You sell the product; clients buy it. You love the guarantees the product provides in the form of guaranteed minimum withdrawal benefits (GMWB); clients love the guarantee, too. But is it worth the risk? More importantly, is it worth the fee? After all, these guaranteed don’t come cheap: Annual expenses greater than 3 percent are the norm. You are paid handsomely for the sale. And the ongoing fee — if you take an annual fee — can be between 0.25 percent and 1.25 percent. This is all great for you, but what about your client? So just what is the value to your client? Can duration risk be managed cost effectively? Is longevity risk reasonably priced?
No less an opponent than Dr. Moshe Milevsky of the IFID Centre at York University in Toronto, Canada has offered a critic’s perspective on this query. In fact, he concludes that the GMWBs of the past 10 years are probably under-priced relative to the risk the carriers assume (1).
So far, we have asked two questions: How can duration and longevity risk be managed best?
Duration Risk
In this case, duration risk applies to the time the client’s capital spends within the product relative to their need for income, as well as to the income it offers when withdrawal begins. Longevity risk applies to the ability of the carrier to cover capital risk with fees charged against each client’s capital base.
The manner in which you choose to invest the capital is of less concern here than the length of time invested. The usual thinking is that the longer you are invested, the lower the risk — the better the chance for acceptable returns relative to the assumed risks. Some feel that they can suggest a far riskier strategy than what’s generally considered normative, as the (hoped for) return may offset the additional fees incurred. For a review of risk management theory versus reality, you may want to read the newest edition of Mandelbrot & Hudson’s “The (Mis)behavior of Markets,” (pp. 7–16). You may also consider pulling up a simple “point-to-point” chart of the S&P 500 for five, 10, 15, 20 and 25 years to review the actual returns that market has delivered, excluding reinvested dividends — they are nominal, at best. So, it would appear that a 5 percent, 6 percent or greater GMWB is worth the cost. After all, the markets have not done that well, so why take the heartache when the results are known (with a GMWB) before the race begins? Before the sale, remember that you certainly need to review — in detail — the duration risk of capital invested. As you do, you may find a disparity between your client’s statement about risk and his retirement aspirations. Adjust accordingly.
Once you have checked for disparities, you can now discuss the income strategy. This is actually why the rider was developed, according to most insurance firms’ actuaries, salespeople and CEOs. How will the income stream be defined — against what asset? Is it the actual sub-account value or the guaranteed “basket”? For how long? Does this include a spousal continuation distribution? If you are quite good, you will perform a discounted cash-flow analysis and share it with your client. What is the actual internal rate of return (IRR) of the discounted future income stream? You don’t need to validate the number, it is what it is. Simply substantiate it. You do need to share it with your client so that he or she can make an informed decision. Once inside this playground, “no one here gets out alive.” The insurer is betting that the capital will be long held, meaning no more exchanges! Is the client satisfied that he is paying a reasonable fee for this income? If so, then proceed.
Longevity Risk Management
The second question, longevity risk management, is one to which there is no answer, only guesses. Each actuarial department and general portfolio management team will offer their best efforts to cover the risk cost with the fees collected, while still suggesting a reasonable profit for the firm. They are essentially buying a put option. In fact, Equitable Life of the UK stopped selling the product in 2000 because they had failed to do just that.
The challenge is “survival of the healthiest.” Our aging cohort of baby boomers is, in fact, far healthier than previous generations. Our kids and grandkids certainly are not, given the growing obesity profiles for their generations, but we baby boomers are. Our financial conditions, our mental conditions and our physical health conditions are far better than the media are willing to play on the Tube. Why else have the GSO Tables changed so frequently during the past 30 years? Actuaries are as prone to error as any other professional, but they do have a far better data base than simple sampling survey “dudes.” I’ll take their impression of the health of a generation over anyone else’s 95 percent of the time.
Ultimately, the risk is to the insurers. Have they adequately priced the GMWB rider of their insurance company’s VA? If you can corner a CFO or CEO out of earshot of the press, ask the question, and then ponder his answer. Hedgies have tried to buy bulk contracts to arbitrage the carriers. While they do have their own set of morality tables, they may be on to something.
Your challenge is to ensure you that you have acted as a fiduciary on behalf of your client. (Your acceptance or not of that standard today is immaterial to the conclusions running at you from Graham-Dodd). You can perform this function, if you ask the right questions. Is there a reasonable chance that the policy will afford the client the income stream he or she expects? Is there a reasonable chance that the fees charged against the account will cover the risk of a healthy lifestyle? If you can help the client answer these two questions, you have helped their retirement stewardship.
P.S. Dr. Milevsky has recently bought his first VA, after suitable due diligence. Critical thinking is a wonderful thing!
1. “Confessions of a VA Critic,” Dr. Moshe Milevsky, Research Magazine, 1/1/2007
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