So… What’s an Annuity?

The defined contribution system gives participants control over decisions such as investments and savings rates, but with this control comes multidimensional risk. For those in retirement, market risk, inflation risk and longevity risk stand out. Poor timing and bad luck can trump decades of prudent participant behavior. Against this backdrop, the industry has responded by designing solutions to help alleviate these risks and meet the (thus far) quixotic objective of stable, sustainable retirement income. As the defined contribution system evolves, this goal has come into sharper focus. Both plan sponsors and participants express a desire for reliable retirement income within defined contribution plans. A majority of plan sponsors (56%)¹ express a desire to keep participant assets in plan post-retirement. On the participant side, 82% of respondents expect to draw down from their employer retirement plan as a source of retirement income.²

This overview considers products that share a common theme: providing an explicit guarantee³ vis-à-vis retirement income. We do not consider the class of products that seek a nonguaranteed drawdown of assets ( managed payout funds). Given the transfer of risk from employer to employee within the defined contribution system, the presence of a guarantee attempts to blunt the impact of market risk. These solutions aim to pool risk and deliver stable outcomes, thus dampening the impact of poor timing and luck on retiree outcomes. To varying degrees they also address other risks (e.g., longevity and inflation risk) facing those in retirement.

SPIAs and DIAs and Floors … Oh My!

A Single Premium Immediate Annuity (SPIA) is fairly straightforward. A participant pays an insurance company a single premium in return for an immediate income stream. Consider a 65-year-old married male who hands over $100,000 to an insurance company. Using current pricing,⁴ in return for this premium, the participant receives $514/month⁵ ($6,166/year) until he passes away.⁶ In exchange for the premium, the participant eliminates the risk of running out of money (longevity risk) and renders himself and his spouse immune from market vagaries (market risk).

While the peace of mind associated with eliminating those risks represents an immense value, such an approach does carry considerations. Timing serves as a principal risk. Annuity rates can fluctuate wildly. So while our hypothetical annuitant would receive $514 today, that figure would have been well north of $650 in 2009 or nearly $450 in 2021. So while we lock in peace of mind, the purchasing power locked in still depends heavily on luck. As noted financial analyst William Shakespeare pointed out, “timing is everything.”

To help alleviate this unpredictability, solutions aim to hedge annuity costs by allocating to assets that provide some correlation to annuity prices. The participant would hold assets that correlate to the price of retirement income. By using the preset asset allocation of a target date fund, solution providers allocate assets over time to a “prefunding” portfolio within the overall asset allocation. Thus, the participant’s assets in the prefunding portfolio rise and fall with the annuity costs prior to the actual annuity purchase. Assets that correlate to SPIA rates range from fixed income securities to newer innovations such as unassigned deferred annuity contracts (UDACs). Fixed income presents a straightforward case: It’s liquid, generally features low transaction costs and, since it is held by insurance companies to back many guarantees, it tends to move with annuity pricing. UDACs function as call options on an annuity purchase. By purchasing UDACs over time, the participant dollar cost averages into their annuity purchase. Compared to fixed income, this provides more certainty in pricing, but comes with higher operational complexity and less transparent price discovery. With any prefunding portfolio, the asset allocator must assess the impact on portfolio performance, cost and operations for those that may not annuitize. In any solution, these participants should be no worse off. Consider it the Hippocratic Oath of retirement income: do no harm.

Insurers offer another option for those looking to solve for longevity risk and lock in a stream of income. In a Deferred Income Annuity (DIA), the participant pays a premium but instead of receiving immediate income, they receive income at a future date. The longer the deferral period, the higher the payout (since more people will die prior to receiving the payout). With DIAs, participants access higher payouts with the risk that they and/or their spouse will pass before recouping payouts that exceed their premium (or more accurately the future value of their premium).

Continuing the previous example, if that same participant instead uses their $100,000 to purchase a DIA that makes payments at age 78 (13 years in the future), they would receive $1,280/month ($15,355/year) upon reaching age 78,⁸ or approximately 2.5 times the income of a SPIA.

A Qualified Longevity Annuity Contract” (QLAC) is functionally identical to a DIA. However it is purchased with qualified assets and carries tax benefits. Premiums paid are netted out of calculations for required minimum distributions. If a participant has $500,000 in Defined Contribution (DC) balances but uses $100,000 to purchase a QLAC, the Required Minimum Distribution (RMD) amount is based on $400K rather than $500K. The lower RMD amount conveys a tax advantage to the participant.

DIAs carry the same prefunding considerations as SPIAs. For some, they carry several advantages relative to SPIAs. With a DIA, a participant takes an open-ended question (how long a retirement do I need to plan for?) and truncates it. They can use a portion of assets as a longevity backstop and use the rest to fund the finite period between retirement and the DIA payments beginning. Additionally, having guaranteed payments begin later in retirement can help offset some concerns about cognitive decline and when to turn over financial decision making.⁹ The decision to purchase either a SPIA or DIA is generally irrevocable (though some do allow for a return of principal feature).

Guaranteed minimum withdrawal benefits (GMWB), also known as Guaranteed lifetime withdrawal benefit (GLWB) products differentiate themselves from DIA and SPIAs by melding the comfort of a guarantee with greater flexibility and liquidity. In a GMWB, an insurance company wraps a multiasset portfolio (e.g., a 60% stock, 40% bond portfolio) and guarantees the participant withdrawals at a predefined amount until they pass away. Once the participant exercises the GMWB, the insurance company guarantees that they can meet withdrawals of 5% of their locked-in principal amount (often referred to as a “high water mark” or “benefit base”).

If we go back to our hypothetical investor, their $100,000 would be invested in a 60/40 portfolio and the insurance company guarantees withdrawals of $5,000 annually. If the balance ever goes to zero, the participant still receives their $5,000. Their assets remain fully liquid and they can withdraw in excess of the $5,000 if they wish to (though such withdrawals would affect their future guaranteed payouts). Such solutions provide the peace of mind that comes with a guarantee along with control of the underlying assets.

GMWBs vary widely in their terms. As with anything in the DC ecosystem, fees present a primary consideration. The locked-in rate must be considered in light of the cost of the guarantee. In many cases, the cost to wrap the portfolio stands at roughly 100 basis points. Many products also allow for the benefit base to increase, though when and what contributes to the increase (market appreciation vs. contributions) differ. Lastly, given the makeup of the underlying portfolio, one can question the value such products present. In the absence of an insurance wrap (and associated fees), could the hypothetical 60/40 portfolio sustain $5,000 nominal withdrawals with the underlying market returns?¹⁰ A participant’s particular risk aversion certainly helps to drive the value of the insurance wrap.

In the annuity family, fixed index annuities (FIA) are cousins to GMWBs. Like a GMWB, there is an insurance wrap on an underlying portfolio. However, with a fixed index annuity, an investor receives the return linked to a reference index (e.g., S&P 500) with a floor to limit losses and a ceiling which limits gains. In lieu of a ceiling there may be a participation rate, i.e., a stated percentage of index gains to which an investor is entitled. For example, with a 70% participation rate, if an index were to rise 10%, the investor would realize a 7% gain (70% of 10%). The annuitant can then decide to annuitize their contract using an income rider. The income rider functions similarly to a GMWB. The holder is guaranteed a set amount of income based on the income rider and the performance of the reference index over time. To illustrate this, let’s return to our hypothetical participant with $100,000:

After these years, the participant then elects to exercise their income rider, which we will assume is set at 5%. He would receive $6,151/year.

FIA provide liquidity, flexibility and downside protection, often with the option to annuitize and turn assets into a stream of income. As with other solutions, these benefits of fixed index annuities come with some inherent drawbacks. As with our other examples, we conveniently assumed away fees and transaction costs. These vary widely but must be factored into the decision. Although fixed index annuities provide peace of mind during market turbulence in the form of the floor, the cap or participation rate limit the upside. Lastly, fixed index annuities often have surrender charges if a participant cashes out, and the income rider can be subject to the same payoff considerations as GMWBs.

Guarantees can play a vital role in providing retirement security. The presence of a guarantee provides peace of mind and, through the magic of risk pooling, helps insulate retirees from the vagaries of markets and general bad luck. Their benefits depend heavily on the specific features and the circumstances of the end user. These benefits must be weighed against liquidity considerations and cost. As defined contribution plans shoulder a larger share of retirees’ income needs, the annuity space will continue to evolve and play a larger role in shaping outcomes.