Investing August 31, 2018

Return on Investments, Mortality and Insurer Expenses Key Factors in Pricing Annuities

Whether looking to provide in-plan guaranteed income solutions for a DC plan or looking for an annuity to purchase for a DB plan risk transfer, plan sponsors have a fiduciary duty to look into annuity prices.
Reported by

An Employee Benefit Research Institute (EBRI) study found that four out of five defined contribution (DC) plan participants are interested in some form of guaranteed lifetime income solutions, Christopher Maarberg, director, product development, institutional income annuities at MetLife in New York said at the 2018 PLANSPONSOR National Conference.

“MetLife also conducted a poll in conjunction with The Harris Poll and found that 21% of people who chose a lump-sum [payment from defined benefit (DB) plans] depleted their lump sum within 5-1/2 years, which is why there is a huge need for guaranteed lifetime income that they are not going to outlive,” he said. “Giving plan participants this option is critical. As fiduciaries you should consider this.”

Never miss a story — sign up for PLANSPONSOR newsletters to keep up on the latest retirement plan benefits news.

Whether looking to provide in-plan guaranteed income solutions for a DC plan or looking for an annuity to purchase for a DB plan risk transfer, plan sponsors have a fiduciary duty to look into annuity prices.

How annuities are priced really comes down to five main factors, says Robert Johnson, professor of finance at the Heider College of Business at Creighton University in Omaha, Nebraska. “The monthly income you get is calculated at the time of the purchase of the annuity, with interest rates prevailing at the time of the purchase of the annuity being one of the biggest factors determining your monthly payout,” Johnson says. “This is because the annuity provider takes the money you pay them and invests, primarily in fixed income securities, and the higher the rate environment, the higher their expected return.”

Nancy Bennett, senior life fellow at the American Academy of Actuaries in Washington, D.C., says the return on the investments “is the single biggest factor in pricing an annuity.” The insurer doesn’t just look at the prevailing interest rate but will “look at a range of investments and do Stochastic analysis to see what the profit returns could be in all market conditions,” Bennett says. “They need to know how their profit will change in different market conditions. That is where a lot of the modeling comes in.”

The second factor an annuity provider considers is the age of the purchaser, Johnson says. “The older you are when you buy an annuity, the higher your annuity payments,” he says. “Simply put, you aren’t expected to live as long, so your expected mortality is taken into account. If you have a serious medical condition that makes your life expectancy shorter, your monthly payout will be higher.”

Thirdly, it also matters for what term the annuitant selects annuity payments, says Doug McIntosh, vice president of investments at Prudential Retirement in Newark, New Jersey. Insurers consider the “age at which the individual purchases the annuity and expects to take the income,” McIntosh says. “The longer I wait for the time I purchase and the time I begin to draw income, the more income I can expect. This is because the insurer gets to hold onto that money and invest it for longer, and every minute the annuitant waits to draw down income, they get closer to the time when they will not be drawing down income.”

For example, with guaranteed minimum withdrawal benefit (GMWB) annuities, there are age tranches that pay different amounts, McIntosh says. “If I start taking the money at age 62, I might get a 3% payout,” he says. “At age 65, that might be 5%, and at age 70, it might be 5.5%. In the case of an immediate annuity, you can either take an immediate or a delayed payout. One form of a deferred income annuity is the qualified longevity annuity contract (QLAC), which typically has the starting date for payout at age 80 or 85.”

With a term-certain annuity, the shorter the term, the higher the payments, Johnson says. “If you elect a 20-year guaranteed payment period, your payments will be higher than if you elect a 25-year payment period,” he says. “If you die before the term is up, your beneficiaries receive the payments for the rest of the term.”

The fourth main factor in determining annuity prices are the expenses that the insurer faces, Bennett says. There are “the business expenses of operating the insurance company and other regulatory requirements,” she says. “When an annuity is issued, the amount of reserves and capital set aside in the first year are greater than any initial investment. If someone takes out a $500,000 annuity, for instance, the insurance company will need reserves amounting to 105% of that. They have a lot of regulations and requirements they need to comply with, which vary state by state.”

The fifth factor affecting annuity pricing is whether or not the annuitant names their spouse or partner to receive survivor benefits, McIntosh says. “That creates more risk for the insurer,” he says. “With a guaranteed minimum withdrawal benefit, for instance, if you put your spouse on the contract, the fee might increase. Or, the fee could stay the same and the payout will go down. In the case of a traditional annuity where there is no explicit fee, you cannot use the fee as a lever, so the payout will be impacted.”
Investing August 30, 2018

Participants Need to Understand Market Cycles

The record bull market may cause retirement plan participants to be overly confident, but they need to understand market cycles and volatility so they can resist making the wrong investment and retirement savings decisions.
Reported by

Surpassing the established 1990 record, the current U.S. bull market, previously commenced on March 9, 2009, earned its longest-standing title on August 22.

 

For more stories like this, sign up for the PLANSPONSOR NEWSDash daily newsletter.

Contrary to a bear market, a bullish market symbolizes upticks in earnings along with added participant spending, an action already credited to nine in 10 Americans. As the record stands with potential for further growth in coming years, how can plan sponsors and advisers speak to participants about these habits, along with the effects of risk and return?

 

Katherine Roy, chief retirement strategist at J.P. Morgan, says it’s imperative for defined contribution (DC) plan sponsors to refocus participants on their retirement savings, and encourage them to act wisely. Often, participants will tense up at language and terms they don’t understand—especially when it’s about the market and concerns their retirement.

 

“It’s always important for people to understand the big picture of where we might be in a market cycle,” Roy says. “[But] participants get so focused on where we currently are in a cycle and get away from the basics of long-term investing and saving, which is really what it takes to be successful for retirement.”

 

It’s common to see participants upset over a bad market day, yet rarely do employees understand how a market cycle can shift in days. Over the past 20 years, six of the best market days occurred within 10 of the worst days, says Roy. In 2015, the best day was only two days after the worst day of the year.

 

“Most investors get out as things are going badly or if the market is declining, and that is an emotional reaction,” she says. “They often don’t recognize just how close in time frame the best day and worst day can be.”

 

DC plan participants may pull money out of their investments to evade loss of earnings, but this in turn causes the very damage they attempting to avoid. Similar effects occur in an opposite scenario, when the market performs well. If investors see an upturn, they assume the market will continue on that stream of steadiness, and will pull funds from their plans for other priorities such as a child’s education or vacation, says Daniel Steele, national sales manager at Columbia Threadneedle.

 

“The thing you want to focus on is long-term saving. Because you have a 10-year bull market, you want to avoid folks pulling out money in your plan for other reasons,” he says. “You don’t want folks to be overconfident over the assets they have in their DC plan.”

 

What plan sponsors can do to mitigate participants’ bad actions

 

Plan sponsors can take steps to ensure that despite the market’s ups and downs, participants are prepared for their retirement, whether that’s in the upcoming or distant future. Asking employees whether they are well-diversified is a great first step, Roy says, as this helps shape a participant’s understanding of their own investments.

 

“If they can’t answer whether they’re well-diversified or not, or haven’t looked into their investments in a long time, step back and consider whether a professionally managed target-date fund [TDF], a target-risk fund or managed account might solve that for them,” she says. “Then, they’re not having to be that cook in the kitchen and having to be that expert in asset classes.”

 

Additionally, utilizing income projection tools offer insight to potential retirement futures. For example, a participant can see the difference in retirement income if he avoids taking that vacation, or using plan assets to pay for a child’s education.

 

“It’ll show them not only their balance, but, if they live to a certain amount of time and their assets grew a certain percentage, [it will show] what they’re stream of income would look like,” Steele says.

 

Aside from ensuring diversification, plan sponsors can refocus participants on respective time horizons, whether that’s a Millennial looking at retirement 30 years down the line, or a Baby Boomer hoping to retire in five years. How can these groups of participants use their years to benefit their retirement?

 

Market volatility during a bull market probably wouldn’t be a participant—or a sponsor’s—first answer, but Roy believes the rockiness can advance younger workers. “It can allow you, if you are in a systematic savings program, to put your savings to work, to buy more shares when markets are low and build a greater nest egg over time. So volatility can be beneficial if you are 20 to 30 years away from retirement, because of that dollar-cost averaging and systematic flow into the market,” she says.

 

Steele says Millennial investors can afford to assume risk given their larger time frame. He also adds how Millennials have a higher risk-averse nature, as most grew up during the credit card crisis of 2008. It’s why TDFs, while volatile, are a successful solution for the younger workforce.

 

“They have such a long-time horizon so they can afford to ride out that volatility,” he says.

 

For those approaching retirement in the upcoming two to three years, Roy notes these prospective retirees should have already derisked to protect wealth, and advises participants to allocate a ‘cash cushion,’ or emergency savings fund. Whereas volatility can serve Millennials well, this is less so for those retiring in the near future. 

 

“It’s also equally important to people getting closer to retirement, so that they have the liquidity or cash they need for their income gap,” Roy says. “When they retire, they’re not pulling money out of a declining market from a sequence of return risk perspective.”

 

Participants stuck in the middle—meaning a solid 10 to 15 years before retiring—should ask themselves if they are derisking appropriately given their time left, Roy says. If participants are either unsure or lack suitable derisking, then it’s crucial for them to invest in a product based on their specific time horizon, like TDFs and managed accounts.

 

“When you start looking at TDFs and thinking about risk and return, most TDFs, even the ones that are geared towards older participants, drive about 90% of their risk from the equity market,” says Steele.

 

Ultimately, understanding the importance of derisking and appropriately investing strengthens retirement savings, whether during a bull market, bear market or even throughout periods of volatility. While plan sponsors and participants are powerless in regulating the market’s every move, implementing supplementary steps for added savings is the fundamental goal, especially during this period, Roy says.

 

“You obviously can’t control what’s in the market, but you can control how much you’re saving and how you’re investing,” she notes. “Now is as good a time as ever to get people refocused on that savings element.”

«