TIAA-CREF has a long-standing reputation for providing cost effective financial services to those in the academic, medical, cultural and research fields. They do this by creating and providing a broad menu of financial products and services that are focused on saving for and providing income during retirement. As a non-profit, TIAA-CREF is able to offer relatively low fee products. TIAA-CREF also provides its products and services through financial consultants who do not receive commissions. TIAA-CREF also happens to be a pioneer in the annuity industry having created and offered the first variable annuity.
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Moshe Milevsky is an Associate Professor in Finance at the Schulich School of Business at York University, and he is one of the world’s leading authorities on retirement income. Professor Milevsky recently published and presented an academic paper on tontines and he is in the process of writing a book on the same topic.
AD: Can you provide some historical context on regulatory issues and why tontines disappeared from the U.S. financial services landscape in the early 20th century? Were the problems related to plan participants, plan sponsors, or both?
Moshe Milevsky: The main problem in the late 1800s and early 1900s was insurance companies who sold "tontine insurance" and mismanaged the funds. The investment fees were too high, the company managers paid themselves too much, the company's bribed regulators and in the end the consumer was left with meager returns. Sound familiar?
AD: How do the past regulatory issues impact the present, and are perceived regulatory obstacles actually still relevant? One can understand how moral hazard might come into play at the participant level, but at the sponsor level how is it really that different from regulating a bank, insurance company or any other custodian of funds?
Moshe Milevsky: Tontine insurance is illegal in most (if not all) U.S. states, so the regulatory obstacle is still on the books. Either the law has to change, or innovators will have to convince regulators that 21st century tontines are quite different from 19th century tontine insurance -- despite the shared name.
AD: Why would state departments of insurance regulate tontines if they are not technically insurance products?
Moshe Milevsky: It is debatable whether 21st century tontines would be considered insurance or not. Yes, there is pooling of risk and the payout is linked to lifespan, so I can see the argument for it being regulated as insurance.I presume insurance companies will want it in their court. On the other hand, there is no need to maintain reserves or capital, so an economist might argue that it is not insurance, per se. I suspect this will be a battle between Vanguard (not insurance) and Metlife (yes insurance) and might reach the supreme court, if this idea catches on.
AD: Are there examples of contemporary tontines that are thriving? If so, where do they exist and how have these plans avoided the pitfalls that led to extinction in the U.S. market?
Moshe Milevsky: One example is the Israeli pension system. They adjust annuity payouts based on actual mortality experience, in relatively transparent way. They call it participating annuity, but I prefer tontine-like. Note that TIAA-CREF also uses such a system. A number of countries in Scandinavia have adopted similar approaches. There is some work in Australia to reintroduce along the same lines.
AD: Are there contemporary examples of tontines that are structured for social welfare optimization as discussed in your paper?
Moshe Milevsky: See above answer.
AD: With an income annuity, longevity risk is removed for the annuity owner but retained by the insurance company. With a tontine, longevity risk is eliminated for both the plan sponsor and participant. Why the difference and how does this work?
Moshe Milevsky: Basically, the pool (i.e. plan sponsor) uses the LAW of LARGE NUMBERS to diversify idiosyncratic longevity risk and the aggregative (systematic) longevity risk is absorbed by the pool itself.
AD: You discuss the inherent cost advantage of a tontine relative to income annuities and the loading thresholds at which risk averse participants would prefer tontines. Can you summarize what this cost advantage looks like, and what is the typical insurance loading on an income annuity?
Moshe Milevsky: The typical loading is 3% to 15% depending on which mortality table you use to determine the mark-up. My understanding is that new capital requirements in Europe (Solvency II) will increase this number by another 10%, which -- to me -- makes tontines more appealing.
AD: Are there any specific considerations or requirements regarding the nature of the “pool” of tontine participants (e.g. age diversification, geographic diversification, etc)?
Moshe Milevsky: The pool must be relatively homogenous in age, gender and health. Otherwise it gets quite tricky how to adjust payouts based on unique mortality rates. Lets keep it simple. My guiding principle is that a tontine annuity should not require an actuary to manage!
AD: What is the minimum number of participants for a viable tontine?
Moshe Milevsky: I would say that at 50 participants you can run a variable tontine and at 500 you have basically eliminated the idiosyncratic component.
AD: What is the ideal legal structure or vehicle for a tontine? Is there, for example, a legal plan and plan document? Are there special purpose vehicles that are similar to what is used for asset securitizations or is it simply a custodian that’s involved?
Moshe Milevsky: Custodian with a simple rule: Split the annual income amongst the survivors. This was done 300 years ago without much fuss.
AD: Are there any similarities between tontines, pass-through mutual funds and the notion of Limited Purpose Banks as advocated by Laurence Kotlikoff?
Moshe Milevsky: Yes. I consider Limited Purpose Banking to be the banking equivalent of the tontine. The insurance company takes no risk and acts at intermediary. And, like Larry's Limited Purpose Banks, I suspect (sadly) that they both stand the same chance of resurrection!
AD: How are tontine assets managed? Is it simply a matter of asset-liability matching or attempting to maintain real purchasing power through TIPS or some other inflation hedge? Would there be any equity exposure?
Moshe Milevsky: The funds would be managed like any other index fund. You (as the annuitant) would pick the asset mix you want, and agree to a tontine overlay.
AD: You discuss subjective mortality in your paper. Doesn’t subjective mortality already come into play in the existing annuity market with the existence of longevity annuities? In other words, can’t individuals who believe themselves to be healthier than the general population choose back-loaded annuity payouts in the form of longevity insurance?
Moshe Milevsky: Yes. The concept of subjective vs. object mortality is well established in the annuity market. It drives pricing, as it would for tontines.
AD: Thanks very much for your time Moshe.
There are relatively little direct distribution in the annuity business when compared with other lines of insurance.
The universe is narrowed further when throwing-in the A++ AM Best rating.
Let's start with listing some companies that fall under the strong financial rating:
I think it would make sense to inquire with the following companies regarding direct distribution:
You can also take a look at the Vanguard annuity platform for what might be some lower cost purchase options.
Hope this helps.
Mark J. Warshawsky is Director of Retirement Research at Towers Watson.
Dr. Warshawsky served as assistant secretary for economic policy at the U.S. Treasury Department from 2004-2006 and he has held senior level economic research positions at the Federal Reserve Board, the Internal Revenue Service and TIAA-CREF.
Mark Warshawsky is the author of Retirement Income: Risks and Strategies. In Retirement Income Mark describes strategies and products that can help financial advisors and their clients address the enormous challenge of creating a sound financial plan for retirement.
We were able to spend some time with Mark discussing Retirement Income and his perspective on challenges that exist in the current environment.
Annuity Digest: Let’s start with Life Care Annuities. What are your thoughts on where things are at and how the market has developed?
My expertise is in the area of annuities and I had the opportunity to work with a couple LTC insurance experts.
As I saw it, the key insight involved addressing LTC underwriting restrictions and the fact that many people still had many remaining years of life. Combining LTC and an immediate annuity balances the risks for insurers and provides value to the insureds through discounts and access to LTC that they might not otherwise have.
Some of our initial thoughts and research on the topic were published in 2001 in the Journal of Risk and Insurance. This article serves as a chapter in the book.
We then held a joint Treasury and HHS conference in 2002 to gauge actual interest among insurers. One of the key issues raised at the time was related to taxation of the combined product. At the time, the tax implications were disadvantageous.
This tax wrinkle and fact that I was serving at Treasury allowed for some relevant and productive discussions and ultimately assistance from Treasury Secretary John Snow and Congressman Bill Thomas who headed Ways and Means at the time.
The Pension Protection Act of 2006 (PPA) resulted in slightly favorable treatment for the combined product which was naturally a pleasing outcome from my perspective.
The PPA change actually took effect beginning in 2010.
To my knowledge--and I could be wrong—is that the industry has decided to take advantage of this product combination with deferred annuities rather than immediate annuities. The assumption appears to be that consumers are not interested in immediate annuities.
While there are comparable tax advantages with both immediate and deferred annuities, I have always maintained that the pricing and underwriting advantages come with the immediate annuity--not the deferred annuity.
Annuity Digest: Other than the Life Care Annuity, have you seen anything interesting and innovative on the healthcare finance front--specifically pertaining to retirees?
Mark Warshawsky: I am somewhat hesitant to say no as I am sure there is something I am forgetting or don’t know, but nothing comes to mind in the private sector beyond the development of HSAs and HRAs.
Over the past 2.5 years I have been largely focused on the government long-term care program (the CLASS program) and overall health reform.
CLASS has disappeared and this is a good thing because it never was a well designed program.
With respect to health reform, one important change for early retirees (e.g. 62) who were not eligible for Medicare involves the exclusion of Social Security income (it would not be counted as part of income to determine eligibility). This has been corrected so it is not likely to be a scenario for middle class people. And, of course, Medicare Advantage plans and the new prescription drug plans as Part D in Medicare.
Annuity Digest: More generally, have you seen anything new and interesting in the area of retirement income product development?
Mark Warshawsky: The variable annuity with guaranteed minimum benefits is an interesting innovation.
Annuity Digest: How would you grade overall adequacy of retirement readiness in the U.S.?
Mark Warshawsky: Here I will cite some of the literature.
The cohort of people who retired before the financial crisis did pretty well in the sense that they were more likely to have decent retiree health benefits and their government benefits--particularly Medicare (e.g. the new drug benefit)--have been improved. The private plans for healthcare are also reasonably generous. Despite other problems, Social Security was not cut. Many also have defined benefit plans. And last, these people did OK financially (salaries, home values, financial asset values, etc) through the late 1990s.
I would have to say that during and after the financial crisis, things have changed in many respects in the benefit area and the overall situation does not look as good.
You know this by seeing the number of people who are delaying retirement. Healthcare costs are a big part of this. Many of the benefits (defined benefit, retiree health, asset values, etc) of previous cohort are simply not there.
Looking forward, the savings rates of younger people are just not high enough and there is an absolute necessity to make changes to Social Security.
It is not a great picture as you make that transition among cohorts and generations.
In the past, life annuities may not have looked so attractive to folks because they did not need them for income. The yield and investment income was there, but almost all other assets were producing more attractive returns.
Now and in the future, people will need to be much more attentive to the risks they face and maximizing income from existing assets will be key.
Annuity Digest: Can you make some comparisons to other countries--who stands-out on a relative basis in terms of retirement income readiness?
Mark Warshawsky: There are a couple countries that seem to do pretty well.
One is the Netherlands. They have a very high coverage rate for defined benefit plans and their public pension plan is pretty generous. Their adequacy of retirement income is high. There are some rumblings and issues though from the financial crisis. For example, everything is indexed which creates issues for plan sponsors.
Another example is Australia. They have a defined contribution system, but it has a very high contribution rate (it will be increased up to 12 percent in near-term which is probably necessary).
Annuity Digest: What are your thoughts on the recent Treasury guidance?
Mark Warshawsky: I would first begin with a word of praise. It is great that they have the overall project which dates back to 2010. It is a nice and appropriate thing that they are doing.
The hearings in 2011 were also well done.
Regarding the output, the one item that interests me most is the required minimum distribution (RMD) issue. Everyone raised the RMD issue as a key obstacle.
I think the dollar amount is too low and there are a few other technical issues.
That said, my key point is that they need to do more. It is all well and good to focus on longevity insurance--it is a reasonable strategy. There are, however, other strategies and paths.
Partial annuitization seems to be where we are headed. There are other (in addition to longevity insurance) ways of heading in this partial annuitization direction, and the rules need to be expanded to accommodate these alternative paths.
Annuity Digest: How large a role for government in retirement income space--specifically with respect to annuities?
Mark Warshawsky: The government needs to remove obstacles, provide education, and create a stable regulatory environment.
Annuity Digest: Can you comment on interest rate risk given durations of longevity annuities and the current interest rate environment? How big is the issue of timing risk in the fixed market at the moment?
Mark Warshawsky: I wrote an article with a colleague on this topic while still at Treasury.
It was truly eye-opening to see how much volatility there is in the pricing of immediate annuities. This analysis has been updated recently in my book and if anything the results are more startling.
The reality is that we have a lot of volatility of interest rates and therefore of annuity prices. This is a real risk. The income variance from year to year can be as much as 25 percent, and this level of volatility is not a 100 year flood scenario, but a common occurrence. This risk needs to be managed, avoided, hedged.
Another element of the pricing risk story that we have not looked at yet involves the fact that some of the value in the immediate annuity is pretty current, and the issuer can more readily hedge this. The 20-30 year horizons with longevity annuities, however, are harder to hedge for the issuer and presumably require more reserves and conservatism in pricing. This is a supposition on my part, as I have yet to do the empirical investigation.
Annuity Digest: What are the compelling retirement income alternatives in light of duration risk and negative real yield at the shorter end of the fixed income spectrum?
Mark Warshawsky: Certainly the risk that comes out of the pricing volatility was part of the motivation (that emerged during our research) of highlighting the strategy of taking a laddered approach to the purchase of immediate annuities.
Our discovery of this emerged during our research in three different ways, and this is important because it is an indication of robustness.
First, and this is the basis of chapter 6 of Retirement Income, we used a highly technical, non-constrained model, to generate results for both couples and individuals.
Model results indicated that retirees should gradually move into an immediate annuity at age 65 over 15-20 years. This is particularly true for middle and upper middle class people. The laddering of purchases did reduce the pricing risk of the immediate annuity. Also, as people age they get more value / utility out of monetizing their mortality.
Second, we just looked at real, actual products on the market and did a comparison of multiple approaches (fees included). Reviewing and comparing this basic mixes of strategies, the gradual, laddered immediate annuity emerged again. On average the gradual laddering approach produced higher income flows with less risk. We did not necessarily anticipate these results.
Third, we tried to take the next logical step to optimize and determine right length of laddering time. The result is a very long time horizon--20 to 30 years, along with systematic withdrawals from the remaining asset portfolio. This is discussed in chapter 7 of the book.
Annuity Digest: Given these risks and the current interest rate environment, can you comment on attractiveness of equity exposure relative to fixed income exposure, or as Warren Buffett states productive assets versus currency based investments? Is a variable annuity combined with living benefits the answer?
Mark Warshawsky: I think that some exposure during early part of retirement period to productive or equity assets is appropriate, and the laddered approach reflects this.
As you annuitize (which creates fixed income exposure), you can be more aggressive with equity exposure.
This is the fundamental logic of these (variable) products which is very good.
The problem with variable products and living benefits--and this is the message from our research--is the level of the fees and the drag it creates.
Annuity Digest: Any thoughts on The Hartford’s recent decisions in light of shareholder pressures?
Mark Warshawsky: No real insights so tough to comment.
Annuity Digest: What about the fixed indexed annuity market--any thoughts there?
Mark Warshawsky: I don’t have as much knowledge as indexed products were not formally included in our analysis.
I would like to learn more about the market.
Annuity Digest: There seem to be pockets of knowledge and theoretical best practices in the retirement income industry. Your book and your research group are one example. In practice, though, retirement income outcomes are as fragmented and varied as the distribution landscape. How does the industry propagate or scale best practices across a massively fragmented financial advisor and consumer landscape?
Mark Warshawsky: This is a great question and something that I have been giving some thought to lately.
The silos do exist and it explains what is going on in part.
That said, there is an opportunity here and someone has to take it.
One option involves the employer market. However, there are two practical impediments. The first is the employer concern about fiduciary risk. The second is that employers not sure what demand (for retirement income solutions) will come from retiring workers.
I personally feel that if the laddered approach is explained well and offered in a favorable light, workers will want it. The problem is that this type of advice and framing does not really exist, and as a result, the demand is not there. It is sort of a chicken and egg problem. Overall, though, I am not sold on this perceived impediment as permanent.
The fiduciary issue is a real issue.
In the retail space, I think there could be some institutional changes that could accommodate a broader platform.
When I was at TIAA-CREF, I used to think about retail issues all the time. I am a bit rusty now.
That said, the notion that a fee-based planner might be open to annuity-based retirement income strategies seems true. However, the fee-based planner must have some compensation that derives from the sale of the annuity. Some version of a fee-based planner who receives some compensation from the annuity sale is what must occur.
Overall, I feel like meaningful change is more likely in the employer space, although not necessarily as an in-plan option.
Annuity Digest: What are your thoughts on the viability of direct-to-consumer distribution?
Mark Warshawsky: I am not as up-to-speed in this area.
I suspect that there is so much suspicion and lack of trust of financial institutions among consumers.
We are talking about a lot of money (life savings) for individuals. It is a lot to expect that this could be done in a direct manner--a lot to expect but not impossible. The trust level would have to be so high.
Annuity Digest: What areas related or relevant to retirement income might completely surprise in the near-term?
Mark Warshawsky: I thought interest rates would be going up already.
I thought this a year ago and was wrong.
Federal Reserve policy is astonishing and completely unprecedented.
If administrations were to change later this year, this policy mix is likely to change as well.
Interest rate policy does not seem sustainable for a low inflation environment and will have to change.
Annuity Digest: Thanks very much Mark.
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