The advent of guaranteed variable annuities will force real change in the retirement markets says John Quinlivan
Every few years we experience shifts which are recognised as industry changing. We are at a time when two such developments may well combine to create such a change over the next decade. The first is the continued development of wraps. The second, and potentially of greater impact, is the development of guaranteed variable annuities. This is the generic term coined in the USA for unit-linked funds with attaching guaranteed features of one type or another.
Examples of these guaranteed features might be:-
- Guaranteed Minimum Death Benefit (GMDB) i.e. a minimum return on death of the total contributions adjusted for withdrawals
- Guaranteed Minimum Accumulation Benefit (GMAB) i.e. a minimum return after 10 years of the contributions paid rolled up at a given interest rate
- Guaranteed Minimum Income Benefit (GMIB) i.e. a minimum income from a certain age expressed as a percentage of the initial investment
- Guaranteed Minimum Withdrawal Benefit (GMWB) i.e. the return of the original investment in equal instalments (5% for 20 years) even if the account falls to zero
- Guaranteed Lifetime Withdrawal Benefit (GLWB) i.e. the payment of a given percentage of the original investment for life, even if the account value falls to zero
Why might guaranteed variable annuities change the industry?
There are five main factors which point to them being a major development:-
- Experience in the USA
Guaranteed variable annuities, in the form of GMDB first hit in the USA in the mid 1990s, but it was the development of the "living benefits"- guarantees which pay out when the investor is still alive, which really captured the imagination. In particular the development of guaranteed withdrawal and guaranteed lifetime withdrawal benefits have been the driving force behind the growth in variable annuities (i.e. unit-linked) business in recent years. At that time advisers in the USA and asset management houses were at best unsure of the impact of these types of solutions. However, clients and markets meant that advisers gradually developed a liking for these solutions. By 2006 approximately 80% of all unit linked products sold by US insurers contained one form of guaranteed benefit or another.
- Lessons from behavioural finance
Behavioural finance and years of anecdotal evidence point to investors being cautiously greedy. Two of the most interesting findings are that broadly speaking the average investor has twice the aversion to loss as a desire for gain and that certainty has significant value/premium. These won't be a surprise to most intermediaries. Picking up on the loss aversion point in simple language this suggests that emotionally an investor will feel the pain of a -10% return to the same extent as they will feel the gain of a +20% return. What does this tell us? There are no doubt a number of interpretations, but certainly one would appear to be that clients value certainty.
- Structured products and other fund developments
Over the last five years we have seen structured products and absolute return funds grow in popularity. The common denominator with both of these is reduced risk but also a perception of security.
Clearly with structured products the fact that a client's assets are guaranteed downside protection, subject to the financial institution not going into default, is what the client values.
Of equal interest is that many advisers to the ultra-HNW make use of structured solutions, which points to certainty being valuable up and down the wealth spectrum
The two downsides of structured products is that individuals pay for guarantees whether they need them or not and although they can in theory be "traded" the market for trading structured products is limited at best.
We are all well aware of the shortcomings in with-profits over recent years but if we focus on what was attractive about with-profits as far as the end consumer was concerned, the security and guarantees were certainly valued.
We all know the value of insurance or sharing or risk, but because of the challenges with-profits has faced the industry has backed away from a key fundamental strength, namely sharing of risk in the savings arena. A consequence of this is that individuals now have transparency but at a price. The price being that they may now have to suffer the peaks and troughs of the investment markets alone.
Our own analysis points to a high chance of individuals outliving their income. In fact, we have independently validated the fact that a 60 year old onshore bond policyholder taking 5% income has a 1 in 3 chance of running out of money before they die.
Pulling all of this together. We know that clients value certainty, we know the capability is there for providers to develop solutions involving guarantees, we know that there is a need for risk sharing between clients/customers (as there always has been) and we know that in a world when many of the historical financial security pillars such as defined benefits have been eroded the market needs solutions which provide certainty.
For all of these reasons we believe that the world of unit-linked savings market will change imminently.
To promote 'long-term investment'
Switching 'hard and expensive'
Smaller funds still packing a punch
To drive progress