down significantly for us to consider them as a recommendation. We believe the payout concept can be replicated through proper planning without the cost of the annuity.
However, this same Advisor went on to say:
But, if retirement plans can deliver this concept in a cost- effective manner I would welcome this.
This cost/benefit analysis is very objective at the pooled level, but it is very subjective at the individual level, as the true final financial outcome will not be known until death occurs with the winners of annuitization being those who live the longest. Remember Dirty Harry’s question: “Do ya’ feel lucky?”
A March 2021 brief by the Center for Retirement Research at Boston College entitled “What is the Value of Annuities” tried to quantify and measure the value of current commercially available annuities from strictly a mathematical perspective by looking at “Money’s Worth” (the ratio of expected lifetime benefits to cost) and then “Wealth Equivalence” (the measure that takes into account the insurance value of the annuity). [Gal Wettstein, Alica H. Munnell, Wenliang Hou, and Nilufer Gok, “What Is The Value Of Annuities,” Center for Retirement Research at Boston College, March 2021, Number 21-5] The brief concluded that the Money’s Worth of annuities for individuals has remained stable over time, with an expected payout of about 80 cents per premium dollar for immediate and indexed annuities and about 50 cents per dollar for deferred annuities. But, after accounting for the insurance value of the Wealth Equivalence, an aggregate pool gained value. While this conclusion may at first blush seem counterintuitive, the brief goes on to explain; “The purpose of an insurance product is not to make money but rather to protect against losses. In the case of annuities, the goal is to protect against outliving one’s assets.” The concept of insurance is built upon the concept of pooling risk and those that don’t experience loss ultimately subsidize those that do. When it comes to the longevity risk equation, those annuitants who don’t live to life expectancy subsidize those who live beyond life expectancy. For this reason, a lifetime income product should be evaluated with an insurance product bias and not an investment vehicle bias in determining its true value.
The Dilemma of Annuity Math
According to the 2019-2020 Federal Reserve SCF data, the average retirement savings of a 60–64-year- old American is only $221,451. [Federal Reserve, 2019-2020 Survey of Consumer Finances (SCF)] While household retirement savings may be higher, when you consider this individual average balance will generate only $800 to $1,200 per month in guaran- teed lifetime monthly annuity income, the decision dilemma manifests. If a retiree doesn’t feel confident his or her individual longevity risk will comfortably exceed average life expectancy the decision to purchase an annuity is challenging. This math likely explains why advisors surveyed by Nationwide’s Advisor Authority study responded that the cohort they would most likely recommend an in-plan annuity for were those participants with balances between $500,000 and $1,000,000. [Nationwide Retirement Institute— Advisory Authority Study, March 1, 2021] While a certain percentage of those below the lower end of the range may certainly benefit from lifetime income guarantees, they may feel they can’t make ends meet with the lower monthly benefit when their personal measurement of lifetime is unknown. At the other end of the spectrum, those above the higher end of range are better funded for longevity with potentially better access to income planning advice thus better equipped to “self-insure” via other risk and investment management strategies. As a side note, as one studies the math of annuitization and the correlation between premium deposits and corresponding income, it certainly triggers a better appreciation of the Net Present Value (NPV) of their own Social Security benefits and why it is such a valuable asset deserving of protection in the financial planning process.
Will the SECURE Act Boost Annuity Inclusion?
The passing of the SECURE Act in 2019 removed existing perceived barriers that previously caused many plan sponsors to hesitate in adopting guaranteed income products within defined contribution plans. Time will tell how much the clarifying provisions of the act will move the needle above the roughly 7 percent static plan level adoption rate illustrated in Exhibit 1.
| Exhibit 1 | 2016 | 2017 | 2018 | 2019 |
|---|---|---|---|---|
| Plans offering annuities | 35,000 | 35,000 | 35,000 | 35,000 |
| Participants in these plans | 3.15 Million | 3.40 Million | 3.47 Million | 3.68 Million |
| Assets covered by annuities | $156.1 billion | $188.7 billion | $182.4 billion | $209 billion |
Initially, a 2019 Willis Tower Watson survey [Willis Towers Watson—Lifetime Income Solutions; Progress, with Work Ahead, 2019] following the SECURE Act passage reported that 60 percent of plan sponsors surveyed, indicated they would then consider offering lifetime income products. However, Principal Financial Group’s more recent Longevity Study found that 75 percent of plan sponsors decided that upon review, they were not likely to offer a solution soon. [Principal Financial Group—FINANCING LONGER LIFE—Retirement Innovation and the New Age of Longevity, September 2020]
Some of the reasons cited were:
- fiduciary, operational, or administrative concerns;
- waiting to see the market evolve more;
- participant utilization concerns;
- difficulty with participant communications;
- cost barriers;
- not interested in making plan enhancements for terminated employees; and
- preference that participants leave the plan upon termination.
The Opportunity for In-Plan Annuities
While there appears to be consensus around the possible planning opportunities when integrating guaranteed lifetime income benefits into strategies that address longevity risk, the debate continues about how best to expand their appeal, application, and utilization. Some key factors to expanded adoption will include, but not be limited to:
- Institutional versus retail pricing (i.e., lower cost products);
- More transparent product design and provider assumptions;
- Flexible rate of return (ROR) crediting strategies to offset the current low-interest rate environment;
- Enhanced education for plan sponsors, participants, and advisers including possible benchmarkretirement income planning strategies and alterntives; One example of this would be guaranteed income (Social Security + Annuity Income) equal to non-discretionary expenses and variable income withdrawals for discretionary lifestyle expenses; and
- Assured product portability between custodians and recordkeepers, including individual retirement account (IRA) providers, catering to terminated defined contribution (DC) participants.
Conclusion
The DC retirement plan evolution of the last 40 years has delivered tremendous innovation and technological advancements to enhance the accumulation phase of the retirement planning equation. Now, with 10,000 Americans turning age 65 every single day and climbing, it is time for the retirement plan industry to work in partnership with the insurance industry and collaborate on evolutionary progress applied to the deaccumulation phase of retirement. The promise and pitfalls of ever-increasing life expectancies requires complicated, multi-faceted and nuanced distribution planning with longevity risk as a core consideration in the equation. Thoughtfully designed and distributed annuities could and should be a vital part of the available and viable solutions considered. ■
Copyright © 2021 CCH Incorporated. All Rights Reserved.
Reprinted from Journal of Pension Benefits, Summer 2021, Volume 28, Number 4, pages 49–53, with permission from Wolters Kluwer, New York, NY, ph: 1-800-638-8437, www.WoltersKluwerLR.com