The Handbook of Variable Income Annuities

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1 The Handbook of Variable Income Annuities JEFFREY K. DELLINGER John Wiley & Sons, Inc.

3 The Handbook of Variable Income Annuities

4 Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in North America, Europe, Australia, and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers professional and personal knowledge and understanding. The Wiley Finance series contains books written specifically for finance and investment professionals as well as sophisticated individual investors and their financial advisors. Book topics range from portfolio management to e-commerce, risk management, financial engineering, valuation, and financial instrument analysis, as well as much more. For a list of available titles, visit our Web site at

5 The Handbook of Variable Income Annuities JEFFREY K. DELLINGER John Wiley & Sons, Inc.

6 Copyright 2006 by Jeffrey K. Dellinger. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, 222 Rosewood Drive, Danvers, MA 01923, (978) , fax (978) , or on the web at Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) , fax (201) , or online at Limit of Liability/Disclaimer of Warranty: While the Publisher and the Author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the Publisher nor the Author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information about our other products and services, please contact our Customer Care Department within the United States at (800) , outside the United States at (317) , or fax (317) Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at Jeffrey K. Dellinger is president of Longevity Management Corporation. He is a Fellow of the Society of Actuaries and a member of the American Academy of Actuaries. The viewpoints expressed herein are those of Longevity Management Corporation, not of the latter two professional actuarial organizations. Library of Congress Cataloging-in-Publication Data: Dellinger, Jeffrey K. The handbook of variable income annuities / Jeffrey K. Dellinger. p. cm. (Wiley finance series) Includes index. ISBN (cloth) ISBN (cloth) 1. Variable annuities. 2. Retirement income. I. Title II. Series. HG8790.D dc Printed in the United States of America

7 To Robert and Margaret Dellinger, my parents and To Orvis and Clela Dellinger, my grandparents

9 Contents Preface Overview xiii xxi CHAPTER 1 Retirement Income Basics 1 A Game 1 Your Retirement 2 Self-Management 2 Fixed Annuities 3 The Game Revisited 4 Fixed Annuities Revisited 6 Variable Annuities 7 Shortcoming of Simplified Retirement Income Projections 11 Shortcomings of Traditional Retirement Income Approach 14 Retirement Income Basics Summary 15 CHAPTER 2 Annuity Categorization 17 Deferred versus Immediate Annuities 17 Life-Contingent versus Non-Life-Contingent Annuities 18 Tax-Qualified versus Non-Tax-Qualified Annuities 18 Summary 19 CHAPTER 3 Immediate Fixed Annuity Mechanics (Non-Life-Contingent) 21 Approach 21 Fixed Annuity Payout 22 Immediate Fixed Annuity Asset-Liability Management 23 Duration 28 Duration Example 34 vii

10 viii CONTENTS CHAPTER 4 Immediate Variable Annuity Mechanics (Non-Life-Contingent) 39 Approach 39 Annuity Units 43 Varying the AIR 48 Volatility of Variable Annuity Income 51 Immediate Variable Annuity versus Systematic Withdrawals 52 Reverse Dollar Cost Averaging 55 Owner Control after IVA Purchase 56 CHAPTER 5 Annuity Payout Options 59 History 59 Annuity Options 60 Considerations in Selecting an Annuity Option 66 Immediate Variable Annuity Prospects 72 Value Equivalence of Annuity Options 74 CHAPTER 6 Annuitant Populations and Annuity Present Values 77 Categorization and Characteristics 77 Population Mathematics 79 Annuity Mathematics (Life-Contingent) 86 Annuity Mathematics (Non-Life-Contingent) 88 Annuity Mathematics II (Life-Contingent) 101 Alternate Derivation of Approximation Formula for Present Value of Annuities Payable More Frequently than Annually 114 Continuous Life-Contingent Annuities 119 Varying Life-Contingent Annuities 121 Population Theory 143 Mortality Improvement 147 The Aging Process 160 Aging Theories, Biomarkers, and Telomeres 165 Force of Mortality 167 Mortality Laws 170 Mortality Tables 173 Mortality Table Construction 178 Considerations in Mortality Table Selection 190 Formula-Based Mortality Tables 198 Law of Large Numbers 201 Life Expectancy 203 Age Distribution Histograms 218

11 Contents ix Mortality Table as Survivorship Model 221 Stationary Population 222 Multilife Annuities 227 Last Survivor Annuities 230 Contingent Annuities 234 Reversionary Annuities 236 Last-Survivor Annuity with Pop-Up Provision 241 Increasingly Important Concept in Tough Economic Times 242 CHAPTER 7 Immediate Variable Annuity Subaccounts 249 Overview of Subaccounts 249 Typology of Variable Annuity Subaccounts 253 Number of Subaccounts and Considerations in Subaccount Selection 256 Modern Portfolio Theory 260 Capital Asset Pricing Theory 263 Total Market Risk versus Security-Specific Risk 264 Random Walk 266 Investment Risk 267 Academic Research and Its Practical Implications for Retirement Income 269 CHAPTER 8 Rate of Return 277 Definition 277 Early Deaths and Late Deaths 278 Annuiland Example 279 Rate of Return Example Using Realistic Mortality Rates 281 Annuity Present Value Distributions 283 Annuity Present Value Appraisals 289 Benefit of Investment versus Benefit of Survivorship 290 Rate of Return Methodologies 294 Rate of Return and Inflation 295 Deflation 297 Rate of Return and Taxes 298 CHAPTER 9 Reserves and Risk-Based Capital 299 Reserves 299 Risk-Based Capital 303 Reserve Laws and Guidelines 306

12 x CONTENTS Mortality Adjustments 309 Immediate Variable Annuity Reserve Calculations 313 Reserve Effect Introduced by Offering Multiple Subaccounts 318 Use of Statutory Immediate Variable Annuity Reserves in Product Design 322 Substandard Annuity Reserves 323 Insurance Company Absorbs Risks 325 Risk Measures Aid in Capital Requirements 328 Risk Measures 328 Risk Measures and Economic Capital 329 CHAPTER 10 Immediate Variable Annuity Taxation 333 Immediate Variable Annuity Income Taxation 333 Use of Immediate Annuities to Avoid 10% Penalty Tax on Premature Distributions 337 Estate Taxation 338 Gift Taxation 340 Premium Tax 341 DAC Tax 342 Tax Incentives 349 CHAPTER 11 Services and Fees 353 Service Features 353 Product Fees and Charges 354 Insurer Perspective: Variable Income Annuity Expenses 358 CHAPTER 12 Product Distribution 363 Financial Advisers 363 Distribution Chain 369 IVA Pricing Optimization Process 370 Wholesalers 372 Sample IVA Wholesaling Story 376 Unbundling 379 IVA Illustrations 381 Buyer Demographics 382 Three-Legged Stool 400 Looking to the Future 401

13 Contents xi Comparison Indexes and Disclosure 403 Uncertainty 406 CHAPTER 13 Individual Immediate Variable Annuity Underwriting 411 Standard Life Underwriting 411 Substandard Life Underwriting 412 CHAPTER 14 Legal Issues 421 Unisex Rates 421 Separate Account Insulation 425 Tontines 428 Nonforfeiture Laws 429 Variable Annuity Contract 429 IVA Contract Provisions 432 IVA Contract Administration 433 Suitability Questionnaire 435 Compliance Costs 435 Market Conduct 436 Intellectual Property 437 Partial Annuitization 438 Privacy 438 Status of Immediate Annuities in Creditor Attachment and Assistance Program Qualification 439 CHAPTER 15 Securities Law 441 Federal Securities Law 441 State Securities Law 446 Organizational Structures of Variable Annuity Issuers 447 Administrative Impacts 450 CHAPTER 16 Forms of Insurance and Insurers 453 Insurance versus Gambling 453 Utility Theory 454 Private Insurance versus Social Insurance 461 Defined Benefit Pension Plans 463 Types of Insurance Organizations 465 IVA Company Organizational Structure 466

14 xii CONTENTS CHAPTER 17 IVA Business Value to Annuity Company 473 Sample Model 473 Example 475 Interplay of Pricing, Reserving, and Risk-Based Capital 483 Immediate Annuity Value Creation 487 CHAPTER 18 Product Development Trends 489 Product Variations 489 Payout Floor Guarantees 491 An Introductory Lesson on Options 504 Liquidity 544 Income Stabilization 552 Other Product Development Possibilities 554 Comments on Product Variations 555 Stochastic Modeling of Mortality 558 Life Annuity Mortality Risk Securitization 558 Proprietary Products 561 Annuity Writers Strategic Bases of Competition 563 CHAPTER 19 Conclusion 565 Appendixes 575 Quotable Wisdom Regarding Longevity 715 Notes 717 Glossary 741 About the Author 743 Index to Notation 745 Subject Index 747

15 Preface Individual retirement security is a multifaceted subject of great importance. The unstoppable demographics of a large number of U.S. citizens transitioning from the accumulation phase of their economic lives to the distribution phase, the lessening percentage of workers covered by defined benefit pension plans, and the uncertain future of a U.S. Social Security program where relatively fewer workers must support relatively more retirees prompt the need for greater private-sector focus on retirement security. Excellent product vehicles already exist to help individuals achieve retirement security on a basis greater than they could achieve by themselves. Such solutions are used today only to a minuscule degree relative to their potential. Several reasons account for this. First, the mere existence of such solutions is not well known to the average retiree or average individual transitioning toward the years where drawing income from accumulated assets will begin. Second, individuals are properly apprehensive about employing specific retirement income solutions because they ve worked decades to amass their nest eggs; they want to avoid any mistakes that could cause them to need to return to work during advanced years when they would prefer not to do so or might be physically unable to do so. Third, financial advisers must feel comfortable enough with such solutions to explain them to clients; and such solutions must be congruent with financial advisers need to receive ongoing compensation for providing ongoing counsel. Individuals must make very real decisions regarding such factors as: Flexibility to change their retirement security program as their needs and situations change. Accessibility to their accumulated assets. Ability of their funds to provide income as long as they live, regardless of how long that is. Preferability of a stream of retirement income known with complete precision at the start of their income period the stream may be level xiii

Risk Management and Financial Institutions

Risk Management and Financial Institutions Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in North America, Europe, Australia and Asia,