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This Annuity Helps Retirees Outperform 4% Withdrawal Rule: RetireOne

By John Manganaro

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What You Need to Know

  • Contingent deferred annuities are designed to break down the barriers to adoption of traditional income annuities.
  • A new analysis suggests CDAs can be effectively integrated into retirement income planning by RIAs.
  • According to the research, this approach can materially increase both income and account value relative to a more conservatively allocated portfolio.

Using an emerging set of insurance solutions known as contingent deferred annuities, financial advisors can now “wrap” their preferred portfolio allocations in a way that meaningfully complements their retirement clients’ safe withdrawal strategies, according to a new white paper published by RetireOne.

Penned by Michelle Richter-Gordon, co-founder of Annuity Research & Consulting and executive director of the Institutional Retirement Income Council, the paper seeks to illustrate the effectiveness of an alternative retirement income strategy that empowers fee-based registered investment advisors to better protect client portfolios and provide guaranteed lifetime income solutions.

In basic terms, the paper examines how the contingent deferred annuity’s unique structure — with its unbundling of lifetime income guarantees from underlying investments in a way that fits the RIA’s fee-based compensation model — can protect a portion of client portfolios and enable advisors to keep their clients allocated to equities in retirement.

According to the research, this approach can materially increase average value of both income and account value relative to a more conservatively allocated portfolio. Specifically, the paper suggests, a more aggressive equity portfolio with 50% of assets covered by a CDA offers significantly better outcomes in terms of net economic benefit than an unprotected portfolio utilizing withdrawal patterns determined by an individual’s required minimum distributions or the ubiquitous 4% withdrawal rule.

More Permanent Than Marriage

As Richter-Gordon writes, despite the significant potential value of traditional income annuities and strong advocacy for the products by some academic economists, Americans don’t typically buy them.

“Many reasons are posited for why Americans choose not to annuitize, including cost, complexity, inflexibility and more,” the paper suggests. “One less frequently posited potential explanation is that purchasing a life-only immediate annuity is a more permanent life decision than is the most mainstream decision we think of culturally as permanent — that is, marriage.”

As Richter-Gordon explains, few people would enter marriage with the intention to later get a divorce, yet some 50% of American couples ultimately do end their marriages.

“This option to divorce is legally available to married couples, and this option has value to it whether it is exercised or not,” Richter-Gordon says. “While the vast majority of annuitized annuities do have liquidity options, few if any allow full commutation, hence the argument that the purchase of an immediate annuity is a more permanent decision for the purchaser than is getting married.”

Framed this way, the paper argues, it is “no puzzle at all” why immediate annuities are not more popular with purchasers.

The What and Why of Contingent Deferred Annuities

As Richter-Gordon explains, contingent deferred annuities are designed to break down the barriers to adoption of traditional income annuities. She writes that one key innovation is the unbundling of insurance protections from underlying investments.

“Unbundling allows the RIA to wrap any approved retail ETFs or mutual funds with which they and their client are comfortable — not merely a limited menu of insurance-dedicated investments — with a contractually separate option for lifetime income,” the paper notes.

As Richter-Gordon points out, separating the income guarantee from the underlying investments creates a flexible structure that allows the assets to remain at the advisor’s or client’s preferred custodian. It further allows for the coverage to be canceled at any time without tax or financial penalties.

According to the paper, a given investor may draw income from the covered asset at a defined payout rate according to a benefit base that is typically guaranteed to not be less than the initial investment. Crucially, this benefit base can grow as the portfolio grows, and withdrawals continue until the covered assets are depleted, at which time the issuing insurance company continues the income payments.

“The annuity, then, is contingent upon asset depletion, and deferred until such time,” Richter-Gordon explains. “As mentioned above, CDAs are cancellable with no surrender charge; one implication of this benefit is that, if portfolio values rise to a point where the investor no longer worries about safely generating income for life, the CDA option can be dropped, and costs saved accordingly.”

The Potential Benefit to Retirees

To demonstrate the benefits of this approach, the analysis considers a theoretical 60-year-old couple with $1 million in retirement savings. The couple intends to start drawing income from their portfolio when they turn 65, and their income target is 4% of their portfolio’s value at the time income commences.

In the scenario, the couple would like to target increasing this spending amount by 2% a year to help offset the impact of inflation on their lifestyle, while their portfolio remains allocated 55% to equity and 45% to fixed income instruments during a 30-year retirement period.

According to the paper, running a traditional Monte Carlo assessment of this couple’s retirement prospects (defining failure as missing the income target by 10% or more in any given year) results in an “unacceptably high” 44% failure rate, and the spread of potential outcomes on both the upside and the downside is vast.

According to Richter-Gordon, using a more sophisticated flexible spending approach that sees retirees adjust their spending depending on market conditions can meaningfully reduce failures in the Monte Carlo projection. Such strategy, however, can result in a degree of annual income variability in unfavorable market scenarios that is not tolerable to many clients.

Part of the benefit of leveraging a CDA, the paper explains, is that it allows the client to embrace a higher equity exposure. In the theoretical example above, by purchasing a CDA to cover half the portfolio, the couple can bump its equity allocation up to 75% without meaningfully increasing the risk of failure, given the annuity-based income backstop.

Importantly, with a CDA, the consumer’s upfront commitment is modest — an annual fee, collected quarterly in arrears, that is similar in magnitude to an advisory fee.

“This low commitment allows the client to make not a one-time, but rather a continuous decision to continue paying for an income guarantee, or to terminate the guarantee if it no longer proves valuable to them,” Richter-Gordon explains. “The CDA allows the client and advisor to retain control of the allocation of assets, including equity exposure, and allows them to avoid the higher fees often associated with deferred annuities with secondary guarantees.”

In the event of a poor sequence of returns, the contingent deferred annuity solves for longevity risk by providing a guaranteed income stream for life, even when the asset is exhausted. In the absence of a market shock early in retirement, this form of portfolio income insurance can also help create more predictable and stable income streams, offer the opportunity to benefit from risk premium, and ultimately provide a better net economic benefit than unprotected withdrawal strategies.

“Based on the above analysis comprising 1,000 Monte Carlo simulations, a portfolio with 50% of assets covered by a CDA offers significantly better outcomes in terms of net economic benefit vs. an unprotected portfolio utilizing RMD-inspired withdrawal patterns,” Richter-Gordon concludes.

(Image: Shutterstock)

John Manganaro

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