GENERATING INCOME FOR LIFE

Transcription

1 GENERATING INCOME FOR LIFE larry norman 1 1 President of Financial Services Group, he obtained his first degree and Master s at the University of North Iowa. He joined Aegon Life Investors in 1987 and worked as chief executive of Marketing in the industrial Division, now par tof Aegon Financial Partners. He also supervises the operations of Transamerica Capital Inc. and the Extraordinary Markets Division. 245

2 INTRODUCTION To understand the concept of converting assets into a flow of income, it is useful to think of the analogy of climbing a mountain. What is the first objective you have in mind when proposing to climb a mountain? Some might say that the main objective is to reach the summit of the mountain, to admire the view. In fact, much of the planning for the retirement stage is approached in just that way. Many people s idea is to concentrate on saving as much as possible until the last day they can, and then to spend it during the rest of their lives. However, if you asks a mountaineer about his objective, the first thing he will come out with is: to get down the mountain safely. Although it may seem odd, 80% of climbing accidents occur when coming down from the summit. This is the real meaning of planning income for retirement: to ensure that we can retire without contretemps in the future. One of the biggest risks for people when they retire is building a flow of income that means they will never be short of money. In this document, we will try to show some of the risks in that process that people will face when they retire. Furthermore, we shall show how variable life annuities with a guaranteed income flow can help to mitigate those risks. To do this we shall explore three concerns that we all need to bear in mind, because they may affect our retirement fund. We shall explain below what is meant by a variable life annuity and how it works. Then we shall see how the U.S. life annuity market has been behaving. Finally, we shall comment on some of the future innovations that may serve to build up a flow of income that is guaranteed for life. 246

3 PENSIONS for the future: DEVELOPING INDIVIDUALly FUNDED PROGRAMS GENERATING INCOME FOR LIFE larry norman THREE COMMON CONCERNS ABOUT RETIREMENT a. Longevity risk The first point that should concern us is what is known as longevity risk. This is the risk of a person living longer than was planned. Although it may sound somewhat gloomy, in fact it should be understood as good news in disguise. The reason is the following: it is a fact that most people underestimate the time they expect to live. This means that it is highly likely that you will live longer than you thought, but it also means that the funds you had saved for your retirement may not be enough. People underestimate their lifetime, because they tend to look at life-expectancy in the United States and think that they will live to a particular age. The problem with this is that life expectancy is calculated for a new-born baby. Once a person has got to age 65, he/she has already bypassed most of the major mortality risks of childhood. The average life-expectancy for a man or woman who is already 65 is 85 and 88 years, respectively. In other words, half the people of age 65 will live beyond those ages and some far beyond. b. Inflation risk The following risk is inflation, meaning basically that the real value of your retirement fund is substantially reduced by inflation. It does not matter what the nominal returns may have been on having invested in bonds, stocks and shares or any other financial asset. What matters are the real returns, in other words, after deducting the effect of inflation on the real spending capacity of those returns. As may be seen in Figure 1, the yields of financial assets such as shares, bonds or cash are affected by inflation. The central point in this is to remember that inflation can affect one s retirement plans. Forty thousand dollars at today s value will not buy the same in ten years time. 247

4 Figure 1 RETURNS BEFORE AND AFTER INFLATION ( ) % Nominal Return (before inflation) Real Return (after inflation) 8 7.2% % 6 5.4% % 3.7% Shares Bonds Cash 0.7% SOURCE: THE AUTHOR c. Volatility risk in withdrawal rates The other risk that must be taken into account, although it is less well-known, is the withdrawal-rate risk. This is the risk that may be caused by a poor market performance in the early retirement years, which leads to less ability to withdraw money in a consistent manner. Figure 2 shows the maximum rates that could historically have been withdrawn during different thirty-year periods, which represent hypothetical retirement horizons. To make the exercise more interesting, three types of investment portfolio are proposed: one slanted towards shares, one slanted towards bonds and the last one balanced. As may be seen in Figure 2, the amount of funds available for retirement depends heavily on the date when one retires. Variable life annuities offer the possibility of guaranteed growth and withdrawal-rate options that can smooth out the inconsistencies seen on this graph. 248

5 PENSIONS for the future: DEVELOPING INDIVIDUALly FUNDED PROGRAMS GENERATING INCOME FOR LIFE larry norman Figure 2 SUSTAINABLE WITHDRAWAL RATES VARY OVER TIME % % shares / 25% bonds 50% shares / 50% bonds 25% shares / 75% bonds SOURCE: THE AUTHOR A POSSIBLE SOLUTION: VARIABLE LIFE ANNUITIES It is important to remember that variable life annuities are long-term financial vehicles. If there is a possibility of the person s needing a substantial part of his/her fund in the short or medium term, then this is probably not the most appropriate financial instrument for that person. They are designed to serve during the retirement stage, especially to provide a guaranteed income for life. If we go into details, a life annuity is a contract between a person and an insurance company. One has to pay the company a premium - either in one single payment or in a series of annual quotas - and in exchange the company agrees to provide a series of payments, as from a certain age. These payments, which are based on a percentage of the assets that one accumulates, are guaranteed, come what may. In a variable life annuity, the investment of the funds is placed in underlying investment portfolios (sub-accounts) that will produce variable returns over time. For example, the investment is made in shares, bonds or money market instruments. All these instruments have variable prices and the invested fund can therefore increase or decrease. In this sense, it is as though it were a mutual fund that is subject to market fluctuations, investment risk and even the loss of part of the 249

6 capital of the investment. However, unlike a mutual fund, the person is not forced to pay capital gains tax. The principal and interest of this investment are not subject to tax and may therefore be a better investment alternative. Another distinctive feature is that the death benefit is guaranteed as soon as one signs the contract. Therefore the heirs will be able to receive these payments in the event of the death of the owner of the premium. In a survey on the needs of clients who are reaching their retirement stage, it was shown that the factors that matter to them most were: (i) to have flexibility of access to their funds; (ii) that it should be possible for the fund and income to grow; (iii) that they should be protected against the risks of living longer than expected, of higher inflation or of great volatility. One product that includes these factors is the so-called guaranteed minimum withdrawal benefit (GMWB) which has been included in this product that we call Five for Life. The way of responding to these concerns is by means of a standard product that makes it possible to withdraw 5% of the fund, but in a form that is guaranteed for life. This payment continues to be made, even if the funds run out. It only ceases to be paid if the owner of the policy dies. In this way, any problem of living longer than expected is avoided, and the impact of market fluctuations that may reduce the value of the saved funds is eliminated. To make the product more attractive, if the value of the investments increases in the future, then the guaranteed income also increases for life. Finally, in order to protect people against the risk of low returns and a short life, a guarantee has been introduced which states that the fund will return to the inheritable estate on the death of the policy-holder. As is inevitable, the client pays a higher premium for these extra benefits. The cost is totally transparent, unlike many other products in the past (structured products, for example, in which rights to future dividends were lost, or the capital lost if certain conditions were not met). This higher price reflects the additional benefit that clients receive from policies of this type. THE VARIABLE LIFE ANNUITY MARKET IN THE UNITED STATES In Figure 3, it is possible to see the recent developments in the variable life annuity market, compared with the mutual fund market in the United States. Both have had a similar behaviour, though clearly the mutual fund market is almost six time larger. The net sales (i.e. of new contracts) are clearly rising. Together with that process, there has already been a significant renovation process in the types of instrument used. 90% of variable life annuities offer some type of guarantee, compared with 250

7 PENSIONS for the future: DEVELOPING INDIVIDUALly FUNDED PROGRAMS GENERATING INCOME FOR LIFE larry norman 63% of the contracts that were offering life-time benefits, just two years ago. It is important to point out that in the last twelve years the product has changed significantly. Initially, policies were offered with the guaranteed minimum income benefit (GMIB), but they had the problem that they insisted on a waiting period of five to ten years. Then policies were introduced that protected the invested funds against market fluctuations. These were called guaranteed minimum accumulation benefit (GMAB). Finally, a withdrawal rate was guaranteed and then policies with guaranteed life-time withdrawal benefit (GLWB) were introduced. Figure 3 VARIABLE LIFE ANNUITY ASSETS IN UNITED STATES COMPARED WITH LONG-TERM MUTUAL FUNDS 1,600 US$ thousand million 9,000 1,400 8,000 Variable Life Annuity Assets 1,200 1, Variable Life Annuity Assets Long-term Mutual Fund Assets ,000 6,000 5,000 4,000 3,000 2,000 1,000 $0 Long-term Mutual Fund Assets SOURCE: AUTHOR INCOME GUARANTEES OR LIFE ANNUITIES? One of the most frequent questions in this market is which of the two alternatives is better: a life annuity or an income guarantee. A central aspect in this discussion is the impact produced by the so-called immediate life annuities, which have become very popular and are the closest rival of the variable life annuities. Given that the latter offer a minimum income with the increasing potential of the investments in securities, it is hard to imagine that immediate life annuities can be a serious competitor, since they only offer a cost of living adjustment of between 3 251

8 and 5%. But all these considerations are subject to the environment of the financial market. If the stock market shows a solid upward trend, nobody cares about having a guaranteed income. This situation changes completely when the market becomes more uncertain and the rates of return offered by the market become more volatile. Volatility is the best proponent of the need to seek protection. As clients retire in a more uncertain environment, there is increased demand for securities with protection against a slump and with potential for growth. Furthermore, an environment of low interest rates stimulates interest in securities and investments with higher returns, such as variable life annuities with the option of a life-time guaranteed withdrawal benefit and a withdrawal rate of 5%. The risk always associated with investment in securities can be mitigated with investment in variable life annuities that offer guaranteed protection. However, these financial products will continue to develop over time, and that same development will make it possible to expand the market to the extent that the products offered approximate more to the various needs of a multiplicity of clients. For example: the variable life annuity contracts will have lower costs and will be easier to understand, there will be more flexible options for disbursement of income, or there will also be conjugal income options. Another interesting option is to combine existing products, such as acquiring a life annuity and benefits in life. In general, what can be anticipated is that this type of income guarantee will begin to be used with other products, such as mutual funds, separate accounts, managed accounts, fixed life annuities, deposit certificates and pension plans. In every case, the aim will be to meet the client s needs. On the basis of this premise, this market will continue to develop with increasing strength. The aim is to have a wide menu of options, so that clients can always find the product that best meets their needs and their demographic characteristics. The two central messages are: a. Products must give the client the chance of more options and greater control. Clients want the flexibility to find the product that best suits them. b. The product must make clients remain in the market, even when they perceive that they no longer wish to do so. This is achieved by having a product that is easy to understand, which means that people will buy it for the rest of their lives. 252