1 summer 2012 How Immediate Annuities Can Help Meet Retirement Goals Wealth Management Institute Whitepaper David Laster, Director, Investment Analytics Anil Suri, CIO, Multi-Asset Class Modeled Solutions A key concern of many clients is assuring that they don t outlive their wealth. One way clients can accomplish this is to consider making immediate annuities part of a welldiversified retirement portfolio. Annuities are the only financial instruments available today that, like Social Security and pensions, can provide an income for life. Thus, annuities can offer clients added peace of mind. Of the myriad financial risks related to retirement, top of mind for many is the risk of outliving their wealth. A Merrill Lynch Affluent Insights Quarterly survey conducted in December 2011 found that two top concerns of those polled were the rising cost of health care (79%) and ensuring that retirement assets will last a lifetime (). Similarly, a 2009 Society of Actuaries survey found that nearly half of retirees and more than half of pre-retirees expressed concern over the prospect of depleting their savings in retirement (Figure 1). 80% Figure 1: How Concerned Are You That in Retirement... (Percentage Very or Somewhat Concerned) 0% 71% 58% You might not be able to keep the value of your savings and investments up with inflation 67% You might not have enough money to pay for adequate health care 62% 49% 52% Your income in retirement may vary based on changes in interest rates 58% 47% You might deplete all of your savings Pre-Retirees Retirees 56% 45% You might not be able to maintain a reasonable standard of living for the rest of your life Key Implications n The challenge As the availability of employer pensions decreases and the outlook for Social Security grows less certain, Americans in or nearing retirement need new sources of income for their later years. n A solution Purchasing an immediate annuity can provide a retiree a regular income stream for life. n An advantage By making a lifetime immediate annuity part of a retirement portfolio, a retiree may substantially reduce the risk of outliving his or her wealth. n The who Immediate annuities are generally best suited for people over age 60 who are in relatively good health. n The how staggering the purchase of immediate annuities over several years can potentially increase the level of payments they generate. Note: Survey sample was 408 pre-retirees and 401 retirees. Source: Society of Actuaries, 2009 Risks and Process of Retirement Survey To address these concerns, Merrill Lynch has developed Goals-Based Wealth Management, which enables Financial Advisors to offer advice and guidance to help clients meet their life goals. 1 Annuities are an instrument uniquely suited to hedging the risk of outliving one s wealth. Yet most consumers are either unfamiliar with annuities or indifferent to them, while many others find them confusing (Figure 2). This note briefly describes what annuities are, the most common types of annuities and how immediate annuities can help clients meet their retirement goals. Figure 2: Household Opinion of Annuities, 2009 I am not too familiar with annuities 29.1% No opinion 12.8% Annuities are too confusing, complex 11.8% Annuities are too expensive 9.8% Annuities are a good way to protect my assets 35.0% 1 Lisa Shalett and Anil Suri, Introduction to Goals-Based Wealth Management, Merrill Lynch Wealth Management Institute, Summer % 10% 15% 25% 30% 35% Note: Top five responses. Source: Cerulli Associates; Phoenix Marketing International Merrill Lynch Wealth Management makes available products and services offered by Merrill Lynch, Pierce, Fenner & Smith Incorporated ( MLPF&S ), a registered broker-dealer and member SIPC, and other subsidiaries of Bank of America Corporation ( BAC ). Investment products offered through MLPF&S and insurance and annuity products offered through Merrill Lynch Life Agency Inc.: Are Not FDIC Insured Are Not Bank Guaranteed May Lose Value Are Not Deposits Are Not Insured by Any Federal Government Agency Are Not a Condition to Any Banking Service or Activity Merrill Lynch Life Agency Inc. is a licensed insurance agency and a wholly owned subsidiary of BAC.
2 What are annuities? Annuities are financial contracts that can pay a stream of income for either a set period of time or over the lifetime of an annuitant. These annuity payments can be monthly, quarterly, semi-annual or annual. What makes annuities both unique and significant is that they are the only financial instruments available today that, like Social Security and pensions, can provide a lifetime income regardless of how long a person lives. 2 Retirees who invest their savings in other assets, such as stocks, bonds or funds, can potentially earn higher returns, but run the risk of outliving their wealth. This might occur due to a financial market downturn, poor investment choices or living longer than expected. Annuities can offer retirees peace of mind as well as a means of boosting their current income. The range of annuities available is so broad that a comprehensive list can easily make a client s eyes glaze over. To avert this paralysis of choice, we focus on a few basic types. Annuities are sold as either immediate or deferred. An immediate annuity converts assets into an income stream and usually starts making payments right away. A deferred annuity accumulates value, often tax-deferred, until it pays distributions, usually during retirement. The investor may withdraw the funds at a later date either in a lump sum, in regular payments until the funds are exhausted, or by rolling the balance into an immediate annuity. Deferred annuities offer a way of saving for retirement; immediate annuities can provide retirees a guaranteed income for life. Another basic distinction among annuities concerns their certainty of returns. Fixed annuities accumulate savings or distribute income at guaranteed rates. Variable annuities accumulate savings or distribute income based on the performance of underlying investment accounts selected by the investor. Many variable annuities offer, in exchange for an additional fee, a guaranteed minimum level of income regardless of how well the underlying annuity investments perform. Based on these two distinctions immediate vs. deferred and fixed vs. variable there are four basic types of annuities (Table 1). 2 All annuity guarantees and payout rates are backed by the claims-paying ability of the issuing insurance company. They are not backed by Merrill Lynch or its affiliates, nor do Merrill Lynch or its affiliates make any representations or guarantees regarding the claims-paying ability of the issuing insurance company. Table 1: Annuities: A Taxonomy Fixed Variable Relevance to Retirement Immediate A fixed immediate annuity makes fixed, regular payments either for a lifetime or for a set period of time. A variable immediate annuity makes regular payments for life or for a set period of time. These payments vary based on the performance of underlying investment accounts. Immediate annuities enable retirees to purchase a lifetime stream of income that they cannot outlive. Variable immediate annuities also offer upside participation in financial markets. Deferred A fixed deferred annuity accrues value, tax-deferred, based on a fixed rate of return. A variable deferred annuity offers the potential to grow in value, tax-deferred, based on the variable investment performance of underlying investment accounts. Because its value is tied to account performance, it is subject to investment risk. Deferred annuities are taxefficient retirement savings vehicles that can be well suited to pre-retirees who already save the maximum allowable amount gin their other retirement plans. 2 whitepaper
3 The growing need for lifetime income Most retirees need to secure a guaranteed income for life. Social Security and pensions both provide lifetime income, but their size and availability are uncertain. Retirees face growing uncertainty as to how large their Social Security benefits will be and to what extent they will be taxed. In 2011, 50% of retirees were either not very or not at all confident that Social Security will continue to provide benefits of at least equal value to the benefits retirees receive today up from 27% a decade ago (Figure 3). Figure 3: Retiree Confidence that Social Security will Continue to Provide Benefits of at Least Equal Value to Benefits Received by Retirees Today 100% 90% 80% 70% 50% 30% 10% 0% 7% 7% 38% 28% Not too or Not at all 30% 38% 11% Source: Employee Benefit Research Institute and Matthew Greenwald & Associates, Inc., 2001 and 2011 Retirement Confidence Surveys This worry is also relevant to many high net worth households: two-thirds of affluent investors are concerned about the future of Social Security benefits. 3 Defined benefit plans (DB), which pay workers a guaranteed income for life, are a vanishing breed. According to the tri-annual Federal Reserve Survey of Consumer Finances, the proportion of workers covered by DB plans has slid from 88% in 1983 to just 36% in 2007 (Figure 4). 4 Because of these trends, today s workers can expect to receive just about a third of their retirement income from Social Security and traditional DB plans, as opposed to nearly 70% for current retirees (Figure 5). Moreover, Social Security represents a smaller fraction of retirement 1% Very Somewhat Not too Not at all Don t know/refused Figure 4: Workers with Pension Coverage, by Pension Type, 1983, 1995 and % 50% 30% 10% 0% 62% 29% 17% Defined benefit 12% 63% 56% Defined contribution 401(k) plans only % 19% 15% Both Source: Boston College Center for Retirement Research, based on data from the Federal Reserve Survey of Consumer Finances income for affluent households than for the overall population. Clients will increasingly need to rely on their defined contribution (DC) plans, IRAs and other savings to fund retirement. By purchasing an annuity, a client can effectively create a personal pension that provides the same income stream that DB plans have traditionally provided. Figure 5: Sources of Retirement Income: Current vs. Future Retirees 100% 80% Social Security 44% Social Security 13% Pension plans 21% Pension plans 25% Personal savings/other 66% Personal savings/other 31% 0 Current Retirees Future Retirees Source: Adapted from Roger Ibbotson, Moshe Milevsky, Peng Chen and Kevin Zhu, Lifetime Financial Advice: Human Capital, Asset Allocation and Insurance, CFA Institute monograph, 2007, p. 4 3 Merrill Lynch Affluent Insights Survey, February A defined benefit plan provides employees a specific level of benefits based on salary history and years of service. A defined contribution plan, such as a 401(k) plan, is one in which employees can elect to defer some percentage of their salaries into the plan. Employers often match some portion of these contributions, but provide no guarantee of future benefits. whitepaper 3
4 Longevity risk: key threat to retirement security A key threat to retirement security is longevity risk, the risk of living longer than planned and exhausting one s assets. The retirees who live the longest face a heightened risk of outliving their wealth. Workers growing reliance on DC plans and savings to fund retirement means that they must increasingly bear longevity risk. This risk is particularly great when financial markets fare poorly. Figure 6, which depicts the survival probability of U.S. 65-year-olds, shows the scale of longevity risk. The bars labeled Joint show the probability of at least one spouse in a married couple living to various ages; the other two bars show this probability for males and females. Nearly 3 in 4 married couples aged 65 will have at least one spouse alive at 85; 23% will have someone live to 95. Moreover, longevity is growing rapidly. Since 1950, the life expectancy of 65-year-olds has increased by 4 years for males and 5 years for females. 5 Thus, people are enjoying substantially longer retirements, but face an even greater challenge of not outliving their assets, particularly in the face of rising prices. Figure 6: Probability of U.S. 65-Year-Olds Living to Various Ages 100% 80% 0% 61% 71% 88% 41% 54% 73% 22% 34% 49% 8% 16% Male Female Joint Source: Calculations by Mary Pat Campbell, FSA, based on Social Security 2010 tables with 1% mortality improvement 23% 5 National Vital Statistics Report, US Life Tables, 2006, June 28, 2010, Table What we call life insurance could more accurately be termed death insurance because it covers the risk of dying. Annuities, on the other hand, could justifiably be called life insurance. 7 The formal name for this is a life income with 20-year period certain SPIA. 8 Based on Merrill Lynch quotes for single life income SPIAs, from several leading providers, as of April 30, Life income only annuities, without the 20-year guarantee, pay slightly more: on the order of 6.4% for a 65-year-old female and 6.7% for a 65-year-old male. How lifetime immediate annuities can help Annuities that provide lifetime income are insurance products uniquely suited to helping investors hedge this longevity risk. In exchange for a lump sum, the buyer receives a stream of income throughout his or her lifetime. Lifetime immediate annuities can be contrasted with life insurance. People buy life insurance to hedge the risk of dying too soon and leaving others in financial need. They buy lifetime immediate annuities to hedge the risk of living so long that they exhaust their assets during their lifetime. 6 There are two basic types of annuities that provide lifetime income: immediate annuities and variable annuities with guaranteed income benefits. Each can play a valuable role in building a retirement portfolio. We now focus on immediate annuities. (Variable annuities with income guarantees will be the subject of a future paper.) Single premium immediate annuities (SPIAs) are particularly relevant to retirement planning because they can provide guaranteed payments for life. SPIA annuity payments are generally for a fixed amount. Some SPIAs, however, offer the option for the payout amount to increase annually by a fixed percentage. The issuing insurance company sets the level of annuity payments based on several factors: payment frequency, gender and age of annuitant and current interest rates. Immediate annuities can help people address longevity risk by providing an income for life that may be higher than they can earn elsewhere. Consider the specific example of a SPIA that pays income for life, but for no less than 20 years, regardless of how long the annuitant lives. 7 At recent prices, a 65-year-old female could purchase a $100,000 SPIA that pays a guaranteed annual income on the order of 5.8%; a 65-year-old male would receive an annual income of about 5.9%. 8 Other lower-risk investments such as CDs and investment grade bond funds generate far less income. The reason for this is simple: someone who purchases a lifetime immediate annuity is exchanging the use of his or her capital after he or she dies for a higher rate of return during his or her lifetime, earning what are known as mortality credits. This trade-off may be worthwhile for retirees who need to generate higher retirement income than is available from other lower-risk investments. Age and health should figure into the decision to buy a lifetime immediate annuity. Since such annuities offer higher payouts for older annuitants, they tend to make the most sense for people in their 60s, and even more sense for those 70 or over. For people under 60, other investments are likely more attractive. Moreover, since the cumulative payout of lifetime immediate annuities generally depends on how long the annuitant lives, they are typically suited for people in reasonably good health for their age. 4 whitepaper
5 Immediate annuities have some key shortcomings worth considering. First, the funds used to purchase an immediate annuity can usually not be accessed after the annuity is purchased except through its periodic payments. Therefore, those funds are unavailable to address immediate needs that might arise, such as unexpected medical expenses. Second, buying an immediate annuity comes at the expense of not being able to leave a bequest from the funds used to make the purchase. 9 Third, the real value of an immediate annuity s payouts declines over time due to inflation. Merrill Lynch Global Research forecasts U.S. long-term inflation of 2.5%. Even at this moderate rate, today s dollar will be worth 61 cents in two decades and of course much less if inflation rises sharply. 10 Moreover, retirees face a somewhat higher rate of inflation than the general populace. 11 It s not all-or-nothing These drawbacks are not as stark as they sound, however, because the decision to purchase an annuity is not all-ornothing. A retiree might, for example, allocate 30% of his or her wealth to an annuity, while investing the remaining 70% in other assets. By so doing, he or she can gain the longevity protection and regular income that annuities provide while allocating capital for other purposes such as future liquidity needs or bequests. This possibility is one unappreciated by many individual investors, who too often view immediate annuities in isolation. In recent years, many investors have come to understand that they gain the best risk-return trade-off by viewing their investments in a portfolio context, and by diversifying across asset classes, such as stocks and bonds. What is less understood is the benefit of diversifying across financial products as well as asset classes. In particular, allocating some of a retirement portfolio to annuities can help address longevity risk, a benefit not available from diversifying across asset classes. A growing body of research suggests that clients can materially reduce the risk of outliving their income by allocating some of a diversified retirement portfolio to annuities that provide lifetime income. 12 One other dimension of the decision to buy immediate annuities concerns timing. There are compelling reasons to purchase immediate annuities gradually rather than all at once. As previously noted, the level of annuity payments increases with the age of the annuitant. Thus, waiting a year or two before buying a SPIA can mean higher payments. Moreover, because interest rates are now low by historical standards, annuity payments are lower today than they have been in the past. It might therefore make sense to wait before buying, in the hope of higher interest rates. Each of these points has a counterargument, however. First, if owning a SPIA provides attractive income, someone who delays buying one forgoes this income in the interim and may, due to inertia, never buy one. Second, although interest rates are low, they could stay low for some time, or decline even further, reducing annuity payments. Moreover, while low interest rates mean lower payouts for SPIAs, this does not necessarily make them less attractive vis-à-vis the other alternatives retirees have. Indeed, in today s low interest environment, immediate annuities are a uniquely important tool for many retirees. In view of these considerations, a client for whom an allocation to immediate annuities makes sense should consider purchasing them over time. Someone with $1 million of assets might, for example, buy a $50,000 SPIA today, and another in each of the next five years. For many clients, immediate annuities can be a valuable part of a sensible, well-diversified portfolio that provides income for life. The inclusion of deferred variable annuities (VA) can further strengthen a retirement portfolio. Though potentially riskier than immediate annuities, VAs are more likely to keep pace with inflation over time. 13 In future notes we will explore how VAs work and how to determine the optimal allocation to annuities for a retirement portfolio. Summary n Because the prospects for Social Security are uncertain and traditional employer pension plans are a vanishing breed, clients will increasingly need other sources of income in retirement. n Longevity risk, the risk of living longer than expected, heightens clients need for lifetime income. This risk is substantial: 23% of couples aged 65 will have at least one member live past 95. n Lifetime immediate annuities, though unfamiliar to many, can help clients boost their lifetime income. n For many, it makes sense to allocate some savings to lifetime immediate annuities. Including these annuities in a portfolio can substantially reduce retirees risk of outliving their wealth. n Lifetime immediate annuities are generally more suitable for clients older than 60 who are in relatively good health. n One approach for clients to consider is staggering the purchase of immediate annuities over several years. 9 Some immediate annuities mitigate this problem, e.g., by paying a joint benefit or by guaranteeing a minimum number of years of payments. These features come, however, at the cost of lower annuity payments. 10 For more on inflation risk, see David Laster, Anil Suri and Nevenka Vrdoljak, Pitfalls in Retirement, Merrill Lynch Wealth Management Institute, Summer According to the Bureau of Labor Statistics, Americans 62 or older faced an estimated additional 0.2% of inflation per year relative to headline CPI, from Examples of this research include: Roger Ibbotson, Moshe Milevsky, Peng Chen and Kevin Zhu, Lifetime Financial Advice: Human Capital, Asset Allocation and Insurance, CFA Institute monograph, 2007, pp , and Milevsky, A Gentle Introduction to the Calculus of Sustainable Income, Journal of Financial Service Professionals, July Ibbotson et al, pp whitepaper 5
6 Anil Suri, Managing Director, is the CIO of Multi-Asset Class Modeled Solutions and the Head of Investment Analytics at Merrill Lynch Global Wealth Management. He leads the development of solutions for goalsbased wealth management, retirement investing, behavioral finance, asset allocation, systematic portfolio management, and performance measurement across traditional, market-linked and alternative investments. Anil has been with Merrill Lynch since 2004, where he was previously Head of Investment Strategy & Analytics in the Alternative Investments area and a Senior Investment Strategist on the Merrill Lynch Research Investment Committee (RIC). Anil s research has been published in the Journal of Wealth Management and discussed in Barron s and The Wall Street Journal. His prior experience includes roles as a senior AI strategist at Citigroup, trader at Credit Suisse and management consultant at McKinsey. Anil earned an M.B.A. with honors from the Wharton School of the University of Pennsylvania, an M.S.E. from Princeton University and a B. Tech. from the Indian Institute of Technology at Delhi. David Laster, Director, Investment Analytics, is responsible for developing analytical solutions and thought leadership in the area of retirement investing. His research has appeared in the Financial Analysts Journal, Journal of Investing and Journal of Wealth Management and has been discussed in the Wall Street Journal, Financial Times and Fortune. Before joining Merrill Lynch, David was a senior economist at Swiss Reinsurance Company and a financial economist at the Federal Reserve Bank of New York. David earned a Ph.D. in economics from Columbia University and a B.A. in mathematics from Yale University. He is a CFA charterholder. 6 whitepaper
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8 Recent Publications from the Wealth Management Institute Summer 2012 How Immediate Annuities Can Help Meet Retirement Goals Laster/Suri Spring 2012 Income Solutions Framework Wagle/Gonzalez/Almadi Spring 2012 Innovations in Behavioral Finance: How to Assess Your Investment Personality Liersch/Suri Spring 2012 Dynamic Asset Allocation Suri/Almadi/MacLean Spring 2012 What Behavioral Finance Has to Say About Generations X, Y and Z Liersch Winter 2012 Systematic Withdrawal Strategies for Retirees Laster/Suri/Vrdoljak Fall 2011 What is Behavioral Investing? Liersch Summer 2011 Introduction to Goals-Based Wealth Management Shalett/Suri Summer 2011 Pitfalls in Retirement Laster/Suri/Vrdoljak Summer 2011 How Behavioral Finance Can Help in Times of Volatility Liersch/Suri Merrill Lynch s Wealth Management Institute offers clients some of the world s best intellectual capital on topics that complement our traditional investment management and portfolio construction advice. The Wealth Management Institute helps clients and advisors create holistic and customized solutions by combining Merrill Lynch s expertise in managing wealth for individuals, families and institutions with our internal thought leadership and professional network of industry luminaries and leading academics. All Wealth Management Institute thought leadership is driven and vetted by the Investment Management & Guidance leadership team. Investment Management & Guidance Leadership Team Contact Information Lisa Shalett, GWIM CIO and Head of Investment Management & Guidance Spencer Boggess, CIO, Alternative Investments Rick Galiardo, Global Head, Advice, Guidance and Research Strategy Victoria Ip, Chief Investment Strategist, Asia-Pacific Rim Tom Latta, Global Head, Traditional Manager Due Dilligence Bill O Neill, CIO, EMEA Jim Russell, CIO, Portfolio Construction and Multi-Manager Solutions Anil Suri, CIO, Multi-Asset Class Modeled Solutions Chris Wolfe, CIO, PBIG and Ultra-High Net Worth Customized Solutions Wealth Management Institute Advisory Board John Hogarty, COO, Global Wealth & Investment Management Andy Sieg, Head of Global Wealth & Retirement Solutions John Thiel, Head of Merrill Lynch U.S. Wealth Management and Head of Private Banking and Investments Group Riley Etheridge, Jr., Managing Director, Head of Client Solutions and Segments Tom Fickinger, Managing Director, Head of Financial Advisor Strategy Keith Glenfield, Managing Director, Global Wealth & Retirement Solutions David Tyrie, Managing Director, Retirement Services IMPORTANT INFORMATION ABOUT VARIABLE ANNUITIES: Variable annuities are long-term investments designed to help meet retirement needs. A variable annuity is a contractual agreement where a client makes payments to an insurance company, which, in turn, agrees to pay out an income stream or a lump sum amount at a later date. Variable annuities typically offer (1) tax-deferred treatment of earnings; (2) a death benefit; and (3) annuity payout options that can provide guaranteed income for life. The return and principal value of variable annuities are subject to market fluctuations, investment risk and possible loss of principal so that, when redeemed, variable annuities may be worth more or less than the original amount invested. There are contract limitations, fees and charges associated with variable annuities which include, but are not limited to mortality and expense risk charges, sales and surrender charges, administrative fees, charges for optional benefits as well as charges for the underlyinginvestment options. Early withdrawals may be subject to surrender charges, and taxed as ordinary income, and in addition, if taken prior to age 59½ an additional 10% federal income tax penalty may apply. Withdrawals reduce annuity contract benefits, values and optional guarantees in any amount that may be more than the actual withdrawal. All contract and rider guarantees, optional benefits and any fixed subaccount crediting rates or annuity payout rates, are backed by the claims paying ability of the issuing insurance company. They are not backed by Merrill Lynch or its affiliates, nor do Merrill Lynch or its affiliates make any representations or guarantees regarding the claims paying ability of the issuing insurance company. Optional guaranteed benefits typically require investment restrictions and may be irrevocable once elected. Please refer to the prospectus for additional information. Asset allocation does not ensure a profit or protect against loss. Variable annuities are sold by prospectus only. Your Financial Advisor can provide you with more information, including a current prospectus. The current contract prospectus and underlying fund prospectuses contain more complete details on the investment objectives, risks, fees, charges and expenses, as well as other information about the contract and the underlying portfolios which should be carefully considered. Please read the prospectuses carefully before investing. This communication was prepared to support the promotion and marketing of annuity products. Any tax statements contained herein were not intended or written to be used, and cannot be used for the purpose of avoiding U.S. federal, state or local tax penalties. Neither Merrill Lynch nor its Financial Advisors provide tax, accounting or legal advice. Clients should review any planned financial transactions or arrangements that may have tax, accounting or legal implications with their personal professional advisors. This communication does not take into account your particular investment objectives, financial situations or needs and is not intended as a recommendation, offer or solicitation for the purchase or sale of any security, financial instrument, or strategy. Before acting on any information in this material, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Any opinions expressed herein are given in good faith, are subject to change without notice, and are only correct as of the stated date of their issue. GWM Investment Management & Guidance (IMG) provides industry-leading investment solutions, portfolio construction advice and wealth management guidance Bank of America Corporation. All rights reserved. ARL1Q