Profile 1: Ultra-conservative investor
Individuals have a declining risk appetite as they get older. For more conservative individuals, the transition from work to retirement can magnify their risk aversion, resulting in a desire to have little, if any, market exposure in retirement. Over a 30- to 40-year retirement, this decision can result in significant erosion of purchasing power and increase the risk of running out of money over a long life.
For this profile, the variable annuity can improve outcomes by offering greater market exposure with guaranteed step ups and income protection. The amount of income protection will be based on amount of annuity purchase and specific annuity benefits.* Our research finds that the annuity provides greater upside opportunity, and benefits from annual guaranteed rollups as well as step ups for ten years prior to income being drawn at an approximate 5% withdrawal rate beginning at age 65.
*Dependent on the claims paying ability of the insurer.
Exhibit 1 compares a conservative portfolio of 20% equities and 80% bonds to a partial allocation (20% and 40% of the initial portfolio value) to an annuity that is invested 65% in equities and 35% in bonds. The allocation raises the likelihood of being able to successfully spend $40K in inflation-adjusted spending to 85% and 92% compared to no annuity allocation which has only a 77% chance of success. Also, in the scenarios that did not last for 30 years, the annuity scenarios continue to provide lifetime income of approximately $11,500 and $23,000, respectively, whereas the non-annuity allocation is depleted.
Likelihood of success: $500k fully invested vs. partial variable annuity (VA) allocation at age 55
Exhibit 1: $40k spending at age 65*
Profile 2: Retirement de-risker
A common strategy to mitigate against sequence of return risk is to de-risk in advance of retirement to a more conservative allocation. This usually means a shift from equities to fixed income — but what if bonds are challenged to provide sufficient returns? In addition, a downshift after a market decline could expose individuals to sequence of return risk. In this scenario, is an annuity a more attractive alternative for the percentage of equity assets that needs to be reallocated? Based on our analysis, the answer is yes.
For this profile, illustrated in Exhibit 2, we assume that the pre-retiree owns a 60% equity and 40% bond portfolio. The advisor and client have established a 40% equity risk target — so the question is what to do with the 20% in equities that needs to be reallocated at age 55.
We compare the reallocation of that 20% to fixed income vs. a variable annuity with a 65% equities/35% bonds investment strategy.
Likelihood of success: $500k invested vs. partial variable annuity allocation at age 55
Exhibit 2: 20% of portfolio shifts to bonds or annuity at age 55; $45k spending at age 65*
Likelihood of success after 30 years in retirement
Exhibit 3: Various withdrawal rates and asset allocation
Profile 3: Long lifer, inadequate saver
The long-lifer, inadequate saver profile is likely the most ideal candidate for an annuity — a household that enjoys relatively good health, has not saved enough, and has a high likelihood of running out of money. They would benefit especially from an annuity to ensure they will have at least a base level of income, however long they may live.
Longevity risk is the risk of running out of assets before running out of time — and is a primary concern for most Americans. Individuals approaching retirement who have a family history of longevity and who are in excellent health as the result of making good lifestyle decisions are likely to experience above-average life expectancy. If they haven’t saved enough to achieve their desired retirement spending goal with a high level of confidence, they need to maximize the amount of income their wealth can provide for life — however long that may be. And if they need to take out more than 4% of their portfolio initially, it is even more difficult to have money last for a lifetime.
Profile 4: Good saver, fearful spender
The good saver, fearful spender household has successfully accumulated more than enough wealth to cover their spending needs and then some — yet has a difficult time spending any principal out of fear of longevity risk.
The best savers are very good at allocating monthly income between current spending needs and future savings goals, and generally have experienced growing wealth over time. As those households shift into retirement, the idea of depleting their wealth to support their retirement lifestyle can feel daunting. In this situation, an annuity can translate a portion of a portfolio into a consistent level of lifetime income that can be used to enhance the household’s retirement lifestyle.
Our research concludes that annuities can:
- Protect long-lifers, inadequate savers by providing some income that will last as long as they live.
- Provide a periodic payment that can supplement other sources of income like Social Security to enhance the retirement lifestyle with greater confidence.
Spending based on level of retirement income ages 70–75
Exhibit 4: Median annual spending