Annuities: the variable kind with the guarantees..

I have excoriated, in the past, these beasts of the financial services industry, especially in the “trough heavy”, high fees universe of Canadian retail financial services.  But what of new lighter, lower cost versions in the US, for example the Vanguard guaranteed lifetime benefit product?   I will address this deeper into this post, but first:

These products main claim to fame is that they guarantee a minimum withdrawal benefit over the lifetime of the product.  My main point has been that the costs of these products, in Canada especially, murder the benefits, are more likely to trigger the guarantee, and you are likely to be better off taking a low cost passive investment approach.   

In fact, referencing the negative scenarios often depicted in insurers’ glossy marketing brochures, you would be much better off selecting an equity only low cost index investment (absurd!).

Another aspect of the marketing for these products is the risk management argument concerning variability of returns: because returns are unpredictable, variability of returns will expose your investment capital when making withdrawals.  But this only applies if you are insane enough to draw down during distressed prices.  

It is simple enough to provide the type of structural protection in a portfolio to avoid the unnecessary selling during downside volatility: have a low risk allocation that can be matched to a portfolio’s liabilities in the event of a risk event over a significant time frame.  Portfolios can be thus structured to provide superior variability of return protection, for many years, and for those conservative individuals, for periods easily in excess of a decade or more.   You know, we have the technology to deliver sophisticated asset/liability management (not the inane efficient market/Monte Carlo driven/stochastic type) for as little as 10 basis points + transaction and indexing costs.

The only events where high cost insurance based products have merit, and I would add the word dubious here, is where we have a financial meltdown scenario.  Why dubious?  The companies offering these guarantees are insurance companies, and the events that would make these products attractive might also risk a default on the guarantee offered.  This is no joke: those buying protection via these policies are taking on board significant counterparty risk.  What is the point of merely replacing one uncertainty for another potentially greater uncertainty?  Just look at the stock price of Manulife!    It is not just the low yields and poor market returns that are stiffing these companies, but their high operational and distribution costs.

One of the mindsets under pinning the financial crisis was the belief (followed mindlessly by mathematicians and financial economists ignorant of real world dynamics) that you could hedge every risk under the sun.  If you share the risk to those that can bear it, you can take on more risk and manage it more effectively: do you remember that one? 

Hedging, in my opinion, should only be carried out for marginal risks, and the individual, and society, would be better off accepting and managing these risks within portfolio structure: risks can be mitigated and managed through conservative planning assumptions and structure.  

You can use assumptions, structure and planning to achieve all the objectives of insured product options (managing longevity risk, volatility and longer term market and economic risks) at a lower cost with much greater flexibility.   Lower costs and greater flexibility are important risk reduction characteristics.

In fact, the 3 biggest risks to the ability of assets to meet financial needs over time are as follows:

  • Too high return assumptions and too few compensating assumptions dealing with inflation, liability risks, liquidity and credit risks: we have a priced to perfection mindset that cannot comprehend the importance of forward looking assumptions that minimise the impact of negative events.  Outlying scenarios may be considered as part of a probability set, but are not the assumptions on which structure and planning are based.  
  • Product, transaction and management costs that are far too high: you should not be paying for indexed like, or consistently below index like returns.  In a low return scenario, much of the industry is pricing itself and the investor out of existence.
  • Improper structure: exposing the return generating components of the portfolio to short term volatility and significant market and economic risks.

Most variable annuities have too high costs and improper structure and are sold on the assumption that they retain upside potential while protecting against the downside risks: in other words they break most of the rules.

I would suggest you should only consider hedging/insurance, on a continuous basis, at the margin on what would be a small portion of your capital.  Because of the costs, such a strategy may only have validity during advanced economic cycles and relatively high valuations. Even then, when a portfolio has to meet liabilities, the cost argument would suggest that the implied transaction (sell the highly valued risky asset and reinvest in a lower risk asset) is the better option.  After all, the real return figure you are looking at, if you will ultimately need to transfer to a lower risk asset, is the low risk return less the cost of hedging/insurance – remember most investors are consuming capital and as the portfolio depletes and the time frame shortens, the low risk component increases.  In other words, the cost of hedging reduces the returns needed to fund withdrawals.

You can partially hedge by buying puts (expensive), by selling forward an asset (a bet that the market will fall), or by realising highly or fairly valued equities or other higher risk assets and transferring to an asset class with a guaranteed nominal or real return.  This latter option is the most simplest, straightforward and cost effective where you have income and capital demands on investment capital. 

Remember a portfolio (out of general equilibrium/random independent price movement/efficient market space) where future liabilities risk capital depletion is comprised of a number of liability specific and time horizon specific components: short term liquidity, medium term low risk asset/cash matched, longer term lower risk assets, medium to long term equity allocation from which transfers will be made (in fair to highly valued markets) to fund consumption of capital or to enhance protection offered by the shorter end of the portfolio as market and economic cycle matures and risk horizon lengthens.   To all intents and purposes, for a given asset/liability demand on the portfolio, a portfolio would retain a balance in upward under valued to fair markets, an increasing bias towards lower risk assets in advanced market and economic cycles, and a decline in low risk allocations (where there are no outperforming components in the risky asset class) during prolonged periods of economic and market weakness.  

Portfolios, with liability demands, should be allocated towards cash/bonds, and equities and or other risk assets based on a) the liability profile and assumptions impacting that liability profile over time, b) assumptions regarding significant market and economic risks (in a non general equilibrium world) including risk return assumptions and the time frame of such,and c) risk preferences and performance risk aversion, including behavioural biases.  

A given bond/cash allocation, if you were only able to access bonds and portfolio income in the event of a significant risk event, might be capable of providing you with x years liability coverage – I personally prefer, prior to a risk event, to look to cover significant historical type risk scenarios, increasing coverage and risk management during periods of high to extreme valuations and/or advanced economic cycles.   

Portfolio hedging can be used to extend the time frame over which your portfolio is capable of managing risk: that is to create an event horizon, or a risk management + zone. 

As discussed, this risk event horizon could, if you wanted, be permanently managed via options (at a cost similar to the cost of the variable annuity riders on lifetime guaranteed vehicles) or other hedging techniques. 

Or, preferably, management of the event horizon could be dynamic, in which case you would only hedge via portfolio insurance during high to extreme valuations and/or advanced economic cycles.  But even them, as discussed, you may as well complete the transaction the hedge is designed to protect and manage the risk by transferring the higher risk/higher return asset, at the margin, to the lower risk liability driven portfolio in a systematic manner. 

In a non general equilibrium environment, where price changes are not truly random and independent, the potential size and duration of a risk event are related to valuations, the maturity of the economic cycle and the structural risks (built up over time) which impact both.

While, ordinarily, you might want to keep a portfolio balance and not run down a lower risk component of the portfolio, there will be times when you would not want to sell risky assets at low valuations, and so would, depending on your paradigm run down a lower risk portfolio: in other words the low risk portfolio would revert to meeting liabilities on a close to cash matched basis – such portfolios are also likely to be effectively immunized in the sense that low risk distributions have no reinvestment risk since they are likely to be consumed.  This type of structure would do away with long term unchanging strategic benchmarks and replace them with liability/market valuation/economic risk sensitive conservative benchmarks. 

So, a portfolio is always run at the event horizon (5, 8 or 10 years, + a marginal risk period reflecting valuations, economic cycles and other accumulated structural risks): that is the time frame of significant risk you always want to cover for normal uncertainty + a marginal risk which could be managed automatically, or dynamically, via insurance or organically via structure. 

A strategy that managed risk at the margin, on a continuous basis, using options could well equal the cost of the lifetime guarantee premium on a variable annuity.   For example, let us say 40% of the portfolio was allocated to lower risk assets, which could last 8 years if run down under conservative assumptions (higher inflation risk, credit and liquidity risk risk assumptions)and longer if not, and let us say that we wanted to manage additional an additional risk period of say 3 to 5 years at the margin, which might well equate to between 10% and 20% of the portfolio.  Let us say the annual cost of hedging the equity component is 6% of the total portfolio, which equates to between 0.6% and 1.2% per annum for the marginal risk management.  Note, if you cut the options coverage when prices fall beyond certain valuation levels and only re-establish your positions as an economic expansion matures and/or market valuations moved to beyond fair valuations, then you could achieve the same type of risk management, more or less, with lower cost and greater flexibility.  

Again, as discussed, you need not take an options approach: you could just increase the low risk allocation to cover the liability risk. 

So what of a low cost, liability driven structure’s ability to meet financial needs while managing issues such as longevity risk?

As long as you establish a long enough time line, use conservative return and risk assumptions, and do not expose yourself to point in time volatility (and longer) through structure and planning, and keep costs down, then there is no reason why you cannot have a perfectly adaptable and acceptable risk management solution without having to tie your money up for good.   A well managed solution should be capable of providing greater certainty of outcome against one where there is uncertainty over counterparty risk during the types of conditions that might validate an insurance company guarantee.

The Canadian GMWBs, I referred to in my many reports, were allowing extraordinarily high equity allocations, meaning the insurers were taking on large risks.  The total cost of the products were close to 4% for high equity content plans, which was also the same as the long term equity risk premium on the Canadian market over bonds over the last 100 years.  Insurers take on a large risk and investors give up their marginal return for a bond like investment with no flexibility and liquidity. 

Unfortunately, in a high cost, high churnover market place, many of these products might have offered attractive characteristics, but only in comparison to the many shipwrecks of portfolios that are out there, and only if some charming salesperson did not transfer them out at some point in time in the future.  

So, what of the lower cost US products issued by the likes of Vanguard?

These products offer access to low cost mutual funds with a guaranteed lifetime withdrawal benefit for a cost of some 0.95% of funds per annum.   For a 60/70 equity and a 40/30 bond split, the cost of the mutual funds are some 0.7%, of which some 0.19% covers the costs of returning the accumulated portfolio value to the estate’s beneficiaries on death – note this product is a US product based on US tax and estate planning rules and I am not commenting on these rules as such. 

As the guaranteed benefit insurance cost could go up to 2%, (crudely speaking) the potential costs on the product range between 1.7% and 2.7% for an equity orientated product allocation.  It is worth noting that the product is an annuity product and the administration costs are a small 0.1% of capital per annum.

While a sophisticated investor could buy a cheaper portfolio and save a significant further bundle of costs, and manage variability of returns, I can see the attraction of the product for less experienced conservative investors who do not want to hire what may be costly asset management.  This does not mean it is a deal of the century and it does not mean that it is not without risks!   

If conditions were to worsen, I would question the ability of many of today’s insurers ability to meet these financial obligations.   Since these products are purchased primarily for their downside event risk protection in the context of longevity of withdrawals, I would not feel comfortable in selling this optionality as a solid 100% guarantee. 

Also, bond yields are terribly low and the costs of the guarantee is between 40% and 60% of government AAA bond yields.  You could take a more conservative strategy outside of a guaranteed product and end up with the same net effect without any insurance.   If the world is forced down the debt monetisation route, then bond yields will be much higher and bond prices much lower, while equity prices could fall or show limited real growth.   In a debt monetisation world, the real value of the guarantee could fall precipitously.

I still feel that you can manage a significant amount of longevity risk (a good few years outside of standard mortality assumptions) via sophisticated and sensible withdrawal strategies and low costs.   For those with real longevity issues, by the time the guarantees on these products kick in, the real value of the guaranteed income could well be, well, much lower. 

Nevertheless, should insurers remain able to fund the guarantee, and should equities produce real returns close to or above average historical risk premiums, investors could see both peace of mind and a nominal increase in drawings from these lower cost guaranteed variable annuity products – note that real returns on the bond component risks being negative in such a scenario and the realised equity risk premium needs to compensate for this drag on real return.  

The reasons why investors have been exposed to longevity risk have been a) the absurdly high nominal expected returns which have failed to account for risk and which have led to to excessive early withdrawals (the newer lighter weight guaranteed products do not require these types of returns given that withdrawal guarantees are generally fixed in nominal terms), b) the often very high costs of financial advisor portfolio solutions which have perverted the risk/return outcomes of portfolios (also a key reason why many with the higher cost plans will be exposed to inflationary risk) and c) far too active and at times inappropriate management of assets during risk events.  

Complex products exist because a) the industry wants to make money from selling things consumers want and b) because many of the things they want cannot be managed by the clients or their advisors.  

While I strongly believe that low cost, sophisticated ALM structures can efficiently manage longevity and other risks, the expertise and systems are clearly not available to the masses.  Low cost guarantee variable annuities, like that offered by Vanguard, assuming no counterparty risk, have validity in such a universe. 

Please note – a more detailed analysis of guaranteed life time benefit products can be found in the following reports.

October 2008

GMWB Risk Modelling & Sequence of Returns Sun Life Data

September 2008

GMWB Sequence of Returns Manulife Data

December 2007

A High Wire Act – Leverage & The GMWB

July 2007

Guaranteed Minimum Withdrawal Benefit Plans Report Compendium;

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