Morningstar - Q3 2023 - 57

Szapiro: Before we dive into some of my wonkier
questions, let's level-set. There's a wide range
of products covered by the term annuities.
Spencer, what are the main types that we should
be thinking about?
Look: From a high level, there are two types:
income annuities and deferred annuities with an
account balance.
Income annuities are a simpler product. In
exchange for a lump-sum premium, you
get a stream of guaranteed cash flows from the
insurer. Single-premium immediate annuities,
or SPIAs, are the most common. As the
name implies, they start right away. You can also
have a deferred-income annuity, where the
payments will start later. In extreme cases, you
can defer payments to age 80 or 85; these are
talked of as longevity annuities or longevity
insurance. Income annuities are efficient vehicles
to generate income, but they're irrevocable
contracts. You can't go back later and get the
wealth that you put in there.
A deferred annuity with an account balance
is like an investment account with tax-deferred
growth. There are a lot of different flavors
of deferred annuities, including variable annuities,
registered index-linked annuities (also
referred to as structured variable annuities),
fixed-rate annuities (also called multiyear
guarantee annuities), and fixed index annuities.
The way that I differentiate among all of these
different types of products is by asking
how does the balance grow and what is the
level of investment risk that's bestowed
on the investor?
With variable annuities, the account balance will
fluctuate up and down with the capital markets.
That's also true with registered index-linked
annuities, but with reduced potential losses and
growth; the payouts are based on options
that the insurance company buys. The return
on a fixed index annuity is also based on
options; the return will be floored at 0%, but its
upside is also scaled back.
With deferred annuities, you can add riders
for an explicit fee. There are riders that provide
enhanced death benefits or long-term-care
benefits, but the most popular rider is a
guaranteed lifetime withdrawal benefit, or GLWB,
rider. With a GLWB, you have a guaranteed
withdrawal benefit that the insurer will provide
based on the contract provisions. At first,
you are taking it from your own account balance.
But at some point, if your account balance
is depleted, the insurance kicks in, which allows
you to withdraw the same amount for the
rest of your life.
Szapiro: Wade, you've looked at newer compensation
models that are designed for fee-based advisors. What
are you seeing in the marketplace?
Pfau: Traditionally, annuities have been commissionbased,
which has been a challenge as financial
advisors increasingly represent themselves as
fee-only. But we have seen the growth of fee-only
annuities that strip the commissions out and
have an infrastructure to allow advisors to charge
their fees on that account balance. That
opens up an opportunity for any sort of financial
professional to be able to talk about annuities
if there's a situation where they may fit within a
client's retirement strategy.
Szapiro: Everyone knows an allocation to annuity
products is about a trade-off between potential
bequests on the one hand and guaranteed income
on the other. But is that a little simplistic?
Pfau: It's important to remember that it's not all
or nothing. It's not, do I put everything in the
annuity, or do I put everything in investments? It's
also important to think about annuities as
a fixed-income replacement. You're not selling
stocks with a risk premium; you're trading
bonds for the annuity. This means that one does
not necessarily have to sacrifice a bequest when
attempting to meet an income need.
This leads to the idea that there are different viable
strategies out there for how people can approach
retirement, whether it's with a total-return
investment strategy, a bucketing strategy, or a
strategy that uses an annuity to build a protective
income floor with additional investments for
more discretionary types of goals.
That led to research I did with Alex Murguia about
retirement income styles to help people identify
what sort of strategy might resonate best with
them. We found there are two important factors.
The first is whether someone leans toward
a probability-based or a safety-first approach.
Probability-based investors are comfortable
investing in a diversified investment portfolio and
relying on the risk premium to support a
higher level of spending than they could have
with bonds alone. Safety-first investors
recognize the potential for stocks to outperform
bonds but don't want to rely on that to fund
their retirement. They'd rather have some
sort of contractual protection to help support basic
expenses and invest outside of that for more
discretionary goals.
The second important factor we found, and
it's one I wouldn't have predicted, was the idea of
optionality versus commitment. If you have an
optionality orientation, you really value the
flexibility of not locking anything in so that you can
make changes, respond to new opportunities.
That contrasts with a commitment orientation.
If you can find something to solve for your
lifetime need, you prefer to commit to that, to lock
it in and potentially help manage cognitive
decline or to help protect other family members.
It was fascinating to see how these two factors-
probability/safety and optionality/commitment-
translate into the popular retirement strategies
discussed more broadly in the consumer media. If
I'm probability-based and optionality-oriented, that
suggests a total-return investing strategy,
systematically spending from a portfolio of 50% to
75% stocks in retirement. In contrast, if I'm
safety first and am comfortable committing to a
strategy, I'd rather build an income floor with
a SPIA or another type of annuity.
The other two style combinations lend themselves
to behavioral-type strategies. Bucketing is
not necessarily a better way to invest, it's just
psychology. You can use bonds for short-term
expenses, which satisfies safety first, but
you also get optionality through a stock portfolio
earmarked for long-term expenses. On
the other hand, if you are probability-based, or
comfortable relying on the market, but also
have a commitment preference because you are
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