The ‘variable annunity’ in vogue overeas is neither entirely variable nor an annuity – so what is it, and what could it do for Australian retirees? Andrew Barnett explains.
Some of the debate in the wealth management industry over the last few years has focused on providing stable incomes during retirement.
This debate has been prompted by the confluence of four tectonic shifts: the switch of our pension system from defined benefit to defined contribution and the resultant transfer of risk; the larger accumulated balances following 20 years of super guarantee (SG); the retirement of the baby boom generation; and the impact of the Global Financial Crisis on their retirement prospects.
Very little debate has covered a product designed to provide a stable income in retirement; however one that is well established in the United States, Europe and Japan is the variable annuity. This article outlines the structure and benefits of variable annuities.
The term ‘variable annuity’ is not a good place to begin because they are neither entirely ‘variable’ nor an ‘annuity’.
A variable annunity is, at its most basic, two things: an investment in a diversified fund, and a notional protected balance which is formed over time based on movement of the diversified fund. The fund itself can be an asset of a superannuation fund (either superannuation and/or pension), or ordinary money.
The protected balance has three defining features:
- the way the notional protected balance is formed, such as based on an annual high-water mark of the diversified fund;
- the length of time over which it converts from a notional amount to an actual amount, such as a 10-year period; and
- the way in which an investor accesses the actual amount, such as through guaranteed minimum withdrawals over time that continue even if the account balance is depleted, or as a lump sum at the end of a period.
A variable annunity is wealth insurance for an investor’s asset, but the investor retains access to the underlying asset and can withdraw any amount at any time.
While large withdrawals impact the remaining value of the insurance, this degree of liquidity and known value sets them apart from annuities.
From a manufacturer’s perspective, variable annuities present a combination of market risk (if the client’s diversified fund falls in value, there is a greater chance of a claim) and demographic risk (if the client lives a long time and had purchased longevity protection, there is a chance of paying claims for a longer period).
Manufacturers control some of these risks through product design, such as limitations on age, how much you can contribute or withdraw, and which diversified funds may be covered by the insurance.
The manufacturer ‘dynamically hedges’ their exposure to market, interest rates, and currency movements. Finally, the manufacturer holds capital to provide for residuals risks that aren’t hedged. However, the hedging program has no impact on the investor’s assets themselves.
Variable annuities were first developed in the USA in 1952. Over the last 60 years, they have evolved to incorporate a multitude of features, ranging from highest daily resets, to guaranteed increases in the protected balance regardless of market movements, to long-term health care features.
The depth of the market is reflected in the diversity: there are 1951 unique products on sale in the USA from 41 providers.
The appeal of variable annuities has led to strong growth. The variable annunity market is bigger than more vanilla structures: variable annunity assets are about $1.5 trillion, which is larger than the market for index funds ($1.2 trillion), and larger than the market for target-date funds and diversified funds combined ($427 billion and $276 billion respectively) (source ICI).
Variable annuities are also significant relative to the entire defined contribution system itself: while managed funds account for $5 trillion of the retirement system, another $1.5 trillion is invested in managed funds with variable annunity insurance wrappers.
Finally, flows to variable annunity products tend to be strong regardless of market conditions.
Where net flows to mutual funds are quite variable (2011 net flows of $53 billion, but 2012 net outflows of -$17 billion), variable annuities enjoyed net flows in both years (2011 $23 billion, 2012 $29 billion). Variable annuities sell on both fear and greed: there has been no quarter of net outflow over the last seven years.
The Australian market is absolutely fertile for the take up of variable annuities. All the conditions are met: the DC system means individuals bear market risks; the allocation to equities is high given the need to grow assets through retirement; 20 years of the SG has created larger individual assets, and the boomer population is retiring and living an increasingly long time.
One of the arguments against using variable annuities is price. The cost varies depending on the nature of the guarantee, but can range from 30 to 200bps.
An uninformed reaction is to consider this much like an administration or asset management fee – which is always a net drag on performance.
In the case of the variable annunity, however, the cost needs to be evaluated as an insurance premium to eliminate tail risk.
Our forecasting techniques gloss over this risk. The typical superannuation calculator presents a tidy “rainbow”: rising and falling assets projected as a single path assuming a single rate of return.
Where we do recognise and try to manage this risk through diversification or using a ‘bucket approach’, we may overlook the fact that diversification assumes stable correlations, which isn’t true (“nothing goes up in a falling market except for correlations”).
Or, relying on the observation that the market rarely has a negative 10-year rolling return is irrelevant to the individual who is reliant on the sequence of returns through a 10-year period.
Instead, we need to consider that the range of outcomes experienced by individuals explodes in a variety of possible scenarios – some good, some great, and some really not so good at all.
We can estimate the value of a variable annunity more formally by looking at the 5th and 95th percentiles of outcomes.
Assuming a 10-year horizon, an investment in a 60/40 fund, and a starting balance of $100,000, the fifth percentile outcome – the account balance at the end of the period – might be $76k after all fees. If protection had been used, this ending balance of course would still be $100k after all fees, and the protection would have ‘cost’ negative $24k.
We can also assess the value of increasing our allocation to growth assets. This might be reasonable if we consider that increasing the exposure to growth assets, when coupled with protection, actually eliminates the risk of loss by the end of the term.
If we assume now an investment in a 70/30 fund, the final balance at the 5th percentile falls from $76k (60/40) to $68k (70/30).
The protected final balance remains $100k for the 70/30 fund. The 95th percentile – the good outcomes – now increases from $288k (60/40) to $326k (70/30) after all fees, including protection fees for the latter.
Market research conducted with 200 advisers found that a variable annunity would appeal to individuals across a range of profiles, with about 80 per cent ‘agreeing’ or ‘strongly agreeing’ it would be appropriate for individuals with little risk capacity (financial ability to withstand loss), or little risk tolerance (emotional ability to withstand loss), those who are invested in cash or more conservatively than they would otherwise, and those who would contribute more to superannuation but don’t because of the risk.
On average, the research suggests that advisers would recommend variable annuities to about one-third of their existing clients, and one-third of new clients. This would be consistent with US experience.
The market may be somewhat larger than this. Separate research with retirement investors found between 60 per cent and 70 per cent would like to invest in products that provide a capital guarantee or an income guarantee, with little difference between more and less affluent individuals.
Variable annuities are relatively new to the Australian market, but their future is bright.
Andrew Barnett is general manager of retirement solutions at MLC.
