TIAA-CREF

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?

Mark Warshawsky: My initial thinking about the combination of an immediate life annuity and long-term care insurance (LTC) goes back almost 15 years ago.

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.