Perspective on annuities for accumulation in defined contribution plans

12 Pages·2017·0.21 MB·English

Perspective on annuities
for accumulation in defined
contribution plans
Vanguard Commentary May 2017
Craig M. Gross, CFA, and Jonathan R. Kahler
■ 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.
Introduction Partial annuitization at retirement
Three long-term, well-documented trends complicate Annuities might play an important role in a retiree’s
investors’ ability to manage the risk of outliving their investment strategy. By guaranteeing a stable stream
retirement savings. First, people are living longer and of lifetime income, they can hedge longevity risk and
must therefore make their assets last longer. Second, simplify investment decision-making later, when the
with diminishing access to guaranteed income through risk of cognitive decline rises rapidly.
employer-sponsored defined benefit plans, today’s
investors must increasingly determine for themselves Neither of these risks is trivial. On average, today’s 65-year-
how best to protect against longevity risk (see Figure 1). old retirees should expect to live well into their eighties.
Third, most defined contribution plan assets do not result A married male/female couple retiring at age 65 has
in a direct income source, leaving investors to manage approximately a 50% likelihood of at least one spouse
their own income generation without the benefit of risk living to age 92 (Society of Actuaries, 2014). Vanguard
pooling. As investors deal with these issues, the industry research demonstrates that a prudent, dynamic withdrawal
seeks to offer solutions. strategy significantly reduces the likelihood of portfolio
depletion. However, it eliminates neither that risk nor
An important distinction must be made between the risk that a retiree will have to decrease his or her real
accumulating retirement savings in annuities and using spending level (Jaconetti et al., 2016). On the other hand,
them to provide income in retirement. Retirees may find by purchasing an annuity, investors can set a floor for their
it prudent to annuitize a portion of their assets to gain income and ensure that this income is sustained for as long
protection against longevity risk and the risk of cognitive as they remain alive. Several studies demonstrate that
decline. However, several considerations temper the partially annuitizing assets can improve the sustainability
case for doing so while in the accumulation phase. In of a retirement income strategy (Ameriks, et al., 2001).
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.
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, 2015. 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.
2
Figure 1. Increasing life expectancy, decreasing defined benefit pension access
s
fit 80% 85
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e
b
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e 80
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efi 60 nc
d a
g ct
eivin 75 expe
s rec 40 70 Life
nt
a
p
ci
arti 20 65
P 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013
Life expectancy of 65-year-old male
Life expectancy of 65-year-old female
Percentage of pension participants who receive defined benefits
Sources: Department of Labor and Center for Disease Control.
Transforming liquid assets into a stable income stream using other assets. Plan sponsors can provide guidance
can also protect against the risk that cognitive decline to participants and potentially offer access to institutional
will impair financial decision-making in advanced age. pricing advantages (Blanchett, 2016).
Several studies have shown that the risk of an individual
experiencing impaired decision-making ability rises after Income annuities are a form of insurance and are not
age 60 (Finke, et al., 2015). This has implications for right for everyone. Investors must determine whether
investors ranging from reduced ability to manage the the value of the protection they offer outweighs their
risk of depleting assets to increased susceptibility to cost, tax, and liquidity implications (Ameriks and Ren, 2008).
financial scams and elder fraud. Annuities may not be appropriate for investors who have
good reason to believe they will not live beyond average
As investors near retirement, they should consider how life expectancy, who are of poor health, who cannot afford
much guaranteed income they desire. Next, they should the purchase, or who are seeking to preserve liquid assets
determine the extent to which sources of income earned to cover possible long-term care expenses or to provide
in their working years—namely Social Security benefits for an inheritance. Investors whose Social Security and
and defined benefit pensions—will satisfy their need. If other pension income is expected to cover the bulk of
they require additional guaranteed income, they should nondiscretionary retirement spending also may have little
consider purchasing an immediate or deferred annuity. use for additional guaranteed income. Although partial
This can be done within an employer-sponsored plan or annuitization could serve some retirees well, we caution
against viewing it as a default solution.
3
In addition to generating or distributing income in Figure 2. Variable annuity costs
retirement, annuities are also offered as accumulation
vehicles embedded in defined contribution plans. In the
300
next two sections, we outline key considerations for
s) Percentiles
doing so. nt key:
oi
p
s 200 95th
si
a
Variable annuities in defined contribution plans s (b 75th
Traditionally, a selling feature of variable annuities in ost Median
c 100 Average
individual investment accounts has been their preferential ual 25th
tax treatment. Investors who face relatively high capital n
n
A
gains and dividend tax rates may benefit from sheltering 5th
0
taxable assets in a variable annuity with low expenses.
Index Active Total Total
However, this feature has no value to investors in a subaccount subaccount insurance net
expense expense expenses expenses
defined contribution plan, because the plan’s preferential
ratio ratio
tax treatment already provides tax-deferred growth.
Notes: Figure includes data from all United States group retirement plan annuities
The costs of administering employer-sponsored and group variable annuities. Distribution of total insurance expense is calculated
at the annuity program level; all other categories are calculated at the subaccount level.
retirement plans can be significant and are largely a
Source: Vanguard calculations, using data from Morningstar as of November 3, 2016.
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
Along with the investment costs, plan sponsors should
costs that might be passed on.
evaluate the benefits of various plan structures and
whether they can meaningfully help participants reach
Depending on the type of plan and how it’s designed,
their retirement goals. Variable annuity contracts that
a choice between mutual funds or group variable
include insurance charges typically provide some kind of
annuities may not make any difference in terms of
death benefit. In the accumulation phase, death benefits
investment costs. Comparing the two is complicated by
vary by contract but are typically limited to shielding
differences in how their expenses are reported. Group
beneficiaries from market exposure after the death
retirement annuities often bundle expenses, whereas
of the account owner. They may guarantee some
mutual funds list fund expenses (expense ratios)
additional compensation if the account value at the
separately from administrative and other costs. Even
time of the owner’s death is less than his or her
so, variable annuities do have a reputation for high costs.
total net contributions minus prior withdrawals and
As shown in Figure 2, this can be attributed to their often
costs. Because the assets are intended to cover long-
actively managed subaccounts and insurance-related
term retirement savings objectives, such protection
expenses. Index funds have become increasingly popular
against short-term market fluctuations has limited
with investors. However, about 92% of the subaccount
value relative to insurance expenses.
offerings listed in Morningstar’s database of group retire-
ment annuities and group variable annuities are actively
Plan sponsors are encouraged to consider the overall
managed. These investments carry expenses that are, on
expenses borne by participants for plan features. All
average, 56 basis points higher than passively managed
else being equal, lower-cost features such as index
options. And insurance costs, typically labeled mortality
mutual funds might enable investors to keep more of
and expense (or “M&E”) charges, can be significant
their returns, enabling superior long-term portfolio growth
if applicable.
relative to those group annuity structures with relatively
higher investment and insurance expenses.
4
Whatever their source, investment costs can erode Fixed annuities as savings vehicles
a participant’s ability to accumulate wealth. Just as
A participant’s decision about whether and how much to
investment returns compound over time, so does
invest in a fixed annuity depends on a relatively complex
the effect of asset-based expenses. Figure 3 shows a
set of trade-offs. We provide perspective on several
hypothetical scenario demonstrating the potential effects
important considerations below.
of investing in higher-cost products over time. In it, we
compare the outcomes of investments with costs varying
Flexibility
from 20 to 160 basis points. The investor is assumed to
Assets in fixed annuities are generally less portable than
earn $65,000 in year one of employment and a 1% real
those in mutual funds. Investors who do not wish to
increase in each subsequent year over a 40-year period.
initiate an income stream or need to change their
The investor saves 10% of her income (including an
investment strategy might be restricted from moving
employer match) each year, and both products are
some or all of their savings. Depending on contract or
assumed to earn an annual real return of 4% (gross
plan rules, they may have to access their assets through
of expenses).
periodic payments that could stretch for ten years or
more. In some cases, lump-sum payouts are subject to
As the figure illustrates, higher expenses can have a
significant surrender charges. Plans seeking to avoid such
substantial effect. Over a 40-year period, the highest-cost
restrictions may be able to relax the rules, but this will
product results in $178,656 less savings than the lowest-
likely affect annuity crediting rates, providing greater
cost option, all else being equal. Although an annual cost
flexibility at the expense of lower returns.
of 1.6% may seem small, it could represent more than
29% of potential market gains given up to expenses
over time.
Figure 3. Lower investment costs mean investors keep more of their returns
$250,000
s
st
o
c
nt 200,000
e
m
st 150,000
e
v
n
ed i 100,000
d
n
u
po 50,000
m
o
C
0
10 years 20 years 30 years 40 years
20 basis points 100 basis points
40 basis points 120 basis points
60 basis points 140 basis points
80 basis points 160 basis points
Notes: The dollar amounts shown are hypothetical and do not reflect any particular investment. There is no guarantee that investors will be able to achieve a similar rate
of return or cost savings. Costs are one factor affecting total returns. There may be other material differences between products that must be considered prior to investing.
Source: Vanguard.
5
Longevity protection versus liquidity products within a plan, sponsors could offer access to
Investors lacking a strong conviction that they will need annuities outside of the plan, through IRA rollovers
additional longevity protection in retirement might also at or in retirement.
want to avoid accumulating in an annuity. Most defined
contribution participants will already have at least one These offers (such as Vanguard’s Annuity Access
form of longevity protection in the form of Social Security. Program) may give investors access to a wider range
During the accumulation phase, it may be very difficult to of features. They can also reduce costs and eliminate
assess how much additional guaranteed income will be sponsors’ fiduciary duty to properly vet insurance
needed in retirement. It may be nearly impossible to providers of in-plan annuities. ERISA regulations require
predict the answers to questions such as these: How sponsors to conduct thorough, analytical searches that
much income will I need in retirement to cover basic consider, among other variables, an insurance provider’s
expenses? What will change in my health and life ability to make all future payments and to then monitor
expectancy, and will I ultimately anticipate a long the provider over time (Canary, 2015). Out-of-plan annuity
retirement? Will I amass sufficient wealth relative to offers involving IRA rollovers do not subject plan sponsors
my spending needs to drastically minimize the risk of to this responsibility.
asset depletion? What level of portfolio liquidity will I
need in retirement? Because the guaranteed income Costs
base (if any) a retiree may eventually need is very hard Annuities are generally more expensive than mutual
to predict, delaying decisions about purchasing protection funds, and higher costs can considerably erode long-
might be prudent. term portfolio growth. Fixed annuity charges generally
do not need to be disclosed in detail. Instead, the rate
Buying an annuity represents a trade-off between of return credited to an account or the payout offered
longevity and liquidity risks. The annuity establishes an in retirement is often quoted net of expenses. However,
income stream that cannot be outlived. However, the insurance companies might still assess fees associated
money used to purchase this protection is no longer with administration and actuarial costs. If so, the fees
available for other uses, which introduces liquidity risk. assessed on investors who choose not to receive
Too little longevity protection may compromise a retiree’s payouts in retirement offset the expenses incurred
ability to cover daily living expenses at an advanced age. by retirees who do elect the annuity stream. For
Conversely, too great a reduction in portfolio liquidity may participants who accumulate in an annuity without a
leave investors vulnerable to unforeseen expense shocks strong intent to eventually initiate a guaranteed income
in retirement and also reduce the wealth available for stream, this transfer of value could be disadvantageous.
a bequest. Annuity prices vary substantially, and participants may
have access to institutionally priced in-plan annuities
The trade-off also has implications for plan design. A with lower costs than those available in the retail market.
participant who contributes too much to an annuity may Ultimately, the costs should be weighed against the
unintentionally create a liquidity crisis in retirement. This potential benefits and eventual longevity protection that
risk is heightened by the difficulty of predicting how much an annuity can offer.
longevity protection and liquidity will be necessary. As
an alternative to offering annuities as accumulation
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Stable growth and interest rate sensitivity Looking ahead, the Vanguard Capital Markets Model has
Fixed annuities used in the accumulation phase typically projected the probability of experiencing negative one-,
offer principal protection and stable growth. Although three-, and five-year annualized returns over the next 40
contributions’ rate of growth may vary with interest rates, years in a globally diversified, investment-grade bond
a set floor ensures that returns do not fall below a specific, portfolio, as shown in Figure 4. Although the current
positive threshold. This could lead investors to view an low rate environment makes negative returns more likely
annuity as an attractive alternative to a long-term, well- than in the past, the risks are still modest, especially
diversified fixed income mutual fund. By masking the over the longer term.
effects of interest rate volatility on the market prices of
the underlying fixed income portfolio, the stable growth Another possible benefit of interest rate volatility is the
feature may increase a participant’s ability to stay link between the rates when contributions are made
committed to an investment strategy. and at the time of the eventual payouts. By buying
into an annuity over time, investors could hedge the
However, the usefulness of this characteristic may risk that interest rates will fall substantially as they
be limited by the nature of long-term, well-diversified near retirement, making the payout rates for annuities
fixed income strategies. Since the inception of the purchased at retirement less favorable. This could
Barclays Aggregate Bond Index in 1976, only about 8% essentially be viewed as a form of dollar-cost
of 12-month returns have been negative, and the index averaging, with similar benefits. Clearly, for this
has never recorded a negative return over any five-year feature to have economic value, interest rates
period. Its maximum drawdown of –12.74% in February must fall over the accumulation period; rising
1980 was one of only five drawdowns greater than 4%. rates would have the opposite effect.
No drawdown period has lasted for longer than 16 months.
In other words, bear markets for well-diversified, high-
quality bond portfolios are generally shallow and
short-lived (Philips et al., 2013).
Figure 4. Bond portfolio return probabilities
s 100%
on The projected likelihood of a negative
cti 12-month return is 20.5%.
oje 80
y pr The projected likelihood of a negative
erl 60 3-year return is 8.7%.
art
u
of q 40
e
g
nta 20
e
c
Per 0
Less than –5% Greater than or equal Greater than or equal Greater than or equal Greater than or
to –5% but less than 0% to 0% but less than 5% to 5% but less than 10% equal to 10%
12-month
3-year annualized
5-year annualized
Note: The figure displays the projected distribution of potential returns over multiple horizons for portfolios of 70% U.S. bonds/30% ex-U.S. bonds, rebalanced quarterly, from
10,000 VCMM simulations over a 40-year period as of June 2016.
Source: Vanguard Capital Markets Model (VCMM).
7
Figure 5 below provides a detailed look at the trade-
offs associated with saving in an annuity versus in a
mutual fund.
Figure 5. Product considerations and attributes
Variable Fixed Mutual fund
Attribute annuity annuity or ETF Comments
Liquidity • Fixed annuities necessitate a loss of liquidity in exchange

for guaranteed income.
• Although they will fluctuate in value, mutual funds and ETFs
generally offer daily liquidity.
Longevity • Although variable annuities provide some level of guaranteed

income, the value of this benefit will fluctuate based on market
returns and withdrawal rates.
• Fixed annuities provide a level or inflation-adjusted payment stream
that is guaranteed for life.
• Disciplined investment and spending strategies from mutual fund
or ETF portfolios can enhance portfolio sustainability but provide
no insurance guarantees should spending patterns and market
conditions result in a premature depletion of assets.
Flexibility • As insurance products, contracts for fixed and variable annuities

will typically include restrictions such as surrender fees or partial-
payment periods spanning several years.
• Fixed annuity investors will generally face greater restrictions
on flexibility, especially once annuity payments have begun.
• With mutual funds or ETFs, altering an investment mix or moving
assets to a new plan or IRA is generally a straightforward process
within the confines of plan or IRS rules.
Stable growth • Variable annuity investments, by design, fluctuate with the market.

• Fixed annuities generally offer a minimum growth rate,
with the ability to earn additional returns if markets
outperform expectations.
• The volatility of mutual funds will depend on the underlying
investments. Some plans offer stable value funds designed
to minimize the risk of periods of negative return.
Product use is consistent with attribute
Product use is partially consistent with attribute
Product use is not consistent with attribute
Source: Vanguard.
8
Conclusion • Variable annuity subaccount—the structure in
which a variable annuity is invested. In many instances,
Annuities are useful for providing retirees with income
subaccounts will be modeled after mutual funds.
they cannot outlive (ignoring inherent counterparty risk)
The account holder selects subaccounts when
and protection against the financial management
entering into a variable annuity contract.
implications of cognitive decline.
• Fixed annuity—an annuity contract that guarantees
However, as accumulation vehicles in a defined
the contract holder positive growth in the accumulation
contribution plan, annuities present several important
phase and the option to initiate level payments of
trade-offs. They are on average more expensive than
guaranteed income in the retirement phase.
mutual funds with comparable investment strategies,
which could erode portfolio growth. Additionally, they
• Death benefit—the rights of an investor’s beneficiaries
offer relatively less liquidity and flexibility even during
to receive the value of an annuity at the time of the
the working years. For many participants, annuities will
account holder’s death. The amount due may vary
not be appropriate retirement income solutions, and this
according to the annuity’s structure and contract.
is challenging to predict during the accumulation phase.
For these reasons, decisions about annuitizing wealth
• L iquidity risk—the risk that an investor will not meet
might be best delayed until closer to retirement.
short-term debt obligations. In the case of annuities,
liquidity risk may arise from the up-front forfeiting of
Key terms assets in exchange for the annuity policy.
• Longevity risk—the risk that an investor outlives
• Surrender charges—the fees paid for withdrawing
his or her retirement savings.
some or all principal before the termination of the
surrender period, during which all or a minimum of
• R isk pooling—the process by which financial risks
the investor’s money must remain in the annuity.
are spread evenly among contributors to a pool.
• A nnuity crediting rates—a method of measuring
• Accumulation—the period of time in which investors
interest changes to an annuity. These rates alter the
build up the value of their investments through
growth of the annuity’s value over a specified period.
contributions to their accounts.
• Principal risk—the risk that a variable annuity contract
• G uaranteed income—a promise of regular income
holder will lose the amount invested in a policy because
to be received for an agreed-upon period of time
of market fluctuations.
(for example, the length of a recipient’s life) that is
backed by the issuer.
• Payout rate—the amount paid from an annuity
to the policyholder. Payouts occur regularly at an
• Variable annuity—an annuity contract in which
agreed-to frequency.
income payments fluctuate with the performance of
the annuity’s underlying investments in subaccounts.
9
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