Doubling up on retirement security
With the dominance of defined contribution (DC) plans in the private workplace, employees bear an increasing share of responsibility for funding their retirement accounts and managing the associated investments. DC plans are now more like "undefined" contribution plans due to elective participation in 401(k) plans. A disturbingly small proportion of workers has the interest, knowledge, skills, or in many cases the extra income to successfully fund retirement. Additionally, while retirement funding has never been simple, today it is positively bedeviling. Rapidly rising healthcare costs, greater need for long-term care (LTC), increasing life expectancies, inflation risk, low investment yields, uncertain futures for Social Security and Medicare, and an increasingly complex investment environment conspire to make even experts sweat the details of how to pay for retirement. The result is that many workers will arrive at retirement age to find that their carefully planned retirement strategy has not produced the desired results or that an unforeseen circumstance decimates or devalues their retirement savings. And many workers have no retirement strategy at all.
This creates a market for insurance companies and financial institutions to develop products that address these risks. In response to market experience, consumer demand, demographic shifts, changes in employer-provided benefits, and so on, providers have continued to pursue innovation in product offerings and structures. Some of these products, such as immediate annuities, have been around for a long time but are being redesigned in response to market shifts. Other products, such as longevity insurance and life insurance/LTC insurance and annuity/LTC insurance combination policies, are relatively new. While this innovation provides choice for retirees and market opportunities for insurers, each has its risks for both parties, as well. In this paper, we look at key areas of risk in today's retirement landscape, the products to address those risks, and how those products are performing from the perspective of carriers and buyers.
Investment risk is the risk that investments will not perform as projected. Most people calculate retirement savings rates and funding targets based on an assumed rate of return. Historically, 8% was often a reasonable rule of thumb for long-term investing; however, that number is commonly moved downward because of the vast changes in financial markets and the world economy. The economic challenges of recent years certainly underscore the difficulty of assuming certain performance. If an individual has a retirement strategy based on an unattainable rate of return, their saving rates are likely to be too low. For persons close to retirement who cannot adjust their strategies to meet new economic realities, this may be an unsolvable problem.
There is a trade-off between investment return and investment risk; consequently, investment risk is hard to avoid. Fixed-yield investments face the risks of low available yields, default, and decrease in value if interest rates rise, while equity investments face the risk of uncertain gains and loss of principal. Only some form of insurance can guarantee a rate of return, but this guarantee will reflect the cost of providing the guarantee. Even an insured guarantee is only as strong as the strength of the insurer; however, state guaranty associations minimize this risk for insurance companies.
U.S. government bonds and FDIC-insured bank CDs provide secure but relatively low returns. Insurance companies provide investment guarantees through deferred annuities, payout annuities, and guarantee floors on variable annuities.
- Deferred annuities: Investment guarantees in deferred annuities generally are for only one year or for a few years.
- Payout annuities: The most comprehensive investment guarantee is provided through either an immediate income annuity or a deferred income annuity (DIA) (also known as longevity insurance). In both cases, although the purchaser sees the guaranteed income, there is an investment guarantee operating behind the scenes.
- Variable annuities: Variable annuities use a variety of mechanisms to provide protection against loss of principal including guaranteed lifetime withdrawal benefits, guaranteed minimum withdrawal benefits, guaranteed minimum income benefits, guaranteed minimum accumulation benefits, guaranteed payout annuity floors, and guaranteed minimum death benefits. Depending on the approach, the payoff may be in the form of guaranteed lifetime withdrawals, a guaranteed annuitization rate, a lump-sum credit to the account value, or a floor on income payments being received. In many cases, the value of the guarantee grows over time.
All guarantees come with a price in the form of a fee to the annuity holder. However, each of these types of annuities provide the advantages of tax deferral, which adds some value to the return.
Challenges related to fixed and variable annuity guarantees
Historically, many companies guaranteed returns of 2% to 6% or more on fixed annuities (which may have seemed conservative at the time). When the recent recession began, interest rates spiked and 5% guarantees were briefly available; however, that quickly gave way to the low interest rates that are currently available. Although fixed annuity guarantees may be relatively attractive in the current market, they are well below what is needed for a long-term retirement strategy. The low rates pose a risk for insurers, too, since an increase in market rates could lead to market value losses if customers choose to cash in their annuities. Fortunately for insurers, lifetime income annuities generally do not allow a cashout; consequently, this risk is limited.
When equity markets turned down, variable annuity guarantees brought great value to contract holders. Insurers who had adequately hedged the economic risk were able to efficiently support the guarantees. Other insurers who hedged the risk of fluctuating reported profit suffered losses in varying degrees; however, they still stood by the guarantees. The current low interest rates make it difficult to either guarantee high fixed annuity interest or provide variable annuity guarantees at the low cost previously offered. In both cases, guarantees have become more modest in order to make them affordable for the insurer. Current interest rates make it difficult to commit to them as long-term investments.
From a retiree's perspective, longevity risk is the risk that one will outlive one's assets. Since expenditures can be cut, it might be viewed as the risk of outliving one's desired lifestyle. Various products are available to provide either full longevity protection or approximate longevity protection. Full protection can be provided through insured products, while approximate protection can be provided through disciplined withdrawals from a retirement portfolio.
Lifetime annuities provide longevity protection because they provide a guaranteed income stream for the lifetime of the annuitant or the lifetime of the annuitant and spouse. This is a form of insurance: in a given pool of annuity holders some will die early and the value that they would have received in lifetime payments goes to fund payments to those who live longer.
The traditional method of longevity protection is the single premium immediate annuity (SPIA) with a lifetime income. With a SPIA, a purchaser gives the insurance company a lump sum in exchange for a guaranteed income stream. SPIAs come in both fixed and variable flavors. SPIAs provide longevity protection because they give holders a payout level that would exhaust a typical retirement fund if the holder lives beyond a certain point. In exchange for the guarantee, the buyer leaves the remaining value to the insurance company in the event of an early death—money that they would otherwise be able to keep as part of their retirement assets. The buyer must weigh the value of longevity risk protection against the cost of the guarantee.
A recent variant is the deferred income annuity (DIA), often referred to as longevity insurance. DIAs enable buyers to lock in deferred payments based on interest rates that prevail at the time of purchase. (This is not to be confused with a deferred annuity, which has a heavy accumulation focus and provides minimal income guarantees.) This simple product provides guaranteed income that kicks in many years later, such as age 85 for an annuity purchased at age 65. The attractiveness of the product is that it provides a lifetime income guarantee from the point where the longevity risk begins to materialize, while it allows the retiree to use the remainder of their retirement fund as a liquid investment account prior to that time. It also relieves the retiree of responsibility of investment management at an age when their interest or ability to manage investments may be limited.
Longevity insurance is relatively inexpensive due to mortality risk sharing and the high mortality at the ages at which it operates. Also, the longer the deferral period, the greater the cost efficiency of the product. Initial sales have been slow, but the product may gain prominence as awareness of longevity risk grows and as financial advisors position it as a small but important part of a retirement plan.
A variable annuity with a guaranteed lifetime withdrawal benefit provides a similar guarantee, although it does not come into play unless the returns on the variable annuity are low. In a sense, a guaranteed lifetime withdrawal benefit (GLWB) is an investment floor of protection denominated in longevity insurance. A guaranteed minimum income benefit provides a similar benefit, although it provides the investment floor through a specific annuity income rather than a guarantee of a withdrawal program. In both cases the guarantee is determined at the issue of the contract, but does not become effective until the owner makes an election.
These guarantees are available not only in a variable annuity that is funding retirement but also in a variable annuity that provides similar benefits in relation to mutual fund investments. In this case the annuity guarantee does not provide any benefits until the mutual fund value has been depleted by the allowed retirement income withdrawals; consequently, it sometimes carries the name contingent annuity. GLWBs are also commonly available with equity-indexed annuities. In this case the lifetime withdrawal guarantee provides the most added value when index-based interest credits have been low.
While the guarantees can be attractive, buyers pay a premium for living benefits on variable and equity indexed annuities. Living benefits are valued in a manner similar to a "put" option on an equity. In this case the insurer is providing an investment floor of protection in the event that the equity underperforms and/or fixed reinvestment interest rates are low. In response, the insurer puts in place a hedge program that covers the put risk.
Challenges related to living benefits
Increasingly sophisticated and generous living benefits were a key driver of variable annuity market growth in the period leading up to the economic crisis. Baby Boomers facing retirement with inadequate savings flocked to products that promised a guaranteed income stream. Insurers could afford to offer these products based on steady and strong investment performance and interest rates that were sufficiently high to keep hedging costs moderate.
Generally speaking, the combination of reduced fund performance, high volatility, and low interest rates makes it exceedingly difficult for insurers to offer the rich guaranteed income products of the past and be able to afford to hedge the resulting risk. In response, carriers have decreased living benefits, increased prices, and in some cases have stopped offering living benefit options altogether. This presents a problem for an industry whose growth was strongly driven by these products, as well as for brokers whose incomes were largely dependent on the commissions associated with variable annuities.
Another potential source of lifetime income is a reverse mortgage. A reverse mortgage is a loan on the equity in one's home that is provided as a lump sum, a line of credit, or a series of payments. Interest on the reverse mortgage is added to the principal balance and is not payable by the borrower until he or she leaves the home. The lien on the home cannot be satisfied by anything other than sale of the home, meaning that the borrower's assets are protected and their heirs are not liable for debts from the reverse mortgage. The vast majority of reverse mortgages are home equity conversion mortgages (HECM) guaranteed by the U.S. Department of Housing and Urban Development (HUD) through the Federal Housing Administration (FHA). When the owner moves or dies, the lender sells the property to pay off the loan. If the selling price exceeds the total payments to the borrower and accumulated interest, the borrower can realize the excess value by the sale of the home. If the sale price is less than the loan balance, the issuer realizes the loss; however, this generally is insured by the FHA.
These products became extremely popular during the housing bubble as homeowners found themselves with high levels of equity even on recently purchased homes. The downside for the issuer and the FHA is that the asset can become devalued. Luckily for lenders (and not so much for U.S. taxpayers), HECM loans are insured by FHA. Because of an uncertain regulatory environment and continued home price declines, some lenders have gotten out of the reverse mortgage market. Still, reverse mortgages remain extremely popular. As part of the American Recovery and Reinvestment Act of 2009, recognized home value limits on FHA reverse mortgages were raised to $625,500, expanding the range of individuals who could benefit from the program. For seniors with substantial home equity who find that their retirement portfolio provides inadequate income, reverse mortgages can greatly increase their standard of living. The market is expected to grow in line with the expanding retiree population, despite declining home values.
A strong majority of reverse mortgages have been line of credit or lump sum borrowings in which most or all of the available value is withdrawn soon after the loan is set up. In that form, reverse mortgages do not provide longevity protection. Another version that provides lifetime income can provide true longevity protection. In either case, it must be recognized that only about 50 to 60% of the home value can be converted into the borrowed amount; the remainder effectively serves as an allowance to cover anticipated interest accruals beyond those covered by home value appreciation.
In lieu of guaranteed lifetime income, some structured withdrawal programs can provide substantial probability that assets will last a lifetime; however, they may not provide certainty of income amount and may have some risk of failure. Investment advisors commonly promote 4% withdrawal programs as an approach to help assure a retiree will not outlive assets. Under this approach, the initial annual withdrawal suggested is 4% of the retirement portfolio and subsequent annual withdrawals would increase 3% or at the actual rate of inflation annually. This provides a high probability of assets lasting approximately 25 years; however, the program may fail if asset values plunge in value in the early years after the program is initiated. It is possible to introduce a hedging strategy into the fund management such that significant losses in any year would be mitigated and the probability of long-term fund adequacy would be increased. Lifetime adequacy can be assured if the program is adjusted downward when significant asset losses have been realized. Of course, the adequacy of the annual income may be compromised with such an adjustment.
Another approach that guarantees continuation of income but not necessarily the adequacy is to take withdrawals in a fashion similar to required minimum distributions from tax-qualified savings. In such a program, an increasing percentage, roughly 1 divided by life expectancy, of the current assets is withdrawn each year. This will guarantee continuation of an annual income throughout a lifetime, but the amount is unpredictable.
Inflation is one of the great killers of retirement savings. Even a small increase in inflation rates can, over time, result in significantly lower living standards in retirement if income cannot keep pace. While central bank policies have recently limited inflation, many observers expect that extremely low interest rates and quantitative easing will result in higher inflation rates in coming years.
Many income annuity products offer the option to increase income in line with inflation, but these options can add substantially to the total cost of annuities. Lifetime income guarantees on variable annuities similarly can provide income that increases to combat inflation, although this means that the initial income will start lower. Inflation protection is particularly important with any solution to the longevity risk, since it will help ensure that the quality of the lifetime income will complement its continuation.
Long-term care risk
With longer lifespans comes increased risk that individuals will need expensive LTC services that are not covered by traditional health insurance. Many retirees remain unaware that Medicare pays very little toward LTC and Medicaid does not pay for LTC unless a person has exhausted their assets, and even then does not pay at a level that will cover more desirable LTC options. These facts create an enormous potential market for LTC insurance. That potential remains largely unfulfilled, largely due to lack of awareness of LTC costs among consumers and a general feeling that LTC funding is something that can be put off in favor of more immediate needs. The market has shown significant growth, but nowhere near what would be expected given the prevalence of LTC use among retirees.
The LTC insurance market has also faced significant challenges recently. Many early LTC insurance products were mispriced, primarily due to lower lapse rates and higher claim rates than were initially assumed. Even more than other retirement products, LTC insurance has a long time horizon, making it difficult to plan for changes in investment performance and interest rates. Mispricing and carrier portfolio declines have led to premium increases for some in-force policies and an exodus of major carriers from the LTC insurance market. New policies are more expensive from the outset to account for assumed claim experience, helping to bolster the sustainability of the products but putting them out of reach for more consumers. Employers offering group LTC insurance as an employee benefit were a major driver of LTC insurance sales growth. The recent economic decline has led many employers to scale back or eliminate such "optional" benefits, further slowing the LTC insurance market.
LTC combination products
Life insurance/LTC insurance and annuity/LTC insurance combination products are one potential bright spot. These products provide that the early costs, e.g., for two years, are covered by drawing down cash values in the underlying product, and the subsequent costs are covered in a fashion like traditional LTC insurance coverage. This provides cost savings to the purchaser because the true LTC coverage does not begin for a significant period of time, while the insured person has prefunded the early costs. As opposed to pure LTC insurance policies in which many policyholders will see no benefit from their premiums, combination products provide a death benefit to survivors even if LTC benefits are not used, and a smaller residual death benefit if LTC benefits are used. Inflation protection is an option on some of these products, but this is both expensive and less important to older buyers.
LTC and CLASS Act
A section of the Patient Protection and Affordable Care Act of 2010 ("healthcare reform") known as the Community Living Assistance Services and Support Act (CLASS Act) is currently a source of considerable uncertainty in the LTC insurance market. The CLASS Act is essentially a government-sponsored LTC insurance program that provides a partial LTC benefit to those who join the program. Many observers have commented that because, among other deficiencies, the CLASS Act combines guaranteed issue with voluntary participation, it is likely to face significant funding difficulties. Voluntary guaranteed issue programs enable people to join the program when they are most likely to need benefits without paying into the program for any length of time. LTC insurance carriers are eagerly awaiting government clarification on the CLASS Act. If the program is changed to enhance its viability, it may offer private carriers the opportunity to sell wrap-around policies. However, it is also possible that the CLASS Act will essentially compete with the private market.
Buyers seek simpler, more transparent retirement risk solutions
Workers wanting to have a secure retirement face growing risks and uncertainties. Insurers and financial institutions have not sat idly by. They have aggressively created innovative products to meet market demand for solutions to retirement risks.
One problem across most retirement products is overly optimistic initial pricing relative to the benefits offered. Insurers did not account for the risk of a major economic downturn such as the recent recession in which both interest rates and equity market returns would remain low for extended periods. It has been and will continue to be difficult to estimate consumer behavior on new products. Whether consumers optimize benefit value or use the product inefficiently can greatly affect the cost to the insurer. The long time horizons inherent in retirement-related products also make pricing difficult. The results have been poor profits for insurers and unpleasant surprises for buyers. The hope is that both insurers and consumers have learned from these events.
More realistic pricing means that many products such as lifetime benefit annuities and LTC insurance are not as attractive as they once were. Products that are less complex and less expensive—such as SPIAs and longevity insurance—may be more attractive to today's consumers, although these products are vulnerable to low available investment yields. Products that provide additional value such as life/LTC and annuity/LTC combination products are also of increasing interest. In the long run, a product that is properly priced provides long-term sustainability in exchange for short-term profits.
From the perspective of retirees, new products offer the ability to protect assets and hedge against various types of risk, but there are tradeoffs inherent in all of them. Ultimately, the necessary starting strategy for consumers is to start saving early and continue prodigiously. Out-of-plan products can then address specific retirement risks.
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Long term care funding and insurance opportunities
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