ENHANCING YOUR CLIENT'S
RETIREMENT INCOME
David Giertz

David Giertz is President of Financial Institution Distributors Agency Inc., Nationwide Financial.
 
 
 

THE TOTAL ASSETS under management for variable annuities at the end of 2006 neared $1.36 trillion, an increase of 38% since 2001. The industry is well aware that the dominant sales driver for variable annuities in recent years has been the introduction of living benefit riders like the guaranteed minimum withdrawal benefit (GMWB).

While this rider is helping consumers fill the income void created from the continuing decline of defined benefit plans, until now it's been difficult to determine exactly what impact adding a variable annuity with a GMWB has on a retirement portfolio.

This question was recently addressed in research sponsored by Nationwide and conducted by Ibbotson Associates. The research studied the benefits created by complementing a retirement income portfolio with a variable annuity GMWB.

The hypothesis was that adding a variable annuity (VA) with a lifetime GMWB to a traditional portfolio would improve the overall retirement income stream while decreasing income risk, defined as the downside fluctuation of the income stream from year to year.

To test this, Ibbotson performed a series of simulation analyses across three portfolio scenarios:

What did the research discover?

After testing the hypothesis using Monte Carlo simulations and historical analysis (1979-2006), Ibbotson discovered that:

1. A VA plus GMWB provided consistent income that didn't decrease and increased as assets grew.
2. The addition of a VA plus GMWB to an existing portfolio reduced the downside fluctuation of the income stream.
3. A combined portfolio consisting of mutual funds and a VA plus GMWB had more assets in 2006 than the portfolio without the VA plus GMWB.
4. A VA plus GMWB created stable income that lasted a lifetime (an assumed 28-year period) without annuitization.

The results showed that the combined portfolios:

• Had higher average total income return.
• Had higher total income withdrawals.
• Had lower negative income return.

These results make sense intuitively, because a variable annuity with a GMWB has no income risk (subject to the claims-paying ability of the issuing company) due to the fact that the income is derived from the benefit base (account value high watermark) and will not decrease (assuming excess withdrawals aren't taken that would reduce the benefit base), even when the market goes down. This differs from a traditional portfolio consisting of equities, because the income it creates is based on the account value, which is subject to market risk. The guaranteed income protection offered by the variable annuity allows the investor to allocate assets more aggressively within a variable annuity that increases the overall equity exposure within the portfolio. More equity contributes to an increase in total income, while the guaranteed income from the GMWB rider helps lower the overall income risk for the combined portfolio.

The proof of the hypothesis

In general, Ibbotson discovered that more-aggressive model portfolios have greater total income and higher semi-deviation (more income risk); however, when you add a VA plus GMWB to the portfolio, the portfolio income risk curve moves up and left. This is because the VA plus GMWB created a guaranteed minimum payment that increased, but did not decrease. In addition, the combined portfolios had a greater equity allocation that contributed to an increase in the total income.

A better solution to manage income risk

If you add a variable annuity with a lifetime guaranteed minimum withdrawal benefit (VA plus GMWB) to a retirement portfolio, you can create consistent income that has the potential to increase over time while reducing the downside income fluctuation.

So what does this mean? How can these findings be best used to benefit your clients?

It's important to understand that this is a complementary strategy to help enhance your client's retirement income; it's not meant to replace how you currently construct income portfolios for your clients. But this small change could have a big impact on their overall success.

The concept of adding a VA plus GMWB to a retirement portfolio to reduce income risk is easy to implement. The premise is to replace a portion of the bond portfolio with a variable annuity that has a more aggressive equity allocation. By doing this, you'll create a slightly more aggressive portfolio while reducing the overall portfolio's income risk.

The retirement landscape is changing. As markets create uneasiness, defined benefit plans are eliminated, and Social Security's future continues to be challenged, consumers are looking to you for answers to questions like:

• What's an ideal strategy for accumulating more assets?
• What should I be investing in?
• How are you going to help me create retirement income that complements my lifestyle?

The findings from the Nationwide-sponsored Ibbotson study help address these concerns, and redefines how risk and return should be viewed when building retirement income portfolios. The approach highlights a new perspective—and it goes beyond longevity risk. It's about how market performance affects the amount of income clients can safely withdraw while maintaining a consistent income stream.

You and your clients may already know that variable annuities provide guaranteed lifetime income, but as this research demonstrates, they can also help increase and stabilize portfolio income while decreasing income risk—yet another reason why annuities should be considered as part of a retirement income portfolio.

When evaluating the purchase of a variable annuity, your clients should be aware that variable annuities are long-term investment vehicles designed for retirement purposes and will fluctuate in value. Annuities have limitations; investing involves market risk, including possible loss of principal. A guaranteed minimum withdrawal benefit is an optional rider available on certain variable annuity contracts for an additional fee, and all guarantees are subject to the claims-paying ability of the issuing company.

The general distributor for variable annuity contracts and variable life insurance policies is Nationwide Investment Services Corporation, member FINRA (in Michigan only: Nationwide Investment Services Corporation). Nationwide is a federally registered service mark of Nationwide Mutual Insurance Company.

The idea is to replace a portion of the bond portfolio with a variable annuity that has a more aggressive equity allocation. This should create a slightly more aggressive portfolio that also reduces overall income risk.

Nationwide, Nationwide Financial, the Nationwide framemark and On Your Side are federally registered service marks of Nationwide Mutual Insurance Company.

Ibbotson Associates, Inc. is a registered investment advisor and wholly owned subsidiary of Morningstar, Inc. The Ibbotson name and logo are property of Ibbotson. The study described herein is the proprietary property of Ibbotson and may not be reproduced in whole or part in any manner without the prior written consent of Ibbotson. Ibbotson and its affiliates are not related to Nationwide and its affiliates.