In my previous articles, I first introduced a new type of longevity product, which I referred to as protected lifetime income benefits (PLIBs) and then compared the PLIB structure to other strategies, such as a SPIA, DIA, and GLWB, based on some previously released research.
The PLIB was remarkably efficient versus SPIAs and DIAs, which may surprise some readers. In this piece, I explore some of the factors driving these outcomes, in particular lapsation, mortality experience differences, accessing the equity risk premium, and the marginal role of annuities as part of a retirement strategy.
PLIBs are likely to appeal to retirees and provide income that is optimal and protected for life, but not necessarily fixed. In the final piece in this series (next week), I will provide some context on optimal risk levels for PLIBs.
Lapsation
SPIAs and DIAs require an irrevocable election, whereby the annuitant cedes the premium in return for guaranteed income for life. The annuitant has no access to the money, like they would for a GLWB or PLIB. This is good and bad for the annuitant and for the insurance company.
Lapsation is the surrender of an investment product before its final, scheduled payment. It is common in the insurance industry; for example, only 50% of level-term life insurance policyholders hold their policies to the end of the term period. The exhibit below shows lapse rates for various life insurance policies.
Lapse rates for individuals with GLWBs vary by a number of factors, but average 6.8% per year after a policy is out of its surrender period. While some of this reflects poor decision making among annuitants/insureds for not using the benefit (since they paid for a benefit they didn’t use), this was not true in all cases. For example, a GLWB gives the annuitant a choice of how to use those assets most effectively versus other strategies that require an irrevocable election (e.g., an immediate annuity). A GLWB also provides an opportunity to “cash out” the policy and buy income at an even higher rate should the markets do well and/or interest rates rise.
Mortality experience
Mortality experience varies across annuities. For example, individuals who purchase life-only annuities have significantly lower mortality rates (i.e., longer life expectancies) compared to those who buy annuities with a minimum payment and liquidity (i.e., variable annuities). This is not a surprise as only the healthiest individuals are likely to purchase an immediate annuity without any refund provision (this is the definition of adverse selection). Providing liquidity within the variable annuity structure means the annuitant makes significantly less commitment than for a traditional immediate annuity behaviorally, and as a result, the collective mortality rates of individuals who purchase VAs tend to be higher (i.e., they have lower life expectancies than those who purchase life-only annuities).
This effect is demonstrated in the table below, which shows data on mortality rate experience in the Society of Actuaries 2009-2013 Individual Payout Annuity Mortality Experience Report for deferred and immediate annuities, and the Ruark 2018 Variable Annuity Industry Mortality Experience Study for variable annuities.
This exhibit demonstrates the monotonic relationship between mortality experience and the “commitment” with respect to annuitization. DIAs reflect the most direct hedge against longevity risk and therefore it is not a surprise that those products have had the lowest mortality experience (i.e., individuals who buy DIAs have higher life expectancies than individuals who buy other products).
The mortality rates for individuals who purchase VAs are clearly higher than other products (notably DIAs and SPIAs) and this can be priced into the payouts of the products. In other words, by compensating for the adverse selection associated with annuities, the implied payouts for products with GLWBs can be higher.
Higher potential returns
Using the VA account structure, the annuitant can capture higher returns (e.g., more of the equity risk premium) than more conservative annuity payout strategies (e.g., an immediate annuity). While this exposes the annuitant to slightly more downside risk, depending on the investment strategy, it also offers more upside if equities outperform.
The outperformance of equities over fixed income has been pronounced historically, both in the U.S. and internationally. This effect is illustrated below, including the distribution of the historically realized equity risk premium of stocks versus bonds from 1900 to 2020 based on the 21 countries1 in the Dimson, Marsh, and Staunton data.
While past performance is no guarantee of future results, stocks have outperformed bonds over the long-term. This gives the annuitant the potential to generate more income than from safer lifetime-protected strategies, which have fixed payments, such as a SPIA.
The marginal role of annuities
Most research on retirement income strategies, in particular safe-withdrawal rates, focuses on the role of the portfolio with respect to generating a set level of income. For example, the optimal withdrawal rate is often determined by ignoring guaranteed lifetime income sources, such as Social Security retirement benefits.
But all Americans have some lifetime income that is guaranteed (i.e., protected). This is incredibly important when thinking about the marginal value of annuitizing savings, since this will be lifetime income that is received in addition to existing sources. This perspective significantly affects the determination of which annuity is “optimal.” Since most households already have fixed/guaranteed lifetime income, adding variable lifetime income is going to be better than adding fixed-guaranteed income. This is something I’ve specifically explored regarding immediate annuities, and the findings relate to PLIBs as well.
Conclusions
Every household is different, yet there are important similarities to consider when determining the optimal lifetime-protected income. Most American retirees already receive a relatively generous lifetime pension benefit that is indexed to inflation (i.e., Social Security retirement benefits). This fact, together with adverse selection issues around annuity selection, the persistence of the equity risk premium, and other factors, make the PLIB structure especially attractive as part of a retirement income strategy.
David Blanchett, PhD, CFA, CFP®, is managing director and head of retirement research at PGIM. PGIM is the global investment management business of Prudential Financial, Inc. He is also an Adjunct Professor of Wealth Management at The American College of Financial Services and a Research Fellow for the Retirement Income Institute.
1Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Ireland, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, South Africa, Spain, Sweden, Switzerland, United Kingdom, and United States
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In my previous articles, I first introduced a new type of longevity product, which I referred to as protected lifetime income benefits (PLIBs) and then compared the PLIB structure to other strategies, such as a SPIA, DIA, and GLWB, based on some previously released research.
