Providing a guaranteed lifetime withdrawal benefit is a risky endeavor for the insurance company. The insurance company must manage both longevity and market risk, as they are obligated to provide lifetime income payments at the guaranteed level if the underlying assets held within the annuity have been depleted. The greater the investment volatility and the higher the guaranteed withdrawals that the insurance company allows, the greater is the cost for creating a risk management framework to support that guarantee. Companies have several methods for managing these risks. First, companies can create a strong culture of financial performance and risk management. This may help to create an edge in obtaining efficiencies around supporting the guarantees in the least costly way. It may be hard to distinguish much in this regard between the leading insurance companies other than to assess their strength and size, as well as their past performance with supporting income guarantees during market downturns. Especially as the income guarantees on variable annuities are not covered by the state guarantee associations protecting fixed annuities, one must take care to choose a company that is likely to be around and be able to support the guarantees it offers.
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Beyond the company’s culture and approach to risk management, insurance companies generally have the following levers for managing the risks around supporting a lifetime income guarantee:
- Supporting a lower guaranteed income amount
- Choosing high-quality managers for the investment subaccounts
- Limiting the volatility allowed within the investment subaccounts, either by capping the allowed stock allocation (investment choices are each labeled as risky or not risky, the allowed percentage of risky investments is capped) or by requiring the use of volatility-controlled investment funds or cash positions within the subaccounts
- Increasing the fees for the variable annuity and the income guarantee rider to provide more reserves and to support the purchase of more financial derivatives to hedge the risk created by market volatility
For the first point, we have already discussed how the insurance company can use different rollup, step-up, and payout features to help better control the amount of guaranteed income it is contractually obligated to support. Companies may reduce their obligations by encouraging consumers to only focus on one detail such as a guaranteed rollup rate. Guarantees can be weakened by using a lower rollup rate, by less frequently vesting the rollups, by not stacking roll ups on step ups, or by connecting the benefit base to lower distribution rates. But this sort of approach may only go so far as it relies on behavioral mistakes by purchasers to focus on only one lever of the income machine. Companies seeking to provide competitive levels of guaranteed income must seek to manage these accepted risks through investment controls and fees.
What are the investment options and constraints for the variable annuity subaccounts?
The risk to the insurance company for supporting an income guarantee grows as the contract value declines and falls further away from the guaranteed benefit base. The insurance company maintains the responsibility to continue funding the guaranteed income levels if the underlying portfolio depletes. And so, as the contract value of remaining assets falls relative to the guaranteed benefit base used to determine income, risk to the insurance company increases. Insurance companies would like to keep the contract value strong and close to the benefit base so that they are less exposed to the costs of providing the lifetime income guarantee.
The ability to invest more aggressively is a clear advantage provided to the retiree by an income guarantee, and this is a risk that must be managed by the insurance company offering the guarantee. Investing aggressively creates more upside potential for the retiree. Investment growth that leads to step-ups means both a larger benefit base and a larger contract value for assets. Retirees then only experience a portion of the downside risk. Market losses will reduce the contract value, but the income guarantee will provide spending power if the assets deplete through a combination of portfolio losses and distributions. The income guarantee behaves as a type of put option on the stock market, as it supports upside growth while reducing the potential harm to the lifetime standard of living resulting from market losses.
Ultimately, while the underlying contract value of assets remains positive, retirees are spending their own money. The insurance company pays from its own resources when the contract value depletes. Contract value depletion is what triggers annuitization, and that is why these are classified as deferred annuities.
Insurance companies can try to control this exposure to market volatility and capital losses either by limiting the total allocation allowed to risky assets, by choosing less volatile funds to be included as part of the subaccount options, or by directly managing the amount of volatility exposure through volatility-managed investment funds or dynamic asset allocation that automatically shift assets away from equities at times of market stress.
Variable annuities will vary by their depth of investment offerings and by the constraints placed on these offerings. Most will provide funds from a variety of leading mutual fund companies. Insurance companies tend to carefully select and manage the fund choices within their annuities with an eye to finding good performers. The insurance companies are incentivized to avoid underperforming or poorly managed funds because this could cause contract values to be depleted more quickly, forcing the insurance company to make good on its guarantees.
As for constraints, the simplest is to create a maximum allowed allocation to risky investment such as stocks. Annuity holders may have investing freedom for choosing among the funds within the annuity universe, but they would be restricted from increasing the overall risky allocation above some limit such as 60 or 70 percent. Some companies will also require that 10 percent of premiums remain in a secured value account that earns a fixed interest amount based on short-term interest rates.
Another trend is to use volatility-managed funds, which automatically reduce the stock allocation to keep a consistent volatility level if volatility rises in the markets. Some companies may require the use of these type of funds or may otherwise require that a portion of the assets within the annuity be held in a cash account with minimal volatility.
This is an excerpt from Wade Pfau’s book, Safety-First Retirement Planning: An Integrated Approach for a Worry-Free Retirement. (The Retirement Researcher’s Guide Series), available now on Amazon
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