LifeX Funds Answer the Call
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The call, in review
Last July, here in Advisor Perspectives, I issued an open letter to the annuity industry requesting the introduction of a product to meet the needs of independent advisors who adhere to a safety-first, goals-based investing philosophy. The desired product would provide the following:
1. A guaranteed, CPI-adjusted income stream…
2. …for the lifetime of the annuitant(s)…
3. …beginning now (like a single-premium immediate annuity or SPIA) or at whatever future date we choose (like a deferred-income annuity or DIA).
4. It can be purchased without death benefit, surrender/remainder value, or other add-on that would reduce income (and increase fees) …
5. …but it has a cash value, or other method of eliminating conflicts of interest for fee-only advisors.
In a twist worthy of an early M. Night Shyamalan movie,1 my call has been answered to a remarkable degree…by a mutual fund company!
Stone Ridge LifeX funds
With the launch of its LifeX mutual fund lineup this month, Stone Ridge Asset Management debuted the first-ever series of U.S. 40-Act funds to incorporate that wondrous secret sauce of the life annuity, mortality pooling.
It accomplished this feat through a two-part structure. First, funds are made available to individuals born in the calendar year in the fund name, with individual tickers for males and females available for each birth year from 60 to 75 years ago.2 These are open-end funds, available for purchase or sale by eligible investors until the year in which they turn 80. At that point, existing fund ownership converts to shares of a “successor fund” that can be neither bought nor sold. By this sacrificial rite, the successor fund conjures the alchemy of mortality pooling, whereby monthly payments to each shareholder may continue until one of the following two conditions is met:
- The shareholder passes away.
- The shareholder lives to see the ball drop after their 100th birthday.
When shareholders in the first category pass away, their claim on fund assets is effectively redistributed among those who remain on this side of the sod. By this means – the “mortality pooling” to which I refer, which was hitherto the sole domain of the insurance/annuity industry – these funds can promise a higher-for-longer monthly payout than would be possible if investors were to build their own income stream, e.g., through laddering or duration-matching.3 The actuarial calculations whereby this higher payout is determined are performed by venerable insurer New York Life.
The best part of all – at least for those who comprehend the impetus for the italicized emphasis in list item #1 in the intro – is that LifeX funds come in two flavors, which I have nicknamed in an unbiased and objective fashion:
- Level nominal income (“LifeX Income Funds” or “bland vanilla”); and
- Inflation-protected income (“LifeX Inflation-Protected Income Funds” or “Cosmic Cookie Dough Delight”)4.
The all-important goal #1 of “my dream annuity” is at last attainable, via a mutual fund holding! How about the other goals? Let’s take them in order:
#2: Income for life(ish)
Did I mention mortality pooling in a mutual fund?! This is not your father’s Oldsmobile. You take dollars that could create income for yourself to, say, age 89 or so,5 you pile them together (in a mutual fund!) with dollars from other folks, you turn a crank,6 and you and the other investors get income that will last as long as you live, unless you live long enough to sing “extremely auld lang syne” in the year you’d turn 101.
Very few people live past 100. Then again, part of my pitch (including in the prior article) to get people to consider life annuities7 is the story of my grandmother, who passed away last year at 102. She would have outlived LifeX payments by 15 months – a minor but not entirely negligible disadvantage relative to traditional life-annuity contracts. For the goal-based advisor, earmarking a small quantity of assets for multi-sigma longevity protection can ameliorate this drawback. Given the other advantages of LifeX, it’s a minor caveat.
There is a less minor caveat. LifeX funds are available only on individual life (male or female). But when I build financial plans for married couples, I aim the secure income sleeve toward the fulfillment of “required/inflexible” expenses. While a few such expenses may approximately halve at the passing of one spouse (e.g., groceries), most do not (property taxes, utilities… worst of all is income taxes, which often rise). Moreover, the bedrock tool for covering inflexible expenses, Social Security, also declines when one spouse passes. Buying half the inflexible income tied to each spouse’s life will often be far inferior to a joint-life solution, even though the latter would of course be more expensive.
Granted, there are difficulties. For example, there are already four separate funds for each relevant birth year (male/female and nominal/inflation-protected),8 and each fund must attract sufficient assets to work properly,9 since they are all independent, self-funding pools (see below). It is highly doubtful separate funds could be launched for numerous combinations of ages.
The less-than-ideal way a joint life fund would likely have to work is that a fund’s actuarial calculation would assume a male and female born in the same year, and a real-life couple would have to buy the fund with the birth year of the younger spouse. For spouses with a wide enough age difference, this may not be economical. Nonetheless, the advantages would be well worth it for many couples of similar ages. For now, I plan to purchase LifeX funds for each such spouse and hope that a joint life alternative emerges before the older spouse turns 80.10
#3: Beginning now or later, and #4: No death benefit, surrender value, or other riders
The rationale behind my request for SPIA/DIA availability beginning whenever we wish was to preserve flexibility (a) for investors who don’t need their income to begin until later, but wish to lock it in safely now; and (b) for investors who would prefer the “technical liquidity” (per Wade Pfau’s terminology) of a TIPS ladder for the early years of income – most notably because plans change.
Ironically, I requested the zero-rider option to reduce flexibility in exchange for maximizing income per dollar invested.
I am satisfied with Stone Ridge’s decision to chart a middle course between offering the benefits of flexibility and the benefits of not-flexibility. Specifically, while investors can buy LifeX funds as early as age 60, they have the flexibility to buy or sell shares until age 80. And should fund owners pass away before the age-80 conversion to a successor fund, they receive the full value of their remaining shares at NAV. After that, the “not-flexibility” kicks in and the mystical mortality magic is invoked.
This flexibility has behavioral advantages. (“Don’t worry, just buy it now, start taking the income, and you can decide down the road if you want to drop it.” But you’ll be used to it by then, so you won’t.)
It has other advantages. For example, the investor who wishes to lock in (now) income commencing in the future can arrange a decent facsimile by buying now and reinvesting the income until it is needed. This involves some reinvestment risk, but far less interest rate risk than would be incurred by waiting to purchase until the desired income start date. It also creates an opportunity for beneficial gamesmanship, in the form of revisiting an investor’s health before the fund conversion.
The disadvantage is that the mortality credits effectively only accrue past age 80, marginally reducing the payout rate. But it is marginal. For example, a scenario analysis the folks at Stone Ridge ran for me showed that in exchange for 10 years of liquidity, a 70-year-old male could still receive approximately 96% of the annual payout that would be available if everything locked in immediately. This is because mortality between 70 and 80 is quite low among the healthy group of investors who would be expected to purchase these funds.
#5: Explicit cash value
These are mutual funds! I can’t imagine an easier mechanism for fee-only advisors to calculate the AUM allocated to longevity protection. Granted, this also means that the day-to-day present value of a LifeX fund may be quite volatile, as that is the unavoidable flipside of securing safe income. (I have written about this tradeoff at great length, including pointing out an ironic, behavioral advantage of SPIA/DIA products that stems from their failure to provide ongoing valuation transparency to annuitants.)
There is also a complication for fee-only advisors. Were fees to be charged on the funds themselves (e.g., by taking fees out of LifeX distributions), this would skew the value proposition by reducing the net payouts a lot more in the early years – when fund assets are highest and payout percentages lowest – than in later years.
The simplest solution is to pull advisor fees from other assets. But given my predilection for segregating assets by goal (as exemplified by my company’s “Layer Cake” methodology), I dislike charging fees for one goal to assets designated for another goal. For example, when I build a TIPS ladder for clients, I can embed our advisor fee into the calculations, so as to compute a “net of everything” rate of inflation-protected income, much as Stone Ridge does with its fee (a 1% advisor fee, by the way) under the hood of a LifeX fund.
An interesting alternative, presented to me in an email from Stone Ridge, would be calculating an economically equivalent “percent of payout” fee – i.e., a flat-fee structure that is lower in the early years and higher in the later years than an AUM-based fee would be. But this creates several complications, including the potential for client confusion and questions about how to determine economic equivalence.
At Round Table, we took an extra step to calculate a supplemental TIPS portfolio with size and duration that shadows the change in value of the LifeX funds, so that a fully net, fixed, real payout rate can be calculated in advance. This is complex and convoluted, and I expect precisely zero other advisors to follow me on this. Unless you are as maniacal about stylistic purity as I am…
But will the LifeX concept really work?
Contra Betteridge, the answer to this section headline is almost certainly “yes”!
Why “almost” certainly?
Consider how and why an annuity guarantee might fail. The “how” is default. I.e., future insolvency could inhibit the insurer from fulfilling its contractual obligations. The “why” could be any (combination) of the following:
- Mismanagement (actuarial or otherwise) or catastrophe at the corporate level;
- A substantial increase in average longevity, e.g., due to medical advances; or
- Defaults on the credit bond portfolios held by the insurer to immunize liabilities.
The last point is worth noting. Annuity providers typically hold portfolios of bonds with credit risk because they provide higher expected payouts versus risk-free bonds. They will typically even pass on a portion of this higher expected return to the annuitant in the form of higher income payouts. As an ardent “safety first” proponent, I (again) confess ambivalence regarding this phenomenon, as I don’t believe you can transmogrify credit risk into risk-free alpha by inserting an insurer into the chain. While the extra payout will probably work out, the worst-case scenario is still default. That means the credit premium is either compensation for the annuitant taking added default risk or – to the extent guaranty organizations can be relied upon – a systemic moral hazard, which presumably is a trap most likely to spring when the taxpayer can least afford it, as usual with moral hazard.
How might LifeX funds fall short? The good news is that there is no credit or default risk. Neither Stone Ridge nor New York Life stands as guarantor; rather the funds are self-contained and self-funding,11 with assets invested entirely in either Treasury STRIPS (for the bland vanilla version) or TIPS (for the Cosmic Cookie Dough Delight version). But there is a minor risk of early asset exhaustion.
LifeX funds are designed to pay out monthly through December of the year in which their investors turn 100. (Again, each cohort has funds – labeled by birth year – in which to invest.) This includes a small built-in safety buffer that would be added to the final payout. But if events conspire to exhaust assets more quickly than expected, payouts will terminate when the pool is empty.
But the actuarial assumptions built into LifeX payout calculations are highly conservative,12 and early exhaustion is improbable. Moreover, the most probable “early exhaustion” drivers (e.g., systemic improvement in mortality due to a cure being found for a major disease) would most likely only accelerate the last payment by a year or less. So (a) a 99-year-old investor would only have to locate perhaps one year of income from other sources; and (b) most investors would experience no difference at all, since relatively few will live past 99.13
So fine, “almost” certainly, but it’s a pretty teensy “almost.”
Odds and ends
LifeX funds will be offered only through financial advisors, who must be pre-approved by Stone Ridge, which generally requires going through an educational session before they can make purchases on behalf of their clients. (To be clear, I have no affiliation with Stone Ridge, other than pursuing this approval myself.)
My firm has a few couples where most assets are in one spouse’s IRA, but we would like to make a LifeX purchase on behalf of the other spouse. Stone Ridge has indicated to me that this will be doable, as it intends to provide a mechanism for manual upload of the necessary demographic information for the other spouse.
Especially for the youngest LifeX investors, a bout of high inflation (i.e., the event for which the benefit of inflation-protected income is greatest) could force the fund to distribute more than the planned amount of income, due to “phantom income” and mutual fund rules regarding distribution of taxable income. When I asked the folks at Stone Ridge about this, they said they would probably just treat a rules-driven overpayment in December as prepayment of subsequent months, which would be withheld until everything evened out.14
Stone Ridge plans to publish payout rates for each fund on the LifeX website starting sometime in February. The numbers will be updated daily, allowing the advisor/investor to know how much lifetime annual income they are purchasing with each share.15 For math nerds like me,16 duration figures are also available from Stone Ridge upon request, enabling more in-depth calculations, including for the shadow TIPS portfolio I mentioned earlier.
For the inflation-protected funds, CPI adjustments are made annually in January, and are based on inflation (CPI-U) over the prior November 1 to October 31 12-month period.
Lifetime income security (to age 100) in a 40-Act wrapper! Stone Ridge LifeX funds are an incredible new tool in an advisor’s arsenal.
In his role as chief investment officer for Round Table Investment Strategies, Nathan Dutzmann is responsible for applying financial science and investment research to the process of constructing portfolios tailored to our clients’ individual needs and goals. Nathan was previously an investment strategist with Dimensional Fund Advisors and a partner and chief investment officer with Aspen Partners. He holds an MBA from Harvard Business School and a master’s degree in international political economy and a bachelor’s degree in mathematical and computer sciences from the Colorado School of Mines.
1 I.e., the Signs/Sixth Sense/Unbreakable/Village genius, not the Lady in the Water/Happening/Last Airbender/After Earth duffer.
2 Five years from now, as the 1948 fund ages and the 1964-1968 funds are introduced, the open-end fund age range will be 60-80.
3 A plausible objection, well known to annuity salesfolk and advisors trying to convince clients to maximize Social Security, is, “What if I expire in a tragic bowling accident at, like, 80.5 years old?” The (accurate) intuition is that under these circumstances, you become the subsidizer of other folks’ longevity insurance, instead of the subsidized. Responses to this objection are two-fold:
1. I feel confident that in the aftermath of this event, you will have little-to-no objection to subsidizing the living. And even more confident that you won’t be able to contradict my confidence.
2. You’re missing the point! Locking in income security in case you live to 100 enables you to start spending more right away! Consequently, you will be able to spend more money – safely – every year through 80.5 than you would if you didn’t protect the long-run. (That highlighted link, an article by American College of Financial Services professor Michael Finke, is probably the best, simplest explanation I’ve seen of mortality pooling and how it enables greater safe spending immediately.)
Granted, “early” demise may reduce legacy assets, but the higher factor of safety also enables more of your other assets to be solely dedicated to legacy, if desired.
4. I realize there are people who prefer vanilla to cookie dough. And people who (think they) prefer nominal income to inflation-protected income. There are probably even people who prefer The Happening to The Village. And who like blood sausage.
5. This is a back-of-the envelope calculation based on the example of a 70-year-old male.
6. Or really, Stone Ridge and New York Life turn the metaphorical crank.
7. For which, to be very clear, my firm and I have never taken a commission.
8. Interestingly, rather than the mortality pooling per se, my understanding is that the fact that the funds, to work properly, must discriminate by age and gender was perhaps the biggest hurdle to overcome in achieving SEC sign-off on the launch of the LifeX funds.
9. However, the numbers I’ve seen are encouraging in terms of how few investors are required to create a high actuarial probability of success.
10. In an email, Stone Ridge noted that a first-to-die joint life insurance policy could complement a two-single-life LifeX positions in a manner that simulates the benefits of a joint life income solution. This could make sense, though it likely wouldn’t be possible to get a policy providing a clean replication and replacement of inflation-protected lifetime income.
11. I must point out that this makes the funds very nearly equivalent to the “tontine annuity” concept for which I lobbed what I thought was surely an impotent plea into the luminiferous aether in an obscure footnote in my prior article. The LifeX wonders never cease!
12. I am familiar with details that back up this assertion, but they are understandably veiled behind an NDA. Granted, this is sort of like saying, “You don’t have to take their word for it! You… have to take my word for it.” But…well, actually there is no “but”… you would just have to take my word for it. Or sign your own NDA, I suppose.
13. The flipside of all this conservatism may be a lower payout rate than an investor might be promised in a similar annuity. One’s philosophy on the aforementioned transmutation of credit risk into higher return will inform one’s conclusions on the relative attractiveness of the two products. Then again, given my clear preference for the inflation-adjusted payout option, there are no directly competing annuity products at present anyway.
14. While I certainly can’t offer tax advice, the rules around taxation of Treasury income may suggest holding a LifeX fund in an IRA when possible.
15. Technically, you’ll see yesterday’s payout rate and buy at today’s price. A volatile interest rate day could make this material, conditional on one’s threshold for materiality.
16. Nathan Roland Dutzmann: “NRD”!
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