Laddering Annuities
Copyright 2009 SourceMedia, Inc.All Rights Reserved Bank Investment Consultant
August 2009
PRODUCT INSIGHT; Pg. 25 Vol. 17 No. 8
1347 words
LadderingAnnuities; This strategy can ensure retirement income, while freeing up assets for growth.
Dave Lindorff
The collapse of financial markets has left people nearing retirement in a state of high anxiety. Many portfolios shrunk 40% in the past year, and the crisis may be far from over. Even the notion that investing in equities will outperform bank deposits over time is being challenged.
Enter the concept of laddered annuities. Or, perhaps, "Welcome back."
In a recent study entitled, Variable Payout Annuities and Dynamic Portfolio Choice in Retirement, published in the Journal of Pension Economics and Finance, Olivia Mitchell, a professor of insurance and risk management at the Wharton School at the University of Pennsylvania, argues that by laddering the purchase of immediate annuities or buying annuities gradually over time, while keeping the rest of a portfolio invested in a mix of equities and bonds-people can substantially increase the likelihood of meeting their retirement income goals. The product used is a "fixed immediate annuity," and the payment rate you get for what you buy with a single premium is based on the client's age at purchase and current interest rates.
"What we've found in this and earlier studies is that people facing retirement want guaranteed income and liquidity, so purchasing annuities over a period of time, even into retirement, makes sense," says Mitchell, who doubles as executive director of the Pension Research Council at UPenn and who co-authored the latest study with scholars from Goethe University in Frankfurt, Germany.
Annuity ladders share an advantage with bond ladders, notes Goethe University's Raimond Maurer, a co-author of the study. You reduce the risk of locking in low interest rates-and payouts-because you are buying the annuities at different times and different interest rates. However, when interest rates are particularly low, as they are now, clients should probably hold off.
BUILDING THE LADDER
Here's how a laddered investment works. Say you have a husband and wife, each 60 years old, who plan to retire at 66 on $200,000 in savings and $40,000 a year from Social Security. They want an additional $20,000 a year, so they buy a $14,000 cost-of-living-adjusted immediate annuity, investing the remaining $186,000 of their funds in 65% equities and 35% bonds. Every year, until they are 66, they purchase another $14,000 annuity until the combined payouts reach their income goal of $20,000. Six years later, if the equity and bond markets perform at even close to historical norms, the couple will still have a substantial investment in securities in addition to a $20,000 income from the annuities for life.
Jerry Golden, president of MassMutual's income management strategies division, suggests this hypothetical scenario: Assume Joe is a 64-year-old widower. In October 2007, Joe had $1 million in assets, two grown children, six grandchildren and a pressing desire to retire at 65. Joe invested 65% in stocks and 35% in bonds, hoping to withdraw $40,000 a year in retirement. He planned to give himself a 3% annual raise to account for inflation.
By October 2008, of course, Joe's investments were a disaster. His stocks were down 38.1% and his bonds were down 9.1%, leaving him with just $719,850. Had Joe left matters alone, he would be facing a 32% chance of exhausting his resources by age 86, his life expectancy.
But suppose, back in October, Joe had taken a third of his assets, $237,551, and purchased an inflation-adjusted income annuity that accepted multiple premiums of $17,141. He could risk shifting the balance of his assets into equities and draw the remainder of his $40,000 target income from that portfolio as required. Each year, for nine years, he would buy more annuities, reaching his required payout of $40,000 per year in nine years. At that point, Golden says Joe could have well over $500,000 left for his heirs-even more if inflation stays under 3%.
Conventional wisdom has been to invest client portfolios in a mix of equities and bonds, with equities providing the long-term growth, and bonds dishing up security, predictability and income. According to this model, the portfolio's allocation shifts more weight into bonds as retirement approaches. But many risk-averse retirees are wondering if they can follow conventional wisdom anymore.
"Annuity laddering is particularly effective relative to investment-based strategies," says Chris Rahm, head of the retirement income practice at Ernst & Young. The annuities can act as a client's most conservative investment, the bond portion of the portfolio. Then "if you were an aggressive advisor, you could argue that the client could move more invested assets into equities," he says. That way, clients can gradually build guaranteed income while maintaining liquidity and growing their assets.
An added advantage of laddering annuity purchases: As the buyer ages, the "survival credit" rises. Essentially, the older the buyer of an annuity, the higher the payout for a given premium, Mitchell explains. According to John Harrell, managing director of sales at Symetra Financial, immediate annuities may also enjoy tax advantages over certain bonds. The annuities have unique exclusion ratios, which means a portion of the income stream is considered a return of principal and thus free from taxation while the client is alive.
TEST OF TIME
Golden has back-tested laddering, examining 181 different time periods from 1965 to 2006, and comparing several annuities strategies to a typical stocks-and-bonds investment strategy. In almost every case, the annuity strategy outperformed a portfolio of only stocks and bonds. While buying even a single immediate annuity at the outset proved better than investing purely in stocks and bonds, Golden says that the laddered approach, on average, tripled the original client asset by the end of the test period, regardless of the economic environment or the period selected. "Laddering annuities allows retirees to stay longer in equities," agrees Tom Modestino, a senior analyst at research firm Cerulli Associates. "And that's a good idea."
In bank programs, a laddering strategy may also help ensure that annuities work in concert with other fixed-income solutions such as CDs. Symetra's Harrell notes that income annuities have sometimes suffered from the notion that they represent a onetime commission for the advisor and the potential loss of future fee revenue or CD sales for the bank. However, by also incorporating period-certain immediate annuities into the ladder, advisors can protect clients from locking in low rates while setting the stage for CD reinvestment later.
For example, Harrell suggests blending into the ladder shorter-term (five- or 10-year period) annuities and opting for annual payouts-particularly for those clients more interested in using an annuity to protect savings than to cover monthly living expenses. The client would later be able to convert the annual income payments into new CDs or other fixed- income investments if rates improve.
The main downside to annuities is their complexity. "The financial advisor has a lot of explaining to do to the client," Rahm says. When a client buys an immediate annuity, the payment is a premium, not an investment, and is no longer an asset controlled by the client. "It may not be what they are used to," he says.
There are positives to the strategy that also need to be explained because they may not be obvious. "People need to know that with this approach you end up with more liquidity, and at the same time you are eliminating two other big retirement investment risks-volatility and timing."
Lisa Plotnick, associate director at Cerulli, cautions that while she likes the idea of laddering annuity purchases, it might not be wise to get locked into one issuer. "With annuities, products are always evolving, and you may find better products or more attractive riders offered by different issuers," she says. "Financial advisors should always shop around to find the best fit for their clients."
Dave Lindorff is a freelance writer based in the Philadelphia area.
For more product stories, see bankinvestmentconsultant.com
http://www.BankingInvestmentConsultant.com/
August 3, 2009
Rock-a-bye Recession; Maternity Benefits Can Go A Long Way To Recession-proof Retention, Women’s Family Plans
Advisor News
Annuity News
Health/Employee Benefits News
Property and Casualty News