- If an investor’s expected Social Security and defined benefit income will not offer sufficient longevity protection, partially annuitizing retirement assets might help.
- However, using annuities to accumulate income in defined contribution plans could have drawbacks, including higher costs and limited flexibility and liquidity relative to mutual funds and other investments.
- The case for using annuities as savings vehicles in defined contribution plans in the accumulation phase rests on assumptions that they will provide income streams after retirement, yet few participants actually convert them into income streams.
- Insuring against longevity risk will not be right for everyone. Because it is challenging to predict whether or how much annuity income will be needed, it may be best to delay decisions about annuitizing wealth until closer to retirement.
Three long-term, well-documented trends complicate investors’ ability to manage the risk of outliving their retirement savings. First, people are living longer and must therefore make their assets last longer. Second, with diminishing access to guaranteed income through employer-sponsored defined benefit plans, today’s investors must increasingly determine for themselves how best to protect against longevity risk (see Figure 1).
Third, most defined contribution plan assets do not result in a direct income source, leaving investors to manage their own income generation without the benefit of risk pooling. As investors deal with these issues, the industry seeks to offer solutions.
An important distinction must be made between accumulating retirement savings in annuities and using them to provide income in retirement. Retirees may find it prudent to annuitize a portion of their assets to gain protection against longevity risk and the risk of cognitive decline. However, several considerations temper the case for doing so while in the accumulation phase. In this paper, we seek to help plan sponsors assess whether the costs associated with various types of annuity offers are justified by the benefits to participants.
Partial annuitization at retirement
Annuities might play an important role in a retiree’s investment strategy. By guaranteeing a stable stream of lifetime income, they can hedge longevity risk and simplify investment decision-making later, when the risk of cognitive decline rises rapidly.
Neither of these risks is trivial. On average, today’s 65-yearold retirees should expect to live well into their eighties. A married male/female couple retiring at age 65 has approximately a 50% likelihood of at least one spouse living to age 92 (Society of Actuaries, 2014). Vanguard research demonstrates that a prudent, dynamic withdrawal strategy significantly reduces the likelihood of portfolio depletion. However, it eliminates neither that risk nor the risk that a retiree will have to decrease his or her real spending level (Jaconetti et al., 2016). On the other hand, by purchasing an annuity, investors can set a floor for their income and ensure that this income is sustained for as long as they remain alive. Several studies demonstrate that partially annuitizing assets can improve the sustainability of a retirement income strategy (Ameriks, et al., 2001).
NOTES ON RISK
IMPORTANT: The projections and other information generated by the Vanguard Capital Markets Model regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Distribution of return outcomes from the VCMM are derived from 10,000 simulations for each modeled asset class. Simulations are as of September 30,015. Results from the model may vary with each use and over time. For more information, please see the Appendix.
All investing is subject to risk, including the possible loss of the money you invest. Investments in bond funds are subject to interest rate, credit, and inflation risk. Diversification does not ensure a profit or protect against a loss. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
There are important factors to consider when rolling over assets to an IRA or leaving assets in an employer retirement
plan account. These factors include, but are not limited to, investment options in each type of account, fees and expenses, available services, potential withdrawal penalties, protection from creditors and legal judgments, required minimum distributions, and tax consequences of rolling over employer stock to an IRA.
Transforming liquid assets into a stable income stream can also protect against the risk that cognitive decline will impair financial decision-making in advanced age. Several studies have shown that the risk of an individual experiencing impaired decision-making ability rises after age 60 (Finke, et al., 2015). This has implications for investors ranging from reduced ability to manage the risk of depleting assets to increased susceptibility to financial scams and elder fraud.
As investors near retirement, they should consider how much guaranteed income they desire. Next, they should determine the extent to which sources of income earned in their working years—namely Social Security benefits and defined benefit pensions—will satisfy their need. If they require additional guaranteed income, they should consider purchasing an immediate or deferred annuity. This can be done within an employer-sponsored plan or using other assets. Plan sponsors can provide guidance to participants and potentially offer access to institutional pricing advantages (Blanchett, 2016).
Income annuities are a form of insurance and are not right for everyone. Investors must determine whether the value of the protection they offer outweighs their cost, tax, and liquidity implications (Ameriks and Ren, 2008). Annuities may not be appropriate for investors who have good reason to believe they will not live beyond average life expectancy, who are of poor health, who cannot afford the purchase, or who are seeking to preserve liquid assets to cover possible long-term care expenses or to provide for an inheritance. Investors whose Social Security and other pension income is expected to cover the bulk of nondiscretionary retirement spending also may have little use for additional guaranteed income. Although partial annuitization could serve some retirees well, we caution against viewing it as a default solution.
In addition to generating or distributing income in retirement, annuities are also offered as accumulation vehicles embedded in defined contribution plans. In the next two sections, we outline key considerations for doing so.
Variable annuities in defined contribution plans Traditionally, a selling feature of variable annuities in individual investment accounts has been their preferential tax treatment. Investors who face relatively high capital gains and dividend tax rates may benefit from sheltering taxable assets in a variable annuity with low expenses. However, this feature has no value to investors in a defined contribution plan, because the plan’s preferential tax treatment already provides tax-deferred growth.
The costs of administering employer-sponsored retirement plans can be significant and are largely a function of plan size (Deloitte, 2014). The costs to participants depend on the operating expenses of the chosen investments along with any other plan-related costs that might be passed on.
Depending on the type of plan and how it’s designed, a choice between mutual funds or group variable annuities may not make any difference in terms of investment costs. Comparing the two is complicated by differences in how their expenses are reported. Group retirement annuities often bundle expenses, whereas mutual funds list fund expenses (expense ratios) separately from administrative and other costs. Even so, variable annuities do have a reputation for high costs. As shown in Figure 2, this can be attributed to their often actively managed subaccounts and insurance-related expenses. Index funds have become increasingly popular with investors. However, about 92% of the subaccount offerings listed in Morningstar’s database of group retirement annuities and group variable annuities are actively managed. These investments carry expenses that are, on average, 56 basis points higher than passively managed options. And insurance costs, typically labeled mortality and expense (or “M&E”) charges, can be significant if applicable.
Along with the investment costs, plan sponsors should evaluate the benefits of various plan structures and whether they can meaningfully help participants reach their retirement goals. Variable annuity contracts that include insurance charges typically provide some kind of death benefit. In the accumulation phase, death benefits vary by contract but are typically limited to shielding beneficiaries from market exposure after the death of the account owner. They may guarantee some additional compensation if the account value at the time of the owner’s death is less than his or her total net contributions minus prior withdrawals and costs. Because the assets are intended to cover longterm retirement savings objectives, such protection against short-term market fluctuations has limited value relative to insurance expenses.
Plan sponsors are encouraged to consider the overall expenses borne by participants for plan features. All else being equal, lower-cost features such as index mutual funds might enable investors to keep more of their returns, enabling superior long-term portfolio growth relative to those group annuity structures with relatively higher investment and insurance expenses.
Whatever their source, investment costs can erode a participant’s ability to accumulate wealth. Just as investment returns compound over time, so does the effect of asset-based expenses. Figure 3 shows a hypothetical scenario demonstrating the potential effects of investing in higher-cost products over time. In it, we compare the outcomes of investments with costs varying from 20 to 160 basis points. The investor is assumed to earn $65,000 in year one of employment and a 1% real increase in each subsequent year over a 40-year period. The investor saves 10% of her income (including an employer match) each year, and both products are assumed to earn an annual real return of 4% (gross of expenses).
As the figure illustrates, higher expenses can have a
substantial effect. Over a 40-year period, the highest-cost product results in $178,656 less savings than the lowestcost option, all else being equal. Although an annual cost of 1.6% may seem small, it could represent more than 29% of potential market gains given up to expenses over time.
Fixed annuities as savings vehicles A participant’s decision about whether and how much to invest in a fixed annuity depends on a relatively complex set of trade-offs. We provide perspective on several important considerations on the next page.
Assets in fixed annuities are generally less portable than those in mutual funds. Investors who do not wish to initiate an income stream or need to change their investment strategy might be restricted from moving some or all of their savings. Depending on contract or plan rules, they may have to access their assets through periodic payments that could stretch for ten years or more. In some cases, lump-sum payouts are subject to significant surrender charges. Plans seeking to avoid such restrictions may be able to relax the rules, but this will likely affect annuity crediting rates, providing greater flexibility at the expense of lower returns.
Longevity protection versus liquidity
Investors lacking a strong conviction that they will need additional longevity protection in retirement might also want to avoid accumulating in an annuity. Most defined contribution participants will already have at least one form of longevity protection in the form of Social Security. During the accumulation phase, it may be very difficult to assess how much additional guaranteed income will be needed in retirement. It may be nearly impossible to predict the answers to questions such as these: How much income will I need in retirement to cover basic expenses? What will change in my health and life expectancy, and will I ultimately anticipate a long retirement? Will I amass sufficient wealth relative to my spending needs to drastically minimize the risk of asset depletion? What level of portfolio liquidity will I need in retirement? Because the guaranteed income base (if any) a retiree may eventually need is very hard to predict, delaying decisions about purchasing protection might be prudent.
Buying an annuity represents a trade-off between longevity and liquidity risks. The annuity establishes an income stream that cannot be outlived. However, the money used to purchase this protection is no longer available for other uses, which introduces liquidity risk. Too little longevity protection may compromise a retiree’s ability to cover daily living expenses at an advanced age. Conversely, too great a reduction in portfolio liquidity may leave investors vulnerable to unforeseen expense shocks in retirement and also reduce the wealth available for a bequest.
The trade-off also has implications for plan design. A participant who contributes too much to an annuity may unintentionally create a liquidity crisis in retirement. This risk is heightened by the difficulty of predicting how much longevity protection and liquidity will be necessary. As an alternative to offering annuities as accumulation products within a plan, sponsors could offer access to annuities outside of the plan, through IRA rollovers at or in retirement.
These offers (such as Vanguard’s Annuity Access Program) may give investors access to a wider range of features. They can also reduce costs and eliminate sponsors’ fiduciary duty to properly vet insurance providers of in-plan annuities. ERISA regulations require sponsors to conduct thorough, analytical searches thatconsider, among other variables, an insurance provider’s ability to make all future payments and to then monitor the provider over time (Canary, 2015). Out-of-plan annuity offers involving IRA rollovers do not subject plan sponsors to this responsibility.
Annuities are generally more expensive than mutual funds, and higher costs can considerably erode longterm portfolio growth. Fixed annuity charges generally do not need to be disclosed in detail. Instead, the rate of return credited to an account or the payout offered in retirement is often quoted net of expenses. However, insurance companies might still assess fees associated with administration and actuarial costs. If so, the fees assessed on investors who choose not to receive payouts in retirement offset the expenses incurred by retirees who do elect the annuity stream. For participants who accumulate in an annuity without a strong intent to eventually initiate a guaranteed income stream, this transfer of value could be disadvantageous. Annuity prices vary substantially, and participants may have access to institutionally priced in-plan annuities with lower costs than those available in the retail market. Ultimately, the costs should be weighed against the potential benefits and eventual longevity protection that an annuity can offer.
Stable growth and interest rate sensitivity
Fixed annuities used in the accumulation phase typically offer principal protection and stable growth. Although contributions’ rate of growth may vary with interest rates, a set floor ensures that returns do not fall below a specific, positive threshold. This could lead investors to view an annuity as an attractive alternative to a long-term, welldiversified fixed income mutual fund. By masking the effects of interest rate volatility on the market prices of the underlying fixed income portfolio, the stable growth feature may increase a participant’s ability to stay committed to an investment strategy.
However, the usefulness of this characteristic may be limited by the nature of long-term, well-diversified fixed income strategies. Since the inception of the Barclays Aggregate Bond Index in 1976, only about 8% of 12-month returns have been negative, and the index has never recorded a negative return over any five-year period. Its maximum drawdown of –12.74% in February 1980 was one of only five drawdowns greater than 4%. No drawdown period has lasted for longer than 16 months. In other words, bear markets for well-diversified, highquality bond portfolios are generally shallow and short-lived (Philips et al., 2013).
Looking ahead, the Vanguard Capital Markets Model has projected the probability of experiencing negative one-, three-, and five-year annualized returns over the next 40 years in a globally diversified, investment-grade bond portfolio, as shown in Figure 4. Although the current low rate environment makes negative returns more likely than in the past, the risks are still modest, especially over the longer term. Another possible benefit of interest rate volatility is the link between the rates when contributions are made and at the time of the eventual payouts. By buying into an annuity over time, investors could hedge the risk that interest rates will fall substantially as they near retirement, making the payout rates for annuities purchased at retirement less favorable. This could essentially be viewed as a form of dollar-cost averaging, with similar benefits. Clearly, for this feature to have economic value, interest rates must fall over the accumulation period; rising rates would have the opposite effect.
Annuities are useful for providing retirees with income they cannot outlive (ignoring inherent counterparty risk) and protection against the financial management implications of cognitive decline.
However, as accumulation vehicles in a defined contribution plan, annuities present several important
trade-offs. They are on average more expensive than mutual funds with comparable investment strategies,
which could erode portfolio growth. Additionally, they offer relatively less liquidity and flexibility even during
the working years. For many participants, annuities will not be appropriate retirement income solutions, and this is challenging to predict during the accumulation phase. For these reasons, decisions about annuitizing wealth might be best delayed until closer to retirement.
- Longevity risk—the risk that an investor outlives his or her retirement savings.
- Risk pooling—the process by which financial risks are spread evenly among contributors to a pool.
- Accumulation—the period of time in which investors build up the value of their investments through contributions to their accounts.
- Guaranteed income—a promise of regular income to be received for an agreed-upon period of time (for example, the length of a recipient’s life) that is backed by the issuer.
- Variable annuity—an annuity contract in which income payments fluctuate with the performance of the annuity’s underlying investments in subaccounts.
- Variable annuity subaccount—the structure in which a variable annuity is invested. In many instances, subaccounts will be modeled after mutual funds. The account holder selects subaccounts when entering into a variable annuity contract.
- Fixed annuity—an annuity contract that guarantees the contract holder positive growth in the accumulation phase and the option to initiate level payments of guaranteed income in the retirement phase.
- Death benefit—the rights of an investor’s beneficiaries to receive the value of an annuity at the time of the account holder’s death. The amount due may vary according to the annuity’s structure and contract.
- Liquidity risk—the risk that an investor will not meet short-term debt obligations. In the case of annuities, liquidity risk may arise from the up-front forfeiting of assets in exchange for the annuity policy.
- Surrender charges—the fees paid for withdrawing some or all principal before the termination of the surrender period, during which all or a minimum of the investor’s money must remain in the annuity.
- Annuity crediting rates—a method of measuring interest changes to an annuity. These rates alter the growth of the annuity’s value over a specified period.
- Principal risk—the risk that a variable annuity contract holder will lose the amount invested in a policy because of market fluctuations.
- Payout rate—the amount paid from an annuity to the policyholder. Payouts occur regularly at an agreed-to frequency.
Ameriks, John, and Liqian Ren, 2008. Generating Guaranteed Income: Understanding Income Annuities. Valley Forge, Pa.: The Vanguard Group.
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Vanguard Capital Markets Model®
IMPORTANT: The projections and other information generated by the Vanguard Capital Markets Model regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. VCMMresults will vary with each use and over time. The VCMM projections are based on a statistical analysis of historical data. Future returns may behave differently from the historical patterns captured in the VCMM. More important, the VCMM may be underestimating extreme negative scenarios unobserved in the historical period on which the model estimation is based. The VCMM is a proprietary financial simulation tool developed and maintained by Vanguard Investment Strategy Group. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include U.S. and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, U.S. money markets, commodities, and certain alternative investment strategies. The theoretical and empirical foundation for the Vanguard Capital Markets Model is that the returns of various asset classes reflect the compensation investors require for bearing different types of systematic risk (beta). At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data fromas early as 1960. Using a system of estimated equations, the model then applies a Monte Carlo simulation method to project the estimated interrelationships among risk factors and asset classes as well as uncertainty and randomness over time. The model generates a large set of simulated outcomes for each asset class over several time horizons. Forecasts are obtained by computing measures of central tendency in these simulations. Results produced by the tool will vary with each use and over time. The primary value of the VCMM is in its application to analyzing potential client portfolios. VCMM asset-class forecasts—comprising distributions of expected returns, volatilities, and correlations—are key to the evaluation of potential downside risks, various risk-return trade-offs, and the diversification benefits of various asset classes. Although central tendencies are generated in any return distribution, Vanguard stresses that focusing on the full range of potential outcomes for the assets considered is the most effective way to use VCMM output. The VCMM seeks to represent the uncertainty in the forecast by generating a wide range of potential outcomes. It is important to recognize that the VCMM does not impose “normality” on the return distributions, but rather is influenced by the so-called fat tails and skewness in the empirical distribution of modeled asset-class returns. Within the range of outcomes, individual experiences can be quite different, underscoring the varied nature of potential future paths.
@The Vanguard Group, Inc. used with permission