Actuaries and mathematicians will tell us that the “actuarial cost” of any annuity you may purchase is effectively the same, no matter what sort of annuity you purchase. After all, your life expectancy is what it is; the interest rates are what they are; and the insurance companies investments supporting the lifetime guarantees are what they are. The thinking then goes that all DC lifetime income decumulation guarantees have essentially the same value.
In reality, however, insurance companies “slice and dice” different annuity guarantees for retirement plans in a variety of different ways, and there can be a bit of diversity in the design and pricing of those guarantees. For example, the promise of an enhanced future benefit which may provide increases in the payout over time (providing a measure of inflation protection) may pay an initial monthly payout amount which may be less than what a comparable premium could purchase as a straight life annuity; or the nature of certain so-called “high water mark” guarantees can differ vastly from product to product, and be balanced by the presence-or absence-of other features. Each insurer builds in these sorts of “favored” features into their products, and each of these choices may differ from insurer to insurer, and product to product.
Even more globally, an insurer may choose (yes, insurers have some degree of choice in such matters) to maintain the highest A.M. Best rating of “A++”, while another may choose instead to maintain an “A” rating. The higher rating can actually be more expensive to maintain because of certain financial requirements for those ratings, like the level of reserves, which also can be reflected in the cost of the annuity. As another example, some insurance companies are simply better than others at hedging investments because of the time and expense they may have put in (or not put in) developing and maintaining those particular skill sets. This can impact the design of equity-related guarantees which any insurer can offer (like the popular GLWB (“guaranteed lifetime withdrawal benefit”)).
Regardless of these choices, common among all of the potential guarantee variants is the simple fact that the longer an insurer holds your money (and with more certainty), the better the guarantee the insurer will typically be able provide to the plan -as guaranteeing risk is, one could say, a risky proposition. That risk becomes more manageable with longer tenured assets. This is one reason why the typical QLAC is relatively inexpensive: the QLAC payout is determinable at the date of purchase; it is set to begin payout at a specified date (perhaps as far out as age 85); there is extremely limited ability to surrender the contract once it is purchased; and there is very little ability for the benefit to grow.
This means that a plan purchasing longevity guarantees is typically accompanied with a number of restrictions which are needed by the insurer to manage the risks it has undertaken. Given that DC investments have been focused almost solely on the simple asset accumulation models, the typical defined contribution plan fiduciary (or, much less, the participant) has little familiarity with this side of the decumulation of assets. It is, however, conceptually similar to those old fixed account programs which placed restrictions on a participant’s ability to transfer to computing funds (or other similar restrictions) in return for their being credited with a higher rate of return; or with the typical design of a “fixed index annuity,” where the insurer limits the ability of the participant to change indices through the year in order to guarantee a “floor” on the plan’s investment in the contract.
So it is with longevity guarantees: there will be what are effectively “time based” restrictions necessary for the insurer to manage its risks in providing those long-term guarantees. A classic example can be found in the design of the typical GLWB. Under the GLWB, the plan participant has the ability to invest their account balance in such a way that it can accumulate an “enhanced decumulation” benefit over time. How this is done is that such programs provide the plan participant with both an “account value” (often referred to as the accumulation value) and a value called the “benefit base.” The accumulation value is the dollar amount which is carried on the participant statement as part of the participants accrued benefit under the plan, and which reflects the cash value of the participant’s assets in the program. This “benefit base,” on the other hand, is a calculated number which actually has no cash value. However, it IS the number upon which the participant’s guaranteed monthly payout will be calculated at the time of retirement (instead of the account value). Each insurer calculates this “benefit base” differently, but it is effectively designed to “grow faster” (sometimes substantially so) than the actual account value. It reflects the larger lifetime guarantee that the insurer will be able to provide to the participant even after the participant’s accumulation value is exhausted through GLWB-permitted withdrawals (withdrawing amounts in excess of those permitted under the GLWB contract will reduce the monthly payment-but only before actual “annuitization”-but more on that in another blog). All or a portion of this accumulated “benefit base” can be lost, however, to the extent the participant liquidates all or a portion of their plan account which is holding the guarantee. Such a participant who then wants lifetime income at retirement will then need to use their plan account value to purchase an annuity, sans the enhanced guarantees.
There are a few key takeaways. First, “accumulating decumulation” rights is very much different than merely accumulating investment assets under a plan. In order to benefit from the value of these enhancements, participants and fiduciaries must be comfortable with accepting some restrictions on accessing plan funds. This is so very opposite to the mutual fund, daily trading world to which participants have become accustomed. Secondly, any such “decumulation accumulations” have built in restrictions which are necessary for the insurer to be able to provide those guarantees. Thirdly, the specifics of these restrictions are not universal from program to program, and should be reviewed and understood. Finally, this blog only discusses the accumulation of guarantees over time within a plan. There is a whole host of valuable guarantees which can also be purchased at the time of retirement as well.
Properly investing a portion of a plan account in a Lifetime Income program really does demand some appreciation-and acceptance- of time and the nature of insurance products. A reset of the familiar mindset, if you will.