Human Capital and Risk

Strategies for Risk Management

Wealth managers employ a range of strategies to manage the risks their clients may encounter. These strategies can encompass advising clients to mitigate, avoid, transfer, or retain risks. Despite the low probability of occurrence, the potential impact of these risks can be substantial.

To mitigate the effects of such low probability but high impact risks, risk pooling, or insurance, is often the most economically efficient approach. However, avoidance, mitigation, and retention are also viable options.

Responses to Employment Risk and Mortality Risk

Respond to employment and mortality risk can disrupt earnings and impact financial stability.

• Human Capital and Risk Avoidance: For instance, a person might choose a career as a tenured professor, which offers a reliable earnings stream and transferable skills, thereby reducing the risk to their human capital.
• Mortality Risk and Employment Risk: Both mortality risk, such as the death of a breadwinner, and employment risk, like sudden job loss in a recession, can cause significant disruptions in earnings.
• Insurance as a Risk Transfer Alternative: Insurance, such as life or unemployment insurance, serves as an economically efficient way to address these risks.
• Precautionary Savings: Another approach is to build a reserve of precautionary savings. For example, a small business owner might choose to save up to a year’s worth of living expenses to protect against unexpected earnings disruptions.
• Opportunity Cost of Mitigating Risks: However, mitigating risks carries an opportunity cost, such as sacrificing potential consumption and investment returns. For instance, maintaining a large safety reserve might mean missing out on potential investment gains.

Life Insurance

Life insurance is a financial safeguard that compensates for the risk of premature death of an income earner. It aims to bridge the gap between the lost future earning capacity of the individual and the expected future expenditure of that individual. The risk is transferred to a third party, typically an insurance company. The optimal amount of insurance to purchase is determined by both the cost of providing the insurance, which includes the expenses of the insurance company, and the size of the difference in expected lifetime utility. The latter refers to the well-being, happiness, and financial stability of the family, with and without the family member.

• Human Life Value Method: Human Life Value Method, which focuses on the asset side of the family’s extended balance sheet, quantifying human capital. This method estimates the net present value of the insured’s future earnings, offset by certain incremental future expenses. These net annual amounts are discounted to present value to ascertain the needed insurance coverage. An additional sum may be allocated for final expenses, such as funeral costs.
• Needs Analysis Method: The Needs Analysis Method is a strategic approach that emphasizes the liability aspect of a family’s extended balance sheet. The primary objective is to maintain stable consumption levels by compensating for lost income and preventing a decrease in family spending. For instance, if the primary breadwinner of a family passes away, this method calculates the immediate death-related costs and ongoing living expenses for the surviving family members. These costs are then discounted to their present value and adjusted for a smaller household size. The total funds required are then calculated by deducting existing assets from these costs, resulting in the final life insurance need.

Evaluating Insurance Coverage

When assessing insurance coverage, it is crucial to consider both the cost of the insurance coverage and the insurance company’s ability to meet its financial obligations. For example, rating agencies like Moody’s and Standard & Poor’s evaluate an insurance company’s financial strength, which indicates the insurer’s ability to fulfill obligations and withstand adverse market conditions.

Life Insurance Policies

Life insurance policies are contracts between an insurer and a policyholder, designed to provide financial security to the beneficiaries upon the death of the insured. The four primary parties involved in these contracts are the insured, the policy owner, the beneficiary or beneficiaries, and the insurer.

Basic Elements of a Life Insurance Policy

The fundamental components of a life insurance policy include the term and type of the policy, the identity of the insured, the premium schedule, and the designated beneficiaries. For instance, a policy might be a 20-year term policy for a 35-year-old male, with a premium payable annually. The beneficiaries are the individuals or entities who will receive the death benefit upon the insured’s death. The insurer, typically an insurance company, is responsible for underwriting the policy and paying out the death benefit.

Policy Details and Modifications

The premium schedule outlines the amount and frequency of premium payments, while the death benefit is the sum that will be paid out upon the insured’s death. The policy may also include a contestability period and certain limitations. Policy riders can modify the policy to suit the specific needs of the policyholder.

Beneficiaries and Payout Options

For jointly owned policies, the actual beneficiary depends on the sequence of deaths among potential beneficiaries. Death benefits can be paid in various forms, such as a lump sum or an annuity, although lump sums are generally more prevalent.

Policy Ownership and Uses

Typically, the policy owner and the insured are the same. However, there are exceptions where a third party may own the policy to hedge against economic loss from another’s death. Life insurance benefits also serve as a tool in long-term wealth planning, especially for affluent families, as they can cover estate and inheritance taxes.

Types of Life Insurance: term life insurance and permanent life insurance

There are two main types of life insurance: term life insurance and permanent life insurance. Both types are assumed to be non-cancelable in this context.

Non-Cancelable Insurance Policy

A non-cancelable insurance policy remains active until either the end of its specified term for term life insurance or the death of the insured for permanent life insurance. For instance, if John purchases a 20-year term life insurance policy, it will remain active for those 20 years, regardless of any changes in John’s health or other circumstances.

Term Life Insurance

Term life insurance provides coverage for a specific period of time, such as 20 years, and expires if the insured survives until the end of the period unless the policy is renewed. The premiums can be constant or increase over time due to elevated mortality risk. For example, if Sarah buys a 30-year term life insurance policy at age 30, she will be covered until age 60. If she survives past age 60, the policy will expire unless renewed.

Level-Term Policies

Level-term policies have higher initial premiums compared to annually renewable policies but become more economical in later years. This is because the premiums of annually renewable policies tend to escalate quickly. For instance, a level-term policy might start with a higher premium than an annually renewable policy, but over time, the cost of the annually renewable policy could surpass that of the level-term policy.

Annually Renewable Policies

Insurers may offer low starting premiums on these annually renewable policies, expecting that customers will continue to pay the rising rates. For example, an insurer might offer a low initial premium on an annually renewable policy to attract customers, but the premium will increase each year.

Permanent Life Insurance

Permanent life insurance is a comprehensive insurance policy that offers lifelong coverage for the insured, provided the premiums are consistently paid. The premiums for this type of insurance are typically fixed, offering stability and predictability.

Investment Feature

One distinguishing feature of permanent life insurance is its investment component. A portion of the premiums paid is invested, creating a cash value. This cash value can generate interest or other returns, similar to a savings account or investment portfolio, and accumulates over time.

Comparison with Term Policy

When compared to a term policy, the premium for a permanent policy is generally higher. This is because a permanent life insurance policy is essentially a bundled product that combines term insurance with an investment account, providing both coverage and a potential return on investment.

Risk Retention and Transfer

Permanent life insurance allows for both risk retention through the cash value and risk transfer via the term insurance component. Upon the insured’s death, the cash value typically reverts to the insurer, while beneficiaries receive the face value of the policy.

Cash Value and Insurance Value

The cash value in a permanent life insurance policy builds up slowly in the initial years. However, as the cash value increases, the insurance value decreases, meaning the ongoing premium is paying for less life insurance over time.

Whole Life Insurance Policy

Whole life insurance policy is a type of permanent life insurance that provides a cash value, which the policyholder can access in several ways. These include withdrawing it upon the policy’s maturation, withdrawing it upon termination of the policy, or by taking out a loan while keeping the policy active. However, it’s crucial to note that any withdrawal or unpaid loan balance will decrease the death benefit available to beneficiaries.

Types of Permanent Life Insurance

There are multiple types of permanent life insurance, with regional variations in popularity. The two most prevalent types are whole life and universal life insurance.

Whole life insurance

Whole life insurance remains in force for an insured’s entire life, with periodic premiums typically paid annually. Failure to pay these premiums can lead to policy lapse. The policy’s non-cancelability makes it attractive to younger, healthier individuals.

Some whole life policies technically mature when the insured reaches 95 or 100 years, offering less-than-lifetime coverage in rare cases but effectively serving as lifetime insurance for most. Such policies can either be participating or non-participating.

• Participating life insurance policies enable policyholders to share in the insurer’s profits via potential dividends above the guaranteed value. On the other hand.
• non-participating life insurance offers fixed benefits that remain unaffected by the insurer’s profits or performance.

The cash value is the amount of money that accumulates over time and can be accessed by the policyholder in several ways. The cash value decreases if there are any withdrawals or unpaid loan balances. The death benefit available to beneficiaries is also affected by these factors.

Endowment Life Insurance

Endowment life insurance is a specific type of insurance policy that shares similarities with whole life insurance, but with a distinct feature of having a limited coverage period, typically spanning from 10 to 20 years. To illustrate, consider a real-world example of a 35-year-old individual who purchases a 20-year endowment policy. If the individual is still alive at the age of 55, the face value of the policy is paid out to the policy owner.

Universal Life Insurance

Universal life insurance, in contrast, provides more flexibility than whole life insurance. It allows policyholders to adjust their premiums and offers a wider range of investment options for the cash value. For instance, a policyholder might choose to invest in a mutual fund or a bond fund. The policy remains active as long as the premiums are paid or the accumulated cash value is sufficient to cover the insurer’s policy expenses.

Non-Forfeiture Clause and Cash Value

Non-forfeiture clause allows policyholders to access a portion of the benefits even if they miss premium payments, prior to the lapse of the policy. The options under this clause typically include

• a cash surrender option, which pays out the current cash value
• a reduced paid-up option, which uses the cash value to buy a single-premium whole life policy
• an extended term option, which converts the cash value into a term policy, usually with the same face value as the original policy

Other Uses of Life Insurance

• Immediate Financial Expenses: Life insurance can be utilized to cover immediate financial expenses that arise due to death. For example, the costs associated with funeral arrangements and legal proceedings, which can be substantial and vary across different regions.
• Legacy Goals: Life insurance can facilitate legacy planning, including charitable donations and bequests. For instance, life insurance wrappers, popular in the European Union, allow investors to place their investment portfolio, such as equities or hedge funds, into a life insurance policy, thereby minimizing tax on investment income.
• Liquidity: Life insurance provides instant liquidity to beneficiaries, bypassing the often lengthy and complex legal process of settling an estate. This is particularly beneficial when the estate comprises illiquid or difficult-to-divide assets.
• Tax-Sheltered Savings: Cash-value policies invest a portion of the premium in tax-advantaged accounts. These funds, initially exceeding the low mortality charge, can grow tax-free and can later be used for rising insurance costs or cashed out.
• Estate Planning: Life insurance payouts can assist beneficiaries in meeting inheritance or estate tax obligations without the need to sell inherited assets. This is particularly relevant for small and medium-sized businesses, their owners, and heirs.

Responses to Longevity Risk

Longevity risk, the risk of outliving one’s savings, is a significant concern for retirees. Various strategies such as annuities, public retirement systems, and defined benefit plans are employed to mitigate this risk.

Annuities

Annuities are a prevalent way to mitigate longevity risk. They work by pooling the risk with other annuitants through an insurance company, similar to how a group health insurance policy works. This provides lifelong income for the annuitant and potentially a spouse. However, the effectiveness of annuities in replacing lifetime income can vary, much like the variability in returns from a mutual fund investment.

Public Retirement Systems

Public retirement systems like US Social Security and Japan’s National Pension Service essentially serve as public annuities. However, they often fall short of replacing lifetime income for most retirees, similar to the inadequacy of public healthcare systems in covering all medical expenses.

Defined Benefit Plans

Defined benefit plans are offered by employers, trade unions, and publicly financed systems. These plans are often inadequate and are increasingly being replaced by defined contribution plans. Defined contribution plans shift the responsibility for managing longevity risk onto employees, particularly in the private sector, much like how a 401(k) plan works.

Precautionary Savings

Precautionary savings involves assuming an extraordinarily long lifespan (e.g., 100 or 110 years) over which to sustain withdrawals in the decumulation phase. Depending on an individual’s bequest motives, this approach can be highly inefficient. It may lead to lower living standards and result in a significant amount of unspent capital during retirement, similar to the risk of over-saving and under-spending in a savings account.

Volatility Control

A key strategy to manage this risk is through volatility control. This involves managing the sequence and volatility of portfolio returns to meet spending needs. However, controlling volatility often results in lower expected returns. Sustainable withdrawal rates, such as the 4% rule, are used as benchmarks to assess fund sufficiency. Asset allocation during the decumulation phase is crucial in controlling volatility, with two main strategies: static and dynamic.

• Static Asset Allocation: Static asset allocation is a well-researched strategy. For example, the 4% rule suggests that retirees should withdraw 4% of their portfolio in the first year of retirement and adjust the amount for inflation each year thereafter. The sustainability of withdrawals doesn’t significantly differ between a 50% and a 75% stock allocation. However, holding too few stocks can notably shorten the sustainability of withdrawals.
• Dynamic Asset Allocation: Dynamic asset allocation allows wealth managers to adjust the allocation dynamically through retirement. For instance, target-date funds shift towards lower equity exposure as retirement approaches. Some research suggests that retirees can take on more risk as they age due to a decreasing withdrawal horizon. Increasing equity exposure during retirement can enhance sustainability. Holding more cash or fixed income early on in retirement can mitigate the impact of poor early returns, thus reducing longevity risk.

Dynamic Withdrawal Programs

Dynamic withdrawal programs are financial planning strategies designed to add flexibility and mitigate longevity risk. These strategies adjust withdrawal rates based on market performance and other factors to ensure the portfolio’s sustainability.

Annual inflation adjustment

• One prevalent strategy is to forgo the annual inflation adjustment following years with negative returns. This ad hoc strategy has been proven to enhance the sustainable withdrawal rate. For instance, during the 2008 financial crisis, investors who adopted this strategy were able to maintain their portfolio value.
• Studies by Guyton (2004) and Guyton and Klinger (2006) using US data demonstrated that this strategy can boost the sustainable withdrawal rate from a range of 4.0%–4.3% to a range of 5.8%–6.3%, depending on the equity allocation in the portfolio.

Flexible spending approach

Implementing a flexible spending approach can help avoid solidifying losses during market downturns. This flexibility mitigates the combined effect of market volatility and withdrawals on depleting the portfolio’s core value.. Despite their benefits, dynamic withdrawal programs can be challenging during periods of prolonged hyperinflation or poor investment performance.

Relying on coupon and dividend payments

Another effective dynamic spending strategy involves using the dividends from stocks and coupon payments from bonds for ongoing expenses. For instance, a retiree might use the dividends from their Coca-Cola stocks and the coupon payments from their US Treasury bonds to cover their monthly bills. This strategy is beneficial due to the lower volatility of dividends and coupon payments compared to capital gains. However, it requires a substantial initial investment.

Adjusting withdrawals based on the portfolio’s current value

Adjusting the withdrawal rate based on the current value of the portfolio. For example, during a bull market when the portfolio value is high, the withdrawal rate might be increased. Conversely, during a bear market when the portfolio value is low, the withdrawal rate might be decreased. This strategy helps to avoid excessive withdrawals in bull markets or insufficient ones in bear markets.

Laddered Bonds

Laddered bonds strategy involves the use of varying non-callable fixed-income securities that mature at intervals matching the retiree’s spending needs. For example, a retiree might invest in a series of bonds that mature every year for the next 20 years, providing a steady income stream. This approach is particularly useful for managing interest rate risk and mimicking fixed annuity payments. However, it does not mitigate longevity risk.

To address the longevity risk, a retiree, for instance, a 65-year-old, can blend a 20-year bond ladder with a deferred annuity that starts payouts after age 85. This ensures financial coverage for life, providing a solution to the longevity risk issue. For example, a retiree might purchase a deferred annuity that begins payments at age 85, providing a safety net in case they outlive their bond ladder.

Bucket Planning and Behavioral Finance

Bucket planning is a behavioral finance concept, pioneered by Richard Thaler, which involves mentally categorizing investments into ‘buckets’ based on specific objectives or time frames. This strategy is often employed in retirement planning to manage longevity risk. The objectives can be specific, like “buy a vacation home” or “fund children’s education”, or based on when the cash will be needed, such as income for Years 1–5, Years 6–10, etc. The purpose of these mental buckets is to meet financial goals over different time frames. This method leverages investors’ inherent mental accounting tendencies, making it easier to track goal funding. It can be seen as a basic form of goals-based planning.

Implementing Bucket Planning

• As clients make withdrawals, their equity exposure is likely to increase. Initially, portfolios can align with a client’s risk tolerance through a time-segmented strategy. For instance, allocating 60% to bonds in buckets 1, 2, and 3, and 60% to stocks in buckets 3, 4, and 5. However, by the end of the first time horizon, the bond allocation will have decreased significantly, causing the portfolio to misalign with the client’s risk profile. Maintaining a consistent risk level requires ongoing asset rebalancing. This process incurs tax and transaction costs, which are often overlooked when evaluating bucketing strategies.
• Investors, particularly those with a behavioral bias, may feel uneasy with an increased equity exposure, even though it may be the optimal choice for rational investors. For instance, a rational investor might increase their equity exposure in a company like Apple Inc. due to its consistent performance, while a behavioral investor might feel uncomfortable due to the perceived risk. It’s crucial to remind investors that each investment bucket is designed to meet a specific financial goal, and the overall portfolio continues to align with their current objectives.
• Using multiple investment buckets may lead to redundant investment positions. For example, if an investor has three different accounts and all of them invest in the same fixed-income mutual fund like the Vanguard Total Bond Market Index Fund, this redundancy could lead to additional transaction costs. Managing these allocations within a single account could introduce complexity and require significant time for reporting and administration. For instance, an investor with a diverse portfolio of stocks, bonds, and mutual funds may spend considerable time managing these assets.

Annuities

Annuities are financial tools that individuals can utilize to manage longevity risk, the risk of outliving one’s financial resources. This risk is transferred to a financial institution, typically an insurance company, which provides a series of payments at equal intervals over a specified period. This is akin to the role of pension funds.

While life insurance protects against premature death, immediate life annuities safeguard against outliving one’s financial resources. There are four primary parties involved in an annuity contract: the insurer, the annuitant, the contract owner, and the beneficiary.

• Insurer: The insurer, usually an insurance company, sells the annuity and manages the longevity risk, making the annuity payments.
• Annuitant: The annuitant is the beneficiary of the annuity payments, receiving the payments at regular intervals.
• Contract Owner: The contract owner, typically the annuitant, purchases the annuity. In some cases, a company may purchase an annuity for a retiring employee, who then becomes the annuitant.
• Beneficiary: While basic fixed annuities often lack a beneficiary, some annuities include life insurance elements that pay out to a beneficiary upon the annuitant’s death. This ensures that the annuitant’s financial resources are not lost upon their death.

Traditional immediate fixed annuity

A common method to mitigate Longevity risk is through a traditional immediate fixed annuity. For instance, an insurance company like MetLife might offer an annuity that guarantees a yearly income for a lump sum investment. These annuities often provide rates that appear more attractive than AAA-rated fixed-income assets like government bonds, maturing around the same time as the annuitant’s life expectancy.

The allure of these annuities lies in their structure. The annuity payments comprise both a return of the initial principal and mortality credits. Mortality credits are essentially the redistributed payments initially intended for annuitants who have passed away, among the surviving annuitants in the pool.

Despite the upfront costs of purchasing an annuity, they generally yield a more favorable financial outcome than a self-managed approach, such as creating a riskless bond ladder. This is particularly true for annuitants who outlive their life expectancy.

The spending improvement, denoted as \(Q\), for any given year is calculated using

$$Q = \frac{(1 – p)}{p}$$

Where: \(p\) = Survival probability

Although \(Q\) is modest in the initial years of an annuity, it significantly increases in the later years, presenting a considerable range of spending improvements.

Fixed Annuities

Annuities are financial products that provide a steady income stream. They are characterized by two payment dimensions: fixed versus variable payments and deferred versus immediate payments.

• Fixed Annuity: A fixed annuity offers a set percentage of the initial investment as annual income, also known as income yield. For example, an investor might exchange a lump sum of USD100,000 for an annual income stream of USD6,000, either for a lifetime or a specified term. The income yield, which is 6% in this example, is influenced by both current interest rates and the annuitant’s age. Payments are usually disbursed monthly and can also be made quarterly or yearly.
• Single-Premium Immediate Annuity (SPIA): A SPIA allows an annuitant to exchange an initial lump sum investment for a stream of annual income either over a lifetime or a predetermined term. There is one premium payment, and payments from the annuity start immediately.
• Lifetime and Period-Certain Annuities: A lifetime annuity gives annuitants the option to receive payments for the rest of their lives, mitigating longevity risk. Conversely, period-certain annuities offer payments for a fixed number of periods and do not account for the annuitant’s lifespan, thus failing to manage longevity risk.
• Life Annuity with Period Certain Guarantee: This annuity ensures a minimum number of payments, say 10 years. If the annuitant passes away prematurely, the remaining payments are transferred to a beneficiary. Think of it as a pension plan where the beneficiary is your child.
• Life Annuity with Return-of-Premium: Here, if the annuitant dies before recovering the initial investment, the beneficiary receives payments equal to the initial principal, excluding fees and adjustments. It’s like an insurance policy where the premium is returned.
• Joint Life Annuity or Survivor Option: This joint-life annuity extends payments over the lifespan of two annuitants, typically spouses. The survivor may receive up to 100% of the primary benefit or a lesser amount, such as 50% or 75% of the full benefit.
• Inflation-Adjusted Payments: This payment type allows annuitants to combat inflation by opting for payments that adjust for inflation or grow by a fixed percentage. However, the latter offers weaker protection against inflation.

Annuity Risk and Its Minimization

Features that minimize these risks or increase payouts over time usually result in a lower income yield. For instance, if you opt for an annuity with a guaranteed period or return-of-premium feature, you’ll need to make a higher upfront payment for the same income. For those focused on maximizing lifetime income and minimizing longevity risk, it’s advisable to avoid these features. However, they could be beneficial for those balancing lifetime income needs with leaving an inheritance.

Immediate Fixed Annuities

Immediate fixed annuities are a type of annuity that begins payments immediately after purchase. They are typically irreversible and illiquid, meaning they can’t be sold or redeemed. Each payment you receive consists of principal, interest, and mortality credits. The income yield fluctuates based on factors like your age, gender, and health metrics, in addition to the selected features.

Life Annuity Payout Rates

Life annuity payout rates vary depending on the type of annuity and the annuitant’s characteristics. For example, a life annuity with no residual benefits will have different payout rates than a life annuity with a 10-year certain payment. Quotes are typically provided for three different types of annuitants: male, female, and joint (a couple). In the case of a joint annuity, the couple is assumed to be of the same age, and the survivor receives 100% of the primary benefit.

Deferred Fixed Annuity

A Deferred Fixed Annuity is an investment vehicle that guarantees a future income stream. It’s akin to a retirement plan where an individual invests money that grows over time and is paid out at a later date. For instance, a 30-year-old could invest in a deferred fixed annuity that starts payouts at age 65, allowing the investment to grow over 35 years.

End of Deferral Period Options

Upon reaching the end of the deferral period, the investor has two choices:

• Annuitize the investment: This is similar to converting the deferred annuity into an immediate fixed annuity, much like a 65-year-old converting their retirement savings into a pension.
• Cash out the investment: This involves withdrawing the accumulated investment after deducting any surrender charges, effectively ending the annuity contract. This option provides liquidity, a feature not available with immediate annuities.

Advanced-Life Deferred Annuity (ALDA)

ALDA is a deferred annuity purchased later in life, typically with a lump sum. For example, a 70-year-old could buy an ALDA that starts monthly payments at age 90. This is more cost-effective than an immediate annuity as payments are deferred for the first 20 years, allowing the investment to grow and benefit from mortality credits.

Advantages of Deferring Payments

Deferring payments, particularly in the context of annuities, can offer several advantages. These include increased retirement spending, economic efficiency, and a fixed and known investment horizon.

1. Increased Retirement Spending

By deferring annuity payments, one can significantly enhance the available retirement spending for each dollar annuitized. For instance, if John decides to defer his annuity payments until he is 70 instead of 65, he will receive higher monthly payments, thereby increasing his retirement spending. This strategy concentrates the benefits of annuitization towards the end of life when the mortality risk is at its peak, making it a more cost-effective strategy.

2. Economic Efficiency

Deferring payments is economically efficient as it transfers specific risks to the insurance company, which is better equipped to manage them. For example, in a Single Premium Immediate Annuity (SPIA), the early time periods carry minimal longevity risk and offer limited added value from the insurer. The real value is derived from the insurer’s ability to diversify longevity risk at later life stages, where the risk of outliving assets is highest.

3. Fixed and Known Investment Horizon

The deferral period establishes a fixed and known investment horizon, which allows wealth managers to develop tailored spending and investment strategies for a specific timeframe. For example, a zero-coupon bond ladder could effectively cover living expenses until the deferred annuity begins, reducing the portfolio’s withdrawal needs to a set period, such as 20 years, instead of an indefinitely long and unpredictable timeframe.

Fixed Annuities and Accumulation Periods

Fixed annuities, similar to a retirement savings account, can be purchased incrementally over fixed time intervals, a phase known as accumulation periods. For instance, an investor might buy smaller amounts of lifetime or period-certain income every month, similar to contributing to a 401(k). These annuities accrue interest or investment returns during the accumulation period, leading up to the payout phase. This approach effectively creates a series of deferred annuities with progressively shorter deferral periods.

Advantages of Accumulation Periods

• Accumulation periods provide an alternative solution for investors who do not have the immediate capital to purchase a Single Premium Immediate Annuity (SPIA). They offer a phased long-term investment approach that merges saving and investing.
• SPIA payouts are influenced by the interest rates at the time of purchase, which can be either advantageous or not. Longer accumulation periods mitigate this risk by diversifying interest rate exposure over time.
• Accumulation periods can counteract behavioral biases commonly seen in investment and annuity decisions. They act as an automated investment program similar to pension deferrals.
• Accumulation periods offer conversion options similar to deferred annuities that provide a degree of liquidity.

Exploring Annuity Types and Payout Scenarios

There are various payout scenarios for key annuity types. These are categorized by payout start time (immediate or deferred) and payout amount certainty (fixed or variable). For example, a fixed immediate annuity might start paying out immediately after purchase, while a variable deferred annuity might start paying out at a later date, with the amount varying based on investment performance. Variable annuities are discussed in the following section.

Variable Annuities

Variable annuities are a type of investment product that individuals can purchase to secure a lifetime income stream. They are similar to Single Premium Immediate Annuities (SPIA) in that they are bought for a lump sum. However, the key difference lies in the fluctuating amount of payments to the annuitant and beneficiaries, which is based on the performance of an underlying investment. This investment could be a mutual fund, an exchange-traded fund (ETF), or an Undertakings for the Collective Investment in Transferable Securities (UCITS) account.

Assumed Investment Return (AIR)

Annuitants have the option to set an Assumed Investment Return (AIR), typically between 3.5% and 5%. The AIR not only determines the initial payment but also future payment adjustments. These adjustments are made according to the actual investment returns relative to the AIR. Lower AIRs result in smaller initial payments but reduce the likelihood of future payment cuts.

Investment Options

Variable annuities offer a range of potential investment options. These usually feature a predetermined target risk allocation managed by multiple investment managers. The options often replicate popular mutual fund strategies. However, it’s important to note that compared to traditional investment vehicles like mutual funds, ETFs, or UCITS, variable annuities may have higher costs and limit investment choices.

Deferred variable annuities

Deferred variable annuities are a unique financial product that allows investors to contribute to an investment account over a certain period, with the promise of payments beginning after this period. The suitability of these annuities varies depending on the individual investor’s financial goals and risk tolerance.

Volatility

Unlike traditional annuities, variable annuities tie their payment amounts to the performance of an underlying investment. For instance, if an investor chooses a variable annuity linked to the S&P 500 index, the annuity payments will fluctuate based on the index’s performance. To mitigate the risk of market downturns, an income floor can be added to immediate variable annuities at an extra cost. This feature ensures a minimum payout, regardless of market performance.

Flexibility

Variable annuities offer more flexibility compared to immediate fixed annuities. They allow withdrawals from the underlying subaccount, albeit usually subject to certain limitations and penalties. This feature can be beneficial for investors who may need access to their funds before the annuity payments begin.

Return-of-Premium Rider

This rider ensures that if the annuitant dies during the deferral or payout period, the beneficiary receives the full premium. It is more valuable in variable annuities due to higher asset volatility, which often results in reduced payouts. For example, if an investor with a $100,000 annuity dies, the beneficiary would receive the full $100,000.

Guaranteed Minimum Withdrawal Benefit (GMWB)

Deferred variable annuities do not guarantee a specific lifetime income. However, annuitants can purchase a GMWB rider, which typically guarantees a fixed percentage (e.g., 4%) of the initial investment for life. The insurance company is obligated to continue payments even if the investment depletes. This means if an investor initially invested $200,000, they would receive at least $8,000 annually for life.

Fixed Annuity Option

Some deferred annuity contracts allow conversion to an immediate payout annuity at the end of the deferral period. However, the final investment value and thus the payout amount remain uncertain. Consequently, few investors choose to “annuitize” their deferred variable annuities this way.

Risk-reducing features or payout-boosting options in an annuity generally result in a lower income yield, as they impose additional risks or liabilities on the insurance company. Variable annuities typically come with higher fees compared to fixed annuities. For example, an annuity with a GMWB rider might have a higher fee than a similar annuity without the rider.

Evaluating the Appropriateness of Annuities

Mortality credits represent the portion of an annuity’s return attributable to annuitants who die earlier than expected, leaving their share of the total asset pool to be distributed among the survivors. For instance, consider a retiree who invests USD 1,000 in an annuity and receives an annual income of USD 70 for life. This income comprises three elements: interest accrued on the remaining initial investment, return of premium, and mortality credits.

Self-Insurance vs Annuity Purchase

An individual who self-insures longevity risk would only receive the interest and return-of-premium portions, which can be distributed differently over time. However, by purchasing an annuity, an individual gains mortality credits that enhance income for surviving annuitants. The trade-off is the cost of insurance, which inherently cannot have a positive expected value without causing financial loss to the insurance company. Thus, buying an annuity provides more income certainty but may result in lower wealth at death and potentially lower lifetime income, depending on the annuity’s cost.

Retirement Income Efficient Frontier

The balance between income security and ending wealth can be modeled through a “retirement income efficient frontier.” This model aids in the annuitization decision, weighing an individual’s preference for wealth maximization against the fear of depleting funds.

Factors Increasing Interest in Annuities

Factors such as longer life expectancy, preference for guaranteed lifetime income, less emphasis on leaving assets to heirs, higher risk aversion, and reduced income from other sources like pensions, increase a retiree’s interest in annuities. For instance, a retiree with a longer life expectancy might prefer an annuity to ensure a steady income throughout their life.

Global Shift and Demand for Annuities

The global shift from defined benefit to defined contribution plans, similar to the shift from traditional pensions to 401(k) plans in the US, has increased the demand for annuities. This makes understanding annuities crucial for investors.

Impact of Rising Demand

The rising demand for annuities can improve investor outcomes. As demand increases, insurance companies gain economies of scale, and issues of adverse selection diminish.

Behavioral Barriers to Annuitization

The behavioral barriers that deter individuals from choosing annuitization, despite its potential benefits. Annuities, specifically immediate fixed annuities or deferred fixed annuities, are financial instruments designed to provide a steady stream of income for life, ensuring financial security. However, several behavioral barriers prevent their widespread adoption.

Emotional Discomfort and Bequest Motives

One significant barrier is the emotional discomfort associated with discussing mortality. Many individuals prefer to leave unused assets to their heirs, rather than investing in annuities. This is a classic example of a behavioral barrier in financial decision-making.

Perception of Annuities as a Gamble

Another barrier is the perception of annuities as a gamble, where outliving the actuarial life expectancy equates to “winning”. However, annuities are risk mitigation tools, similar to insurance policies. They protect against the financial risk of outliving one’s assets.

Addressing Longevity Risk with Fixed Annuities and ALDAs

Among various types of annuities, fixed annuities and Advanced Life Deferred Annuities (ALDAs) effectively address this longevity risk. ALDAs, in particular, delay the start of annuity payments, reducing both the cost of annuitization and the psychological barrier associated with it.

Property and Liability Insurance

Property insurance is a strategic tool employed by individuals to mitigate risks associated with their assets, primarily their homes or vehicles. It plays a pivotal role in managing liability risk, which refers to the potential legal obligation one may have for causing bodily harm or property damage to others, either through direct actions or failure to act when legally required.

Managing Liability Risk

To manage this liability risk, individuals often secure liability insurance. This insurance can be supplemented with a personal umbrella liability policy to adequately cover their liability risks. This type of insurance offers specified limits and pays claims when the liability limits of the home or auto insurance are exhausted, providing additional coverage.

For instance, consider a celebrity who has an auto policy with a limit of USD1 million and an umbrella policy with a USD3 million limit. If they cause an accident resulting in USD 1.5 million in damages, the auto policy would cover the first USD1 million, and the umbrella policy would handle the remaining USD500,000.

Importance of Umbrella Policies

Umbrella policies are generally cost-effective. High Net Worth Individuals (HNWIs) and Ultra High Net Worth Individuals (UHNWIs) often face heightened legal risks due to their public visibility and the likelihood of being targeted in lawsuits. Personal umbrella insurance coverage is essential for these individuals.

In the United States, a standard recommendation is a personal umbrella insurance coverage of around USD20 million to shield against frivolous and serious legal claims. This amount generally surpasses most court judgments, providing robust asset protection and minimizing the need for out-of-pocket expenses. This level of coverage is more than sufficient for most legal challenges.

Considerations for Liability Insurance

When considering liability insurance, the focus should be on safeguarding one’s financial assets. Some jurisdictions exempt certain assets like primary residences or retirement funds from being seized if liability exceeds the existing insurance coverage. Therefore, one should evaluate the worst-case scenario for both personal financial risk and the financial consequences that an injured party could face.

Assessing Life Insurance Needs

Assessing life insurance involves understanding different types of policies and their implications on the insured’s financial situation.

Term Policy

• Consider the case of a 30-year-old professional choosing between an annually renewable term policy and a 20-year level term policy. The former is cheaper initially, but the latter provides a fixed premium for a longer period.
• By the time the insured reaches 50, they are likely to be nearing retirement, and their dependents, if any, would be self-sufficient adults.
• At this stage, both human life value and needs analysis methods may suggest reduced or no further need for additional insurance.
• An alternative, cost-effective strategy is to buy four staggered term policies of 5, 10, 15, and 20 years, which in the aggregate gradually reduces the amount of coverage as the value of the insured’s human capital decreases.

Whole Life Policy

• Whole life policies, like the ones offered by MetLife or Prudential, are costly.
• Due to the pricing, cash build-up and possible surrender charges at this point in the policy’s life make it unwise to replace the policy with term coverage now.
• If retained, its cash value should be part of a conservative retirement asset allocation.

Beneficiary Designations

• The primary beneficiary should be the person who would be responsible for the dependents.
• Trusts or third-party guardians could be named if minors or tax implications are a concern.
• The old policy should be changed to include these beneficiary designations as well.
• Making death benefits payable to the estate can slow payments significantly due to probate and may subject benefits to greater taxation.

Life Insurance for Low-Income Individuals

• Even if the individual’s current income is low, they should have life insurance.
• Their death would result in lost future income and added expenses.
• Premiums would be low given their age and health, although the exact coverage amount is hard to calculate because the dependents will likely be independent when the individual returns to full-time work.
• Their coverage would be substantially less than a high-income individual’s.

Practice Questions

Question 1: A wealth manager is advising a client on strategies to manage potential risks. The client is particularly concerned about risks that have a low probability of occurrence but could have a significant impact. The wealth manager suggests several strategies including mitigation, avoidance, transfer, and retention. However, the manager emphasizes one strategy as the most economically efficient approach. Which strategy is the wealth manager most likely referring to?

1. Mitigation
2. Transfer
3. Risk pooling or insurance

Answer: Choice C is correct.

The wealth manager is most likely referring to Risk Pooling or Insurance as the most economically efficient approach to manage potential risks that have a low probability of occurrence but could have a significant impact. Risk pooling or insurance is a strategy where risks are combined and shared among a large number of participants, thereby reducing the potential impact on any one participant. This is particularly effective for risks that are low in probability but high in potential impact, as the cost of insuring against such risks can be spread across a large number of participants. In this way, the individual cost for each participant becomes manageable, while the potential impact of the risk is effectively mitigated. This makes risk pooling or insurance an economically efficient strategy for managing such risks.

Choice A is incorrect. Mitigation refers to actions taken to reduce the likelihood or impact of a risk. While this can be an effective strategy for managing certain types of risks, it may not be the most economically efficient approach for risks that are low in probability but high in potential impact. The cost of mitigation measures may outweigh the potential benefits, especially if the probability of the risk occurring is very low.

Choice B is incorrect. Transfer involves shifting the risk to another party, typically through a contract or agreement. While this can be an effective strategy for managing certain types of risks, it may not be the most economically efficient approach for risks that are low in probability but high in potential impact. The cost of transferring such risks may be high, especially if the other party requires a significant premium to accept the risk.

Question 2: A wealth manager is discussing risk management strategies with a client. The manager explains that while the terminology used aligns with US insurance industry standards, similar products with different names and comparable features are available globally. What is the wealth manager implying with this statement?

1. The client should only consider US-based insurance products.
2. The client can find similar risk management strategies in other countries.
3. The client should avoid global insurance products due to differences in terminology.

Answer: Choice B is correct.

The wealth manager is implying that the client can find similar risk management strategies in other countries. The statement suggests that while the terminology used to describe these strategies aligns with US insurance industry standards, similar products with different names and comparable features are available globally. This means that the client is not limited to US-based insurance products and can explore similar risk management strategies offered in other countries. The wealth manager’s statement is intended to broaden the client’s perspective and understanding of the global insurance market. It is also a reminder that while terminology may differ, the underlying principles and features of these products remain the same. Therefore, the client should not be deterred by unfamiliar terms or names when considering insurance products from other countries.

Choice A is incorrect. The wealth manager’s statement does not imply that the client should only consider US-based insurance products. On the contrary, the manager is suggesting that similar products with comparable features are available globally. This implies that the client has a wider range of options and is not limited to US-based products.

Choice C is incorrect. The wealth manager’s statement does not suggest that the client should avoid global insurance products due to differences in terminology. Instead, the manager is explaining that despite differences in terminology, similar products with comparable features are available globally. This implies that the client should not be deterred by unfamiliar terms or names when considering insurance products from other countries.

Glossary

• Fixed Annuity: An annuity that offers a set percentage of the initial investment as annual income.
• Single-Premium Immediate Annuity (SPIA): An annuity that allows an annuitant to exchange an initial lump sum investment for a stream of annual income.
• Lifetime Annuity: An annuity that provides payments for the remainder of the annuitant’s life.
• Period-Certain Annuity: An annuity that offers payments for a fixed number of periods.
• Life Annuity with Period Certain Guarantee: An annuity that ensures a minimum number of payments, transferring remaining payments to a beneficiary if the annuitant dies prematurely.
• Life Annuity with Return-of-Premium: An annuity where if the annuitant dies before recovering the initial investment, the beneficiary receives payments equal to the initial principal.
• Joint Life Annuity: An annuity that extends payments over the lifespan of two annuitants, typically spouses.
• Inflation-Adjusted Payments: Payments that adjust for inflation or grow by a fixed percentage to combat inflation.
• Annuitant: The beneficiary of the annuity payments.
• Contract Owner: The individual or entity that purchases the annuity.

Private Wealth Pathway Volume 2: Learning Module 5: Preserving the Wealth;

LOS 5(b): Describe and recommend strategies to manage risks to human capital