SPIA and DIA offer the most efficient forms of longevity insurance and can be viewed as the best substitute for traditional pension which many individuals no longer own. Conversely, unless one purchases an income annuity with increasing payments (Cost of Living Adjustment (COLA) or CPI-U indexing options), the SPIA/DIA scores the lowest on its ability tackle inflation.
It should be noted that SPIAs with an option for increasing payments are the only products that provide longevity protection and explicit inflation protection, this option is not considered here as it tends to be expensive and rarely used in practice.
Given the fixed nature of payments, SPIA/DIA offers a good hedge against Sequence-of-Returns risk and the product typically provides the least expensive way to establish a guaranteed income floor in any retirement plan.
On the other hand, a SWP’s risk management attributes are opposite to that of a SPIA/DIA. The investment choices with the SWP are virtually endless and the underlying asset allocation is under complete control of the investor. When managed well, the asset allocation offers indirect protection against rising inflation because in most years the market outperforms inflation.
Hybrid accounts such as Fixed Index Annuities (FIA) with GLB riders offer a good hedge against the sequence-of-returns risk. Guarantees and promises are the core of GLBs. Many promise at least the return of the initial investment, despite the performance of the market. GLBs are analogous to (albeit complex) long-term equity put options that can be purchased in the open market to provide downside protection on a portfolio. Thus, their embedded guarantees, earn GLBs the high score for hedging sequence of return risk.
However, not all GLBs are created equal. While some variations guarantee an income for life, thus providing some longevity protection, they are typically more costly than the pure form of longevity insurance offered by SPIA/DIA. Finally, like managed accounts, GLBs do not typically provide explicit inflation protection; however, many offer systematic payment step-ups or minimum percentage increases that could potentially offset the impact of inflation.
These inflation protection attributes can be thought of as more costly than those of a managed account because the fees for these hybrid accounts are typically higher than those of managed accounts.
From a financial engineering perspective, while a SWP and a GLB behave similarly in the first few years, the GLB contains a long dated put option that kicks in if and when the underlying account hits zero. Thus, while a SWP would terminate and cease providing income if the underlying account hits zero, a GLB on the other hand would continue to provide with a lifetime of guaranteed income. Stated differently, this means that a client who relies exclusively on a SWP to fund retirement is essentially ‘short’ this long-dated put option, which exposes him/her to both longevity and sequence of returns risk and may therefore reduce the probability of providing a bequest or estate transfer.
As seen in Figure 5 (previous page), the risk management attributes of the three retirement income products are only half of the story. The allocation among the products should also be selected in the context of at least three goal-achievement objectives: liquidity, behavioral “self-discipline”, and legacy (or estate value).
For instance, a total allocation to a SPIA/DIA would be inappropriate if the retiree’s primary future goal was to leave a large sum to his or her estate. Likewise, if the client spends their full monthly benefit payment, the client may have difficulty budgeting for a fluctuating spending rate or large lump sum withdrawals for unexpected cash needs. After all, the reason SPIA/DIA is able to offer such effective longevity insurance is the irreversibility of the initial lump sum payment.
Thus, while some SPIA/DIA contracts do address liquidity, other products address these needs better.
On the other hand, the SPIA/DIA is highly effective at overcoming potential behavioral mistakes that investors are prone to making – such as spending beyond their means. Further, many of us are susceptible to making irrational decisions and errors with our investments in the absence of restrictions or a guiding system in place and that can decrease the chances of meeting our spending goals in retirement.
When the initial irreversible payment is made to the insurance company issuing the SPIA/DIA, the control over the investment management decisions is also transferred away from the investor and the insurance company guarantees the monthly benefit payment for life. This leaves little room for the client’s behavioral biases and blunders.
With a SWP, a disciplined and well-informed investor can meet liquidity needs and estate goals because he or she retains the control over asset allocation and withdrawal rate; but without discipline of, for example taking a cut in income when necessary, and the financial acumen of, for example knowing when a cut is necessary, the SWP ranks low in effectiveness in helping the investor to avert behavioral mistakes.
The GLB’s liquidity is restricted by withdrawal limits imposed by the rider. Moreover, GLBs restrict withdrawals beyond a certain limit by charging surrender fees as well as reducing the benefits. The policyholder does have
liquidity with a GLB, even if it may come at a hefty price and it is therefore superior to a SPIA on this trait.
A GLB rider can also be effective in addressing some behavioral weaknesses because the surrender charge acts
as a deterrent to making excessive withdrawals. When purchasing a GLB, the investor effectively purchases protection against poor market performance in that if the account value goes to zero, the product will continue to provide guaranteed payments for life.
On the other hand, if the variable annuity is annuitized or if the
underlying investments perform poorly, and the GLB is irreversibly converted into a retirement income stream then no death benefit will be paid. This attribute makes the GLB good for purposes where the estate is of secondary concern after the client’s requirements for guaranteed lifetime income.
Finally, when it comes to evaluating fees, the basic SPIA/DIA tends to be the cheapest product option while the GLB is the highest because of the fees that must be charged for the embedded options, guarantees and the management of the underlying investments. The fees charged for a SWP typically fall between that of the other two income products because it is simpler than a GLB but its management is typically more involved than a SPIA/DIA.
