Required Yield: The Pre-Retiree s Cost-of-Waiting Metric When Purchasing Guaranteed Lifetime Income. Introduction. Options for Guaranteed Income

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1 Required Yield: The Pre-Retiree s Cost-of-Waiting Metric When Purchasing Guaranteed Lifetime Income Capturing yield has become difficult with most fixed income vehicles offering returns impacted negatively by the current interest rate environment. Introduction Investors gearing up for retirement often face tough choices and tradeoffs in structuring their portfolios to provide a lifetime income stream. This is especially true in the current economic environment, which is plagued by low consumer confidence 1, historically low interest rates 2, and high volatility in equity markets 3. These factors combine to create low consumer expectations for returns on their most conservative investments. Capturing yield has become difficult with most fixed income vehicles offering returns impacted negatively by the current interest rate environment. Facing these investment obstacles, pre-retirees are often left to choose between generating additional assets by working longer, reducing planned retirement spending, or making riskier investments in an effort to capture higher yields. Options for Guaranteed Income An income annuity provides a secure and efficient way to generate guaranteed lifetime income for consumers willing to give up liquidity. In fact, because the payout of an income annuity includes mortality credits, as well as interest and return of premium, it can often provide more income than other strategies. For pre-retirees who, during their final working years, seek to secure a level of income that starts at retirement, a Deferred Income Annuity (DIA) may be an optimal option. Because income payments do not start immediately, a DIA is better suited for those investors who need Income Soon. Retirees, on the other hand, represent the Income Now demographic and may be better served by another type of income annuity, the Single Premium Immediate Annuity (SPIA). This leaves pre-retirees with two options for funding guaranteed lifetime income for retirement: Option #1 Option #2 Purchase a DIA today that guarantees a lifetime income stream that starts at retirement in the future Look to capital markets to generate a consistent and relatively safe investment return up until retirement, then convert the accumulated balance into lifetime income by purchasing a SPIA at retirement 1

2 How would one evaluate the economic benefits of these two options? This question is pertinent today, as 73% of investors begin allocating their assets to a retirement income plan prior to retiring 4. A new metric, the Required Yield, can help shed some light on the decision. Required Yield Required Yield is the annual return necessary to ensure enough assets are available using Option #2 to purchase the equivalent amount of guaranteed income available using Option #1. As such, Required Yield can be used to measure the relative value of a DIA (Option #1) as compared to the cost of waiting. The DIA may be a better option for generating guaranteed lifetime income if the investor believes he/she cannot realistically achieve returns greater than the Required Yield on investable assets and, as such, may be unable to purchase a SPIA at retirement to generate the same income as a DIA today. Unlike most metrics used to evaluate retirement income strategies, the Required Yield on investable assets is unique to every pre-retiree, according to his/her gender, age, and length of time before the income start date. Because it is a customized decision metric, the Required Yield can play a critical role in the decision making of pre-retirees. Example of Required Yield in the Current Market A 55-year old male who wishes to retire at 65 determines he will need $10,000 in guaranteed income every year in retirement. Following the strategy in Option #1, he can use his assets to purchase a DIA today for $90,851 that will pay $10,000 annually during his lifetime, beginning 10 years from now 5. Alternatively, he can choose Option #2 and wait to convert his assets into guaranteed income, purchasing a SPIA in 10 years upon retirement. Based on today s interest rates, under Option #2, he would need to amass $158,488 in order to buy an immediate annuity that generates the same $10,000 per year, starting at age 65. Effectively, over the course of 10 years, he would need to achieve annual compounded returns of 5.72% on his assets, or risk ending up with a lower level of guaranteed lifetime income. This metric is the Required Yield necessary on his investable assets to make him indifferent between purchasing a DIA today and a SPIA 10 years from now. The Formula The Required Yield calculation is determined by the following formula: Investment (1 + Required Yield) t SPIA payout rate = Investment DIA payout rate - Where the SPIA payout rate is at retirement age - DIA payout rate is t-years prior to retirement, and - t is the DIA deferral period 2

3 The growth factor of the formula, (1+Required Yield) t, is the mathematical expression of the two sources of the DIA s comparative economic advantage over a SPIA purchased at a later date: (1) a longer investment period, and (2) additional mortality credits. By purchasing a DIA well before the income start date, the pre-retiree enables the insurance company to invest his/her premium in longer-term fixed income assets, which earn a higher yield than the investments of SPIA premium. In addition, mortality credits accumulate during the DIA deferral period, which also increases the growth factor. Solving for Required Yield in the expression above produces the formula to calculate Required Yield on investable assets 6 : Waiting to purchase a SPIA in the future provides less certainty than purchasing a DIA today and may increase the cost of guaranteed lifetime income. Limitations of the Required Yield Concept In order to best simulate actual experience in the market, this analysis uses the average DIA and SPIA rates as listed on the CANNEX exchange as of 02/21/12. However, given the limitations of predicting future rates, the analysis uses today s SPIA rates as a proxy for future rates. The possibility of rates rising in the future naturally impacts the value of the Required Yield metric. For example, if we assume that SPIA rates will rise 200 basis points over the next ten years, the Required Yield would drop from 5.72% to 3.94%. The Required Yield is NOT the return earned on an investment. It is an economic tool used to facilitate decision making and should not be confused with an actual return on investment. Because income annuities are neither securities nor traditional deferred annuities, they often have no cash surrender value, don t permit withdrawals, and in cases in which a Life Only payout option is selected, the contracts do not provide a death benefit either prior to, or after, the designated income start date. Also, all guarantees are subject to contract terms, and the claims-paying ability of the issuing insurer, so financial strength should be considered in addition to the Required Yield. Understanding Current Market Conditions While possible, a 10-year average return of 5.72% on a fixed income investment is far from certain, especially in today s economic environment. The Required Yield on investable assets is four times the return on a five-year CD, almost three times the return on a 10-year treasury, and nearly twice the return on a AA rated corporate bond. Also, while past performance is not a predictor of future performance, an investment in the S&P years ago would have fallen well short of the returns needed to meet the Required Yield on investable assets that would make a consumer indifferent between purchasing a DIA today and a SPIA 10 years from now. (See chart on next page). It should be noted that if one assumes a 200 basis point rise in SPIA rates 10 years from now, and if the purchaser is comfortable with the risk profile of AA corporate bonds, the purchaser will be approaching a point of indifference between a DIA today and the option of investing in those AA rated corporate bonds and purchasing a SPIA in the future. However, this point of indifference requires the purchaser to make assumptions about future investment performance. The pre-retiree is left guessing the direction of the market, a position in which he/she may not be comfortable. 3

4 Waiting to purchase a SPIA in the future provides less certainty than purchasing a DIA today and may increase the cost of guaranteed lifetime income, creating a real opportunity cost to the client. Yields on commonly held savings vehicles and fixed income investments* * These rates are as of the date noted and are subject to change: Money market: 0.33% - APY for national average of Jumbo MM & Savings rate Bankrate.com (2/21/12) 5yr CDs: 1.43% - APY from Bankrate.com site average (2/12/12) 10yr Treasury Note: 2.04% - current yield from Yahoo Finance (2/12/12) 10yr AA Corporate Bonds: 3.18% - current composite yield from Yahoo Finance (2/12/12) Additional Information US Treasuries and corporate bonds are backed by the credit worthiness of the issuing entity and investors receive their principal at maturity. While these fixed income investments are debt securities that pay fixed interest to the investor and offer more liquidity than an income annuity, they are subject to interest rate and credit risk. Similar to traditional fixed income investments, CDs pay fixed interest to the investor and investors receive their principal deposit at maturity. CDs are short-term savings vehicle that are FDIC-insured and withdrawal prior to maturity may be subject to penalty. Similar to a traditional fixed income investment, a deferred income annuity returns premium (or principal) and interest. However, unlike US Treasuries and corporate bonds, the payout rate of the DIA also includes mortality credits, which enable the DIA income payment to continue for the duration of the investor s lifetime and is dependent on factors such as age, gender, premium amount, payout option and deferral period. Under certain payment options, DIA contracts have no cash surrender value. The DIA income payment is dependent upon the claims-paying ability of the issuing company. 4

5 Conclusion The Required Yield on investable assets is simply the expression of the possible economic advantage of a DIA; it highlights the opportunity cost of waiting to purchase a SPIA. This concept presents a compelling case for the Income Soon investor to consider retirement income planning early, especially in the face of the current economic environment. For most pre-retirees, the scarcity of reliable, high-yielding investment opportunities in today s economic environment makes securing guaranteed future income extremely appealing. The longer investment strategy and the mortality credits of the DIA result in a comparatively high Required Yield (needed on investable assets to consider alternatives to a DIA), and strengthens the case for a Deferred Income Annuity as a prudent vehicle for the pre-retiree. 1 Bloomberg Consumer Comfort Index 2 Department of the Treasury 10Y Treasury historical chart 3 Bloomberg quote for VIX index 4 LIMRA s Positioning Assets in Retirement, published 2/23/10 5 Rates for both DIA and SPIA are based on the average payout rates for the same payout option among A.M. Best A++ insurers, as quoted by Cannex on 02/21/12 and are subject to change. 6 Calculating the Required Yield Use the DIA modal income as a SPIA illustration input and solve for premium amount to match the modal income. Divide the DIA premium by the SPIA premium to solve for total growth needed. Split the total growth needed over the number of years, by setting the quotient of SPIA premium/dia premium to the power of 1/deferral years. Subtract by 1 for the Required Yield. New York Life Insurance Company New York Life Insurance and Annuity Corporation (a Delaware Corporation) 51 Madison Avenue, New York, NY newyorklifeannuities.com ANNUITIES Not FDIC/NCUA Insured Not a Deposit May Lose Value No Bank Guarantee Not Insured by Any Government Agency AIS38a-03/ CV (3/13) 5

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