Beyond Reproach: Ethics,
Integrity and Trust
By David B. Loeper, CIMA
HOW MUCH IS THAT GUARANTEE IN THE WINDOW?
“The fact that a great many people believe something is
no guarantee of its truth.” — W. Somerset Maugham
Guaranteed income for life! This is the marketing cry of
the insurance industry, and emotionally it has a lot of
appeal. The soothing comfort implied is so enticing that
there are actually proposals from the Obama administration
to encourage Americans to buy annuities with their retirement
savings (see: Retiree Annuities May Be Promoted by
Obama Aides – Bloomberg, January 8, 2010). I guess
this is what happens when the government owns an
Even The Wall Street Journal has fallen prey to this marketing
ploy as exemplified in the story, Locking in Future Income –
December 9, 2009. In this story about variable annuities,
the WSJ does a reasonable job of disclosing the “very
steep fees” (the price of the guarantee? …not really as
you will learn) and that you can’t get the guaranteed
amount in a lump sum. They also warn about the complexity
of these products and offer a summary of additional
warnings. But, a favorable message about the value of
the guarantees in the “timing” section of the article stated:
“If, for instance, the market falls sharply just after you buy
and your underlying funds take a dive, the guarantee
could prove quite valuable.”
Let’s examine this “quite valuable” benefit the WSJ article
highlighted. What happens if the markets fall sharply just
after you buy? This is after all one of the two main things
you are trying to protect yourself from by buying an annuity
(the other is the risk of outliving your wealth).
The example the article used was a 60-year-old who put
$100,000 in a variable annuity in 2000 just as the bear
market at the beginning of the decade started. Fortunately,
the annuity had an annual “guarantee” of 5% growth per
year for the benefit base. As of October 31, 2009, this
means the benefit base (not available in a lump sum) would
entitle the annuity buyer to an annual lifetime income of
$7,500 because of the guarantee that protected his
benefit base. That $7,500 annual benefit is based on a
5% payout rate for the annuitant who is now 69 years old
and a benefit base that has grown to $150,000 (according
to the article). At normal life expectancy (50/50 odds),
the annuitant would receive $120,000 in annuity
payments for tying up $100,000 for 26 years. Care to
calculate the IRR on that? The consumer (and most
agents that sell these things) would believe they were
getting a 5% return because of how the insurance
company promotes the 5% guaranteed increase to the
benefit base and the 5% payout rate. In reality though,
this is the equivalent of getting a 1.84% return for the
first 10 years and zero for the next 16 years. Does this
sound like a good deal to you? Sure doesn’t seem
anywhere close to 5%.
Let’s back test all of these cash flows historically. We
have a 60-year-old who invests in a simple 60/40 portfolio
(60% domestic equities, 37% government bonds, and 3%
cash) and pays an advisor a 1% annual advisory fee.
Each year we will calculate and tax his investments
assuming moderate Virginia state income taxes and
current Federal tax rates. We will assume annual
rebalancing plus 20% annual turnover and 80% of
capital gains being realized as long term. Also, we will
withdraw the same $7,500 a year (but in our case net
after tax and after expenses) starting at age 69 and
continuing to death at normal life expectancy.
Going back to 1926, there were 697 twenty-six year
periods for us to back test based on monthly data.
If this investor started in September, 1929 right before
the Crash of ’29 and the ensuing Great Depression,
he would have ended up with $42,241 left over versus
ZERO in the annuity at normal life expectancy. In fact,
in EVERY ONE of the historical periods, the annuity
guarantee that the WSJ called “quite valuable” cost
the investor at least $42,241 or more. At the 90th
percentile outcome, the guarantee cost the investor
$250,089. At the 75th percentile, the guarantee of the
annuity cost the investor a whopping $339,068— more
than three times the initial investment. There was a 50%
chance the guarantee would cost the investor an incredible $441,896!
But, these ending values of what is leftover in the portfolio
are not all profit for the insurance company. That’s because
there is a 50% chance the investor will live past normal
life expectancy. Before we examine the effect of the value
of the lifetime income guarantee though, objectively think
about this example and what the insurance company is
coercing agents to sell. Half of all of the clients who were
sold this product will end up dying before normal life
expectancy and if the Crash of ’29 and the Great Depression
were to start the month following each of their initial
investments, the annuity would cost all of them AT LEAST
42% of their initial investment; MORE if they die before
normal life expectancy or if the markets aren’t as bad
as the Great Depression.
As would be expected though, the insurance company
actuaries have designed the product to have very favorable
odds for them to profit. There is a risk that many of the
annuitants (about half) will live past normal life expectancy
and the insurance company needs the “premiums” of the
other half of the annuitants who lose out on this bet to
insure this longevity risk they are taking with the other
half. Do not assume that the actuaries haven’t figured
out how to still profit on this risk.
The 60-year-old in our example has a 71% chance of
being dead by age 90 (you may wish to find a better way
of articulating this). Running the same historical back test
for the 637 thirty-one year periods back to 1926, we find
that the simple balanced portfolio STILL exceeded the
cash flow from the annuity in every historical period. In
the worst historical period starting with the ’29 Crash,
the guarantee of the annuity cost the investor $14,758.
Starting in December, 1926 (the 95%-tile outcome) the
guarantee of the annuity cost the investor $213,447.
Starting in June of 1926 (the 87th %-tile outcome) the
guarantee of the annuity cost the investor $403,385.
Remember, the investor only has a 29% chance of
living this long.
Extending the life expectancy to age 97 (less than a
10% chance of the investor living this long) we see
where the risk is for the insurance company (note …
this is sarcasm). Of the 553 thirty-eight year historical
back tests going back to 1926, there were TWO of the
553 periods where the balanced portfolio would have
run out of money. The cost of the annuity guarantee,
IF the investor lives to age 97 (less than 1 in 10 chance
of this) had a 95% chance of costing the investor more
A one in ten chance of outliving your money is still scary…
or so the insurance company would like to have their
agents and annuitant victims believe. There is essentially
no chance (at least from actuarial tables less than a 1
in 1,000 chance) of the annuitant living to 111. Back
testing the balanced portfolio back to 1926 once again
sheds light on how conservative actuaries are in
ensuring profits for the insurance company at the
expense of their customers.
There were 385 fifty-two year periods for us to test
going back to 1926. In about 2% of those (seven to
be exact), the investor would have run out of money
IF he or she lived to 111. If he started in July of 1929
(the 95th %-tile outcome), just a few months before the
’29 Crash and the Great Depression and he lived to age
111, the cost of the guarantee of the annuity would have
Understanding the combination of how unlikely the perfect
storm of remote odds are can be daunting because we
have uncertain market returns, uncertain timing of returns
that can impact the wealth, and uncertain mortality.
Our company has the rights to a patent to assess these
risks together using Monte Carlo simulation so we can
come to one simple probability of the odds of whether
or not the annuity guarantee has value.
Out of 1,000 random lifetimes with simulated random
returns even more extreme than have been historically
observed, in 997 of the outcomes the annuity had a
negative relative value to the simple balanced portfolio.
There was a 90% chance the annuity guarantee would
cost the investor more than $149,000 (about 1.5 times
the initial investment) and a 75% chance it would cost
more than $243,000.
Does this sound “quite valuable” to you? Think about
the other factors on top of this. The cash flows we
modeled for spendable income were net after taxes
and fees versus the annuity that would likely have
some portion of the payment being taxed at ordinary
income rates. The annuity has zero liquidity where the
balanced portfolio offered flexibility to adjust future income
withdrawals if there was an unexpected immediate cash
need. Of course, we are also assuming the insurance
company financially survives a Great Depression environment
and can honor its promise to pay.
In the Wealthcare process we avoid needless risk so, in reality,
it is unlikely we would recommend a portfolio with 60% equity
exposure to the client if it wasn’t needed to confidently fund their
income need. In fact, the Monte Carlo simulation with random
returns and life spans actually showed the annuity guarantee
costing the investor in 999 of 1,000 simulations if the portfolio
had 45% equity exposure (our balanced income allocation) and
997 simulations for our 30% equity exposure (our risk averse
allocation), the same odds of the balanced portfolio.
Do the odds against the annuity having value sound like the
kind of recommendations someone would give in a practice
that is beyond reproach?
David B. Loeper is the CEO of Financeware, Inc. which does
business as Wealthcare Capital Management. An SEC
Registered Investment Adviser with nearly 25 years experience,
Loeper has appeared on CNBC and has been a featured
contributor on Bloomberg TV and CNN.
Loeper joined Wheat First Securities as vice president of
investment consulting in 1988, where he served for 10 years.
He was promoted to managing director of investment
consulting, and then eventually to managing director of
strategic planning for the retail brokerage division. He left
his position at Wheat First Securities in 1999 to found Financeware.
Active in industry associations throughout his career,
Loeper has been a member of the Investment Management
Consultants Association (IMCA) for over 20 years, serving on
the advisory council for more than 5 years, most recently as
chairman. Loeper was also appointed by the governor of
Virginia to serve on the Investment Advisory Committee of the
nearly $30 billion Virginia Retirement System. He received his
CIMA® designation in 1990 by completing a program offered
through Wharton Business School, in conjunction with IMCA.
Drawing on years of experience in financial services including
serving as a fiduciary for all types of ERISA plans, Loeper has
authored numerous whitepapers and books including the top
selling book, Stop the 401k Rip-off! as well as The Four
Pillars of Retirement Plans, Stop the Retirement Rip-off and
Stop the Investing Rip-off