Glenn Daily is one of the top financial advisors in the country.
Specializing in life insurance and annuities, Glenn is widely recognized for his deep technical expertise and high level of objectivity as his services are strictly on a fee-only basis.
The annuity buying decision is complex and can be affected by commission-based financial incentives. Glenn’s writing, interviews and services are a great way to cut through some of the clutter.
Annuity Digest: You are an advocate of real options analysis and its application to financial planning decisions. Can you provide a simple description of how real options analysis can be applied to the annuity purchase decision?
Glenn Daily: Variable annuities with guaranteed lifetime withdrawal benefits (GLWBs) have been very popular for several years, and annuity advocates point to the recent financial crisis as proof of their merit.
I’m not convinced. Let’s look at the situation in 2007 before stock prices fell. Variable annuities were heavily promoted, and several economists had demonstrated mathematically that guaranteed withdrawal benefits were underpriced. Knowing that, did I encourage my clients to buy them? No. Do I now regret that? No.
If you had set up a diversified portfolio with a 50% equity/50% bond allocation in October 2007, you could be just about back to even now, depending on the specific assets selected and rebalancing. If you had bought one of the popular variable annuities in October 2007 and invested in the most aggressive option that was allowed, your account value might still be down about 15%, and you would have ongoing expenses of over 3% a year and a current surrender charge of 4%. On the positive side, you would have a guaranteed lifetime annual withdrawal amount of 5.7% of your original investment.
So after one of the worst financial environments in decades, who is in the better position going forward: the annuity owner with an in-the-money GLWB, an underwater account value, high ongoing expenses and limited investment choices, or the diversified investor who has almost all of his original capital available and the entire world of investment opportunities to choose from, including the opportunity to buy an annuity?
Real options analysis teaches that you have to be compensated for giving up flexibility, and there was — and still is — much to dislike about variable annuities. In 2007 I wasn’t convinced that the underpricing of guaranteed living benefits provided adequate compensation, and I don’t see how recent history is a clear win for the annuity advocates. It’s a toss-up at best.
Annuity Digest: Does this wait and see approach apply to all annuity types?
Glenn Daily: Real options analysis applies to investment decisions that involve uncertainty, irreversibility and the option to wait, and that describes most annuity purchase decisions. The main insight is that when you make an investment today you give up the opportunity to make it tomorrow, so you have to take that cost into account in the investment decision.
Imagine that you hold in your hand the opportunity to buy an annuity. If you invest now, you immediately enjoy the annuity’s benefits, such as tax deferral, guarantees or monthly income, depending on the type of annuity. However, you have to give up the opportunity that you are holding, because you have now committed your money. That opportunity might actually be more valuable than the annuity itself, because it lets you enjoy the future benefits of the annuity while waiting to see how the uncertain future unfolds.
To make a decision about waiting, you have to weigh the value of having the annuity now versus the value of retaining the opportunity to buy it later. In some limited situations, such as puts and calls on common stock, you can use option-pricing techniques to decide what to do. In most real-life situations, however, real options analysis provides a way of thinking about the decision, but not a quantitative answer to guide you.
Most applications have been in the business world, but real options analysis has also been applied to many personal finance decisions, including annuitization, term versus cash value life insurance, life settlements, Roth IRA conversions, Social Security benefit elections, car leases, defaulting on mortgages, and paying off debt. So I’m hopeful that real options analysis will gradually have more influence on consumer decisions, either directly or indirectly through financial advisors.
Annuity Digest: Is the irreversibility of the annuity purchase decision the primary concern? Can you offer some commentary and prioritization of other factors that support the case for waiting such as: expense and surrender charges, lack of liquidity and transparency, interest rates, new product features, favorable tax law changes, credit risk and health changes?
Glenn Daily: If you can reverse your investment decision essentially without cost, you don’t need real options analysis, because you are not giving up anything by investing today. Lack of commutability, surrender charges and penalty taxes create irreversibility, or at least partial irreversibility.
You listed some of the sources of uncertainty about the benefits of the investment. I would add future research, which may contradict the conclusions of the existing research that you are relying on to justify making the investment; perhaps that could be called “knowledge risk.” Anyone who has tried to keep up with the science on whether a particular food is good or bad for you will appreciate this risk.
Your list includes “new product features,” and that’s an important item. Marketers may not realize that each glowing product announcement sends a contradictory message. If today’s new product is so much better than yesterday’s, why not wait for the next announcement? Why would you think that we have reached the end of product development?
Annuity Digest: Are there downsides and opportunity costs associated with postponing an annuity purchase? For example, what about the impact of market risk, interest rate risk, inflation or deflation?
Glenn Daily: Absolutely. Real options analysis does not say “Wait”; it says “Weigh the benefits and costs of waiting before you make a decision.” If the costs of waiting exceed the benefits of waiting, you shouldn’t wait.
Real options analysis applies only when significant features of the situation – such as tax treatment or expenses – are stable, so that you really do have the option to wait until tomorrow to make the decision. It’s okay to have some market-based elements, such as interest rates, especially if there’s a way to hedge, but there have to be some stable elements.
For example, you can’t use real options analysis to justify waiting to invest in the stock market, because you don’t have the option to buy stocks at today’s price tomorrow unless you buy that option today. Going back to the image of holding an opportunity in your hand, a real option would feel solid, whereas the opportunity to buy stocks tomorrow at tomorrow’s price is like trying to hold air.
Annuity Digest: What are some of the best alternatives to annuities for principal protection and, in particular, protection from sequence of returns risk?
Glenn Daily: Diversification, a conservatively-invested fund for several years of living expenses, out-of-the-money put options, and inflation-protected securities have been suggested by various advisors.
Insurance companies have a legal monopoly on insuring against mortality-related events, but they don’t have a special role in providing principal protection. That can be done by any institution that can issue structured products. Insurers tend to have a high cost structure, so they are not likely to be low-cost providers of principal protection.
Annuity Digest: What are the best alternatives to annuities for longevity risk protection?
Glenn Daily: First, you can reduce the need for fancy financial products if you save more money, retire later, and work part-time in retirement. Most people probably don’t want to hear that, but it’s true. My grandfather wouldn’t have needed guaranteed lifetime withdrawal benefits; he happily worked until he died at age 84, and he didn’t need to draw down his savings.
Second, families can provide longevity risk protection. In a frequently-cited paper (“The Family as an Incomplete Annuities Market,” Journal of Political Economy, April 1981), Laurence Kotlikoff and Avia Spivak argued that the natural risk sharing that occurs in families is a partial substitute for commercial annuities.
But I don’t want to discourage people from buying annuities for longevity risk protection. I’ve had a favorable view of immediate annuities for 20 years, and I also like deferred income annuities and the new concept of a ruin-contingent life annuity, which is basically a freestanding GLWB. These are relatively efficient ways to turn a nest egg into an income that you can’t outlive. New variations that combine lifetime income with long-term care insurance may also be appealing.
So in my view, the question is when to buy, rather than if to buy, an annuity. It’s a timing decision.
Annuity Digest: Would you agree that annuities are a fairly efficient way to provide a very complex product offering to a mass market? For example, with indexed annuities one is able to essentially outsource the construction and ongoing management of a derivatives and fixed income portfolio to an insurance company. How would one go about creating this otherwise, and while the products may not be perfect, does it make sense to wait for perfection?
Glenn Daily: The real options perspective is not about waiting for perfection. It is about managing your valuable options wisely. In that sense, it is an extension of the principles of prudent investing. Prudent investors demand adequate compensation for giving up flexibility, just as they demand adequate compensation for taking additional risk. And prudent investors don’t squander their options, just as they don’t incur unnecessary investment expenses.
I agree that individuals need to rely on institutions for most financial engineering activities. But again, insurance companies have no special expertise in financial engineering. My impression is that most of what they know about derivatives-based hedging programs has come from investment banks, although some insurers do have very sophisticated hedging operations. You also have to examine their cost structure, including the costs of capital and distribution.
Indexed annuities are controversial; economists disagree on their efficiency. There is more consensus on the efficiency of immediate and deferred income annuities. Most studies conclude that income annuities have a money’s worth — that is, the expected present value of benefits divided by the expected present value of premiums — of at least 90% for healthy buyers. So longevity risk protection doesn’t cost much, and that’s why there is also a consensus among economists that income annuities enhance consumer welfare.
There are not many types of insurance that give you a money’s worth of over 90%. Long-term care insurance might be 60% to 85%. The recent health care reform legislation requires 80% for individual health insurance, and that is supposed to be an improvement over existing policies. Most life insurance is probably less than 90% if you take lapses into account.
Annuity Digest: With annuities, isn’t there always a case to be made for waiting?
Glenn Daily: Not at all. By analogy, sometimes it makes sense to exercise a call option on a dividend-paying stock before the maturity date. In the real options framework, it would make sense to buy an annuity when the costs of waiting exceed the benefits of waiting.
For immediate annuities, the Implied Longevity Yield developed by Moshe Milevsky at the IFID Centre in Canada is a measure of what you give up by waiting to buy the annuity, and that would be an important element of a real options analysis. You might also consider the cost of hedging against a decrease in interest rates, which would lead to a higher annuity price.
Annuity Digest: What would serve as legitimate triggers for a future purchase?
Glenn Daily: A good example would be an unfavorable tax law change with grandfathering for existing contracts. Or an annuity that has very low expenses and no surrender charge, leaving little room for improvement. Or a significant forgone benefit, such as immediate annuity payments at older ages.
The trigger point will rarely be obvious. If you can’t think of potential benefits from waiting, and you can see that you might miss out on something good by waiting, that would be a clue.
Annuity Digest: While real options analysis works well in theory, what about the practical aspects—the whole world does not necessarily have access to Glenn Daily as an advisor to help them keep a clear distinction between waiting and procrastinating?
Glenn Daily: Waiting and procrastinating feel different. Waiting feels like you have more self-control; procrastinating feels like you have less.
Real options analysis is a way of thinking about the value of flexibility. After you have learned that way of thinking, you shouldn’t need me to tell you what to do, any more than you needed your math teacher to give you the answers after you learned how to solve the problems. In fact, I don’t claim to be especially talented at identifying the optimal exercise time for real options. I just know that real options analysis has something to contribute to the decision-making process.
Reasonable people can certainly come to different conclusions about when to stop waiting, based on their differing assessments of the costs and benefits of waiting. The most important thing to remember is that waiting has benefits as well as costs. Product vendors naturally don’t want you to wait, so you shouldn’t expect to hear about the benefits of waiting from them.
Think about your own life experience. When you have postponed taking an action, how has it worked out for you? How often have you actually missed out on something good, and how often has something better come along while you were waiting? Sometimes you can get ahead in life just by standing still.
Annuity Digest: Thank you Glenn.
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