When is the last time you saw a penny in the street and stopped to pick it up?
Most likely, it’s been awhile, and with good reason. Over time, the penny has lost its value, to the point that the U.S. Government has considered decommissioning the penny as official currency. In fact, it now costs more money to manufacture a penny than that penny is worth.
But what if I told you a penny could be worth as much as $100,000. Would you reconsider? Although not many are in existence, the 1943 Copper Wheat Penny has attained great value amongst collectors–certainly enough to make someone think twice before walking past a lonely penny without at least checking the date.
So what does that have to do with variable annuities?
The penny example is actually a great way to illustrate how a slight change in perspective can lead to innovative new thinking about the benefits these products provide and different ways they can deliver those benefits. As part of this discussion, it’s important to understand that variable annuities can help meet your clients’ long-term retirement goals by providing tax deferral1, a broad range of investment options, a death benefit and guaranteed lifetime income, along with optional riders and benefits that may be available for an additional cost.
Although the annuity industry often notes the innovation that has taken place over the last decade, advancements with living benefits on variable annuities have been slower to occur. In fact, many of today’s living benefits don’t look much different than they did 10 years ago, with several carriers pulling back benefits or leaving the market altogether.
The “arms race” that occurred with living benefits on variable annuities a decade ago has turned into a race for survival today as many carriers seek to deliver the type of innovation that may be needed in today’s low interest rate, high volatility environment–a new way to help protect purchasing power once the contract holder starts taking income.
Traditional guaranteed roll-up benefits have been utilized by many people who own variable annuities within their retirement plan. These benefits, which typically provide an annual increase to the benefit base (a value that may be used to determine income payments), can be an effective way for people to incorporate some guarantees into their retirement planning while continuing to build their contract value.
In the past, product manufacturers have offered consumers higher roll-up amounts and have also increased the frequency with which those roll-ups are awarded. This may be appropriate for people that are still building their retirement savings. Baby boomers–especially those boomers in the crucial transition phase five to 10 years before retirement–need to start thinking about retirement income. Therefore, they may want to review their situation to determine if this type of benefit is appropriate for them.
New perspective leads to innovation
This brings us back to the discussion of how viewing a penny in a new light can trigger different opinions about things we’ve previously taken for granted. For example, new innovations within some living benefits in variable annuity contracts are changing the way we think about generating retirement income.
Regardless of whether your client is in the accumulation or distribution phase, they always have to be conscious of protecting their purchasing power. New options with some living benefits can change the way that clients plan for income by giving them different possibilities for increasing their withdrawal amounts once they start taking income in addition to the potential for increasing income during accumulation.
By placing more emphasis on withdrawal rates than the benefit value used to calculate payments, product manufacturers can help retirees add a level of certainty to their bottom line through the guarantees provided with the optional living benefit that may be available at an additional cost. (Guarantees are backed by the financial strength and claims-paying ability of the issuing company and do not apply to the performance of the variable subaccounts, which will fluctuate with market conditions). The key is not how much the increases are, but how often they happen. Keep in mind that in order to receive a potential increase in income, there may be restrictions that need to be met (such as age restrictions, taking annual maximum withdrawals each year, etc.).
It’s important to understand that the potential for increasing income in retirement is crucial not only to help keep pace with the effects of inflation, but also to protect against factors like sequence of returns risk. Investors focused on accumulation of retirement savings often have time on their side. They have more time to weather volatile markets. However, for retirees who are already drawing down assets or taking income from their portfolio, market volatility and its influence on investment performance can have a huge impact.
Sequence of returns can have a profound effect on retirement savings by reducing values for a retiree starting their distributions in a down market year. In the example below, assume four distinct hypothetical rate-of-return values cycling every four years. The four values would show a portfolio earning 27 percent in year one, 9 percent in year two, 7 percent in year three and -15 percent in year four. The rotation begins by applying these market returns to the portfolio while withdrawing an inflation-adjusted $50,000 per year until the value hits zero (sequence of returns line 2). Then consider the reverse sequence rotation starting with -15 percent, then 7 percent, 9 percent and 27 percent (sequence of returns line 3). Just this different sequencing of returns results in a 13-year difference in how long the portfolio could last.
This illustrates the profound impact that sequence of returns can have on retirement savings. If returns start out negative, money can run out more quickly than anticipated, making it more difficult to rebuild assets from those initial losses and get them back on track to extend the life of their savings. Yet, by incorporating a variable annuity with living benefits that offer the potential for increasing income, that same retiree can add a level of protection against sequence of returns risk.
As financial professionals start to think more about how variable annuities and their available living benefits may work for their clients in retirement in addition to saving for retirement, they need to understand that generating additional income during retirement can also be an important part of the plan. Traditional living benefits may not be the only answer. Transitioning boomers who experience increased spending in categories most affected by inflation–medical care and housing (U.S. Department of Labor, Bureau of Labor Statistics, 1983-2011)‑will want to consider which type of living benefit may be appropriate for their situation.
As financial professionals consider each individual’s specific situation before recommending a potential solution, they should consider what is suitable for that client and determine if a living benefit that offers the potential for increasing income is right for them. This approach can have a profound effect on long-term benefits, and demonstrate how innovative new options can help your client prepare for a more secure retirement.
Purchasing an annuity within a retirement plan that provides tax deferral under sections of the Internal Revenue Code results in no additional tax benefit. An annuity should be used to fund a qualified plan based upon the annuity’s features other than tax deferral. All annuity features, risks, limitations and costs should be considered prior to purchasing an annuity within a tax-qualified retirement plan.
1Withdrawals will reduce the contract value and the value of any protection benefits. Additional withdrawals taken within the contract withdrawal charge period will be subject to a withdrawal charge. All withdrawals are subject to ordinary income tax and, if taken prior to age 59-and-a-half, may be subject to a 10 percent federal additional tax.