[UPDATE, 7/20/2023: This article is now available on Advisor Perspectives! — www.advisorperspectives.com/articles/2023/07/20/bonds-stock-annuity-income-inflation]
What follows is an open letter to the annuity industry.
We know you are looking for ways to expand your reach into the fee-only advisor space, and we are sympathetic. Progress has been slow, fraught as it is with the perils of product complexity and the industry’s past reputation for shenanigans. Yet you have some things to offer that advisors and their clients simply cannot do with traditional investments alone.
I humbly request you bring to market a product that looks like this.
My Dream Annuity: Characteristics in Brief
My dream annuity has the following characteristics:
- It pays a guaranteed, CPI-adjusted income stream…
- …for the lifetime of the annuitant(s)…
- …beginning now (SPIA) or at whatever future date we choose (DIA).
- It can be purchased without death benefit, surrender/remainder value, or other add-on that would reduce income…
- …but it has a cash value, or other method of eliminating conflicts of interest for fee-only advisors.
Motivation and Context
Through risk pooling and mortality credits, annuity providers can offer lifetime income guarantees that retirees cannot create for themselves. This is why the “optional frosting” on “Layer #2” of Round Table’s Layer Cake retirement income and investment model is a deferred income annuity (DIA).
Social Security, the bedrock of “Layer #1” in the Layer Cake, provides a CPI-adjusted (i.e., inflation-protected) stream of income for a retiree’s lifetime. However, for many retirees, Social Security may be insufficient to offset the fixed/inflexible annual expenses that they will incur throughout their golden years.
For those situations, Round Table’s Inflation-Protected Income (IPI) model (Layer #2) supplements secure income by building an inflation-protected income stream from government-guaranteed securities. This effectively supplements Social Security’s inflation-protected income, notably without the budget/legislative risk of future payout reductions. But it cannot supplement the longevity hedge arising from Social Security’s lifetime payouts. The IPI model can only secure income for a preselected range of years, generally no longer than the 30-year maximum TIPS tenor.[1]
This is where the DIA comes in, providing a contractually guaranteed lifetime income stream that can pick up right when the IPI income leaves off. This effectively supplements Social Security’s longevity insurance, also without the legislative risk, albeit introducing a degree of credit risk.[2] However, it fails to match the inflation insurance deriving from Social Security’s CPI adjustments.
This brings us to the first element in the construction of my dream annuity:
Characteristic #1: My dream annuity pays a guaranteed, CPI-adjusted income stream
As noted above, the primary benefit to be derived from this annuity is the protection of income in the event of longevity. But the event of longevity is precisely the set of conditions under which persistent inflation has the most cumulatively devastating effect on the purchasing power of a nominal income stream.
We love the concept of secure income at Round Table. But income that does not adjust with inflation is not sufficiently secure against all contingencies.
Characteristic #2: My dream annuity pays out for the lifetime of the annuitant(s)
No need to belabor a point we’ve covered already. Whether single or joint life, the primary goal of my dream annuity is to provide inflation-protected lifetime income for our clients, an unpredictable subset of whom will likely live to a ripe old age—an eventuality for which no traditional investment product is a suitable liability-driven substitute.
Characteristic #3: My dream annuity can begin immediately (a CPI-adjusted SPIA) or at any time we choose in the future (a CPI-adjusted DIA)
Our IPI model[3] (basically a TIPS ladder once you hit retirement) and my dream annuity are nicely complementary. Having the ability to pay now but choose precisely when the annuity’s income kicks off would give us the freedom to balance considerations of liquidity, custody, transparency, creditworthiness, mortality credits, and customer preference (along each of those axes and more) to pick the precise point in the future to have IPI end and the annuity begin.
But there are a couple very important caveats that must be understood if my dream annuity is to work properly:
Caveat A: No matter how far in the future we choose to start the income, the CPI adjustments must begin as soon as we make the purchase.
Look back at that chart under Characteristic #1. If a client opts for 25 years of IPI income followed by a DIA, it simply won’t do for the first 25 years of inflation to be ignored in the DIA, only to start accruing CPI adjustments in year 26.
For all practical purposes, that would put us back in the same position we’re in now, having to guess at a future inflation rate[4] to pick the correct amount of future income. If we’re creating, say, $10,000/year in real income in IPI, we should be able to buy $10,000 in real (today’s dollars) income in the DIA—at a fair price for the inflation adjustments, of course—so it seamlessly picks up where IPI leaves off.
Caveat B: We should have the option to buy a DIA with income starting as far out in age we please.
Some clients may simply choose a CPI-tracking single premium immediate annuity (SPIA) and be done with it. Others may elect to cover, say, their current life expectancy with IPI, and buy a DIA starting then. Still others may retire at 60 or 65, lock in 25-30 years of IPI income with TIPS, and look to purchase a CPI-tracking DIA for extended longevity insurance alone.
The last option is the most common recommendation for us presently. Partly this is because today’s DIAs don’t track CPI, so they aren’t offering everything we want from them. But as Michael Kitces and Wade Pfau have demonstrated, mortality credits accrue most of their benefit when people outlive their life expectancy anyway, and clients will sometimes prefer the idea of staying liquid for the years when TIPS in a brokerage or IRA account can accomplish the job.[5] For this reason, it is important in our practice to be able to purchase a DIA with income starting as late as age 90, or possibly even later. (This isn’t crazy! My grandmother is 101 and still sharp as a tack.)
Thankfully there are annuity providers who allow for this, but we’ve noticed to our chagrin that many DIAs have much younger age cutoffs for the income start date. Please don’t do that with my dream annuity!
Characteristic #4: My dream annuity can be purchased without death benefits, surrender/remainder value, and the like
If you feel compelled to offer these riders as optional add-ins, I will understand. But that just adds the burden on us of explaining to our clients why we don’t recommend them, especially for the DIAs we just discussed.
The goal here is to maximize bang for the buck in purchasing inflation-protected lifetime income, and these goodies increase the upfront cost per unit income. Legacy and liquidity are goals we are confident we can target more effectively with IPI and especially with other layers of the Layer Cake, including with dollars that are not spent on annuity riders.
Characteristic #5: Yet somehow my dream annuity has a cash value, or other method of eliminating conflicts of interest for fee-only advisors
Okay, I’m gonna ditch the obfuscating euphemism in the foregoing section heading: An ideal annuity is one on which a commission-free advisor can still charge an AUM-based fee:
- Ideal for the advisor because, well obviously.
- Ideal for the client because it might actually get recommended by sizable swaths of the advisory community.
- Ideal for the annuity industry for the same reason.
We know the annuity industry has gotten the message: Advisors increasingly understand the potential value of annuities, but fee-only advisors don’t want to switch to being product salespeople just so they can make annuities work in their practice. Commission-free annuities are a good start. Annuities with a cash value they can advise is a huge step. But the kinds of products on which that feature presently exists add complexities we and many other advisors simply aren’t interested in. Offer SPIA/DIA products—especially CPI-adjusted versions—with a fee-able cash value notwithstanding illiquidity and I believe you’ll have hit the jackpot at last. (This doesn’t seem ridiculous to us! They have a present value after all! Find a way to make it explicit!)
Admittedly I don’t quite know how this would work. Perhaps the “cash value” would be based on the ever-changing actuarial value of the future income. Perhaps it would be based on an amortization of principal. Also, if the client fires their advisor, does the fee go to the client as additional income? Perhaps the whole thing could be structured as some sort of simplistic FIA, where the reference index is CPI (but with no rate cap)? We’re open to suggestions! But if you want to unlock the enormous potential from the fee-only investment advisor community, this is something you’ll want to solve, if possible.
No Substitutes
COLAs are not a viable substitute for CPI adjustments.
A 2% COLA is like a sad joke if we experience persistent 5% inflation. A 5% COLA could still fall short of even worse inflation, but more importantly, with breakeven rates under 2.5% across the Treasury curve, it’s far too expensive relative to what a superior, CPI-adjusted guarantee should logically cost.[6]
Yes, we know persistent 5%+ inflation is unlikely. But the unlikely event of multi-sigma longevity plus multi-sigma inflation is exactly the risk we’re trying to offset here.[7] And those sigmas are why we think it should be affordable! (Contra long-term care insurance, for example.) If we knew in advance that each of our clients would experience average longevity against a serene backdrop of 2% inflation, we wouldn’t need life annuities in the first place.
Fixed indexed annuities are not a viable substitute for my dream annuity
FIAs are viable products for some advisors. With their “everything in one package” convenience, they can have their uses. But not in our Layer Cake system, which is designed to be a sophisticated, multi-pronged, liability-driven, lifecycle approach to solving the retirement puzzle.
Yes, we know FIAs will produce superior income to my dream annuity if we get historical average equity returns. But if we knew in advance that we would get historical average returns, clients wouldn’t need an annuity at all, because a total return approach can produce even more income while growing the asset base.[8]
Yes, we also know long-run bad stock returns are also unlikely. But we consider a very low probability of eating cat food in your nineties to be an unacceptable risk nonetheless, which is why we’re looking at annuities in the first place. We still recommend risk assets in Layer #3 and Layer #4 of our Layer Cake, after non-negotiable expenses are covered. Moreover, this approach increases risk capacity with those assets, and enables us to effectively craft a rising equity position across the total portfolio (again à la Kitces and Pfau) with minimal cognitive dissonance for our clients.
And finally, yes, we understand a FIA promises a better return in that unlikely ugly scenario than does a total return strategy. But a CPI-linked SPIA/DIA will do better still. Of course it will! It isn’t taking stock market risk!
Wrap-up
Okay. I’ve said my piece. I’ve pulled no punches. My cards are on the table. I’m out of dumb clichés.
Please make this happen! Social Security has been automatically adjusting for inflation for nearly 50 years. We’ve known for a long time that CPI-adjusted lifetime guarantees are the ultimate bedrock for a secure retirement. A product that enables retirees to deepen that bedrock layer would be the ultimate annuity home run.[9]
[1] Technically, duration-matching may produce a decent facsimile to the CPI target beyond 30 years, but this essentially sacrifices a degree of certainty in the earlier years to create something of benefit in the later years. And there are other reasons why it may not be worth it, including the fact that the mortality credit tradeoff looms large 30+ years into a typical investor’s retirement. However, we do use the duration matching technique in the IPI model’s pre-retirement glidepath, to begin semi-securing a future stream of inflation-protected income well before the target retirement date, when the final years of the projected income stream may be far beyond 30 years out.
[2] Pray excuse an obscure footnote wherein I lob into the luminiferous aether an impotent plea for the development of CPI-adjusting tontine annuities.
[3] Reminder: IPI is Round Table’s Inflation-Protected Income model, Layer #2 of our Layer Cake retirement methodology.
[4] Or else inefficiently trying to offset any underestimate with additional long-term TIPS.
[5] A possible counterargument could exist in cases where there aren’t sufficient IRA assets for us to locate the IPI strategy in an IRA: “Phantom income” rules, while understandable, nonetheless rather frustratingly front-load taxable income on a TIPS ladder. (Important note: This is a totally different meaning of the word “income” to what is used everywhere else in this article! And neither definition is the same as the coupon/dividend meaning of “income” that investment folks often use.) I don’t know how taxation would work in my dream annuity, but if it smooths out the taxable income over time, that could be a big reason to put the IPI/annuity boundary earlier, or even just do the SPIA version.
[6] Okay, I get it: The same TIPS that limit us to 30 years of IPI income limit your options in the “deep longevity” years as well. But on top of mortality pooling, inflation swaps and the like are another set of tools to which your finance departments have access while our clients do not.
[7] To make matters worse, it seems probable to me that the most likely scenario for persistently high inflation is one in which the economic costs of fighting inflation are ultimately deemed too high to be worth it…which is likely the same scenario under which risk assets’ real returns are most likely to underperform, rendering a guaranteed real income floor that much more important!
[8] Here we’ve glossed over lots of details about withdrawal rates, our “Dynamic Income and Growth” total return methodology (basically a modified Guyton-Klinger approach), sequence of returns risk, etc. However, if we dug into all those details, we would still draw the same conclusion. The main thing to bear in mind here is that while an annuity company can create value that no individual can create by pooling mortality risk across many annuitants (since they will all die at different times), they cannot create additional value by pooling market risk across many annuitants, because there is only one market.
[9] Oops, I guess I had one dumb cliché left.
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