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ANNUITIES

High Anxiety: How DIAs Answer Your Clients’ Deepest Fears

Less than 20 percent of Americans believe it is “extremely likely” that Social Security will be available for them. 

In the past five years, a new category of annuity products — deferred income annuities (DIAs) — has emerged as a key strategy for advisors developing retirement income plans for clients. 

DIAs allow your client to start receiving guaranteed income sometime in the future regardless of their current age. But keep in mind that income annuity payments taken before age 59½ may be subject to ordinary income tax and a 10 percent IRS penalty.

Sales of DIAs are growing, going from $1 billion by the end of 2012 to $2.2 billion in 2014, according to LIMRA.

The growing use of DIAs is not surprising in the face of the planning challenges advisors must address when it comes to helping clients secure retirement income. Chief among the challenges are market volatility and longevity. We can’t predict how the market will perform leading into or during a person’s retirement, nor can we know how long that individual might spend in retirement.

Yet tackling the challenges of market volatility and longevity risk is critical to giving individuals the confidence they will have financial security in retirement and not outlive their savings as so many fear they will. 

In fact, according to Northwestern Mutual’s 2016 Planning & Progress Study, 34 percent of individuals believe there is a greater than 50 percent chance they’ll outlive their savings in retirement, and an additional 20 percent believe there is a greater than 75 percent chance. Less than 20 percent of Americans say it is “extremely likely” that Social Security will be around for them.

Retirements also are getting longer. A person’s needs can change, often significantly, during retirement. This further underscores the need for plans that can deliver a base of guaranteed income but also the opportunity for continued asset growth and income generation. 

This is why advisors are turning to planning strategies that are equal parts offense and defense — certainty alongside flexibility — and DIAs are playing a key role. Since first becoming available, DIAs have been well-received by individuals who want a guaranteed lifetime income. The level of income depends on the amount of premium that clients put into the annuity and how long they choose to defer taking the income. The longer the deferral period, the higher the income stream. 

Northwestern Mutual partnered with Michael Finke, dean and chief academic officer at The American College, and Wade Pfau, professor of retirement income at The American College, to study the impact of DIAs on retirement plans.

The professors conducted more than 50,000 Monte Carlo simulations to determine how a portfolio designed to provide $100,000 of real lifetime income behaves, both with and without a DIA. The simulations were adjusted for longevity, stock and bond market performance, and inflation.

The research found that including a DIA in a retirement portfolio can help reduce the cost of funding retirement while also helping offset risk and providing asset allocation flexibility. In a paper based on the research, “The Retirement Income Challenge,” the professors detailed three important findings. 

1. DIAs help mitigate uncertainty and can help reduce the cost of retirement. The cost of retirement includes the actual cost of generating a guaranteed income in retirement in the face of unknown variables such as longevity and asset returns. When a retirement plan allocates a portion of assets to a DIA, the average cost of retirement can be reduced. This happens because the DIA softens the potential financial blow of a long lifetime or poor market returns by guaranteeing a portion of retirement income. 

2. DIAs allow clients to take on more equity risk. Setting aside assets before retirement to buy a DIA places a portion of the retirement portfolio into a bondlike asset. With a level of guaranteed income, individuals may then invest the rest of their assets more aggressively while maintaining the same risk profile. 

3. Participating DIAs that have potential for dividends can also help overcome low-interest rate environments. Dividend-paying DIAs offer a lower guaranteed income floor with possible upside potential through the distribution of dividends, providing potential additional value alongside the protection against inflation and longevity. Dividends can be distributed as cash or used to buy additional retirement income. 

What to Tell Clients About DIAs

When helping clients determine whether a DIA would work in their personal retirement plans, a few areas are important to consider.

Help your client understand that a DIA provides added diversification across assets, not just investments.

Many people think about diversification in terms of the mix of equity and fixed income in their investment portfolio and consider that key to mitigating risk. But it is important to see that the addition of a DIA provides an added level of risk mitigation by diversifying among assets not just investments. 

A DIA is ensuring income payments for a lifetime, which can’t be compared directly to the income possibilities of investments.

Is your client comfortable setting aside money today for income tomorrow?

While DIAs let the client lock in a stream of guaranteed income years before retirement — something no other financial tool can do — it does mean that they are giving up some liquidity, or access to that money. Deferred income annuities have no cash value, premiums are nonrefundable and once the DIA is issued, accessing the money used to pay the premium is limited and subject to fees.

So, like a 401(k) or other retirement tool, a DIA works best if the client is following a strategy of “contribute and don’t touch,” as these assets are for future income generation.

If clients do not have the funds needed for their current day-to-day living or unexpected expenses, they should not purchase a DIA.

Is leaving money to loved ones important?

For many people, life insurance often serves as the financial solution to leave a legacy for loved ones. However, if your client does not have life insurance in place and wants to ensure a portion of the annuity premium is passed to beneficiaries if the client should die early, DIAs can be designed to include certain features, including: 

» Providing a death benefit to a beneficiary should the client die during the deferral period. 

» Allowing payments, if already started, to continue to a beneficiary for a certain number of years after the policy owner's death. 

» Making income payments for the length of two lifetimes (joint annuity) versus one (single). 

Deferred income annuities can be an integral part of comprehensive retirement plans, allowing individuals to cover their fixed expenses (such as housing, health care and transportation) with a reliable income stream. A growing number of investors are finding that a DIA can help bridge the gap between their income needs and what Social Security and their pension benefits (if any) may provide.

DIAs are not an all-or-nothing solution, though. Rather, it’s best to think of them as one part of a larger retirement income strategy, and they should be considered carefully in context with other factors such as income, how much clients have saved and how much they will need to save to reach their retirement goals. 

David Simbro is senior vice president, life and annuity products, Northwestern Mutual. David may be contacted at [email protected]

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