Can Variable Annuities Help You Meet Your Retirement Goals?

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1 Can Variable Annuities Help You Meet Your Retirement Goals? WEALTH Management INSTITUTE Portfolio Construction & Investment Analytics WINTER 2014 Investors seeking to fund retirement face a growing array of challenges: longer life expectancies, employers shift from pensions paying defined benefits to defined contribution plans, and uncertainty regarding Social Security. Many investors fund retirement through mutual funds, which offer scant protection against the risk of a market downturn or of outliving one s wealth. This paper explores a solution that can help mitigate these retirement risks: a variable annuity with a guaranteed lifetime withdrawal benefit (VA+GLWB). Our analysis demonstrates that including a VA+GLWB in a diversified portfolio can reduce the risk of running out of money in retirement. 1 What are variable annuities? A variable annuity is a long-term contract with an insurance company through which an investor may accumulate assets tax-deferred in professionally managed subaccounts that resemble mutual funds. Variable annuities have been among the most rapidly growing financial products in recent decades. From 2002 to 2012, assets under management increased from $777 billion to $1.64 trillion. 2 In recent years, insurers have begun offering variable annuities with a product feature known as a guaranteed living benefit (GLB). A GLB is a rider (contract clause) that, in exchange for a fee, provides the owner lifetime income through guaranteed withdrawals. In the past few years, the share of variable annuity purchasers who elect to buy a GLB has ranged from 84% to 90%. 3 Another feature of variable annuities is that they provide investors control of the underlying assets. At the end of the annuity holder s life, the contract value is payable to his or her beneficiaries. Immediate annuities, which can also provide a guaranteed income for life, generally do not offer this control. This paper focuses on variable annuities with the most popular type of GLB, a guaranteed lifetime withdrawal benefit rider, or VA+GLWB. 4 A VA+GLWB gives the owner the right to take annual withdrawals of a specified level for life, regardless of how the underlying investments perform or how long the owner lives. David Laster Director, Portfolio Construction & Investment Analytics Anil Suri Managing Director, Head of Portfolio Construction & Investment Analytics Nevenka Vrdoljak Director, Portfolio Construction & Investment Analytics Key Implications Protection and control A variable annuity with guaranteed lifetime withdrawal benefit (VA+GLWB) provides downside risk protection in the form of guaranteed withdrawals for life, upside exposure to equities and control of the underlying assets. IMPROVED outcomes This analysis shows that allocating a portion of a retirement portfolio to a VA+GLWB can reduce the risk of exhausting one s assets while assuring a minimum level of income for life. Decrease in bequest potential These gains come at the cost of a decrease in the expected future bequest. Longevity and sequence of returns risk Long life or poor returns in the early years of retirement can heighten the risk of outliving one s wealth. An allocation to a VA+GLWB can help mitigate these risks. Timing In deciding when to take withdrawals from a VA+GLWB, it may be worthwhile to wait to reach an age at which the guaranteed minimum withdrawal rate is more generous. Asset allocation within an annuity Having as high an allocation to equities in a VA+GLWB as the rider permits can enable an investor to realize the maximum benefit from the guarantee. Trade-offs Investors should consult their Financial Advisors to weigh the benefits of a VA+GLWB against the associated product fees, restrictions, credit risk and complexity. 1 The suitability of adding a VA+GLWB to a portfolio depends on a range of client-specific factors, including one s risk tolerance, financial needs, investment objectives, investment time horizon and liquidity needs. 2 Insured Retirement Institute (2013). 3 LIMRA Variable Annuity Guaranteed Living Benefit (GLB) Election Tracking Survey, First Quarter Election rates are based on the percentage of new premium for which annuity buyers elected a GLB when one was available. 4 According to LIMRA, more than three-quarters of GLBs sold in 2013Q1 were GLWBs. Merrill Lynch 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 Bank of America Corporation. All rights reserved.

2 Addressing retirement risks Two key risks that threaten the financial well-being of retirees are longevity risk and sequence of returns risk. Longevity risk is the risk of outliving one s wealth. Sequence of returns risk is the risk that a portfolio will perform poorly around the time one retires, compromising its capacity to provide a stream of income for life. A variable annuity with a guaranteed lifetime withdrawal benefit (VA+GLWB) can help mitigate these risks. Some drawbacks and risks Investors must weigh these potential benefits against the drawbacks of variable annuities, notably: 1. Fees and complexity. Variable annuities are more complex and charge Mortality & Expense fees and rider charges, which mutual funds do not. 2. Credit risk. The assets in a variable annuity are held on behalf of the owner in a separate account, providing a measure of safety. The GLB, however, is paid by the insurer and depends on the insurer s claims-paying ability. 3. Market Risk. The return and principal value of variable annuities are subject to market fluctuations, investment risk and possible loss of principal so that when redeemed they may be worth more or less than the original amount invested. 4. Impact of withdrawals. Withdrawals of amounts in excess of the guaranteed amount will reduce the guarantee. 5. Surrender charges. Variable annuities are subject to surrender charges in the five to seven years after they are purchased. These charges are typically 5-7% of assets initially, declining by 1% per year, to zero. How a variable annuity with guaranteed lifetime withdrawal benefit works A variable annuity with guaranteed lifetime withdrawal benefits (VA+GLWB) resembles a mutual fund. The GLWB is a rider (contract clause) that guarantees the payment of income for life, no matter how the underlying investments perform. For example, a 60-year-old who purchases a VA+GLWB for $100,000 with a 4 percent income rider is guaranteed a payout of at least $4,000 ($100,000 4%) per year for the rest of his or her life even if the value of the underlying assets falls to zero (see Figure 1). On the day of purchase, the contract value (the account value) and the benefit base (the notional amount used to calculate income payments) are the same $100,000 in our example. For the rest of the investor s life, he or she will receive annual income of at least 4 percent of the benefit base (or $4,000), provided that the investor draws down no more than this amount. There are two ways to boost the guaranteed lifetime income level of a VA+GLWB: by waiting to collect income or through market appreciation. Waiting to Collect Investors commonly purchase VA+GLWBs prior to when they need the income. If the investor delays making withdrawals, then the benefit base will automatically increase, or roll-up, by a certain percentage (typically 5%) per year for a specified number of years. When the investor begins receiving payments from his or her VA+GLWB, they will be calculated using the new, higher benefit base. Thus, in our example, if the investor delays making withdrawals for five years, the benefit base will grow to $125,000 (Figure 1). Waiting can also confer another Figure 1: VA+GLWB Contract Value and Benefit Base $140,000 $125,000 $120,000 $100,000 $80,000 $60,000 $40,000 Contract value - the market value of investment Benefit base - amount used to calculate income payment Roll-up - the benefit base grows at 5% for 5 years, until the client begins taking withdrawals Step-up - at age 71 the contract value surpasses the benefit base, which steps up to it $20,000 $ Client s Age Example is for illustrative purposes only and does not represent an actual investment. Can Variable Annuities Help You Meet Your Retirement Goals? 2

3 Figure 2: VA+GLWB Annual Lifetime Withdrawals Client begins taking annual withdrawals of $6,250, 5% of the benefit base Annual withdrawals step up to $7,000, 5% of the new, higher benefit base $7,000 $6,250 Annual Withdrawals $ Example is for illustrative purposes only and does not represent an actual investment. Client s Age advantage. Guaranteed withdrawal rates depend on age, so waiting until age 65 can boost this rate to, say, 5%. In our example, waiting five years before taking withdrawals boosts the annual guaranteed lifetime withdrawal from $4,000 to $6,250 ($125,000 5%; see Figure 2). Market Appreciation In addition to annual roll-ups, the lifetime guaranteed income from a VA+GLWB can also rise due to market appreciation. The funds used to purchase a VA+GLWB are invested in subaccounts whose account balance (contract value) fluctuates daily based on the performance of the underlying investments. If the annuity s investments perform well and the contract value exceeds the value of the benefit base, the base will be reset to this new, higher level. Most VA+GLWBs allow the benefit base to be reset once a year, a process known as a step-up. Figures 1 and 2 illustrate how a step up works at age 71, with an increase in the benefit base to $140,000 and the annual lifetime withdrawal amount to $7,000. Preserving the guaranteed lifetime withdrawal benefit The guaranteed lifetime withdrawal benefit is contingent on the annuity owner s not withdrawing more than this benefit amount in a given year. If, in our example, the annuity owner took an annual withdrawal in excess of the $6,250 available at age 65, then the guaranteed minimum withdrawal he or she could take in subsequent years would be reduced. Retirement outcomes and VA+GLWB To examine how allocating assets to a variable annuity can affect the performance of a retirement portfolio, we consider a 60-year-old woman with a $1 million retirement portfolio that consists of a Systematic Withdrawal Program (SWP) 5 and a VA+GLWB. Each year she draws down her assets to provide income and then rebalances the remaining assets held in the SWP to a target allocation. This drawdown increases over time in line with inflation. Assume, in this example, the investor waits until age 65 to begin drawing funds from the VA+GLWB. Between the ages of 60 and 65, she draws down assets exclusively from the SWP, leaving the VA+GLWB untouched. Starting at age 65, she takes the guaranteed lifetime withdrawal from the VA+GLWB each year and draws down assets from the SWP as needed. Retirement Outcome Metrics Expected lifetime shortfall denotes the amount by which investors can expect to undershoot their lifetime spending plans in scenarios in which they outlive their wealth. Expected bequest represents the wealth a client can expect to have remaining at the end of his or her life. 5 A Systematic Withdrawal Program (SWP) is a common way to invest in retirement. The client allocates her account to a fixed mix of investments, from which she periodically draws down funds and then rebalances. Can Variable Annuities Help You Meet Your Retirement Goals? 3

4 Table 1. SWP and VA+GLWB Simulation Model Inputs Client Current age 60 Retirement age 60 Gender Female Martial status Single Financial Assets $1,000,000 Annual spending needs $32,100 SWP Asset Allocation Stocks 40% Bonds 60% Fees Stocks 1.5% Bonds 1.1% GLWB Asset Allocation Stocks 60% Bonds 40% Fees Mortality & Expense fee 1.3% Benefit fee 1.0% Asset Management Fees Stocks 0.95% Bonds 0.75% Withdrawal Benefit Purchase age 60 Withdrawal age 65 Guaranteed withdrawal rate 5% Roll-up percentage 5% Step-up frequency Annual Note: Asset management fees for SWP and VA+GLWB are based on Morningstar data. The asset allocation mix of the SWP is assumed to be 40% equities and 60% bonds, which our research suggests works well for many retirees. 6 Consistent with typical industry offerings, the asset allocation mix of the VA+GLWB portion is assumed to be 60% equities and 40% bonds. 7 The analysis also assumes annual step-ups and a 5% roll-up. Table 1 summarizes our assumptions about the client, her Systematic Withdrawal Program and the VA+GLWB. Simulation analysis To measure the range of possible outcomes, we run 20,000 market simulations. For each simulation, we measure how the 60-year-old client would fare if she lived one year in retirement, two years and so forth, through 50 years. Thus, the analysis effectively considers a million (50 20,000) scenarios. It weighs each scenario by the probability of the corresponding lifespan, based on the Society of Actuaries Annuity 2000 Mortality Table. 8 Results: Lifetime shortfall Allocating a portion of a retirement portfolio to a VA+GLWB can reduce the risk of exhausting one s assets. Assume that the retiree in our example wishes to make annual withdrawals while remaining highly confident that she will not exhaust her assets. Our previous research on systematic withdrawal programs found that a 60-year-old woman seeking 95% certainty of not outliving her wealth can spend 3.21% of assets ($32,100) the first year and increase this amount each subsequent year in line with inflation. 9 Thus, a retirement portfolio allocated 100% to an SWP has a 5.0% probability of running out of money in her lifetime. As the portfolio s allocation to a VA+GLWB increases, this likelihood of a shortfall steadily declines. For example, if she allocates 30% to a VA+GLWB, her risk of exhausting her assets falls to 3.6% (Figure 3). Moreover, even in scenarios in which she has completely exhausted her wealth, the VA+GLWB continues to pay her some level of income for life. 10 Figure 3: Risk of Outliving Assets, by Level of Shortfall Probability 6% 5% 4% 3% 2% 1% 0% Expected Lifetime Shortfall 5.0% $0-$100, % $100,000-$250, % more than $250, % 0% 10% 20% 30% $154,000 $139,000 $123,000 $110,000 VA+GLWB allocation Lifetime Shortfall 0% 10% 20% 30% more than $250, % 0.8% 0.5% 0.3% $100,000-$250, % 1.7% 1.6% 1.3% $0-$100, % 2.0% 2.0% 2.0% Notes: Analysis is for a 60-year-old woman with a $1 million retirement portfolio that combines an SWP and VA+GLWB. The combined retirement portfolio assumes a fixedpercentage annual withdrawal rate of 3.21%. A fixed 5% annual withdrawal rate is assumed on the benefit base of the VA+GLWB and does not commence until age 65. The asset allocation mix of the SWP portion is assumed to be 40% to equities and 60% to bonds. The asset allocation mix of the VA+GLWB portion is assumed to be 60% to equities and 40% to bonds. See Appendix 1 for capital market and mortality assumptions and Table 1 for SWP and VA+GLWB simulation model assumptions. 6 David Laster, Anil Suri and Nevenka Vrdoljak, Systematic Withdrawal Strategies for Retirees, Journal of Wealth Management, Vol. 15, No. 3 (Winter 2012), pp It bears mentioning that not all VA+GLWB providers allow this asset allocation. A growing number require the owner to invest in a managed volatility fund. Managed volatility funds incorporate a volatility control process that seeks to reduce risk when portfolio volatility is expected to deviate from the target total return over a specified period. So, the asset allocation changes with changing market conditions. 8 Appendix 1 details our mortality and capital market assumptions. 9 Laster et al., op. cit., Exhibit 12 reports achievable spending rates to the nearest 0.1 percent. 10 In this example, her $300,000 investment in a VA+GLWB will have a benefit base that rolls-up to at least $375,000 ($300,000 x (1 + 5 x 5%)), generating at least $18,750 per year of income starting at age 65, for the rest of her life. Can Variable Annuities Help You Meet Your Retirement Goals? 4

5 Allocating part of her retirement portfolio to a VA+GLWB reduces not just the likelihood, but also the potential magnitude, of a lifetime shortfall in adverse scenarios. The expected shortfall in the unlikely case that the investor exhausts her wealth would be $154,000 if she invests entirely in an SWP, but $110,000 if she allocates 30% to a VA+GLWB. Whereas investing exclusively in an SWP leads to a severe lifetime shortfall (in excess of $250,000) 1.0% of the time, allocating 30% to a VA+GLWB reduces the likelihood of this extremely unfavorable outcome to 0.3%. Bequest potential The reduction in risk that a VA+GLWB can provide comes at a cost: a reduction in bequest potential. A retirement portfolio allocated 100% to an SWP provides an expected bequest of $877,000. But as the portfolio s allocation to annuities increases, this expected bequest declines to $790,000 (Figure 4). Bequest Figure 4: Expected Bequest $1,000,000 $900,000 $877,000 $848,000 $800,000 $819,000 $790,000 $700,000 $600,000 $500,000 $400,000 $300,000 $200,000 $100,000 0% 0% 10% 20% 30% VA+GLWB allocation Notes: Analysis is for a 60-year-old woman with a $1 million retirement portfolio that combines an SWP and VA+GLWB. The combined retirement portfolio assumes an initial annual withdrawal rate of 3.21%. A fixed 5% annual withdrawal rate is assumed on the benefit base of the VA+GLWB and does not commence until age 65. The asset allocation mix of the SWP portion is assumed to be 40% to equities and 60% to bonds. The asset allocation mix of the VA+GLWB portion is assumed to be 60% to equities and 40% to bonds. See Appendix 1 for capital market and mortality assumptions and Table 1 for SWP and VA+GLWB simulation model assumptions. Thus, investing in a VA+GLWB entails a trade-off. As the allocation to VA+GLWB rises from 0% to 30%, the retiree s risk of outliving her wealth declines; but so too does her expected future bequest. 11 How VA+GLWBs can mitigate key retirement risks As noted above, two key risks that confront retirees are longevity risk and sequence of returns risk. We next quantify these risks and the extent to which including a VA+GLWB in a diversified retirement portfolio can help mitigate them. Figure 5: Risk of Outliving Assets in Long-Life Scenarios $0-$100,000 $100,000-$250,000 more than $250,000 18% 16.8% 16% 15.6% 14.3% 14% 13.1% 12% 10% 8% 6% 4% 2% 0% 0% 10% 20% 30% Expected $160,000 $140,000 $122,000 $106,000 Lifetime Shortfall VA+GLWB allocation Probability Lifetime Shortfall 0% 10% 20% 30% more than $250, % 2.3% 1.1% 0.5% $100,000-$250, % 7.1% 6.7% 5.7% $0-$100, % 6.2% 6.5% 6.9% Notes: Analysis is for a 60-year-old woman with a $1 million retirement portfolio that combines an SWP and VA+GLWB. The combined retirement portfolio assumes a fixed-percentage annual withdrawal rate of 3.21%. Withdrawals from the VA+GLWB begin when the owner reaches age 65, at which time the guaranteed annual withdrawal rate is 5%, The asset allocation mix of the SWP portion is assumed to be 40% to equities and 60% to bonds. The asset allocation mix of the VA+GLWB equity portion varies from 60% to 40%. Refer to Appendix 1 for capital market and mortality assumptions and Table 1 for SWP and VA+GLWB simulation model assumptions. Longevity risk Long life heightens the risk of outliving one s wealth. A 60-year-old female such as the one in our example has a 1-in- 10 chance of living past age 98. If she invests in a balanced portfolio and spends at a sustainable (3.21%) rate, her risk of running out of money is 5.0%. But living to age 98 increases this risk to 16.8% (Figure 5). A portfolio allocation to a VA+GLWB can mitigate this risk. A 30% allocation, for example, lowers her risk of a lifetime shortfall from 16.8% to 13.1%. And by assuring some level of income for life, it also lowers the risk of a severe lifetime shortfall, in excess of $250,000, from 3.5% to 0.5%. Addressing sequence of returns risk Sequence of returns risk is the risk that a portfolio will perform poorly around the time one retires, compromising its capacity to provide a lifetime income stream. Some observers argue that because interest rates are now historically low, this risk may be especially pronounced today. 12 Consider a set of low-return market environments, defined as the five percent of scenarios in which the balanced portfolio in our analysis (40% stocks and 60% bonds) fares the worst over the first five years of 11 This trade-off can be partially mitigated by purchasing an optional guaranteed minimum death benefit for the annuity. 12 See for example David M. Blanchett, Michael Finke and Wade D. Pfau, Low Bond Yields and Safe Portfolio Withdrawal Rates, Journal of Wealth Management, Fall Can Variable Annuities Help You Meet Your Retirement Goals? 5

6 Figure 6: Risk of Outliving Assets in Bad-Market Scenarios Probability 20% 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% Expected Lifetime Shortfall 18.6% $0-$100, % $100,000-$250, % more than $250, % 0% 10% 20% 30% $186,000 $162,000 $140,000 $120,000 VA+GLWB allocation Lifetime Shortfall 0% 10% 20% 30% more than $250, % 3.7% 2.3% 1.3% $100,000-$250, % 6.2% 5.3% 4.1% $0-$100, % 6.3% 6.1% 5.7% Notes: Analysis is for a 60-year-old woman with a $1 million retirement portfolio that combines an SWP and VA+GLWB. The combined retirement portfolio assumes a fixed-percentage annual withdrawal rate of 3.21%. Withdrawals from the VA+GLWB begin when the owner reaches age 65, at which time the guaranteed annual withdrawal rate is 5%, The asset allocation mix of the SWP portion is assumed to be 40% to equities and 60% to bonds. The asset allocation mix of the VA+GLWB equity portion varies from 60% to 40%. Refer to Appendix 1 for capital market and mortality assumptions and Table 1 for SWP and VA+GLWB simulation model assumptions. Bad Market Scenarios are represented by the bottom 5th percentile scenarios of a portfolio with 40% to equities and 60% to bonds with reference to the returns in the first five years. Refer to Appendix 1 for capital market and mortality assumptions and Table 1 for SWP and VA+GLWB simulation model assumptions. retirement. In these low-return environments, a client investing entirely in this balanced portfolio has an 18.6% risk of outliving her wealth, as opposed to 5.0% in the general case (Figure 6). A 30% allocation to VA+GLWB reduces this risk from 18.6% to 11.1%. By assuring some level of income for life, this allocation also reduces the retiree s risk of a severe lifetime shortfall from 5.4% to 1.3%. In summary, retirees face heightened risk of outliving their wealth in cases where they live long or where market returns are low in the years immediately following retirement. In these instances, the inclusion of a VA+GLWB in a retirement portfolio guarantees some level of lifetime income, materially reducing the risk and potential magnitude of a lifetime shortfall. Variable annuity strategies Timing of withdrawals The analysis has so far considered a 60-year-old retiree who purchases a VA+GLWB and waits five years before taking withdrawals. We next compare this to a case where the retiree instead begins taking withdrawals from the VA+GLWB immediately. As previously noted, waiting to take withdrawals boosts the contract s benefit base through a roll-up. Regardless of investment performance, the benefit base rolls up by an annual fixed percentage in our example, 5% per year or 25% over five years. To assess the impact of this roll-up, we compare waiting until age 65 and collecting the roll-up to taking withdrawals from the VA+GLWB immediately and forgoing the roll-up. If we assume the same 5% guaranteed withdrawal rate as before, the retiree fares slightly better by taking withdrawals immediately as opposed to Figure 7: Risk of Outliving Assets: Withdrawing Today vs. Waiting Five Years Probability 7% 6% 5% 4% 3% 2% 1% 0% Immediate 4% guaranteed withdrawal rate Immediate 5% guaranteed withdrawal rate Delayed 5% guaranteed withdrawal rate 5.8% 5.3% 5% 5% 5% 4.5% 4.4% 4.1% 3.9% 3.6% 3.4% 0% 10% 20% 30% VA+GLWB allocation Notes: Analysis is for a 60-year-old woman with a $1 million retirement portfolio that combines an SWP and VA+GLWB. The retirement portfolio SWP allocation is 70%, and the VA+GLWB allocation is 30%. The combined retirement portfolio assumes a fixed-percentage annual withdrawal rate of 3.21%. For the delayed case, a fixed 5% annual withdrawal rate is assumed on the benefit base of the VA+GLWB and commences at age 65. The asset allocation mix of the SWP portion is assumed to be 40% to equities and 60% to bonds. The asset allocation mix of the VA+GLWB portion is assumed to be 60% to equities and 40% to bonds. See Appendix 1 for capital market and mortality assumptions and Table 1 for SWP and VA+GLWB simulation model assumptions. waiting until age 65. Doing so slightly reduces her risk of outliving her assets from 3.6% to 3.4% for a 30% allocation to VA+GLWB (Figure 7, left two bars in right-hand cluster). But this comparison neglects another key factor: The guaranteed withdrawal rate of a VA+GLWB can increase with age. In the illustrative example shown in Table 2, waiting to turn 65 makes a big difference. If the retiree starts taking Table 2. Illustrative Guaranteed Withdrawal Rates for VA+GLWB Age Guaranteed Withdrawal Rate /2% % % /4% Notes: These illustrative rates are based on terms offered by several leading variable annuity providers, as of November 19, Sources: Merrill Lynch Wealth Management, IMG Portfolio Construction & Investment Analytics 6.4% Can Variable Annuities Help You Meet Your Retirement Goals? 6

7 withdrawals prior to age 65, her guaranteed withdrawal rate would be 4%, not 5%. This consideration decisively tips the scale against the 60-year-old s taking withdrawals immediately. In this illustrative example, doing so would actually increase her risk of outliving her wealth compared to investing entirely in an SWP (Figure 7, right hand bars in each cluster, see page 6). The take-away is that investors should be cognizant of how guaranteed withdrawal rates increase with age. While it sometimes makes sense to begin taking withdrawals immediately, in instances such as the one considered here it can be worth waiting until one reaches an age threshold before beginning to take withdrawals from a VA+GLWB. Asset allocation within a VA+GLWB An investor purchasing a VA+GLWB must decide how to allocate assets within the annuity. Consider, once again, the case of a 60-year-old female retiree whose initial spending rate is 3.21% (or $32,100). Suppose she allocates 30% of her $1 million portfolio to a VA+GLWB and waits five years before taking withdrawals from the annuity. Figure 8 summarizes the potential range of bequest or shortfall for VA+GLWB equity allocations ranging from 0% to 100%. For each level of equity allocation within the VA+GLWB, the light bar shows the potential range of bequests or shortfalls that the client might achieve. The bottom of the bar marks the lowest 5th percentile, to which we will refer as the worst-case scenario. The top of the bar shows the 95th percentile, or best-case scenario. The dark bar shows the 25th through 75th percentiles, a range of middle-of-the-road outcomes with a 50% chance of occurring. Figure 8: Bequest/Shortfall for Various VA+GLWB Equity Allocations Bequest/Shortfall ($ millions) $2.5 $1.5 $0.5 -$0.5 95th Percentile 75th Percentile 50th Percentile 25th Percentile 5th Percentile 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% VA+GLWB (Equity Allocation) Note: Analysis is for a 60-year-old woman with a $1 million retirement portfolio that combines an SWP and VA+GLWB. The retirement portfolio SWP allocation is 70%, and the VA+GLWB allocation is 30%. The combined retirement portfolio assumes a fixed-percentage annual withdrawal rate of 4%. Withdrawals from the VA+GLWB begin when the owner reaches age 65, at which time the guaranteed annual withdrawal rate is 5%. The asset allocation mix of the SWP portion is assumed to be 40% to equities and 60% to bonds. The asset allocation mix of the VA+GLWB equity portion varies from 0% to 100%. Refer to Appendix 1 for capital market and mortality assumptions and Table 1 for SWP and VA+GLWB simulation model assumptions. As the VA+GLWB equity allocation rises (moving from left to right), the worst-case outcome improves slightly while the bestcase outcome improves markedly. Thus, allocating more of the VA+GLWB to equities boosts the potential upside and slightly limits the downside a win-win for investors. Because the GLWB rider offers protection against adverse market outcomes, investing aggressively within the VA+GLWB allows one to reap the benefits of favorable market performance while limiting the fallout from poor performance. This confirms Milevsky s (2011) finding that the greater the allocation to equities, the more valuable a GLWB rider s protection becomes. Most insurance carriers limit how aggressively one can invest in a VA+GLWB. Similarly, the median bequest, marked with a black dot, rises as the allocation to equities increases. Thus, increasing the equity allocation within the VA+GLWB can increase the retiree s potential bequest while reducing the risk of outliving her wealth. This suggests that VA+GLWB buyers should consider making a large allocation to equities in their VA+GLWB. Insurers that sell VA+GLWBs typically limit this allocation to about 70%. 13 Additional considerations This analysis demonstrates that an investor who allocates a portion of her retirement portfolio to a variable annuity with a guaranteed lifetime withdrawal benefit (VA+GLWB) and waits to take withdrawals can reduce the risk of outliving her wealth. Though VA+GLWBs are the most popular type of annuity that provides income for life, other types exist. These include immediate annuities, longevity insurance (deferred income annuities) and variable annuities with other GLB riders, such as guaranteed minimum income benefits (GMIB). Our prior research examined the advantages and drawbacks of immediate annuities. 14 In future work, we will assess other strategies for generating lifetime income. Conclusions By guaranteeing regular payouts for life regardless of market fluctuations, variable annuities offer unique protections against market risk and longevity risk the risk of outliving one s wealth. Because it offers risk mitigation features, adding a variable annuity with a guaranteed lifetime withdrawal benefit to a portfolio can help strengthen one s financial preparedness for retirement. It can decrease the risk of running out of money as well as the expected level of shortfall in scenarios where investors outlive their wealth. This comes at the cost of a decrease in the expected size of the bequest. Living a long life or experiencing poor returns in the early years of retirement can heighten the risk of outliving one s wealth. In these situations, allocating some of a portfolio to a variable annuity with a guaranteed lifetime withdrawal benefit can help mitigate the risk and potential magnitude of a shortfall. 13 Not all VA+GLWB providers allow this asset allocation. A growing number require the owner to invest in a managed volatility fund. Managed volatility funds incorporate a volatility control process that seeks to reduce risk when portfolio volatility is expected to deviate from a target level over a specified period. Thus, the asset allocation can change with market conditions. 14 David Laster and Anil Suri, How Immediate Annuities Can Help Meet Retirement Goals, Merrill Lynch Wealth Management, Spring Can Variable Annuities Help You Meet Your Retirement Goals? 7

8 Variable annuities are designed to be long-term investments. As such, they should be part of a diversified portfolio that includes other liquid investments that the investor can access as needed. Investors should be aware that variable annuities are generally subject to surrender charges in the first five to seven years after they are purchased. 15 Moreover, a guaranteed lifetime withdrawal benefit only allows annual withdrawals up to a certain specific amount. We recommend withdrawing this amount each year once withdrawals have begun. This analysis points to two additional strategic insights. First, it may be worthwhile to wait before taking withdrawals from a VA+GLWB until an investor reaches an age at which the guaranteed minimum withdrawal rate becomes more generous. Second, to take maximum advantage of the lifetime income guarantee, the investor should make as large an allocation to equities within the VA+GLWB as the rider permits. A VA+GLWB provides guaranteed income for life, regardless of how the underlying investments perform or how long one lives. It also affords control over how the assets are invested. Investors should consult their Financial Advisor to determine whether a variable annuity with guaranteed lifetime withdrawal benefits (or similar guaranteed living benefits) might enhance their retirement portfolio. Appendix 1 Capital Market and Mortality Assumptions Our analysis is based on return simulations for stocks and bonds as well as inflation. The analysis further assumes annual asset management fees in line with the Morningstar averages for mutual funds. It does not, however, take account of taxes. As with any set of simulations, expected rates of return and standard deviations are key inputs. We assume geometric mean returns, net of fees, of 6.5% (= 8.0% 1.5%) for stocks and 4.0% for bonds, as well as expected inflation of 2.5% (Table 3). The return simulations are generated using a block bootstrap. We begin with historical returns for stocks, bonds, cash and inflation from 1926 to We then apply a linear transformation to each return series, calibrating it so that the expected return and risk for each asset class matches our return assumptions. We randomly draw a series of five-year blocks from this scaled history to create a time series of returns. In total, we create 20,000 sets of time series with which to run simulations. This approach offers several advantages: It accommodates non-normal return distributions, incorporates Table 3. Capital market asset and fee assumptions Expected Geometric Return Expected Volatility Fees U.S. Stocks 8.0% 18.0% 1.5% U.S. Bonds 5.1% 6.1% 1.1% U.S. Inflation 2.5% 1.3% N/A Notes: The proxy for U.S. stocks is the S&P 500 Index; for U.S. bonds, it is the Ibbotson U.S. Intermediate Government Bond Index; for cash it is 1-month Treasury bills; for U.S. inflation it is CPI. Sources: Capital market assumptions: Merrill Lynch Wealth Management, IMG Portfolio Construction & Investment Analytics, 2013; fee assumptions: Morningstar data. Figure 9: Mortality assumptions Survivors 100,000 90,000 80,000 70,000 60,000 50,000 40,000 30,000 20,000 10, Age Male Female Joint Note: Number of survivors from a cohort of 100, year-olds. Source: Society of Actuaries, Annuity 2000 Mortality Table. serial correlation and reflects return and volatility expectations. A weakness of the approach is that it is limited by the availability of data. Further details on block bootstrapping are in Kunsch (1989). One unique feature of the analysis is how it accounts for longevity risk. Rather than assuming a fixed lifespan, e.g., 30 years, the analysis recognizes that people retire at and live until a wide range of ages. For example, in a representative sample of 100, year-old women, 62,000 will live to age 85 and 19,000 will live to 95 (Figure 9, bold line). The dashed line in Figure 9 displays joint mortality. It shows, for example, that in a group of 100, year-old couples, 10,000 are expected to have at least one spouse live to age However, most variable annuities allow annual withdrawals of up to 10% of the account value free of surrender charges. Can Variable Annuities Help You Meet Your Retirement Goals? 8

9 Appendix 2 Glossary Benefit base Contract value Lifetime withdrawal amount Roll-up Step-up Mortality and expense charge Benefit charge Surrender charge The value used to determine a variable annuitant s withdrawal amount. The benefit base may fluctuate depending on when one makes withdrawals and can increase through automatic step-up and roll-up features. The benefit base generally differs from the contract value and is not available as cash or as a lump sum distribution. Account value of a variable annuity, which is subject to market fluctuations, investment risk and possible loss of principal. Thus, when redeemed, a variable annuity may be worth more or less than the original amount invested. The maximum withdrawal amount permitted annually. It is typically calculated by multiplying the benefit base by the withdrawal rate (which may vary by age) as specified in the contract. If the investor withdraws more than this amount in a given year, it may reduce the maximum withdrawal amount permitted in future years. A specified rate at which the base will accumulate as long as no withdrawals are made. For example, a 5% roll-up is equal to the variable annuity s premiums accumulated at 5% interest. The roll-up, which typically ends after ten years, can be specified in the contract as either simple or compound interest. This feature automatically increases one s benefit base, or steps up to the current contract value, if higher, at specified intervals for example, on a contract s anniversary. A charge for the standard risks the issuer assumes by issuing the contract as well as for the distribution expenses associated with the product. The charge also typically covers the cost associated with providing a death benefit equal to the greater of the contract value or total purchase payments adjusted for withdrawals. A charge assessed by the insurance company for an optional guarantee elected by the purchaser. A charge imposed on withdrawals from the contract before the end of the surrender charge period, which lasts typically five to seven years. References David M. Blanchett, The Expected V alue of a Guaranteed Minimum Withdrawal Benefit (GMWB) Annuity Rider, Journal of Financial Planning 24 (July 2011): pp David M. Blanchett, Michael F inke and Wade D. Pfau, Lo w Bond Yields and Safe Portfolio Withdrawal Rates, Journal of Wealth Management, Fall Jeffrey K. Dellinger, The Handbook of Variable Income Annuities (Hoboken, N.J.: Wiley Finance, 2006). Gaobo Pang and Mark J. Warshawsky, Comparing Strategies for Retirement Wealth Management: Mutual Funds and Annuities, Journal of Financial Planning 22 (August 2009): pp Benny Goodman and Seth Tanenbaum, The 5% Guaranteed Minimum Withdrawal Benefit: Paying Something for Nothing? TIAA-CREF Institute: Research Dialogue Issue No. 89 (April 2008). David Laster and Anil Suri, How Immediate Annuities Can Help Meet Retirement Goals, Merrill Lynch Wealth Management (Spring 2013). David Laster, Anil Suri and Ne venka Vrdoljak, Systematic Withdrawal Strategies for Retirees, The Journal of Wealth Management, Vol. 15, No. 3 (Winter 2012), pp David Laster, Anil Suri and Ne venka Vrdoljak, Pitfalls in Retirement, Journal of Retirement Vol. 1, No. 1 (Summer 2013), pp Insured Retirement Institute. IRI 2013 Fact Book. Kunsch, Hans R. The Jackknif e and the Bootstrap for General Stationary Observations. The Annals of Statistics, Vol. 17, No. 3 (September 1989), pp Moshe A. Milevsky, Jackson National s Perspective II, Research Magazine, May Moshe A. Milevsky and Vladyslav Kyrychenko, Asset Allocation within Variable Annuities: The Impact of Guarantees, Pension Research Council working paper, June Moshe A. Milevsky and Vladyslav Kyrychenko, Portfolio Choice with Puts: Evidence from Variable Annuities, Financial Analysts Journal 64:3 (May/June 2008): pp Moshe A. Milevsky and Alexandra Macqueen, Pensionize Your Nest Egg: How to Use Product Allocation to Create a Guaranteed Income for Life (Hoboken, N.J.: Wiley 2010). John L. Olsen, Guaranteed Living Benefits: Are The y Worth It? Journal of Financial Planning (June 2008). John H. Tobinson, A Context for Considering Variable Annuities with Living Benefit Riders, Journal of Financial Planning (May 2008): pp Joe Tomlinson, Annuities versus Systematic Withdrawals: Understanding Tax Effects, Advisor Perspectives (May 8, 2012). James X. Xiong, Thomas Idzorek and Peng Chen, Allocation to Deferred Variable Annuities with GMWB f or Life, Journal of Financial Planning 17 (February 2010): pp Can Variable Annuities Help You Meet Your Retirement Goals? 9

10 David Laster, Director, Portfolio Construction & 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. Anil Suri, Managing Director, Head of Portfolio Construction & Investment Analytics, Anil leads the development of frameworks and solutions for portfolio construction and management, retirement investing, goals-based wealth management, asset allocation, and performance measurement across traditional, market-linked and alternative investments. Anil has been with Merrill Lynch since 2004, where he previously led investment strategy development and analytics in the Alternative Investments area and was 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. Nevenka Vrdoljak, Director, Portfolio Construction & Investment Analytics, holds analytical responsibilities in the areas of asset allocation and retirement investing. Nevenka developed Merrill Lynch Wealth Management s target date asset allocation approach for institutional plan sponsors. Her research has been published in the Journal of Wealth Management and Journal of Retirement. Previously, Nevenka held analytical roles at Goldman Sachs Asset Management (London) and Deutsche Bank Asset Management (Sydney) in the fixed income, currency and derivatives areas. She holds a bachelor s and master s in economics with honors from the University of New South Wales (Sydney). She was awarded an Australian Commonwealth Scholarship where she completed advanced studies in econometrics at Georgetown University. Nevenka graduated from Columbia University with a master s in mathematics of finance. Can Variable Annuities Help You Meet Your Retirement Goals? 10

11 Recent Publications from IMG, Portfolio Construction & Investment Analytics Winter 2014 Can Variable Annuities Help You Meet Your Retirement Goals? Laster/Suri/Vrdoljak Winter 2014 Target Date Asset Allocation Methodology Vrdoljak/Laster/Suri Summer 2013 Pitfalls in Retirement Laster/Suri/Vrdoljak Spring 2013 How Immediate Annuities Can Help Meet Retirement Goals Laster/Suri Winter 2013 A Path to Retirement Success Suri/Laster/Liersch/Vrdoljak Winter 2013 Claiming Social Security Laster/Suri Winter 2013 Managing Your Personal Liabilities Vrdoljak/Laster/Suri Winter 2012 Systematic Withdrawal Strategies for Retirees Laster/Suri/Vrdoljak 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 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 arfad4bk