Why Insurance Products Provide Better Retirement Solutions Than Bonds

With interest rates at near 20 year highs, guaranteed lifetime income allows you the ability to lock-in these rates for the rest of your life while creating better retirement outcomes

If you own a home, then you’re probably wishing you had locked in a mortgage rate back in 2020 when 30 year mortgage rates were under 3%.

Buying a home in 2023 is not nearly as attractive when interest rates are at near 20 year highs.

While high interest rates are not good for borrowers, they are for lenders who lend money at high interest rates.

Well, what if there was a product that allowed you to be the lender and lock-in today’s high interest rates for the rest of your life?

Guaranteed lifetime income products are one such product.

By lending money to an insurance company today, you are locking in these high interest rates for the rest of your life while also benefitting from mortality credits that improve the return, protection from interest rate risk and tax-efficiency.

Table 1: Pre-Tax and After-Tax Income Yields of Bond Indices vs
Guaranteed Lifetime Income Annuity

*68% of the annuity payout in this example is taxable for the first 24 years of payout. After that it’s 100% taxable.
The assumed effective tax-rate is 22%.

As we’ll show in this article, guaranteed lifetime income products help to provide significantly more after-tax wealth than traditional retirement solutions for the following reasons:

1) Access to long-term bond yields without interest rate risk:

At its core, all insurance and annuity products provide clients access to the long-term bond yields of an insurance company’s investment portfolio without having to absorb the interest rate risk. The insurance company absorbs the interest rate risk on behalf of the client in exchange for a spread earned on the assets in between what the portfolio is making and what they’re crediting to clients.

This allows clients to access higher risk-adjusted yields than just investing in short-term bonds or long-term bonds directly.

The interest rate risk is what creates volatility in bond portfolios–not the coupon payment. The coupon payment is fairly stable.

So by investing in long-term bond coupon payments without the interest rate risk, clients are capturing a higher risk-adjusted yield–and as we’ll discuss later on, doing so in a more tax-efficient fashion as well.

So it’s a higher tax and risk-adjusted yield clients are getting.

2) Access to risk-pooling and mortality credits:

Guaranteed lifetime income annuities also provide the ability for clients to access higher yields than just investing in long-term bonds due to risk-pooling and the benefits of mortality credits. In other words, since the insurance companies know that some clients will die early, they can provide every client higher income yields than these clients would be able to achieve if they were to just invest in long-term bonds directly—as we saw in Table 1 above.

Obviously some clients will die early and receive less than they would have received if they just invested in short-term or long-term bonds directly.

We can look at the after-tax IRRs of all three options (short-term bond (AGG), long-term bond (IGLB), and the Guaranteed Lifetime Income (GLI) Product below:

We can see from the graph above that if both insureds die before 83, then investing in short-term bonds (AGG), the orange line, would have beaten the GLI product.

If both of the insureds would have died before 87, then investing in long-term bonds (IGLB, the grey line) would have outperformed the GLI product.

However, as long as one of the insureds lives past 87, then the clients receive a higher after-tax total return from the GLI product (in addition to the higher after-tax cash flow yield they were receiving while they were alive).

This should bring up the question:

What is the chance that at least one of the insureds lives past ages 83 or 87?

The answers are shown in the table below.

Table 2: Total lifetime income paid vs chance of death

*Source: Table2010CM

As the table above shows, there is only a 5.32% chance that both insureds die before age 83 and only a 13.22% chance that both insureds die before age 87.

In other words, there is a 94.68% and 86.78% chance that the GIL product outperforms the short-term bond index (AGG) and the long-term bond index (IGLB).

There are two key reasons why the GIL product is so much better for wealthy clients like the 55 year old couple in this example:

1) Wealthy people live longer than people from lower socioeconomic brackets and there is no underwriting for these products
Due to better access to healthcare and environmental conditions, wealthy individuals live notably longer than their less wealthy peers.

This means that in products like guaranteed lifetime income products in which there is no underwriting, wealthy individuals who live longer are getting higher returns that are subsidized from their less wealthy counterparts who are purchasing the product and dying earlier.

In the example above, the insurance company is pricing the product expecting the last of the two insureds to die at age 89.

However, with wealthy individuals like the married couple in the example who will have around $5M when they retire at age 65, the last of the two are expected to die at age 94.

2) Unequal utilization of the benefits
The most beneficial form of the guaranteed lifetime income benefit is found within what’s known as a Fixed Indexed Annuity (FIA). The FIA offers an optional guaranteed lifetime income withdrawal benefit where it guarantees you a stream of income for the rest of your life. You can choose when you want the stream of income to start. The longer you wait, the higher the income stream is.

However, in order to get this optional feature you have to pay an additional cost (usually 1%) of the account balance.

So people sign up for this additional benefit thinking that they will turn on the feature in the future.

But what invariably ends up happening is that all people pay for a product that not all people end up using.

What does this mean?

This means that the few who do use it are getting a discount on the true cost of it because the rest of the people are subsidizing it.

Think about it this way. Let’s say the cost of each person to use a gym membership is $50/month. I can get two people to pay $50/month each to use the gym. Or I can advertise that the cost of the gym membership is only $25/month knowing that 1 person is going to sign up and not use it while the other gets the benefit.

Also the fact that the cost is only $25/month instead of $50/month means more people are going to sign up for the gym.

Life insurance works the same way.

The goal is to make sure you’re on the side of the equation that benefits from the subsidy instead of just the one paying into it.

3) Tax-efficient income distributions benefit the wealthy:
Another key advantage of guaranteed lifetime income annuity products over bonds is due to the fact that guaranteed lifetime income annuity payouts are less taxable than bond coupon payments. This is due to the fact that bonds only return your principal at the maturity of the bond, whereas guaranteed lifetime income annuity products are slowly returning your principal to you over time.

Since principal payments back to the client aren’t taxable, whereas bond coupon payments are fully taxable, that means a $1,000 guaranteed lifetime income annuity payout will be less taxable than a $1,000 bond coupon payout.

This is why in table 1 above, the after-tax yield of the guaranteed lifetime income annuity was 11.06% for the first 24 years of payouts and 10.14% afterwards, but only 4.84% for the long-term bond index (IGLB).

Since wealthier clients are in higher tax-brackets, they benefit more from this tax-protection on the income.

In our example we assumed that the clients were in a 22% total federal and state effective tax-bracket. To the extent that clients are in a higher tax-bracket the value proposition would be higher than what was indicated in the tables above.

4) Wealthy benefit more from tax-breaks and compounding
Since clients are getting a higher tax-efficient yield from the guaranteed lifetime income product as opposed to bonds, they are able to invest in their equity portfolio for longer durations since they don’t need to sell as much of their equity portfolio to either rebalance or meet income needs.

Selling off the equity portfolio to rebalance exposes clients to taxes and drag as opposed to just allowing the equity portfolio to compound over-time.

Furthermore selling off the equity portfolio to meet income needs takes away assets from a portfolio that could be earning higher returns over the long-run by letting that portfolio compound instead.

Since high net worth clients are in high tax-brackets, the more they’re able to allow their unrealized gains to compound—as opposed to having to sell and expose themselves to tax-drag—the more their portfolio is able to grow.

We’ll see this more in detail in the next section.

Using guaranteed lifetime income instead of bonds increases successful retirement outcomes, after-tax wealth, and reduces volatility in retirement outcomes

A great way to quantify the value of guaranteed lifetime income is to replace the bond part of the portfolio with guaranteed lifetime income and have that be the primary basis for retirement spending.

This allows the equity portfolio to compound to a greater degree.

We can see the effect of this by looking at the chance of a 55 year old married couple meeting their retirement goals if they were to replace the bond allocation with a deferred income annuity that starts paying out at age 65 when they retire and pays as long as at least one of them is alive.  So for example, instead of a 70% Stock/30% Bond asset allocation the client would utilize a 70% Stock/30% Guaranteed Lifetime Income Annuity allocation.

Table 3: Effect of Replacing the Bond Allocation with a Guaranteed Lifetime Income Allocation

As the above table shows, using a guaranteed lifetime income annuity in place of a bond allocation provides the clients with a greater after-tax wealth and reduced volatility in their retirement outcome:

1. Using the guaranteed lifetime income annuity improves chance of meeting retirement goals
   In both the 70/30 portfolio and the 60/40 portfolio the chance of the client meeting their inflation adjusted $200k/year is increased by using the guaranteed lifetime income annuity instead of the bond allocation due to the high after-tax yield of the guaranteed lifetime income annuity.
   
   In the 70/30 portfolio the chance of the client meeting their annual retirement income goal is increased from 80% to 84% by using the guaranteed lifetime income annuity in place of a bond allocation. With the 60/40 portfolio it is increased from 77% to 85%.
   
2. Using the guaranteed lifetime income annuity increases after-tax wealth significantly
   The greatest impact of using the guaranteed lifetime income annuity is on the after-tax wealth that the client leaves to their beneficiaries at age 95.  For example, using a 70% equity/30% guaranteed lifetime income annuity allocation increases the median after-tax wealth age 95 by 58% from $8,305,130 to $13,138,064.
   
   The 60% equity/40% guaranteed lifetime income annuity allocation increases this wealth by 96% over its 60% equity/40% bond counterpart ($6,072,735 to $11,909,058).
   
3. Using the guaranteed lifetime income annuity reduces the volatility in the portfolio
   While increasing the median after-tax wealth of a retirement solution is important, so is reducing the volatility of the downside scenarios. The guaranteed lifetime income annuity is able to improve upon this significantly over the use of taxable bonds. This is due to the fact that the value of a stock-bond portfolio can reduce to $0 and fail to produce any retirement income portfolio at all for the client from that point forward.
   
   However, with an equity-guaranteed lifetime income annuity portfolio, even if the equity portfolio reduces to $0, the guaranteed lifetime income annuity is still producing income to the client. While this income isn’t the full retirement income of an inflation-adjusted $200k/year that the client wanted, it’s still $80k-$110k/year of annual income that they otherwise wouldn’t have had if they went with a stock-bond portfolio instead that had $0 in value.
   
   We can measure this reduction in downside volatility by looking at the Sortino ratio in each of the scenarios. From the table above we can see that for the 70/30 portfolio the Sortino ratio increases by 152% from 1.95 to 4.94 when the guaranteed lifetime income annuity is used instead of the bond allocation.
   
   For the 60/40 portfolio, the Sortino ratio increases by 232% from 2.03 to 6.77.

It’s worth noting that most guaranteed lifetime income annuities are commissionable. This means that there is no ongoing fee as there would be with an advisor. The results shown in the table account for the fact that the commission to the agent has already been paid.

However, an advisor that charges an ongoing fee would have to deduct their fee from the portfolio. This would make the traditional equity-bond retirement results look significantly worse—as we saw in a previous article we wrote.

Therefore, an advisor using a traditional equity-bond model as a retirement solution and charging an ongoing fee on both the equity and bond portfolio amounts would have significantly worse results for their clients than an advisor who is charging an ongoing fee only on the equity portfolio and using a commissionable guaranteed lifetime income annuity in place of the bond portfolio.

The industry is changing to become more friendly to RIAs that charge an ongoing fee and coming out with guaranteed lifetime income annuity products that allow for RIAs to charge their fee on the assets.

While guaranteed lifetime income annuity products that RIAs can charge their fee on are currently not as competitive as their commissionable brethren (that only charge an upfront fee), these “fee-only” guaranteed lifetime income annuity products allow RIAs that otherwise wouldn’t use guaranteed lifetime income annuity products the ability to do so in a way that aligns with their business model.

And ultimately, even these fee-only guaranteed lifetime income annuities will provide better retirement outcomes for clients than just using a traditional stock-bond portfolio as a retirement solution.

The Failure of Traditional Retirement Models

As the Table 3 above shows, if your entire retirement strategy—or the one your financial advisor devised for you—consists only of shifting assets away from stocks and towards bonds that choice is going to cost you and your beneficiaries millions of dollars over the course of your retirement without providing any guaranteed protection that you’ll be able to meet your retirement goals.

The problem with the traditional retirement approach used by AUM based advisors is that it doesn’t properly account for the fact that the stock part of the portfolio is responsible for generating tax-deferred (or tax-free with step-up in basis) wealth, while the bond portion of the portfolio is responsible for providing yield and downside protection against sequence of return risk.

So what are ways that would better utilize the tax-efficient nature of stock investments with the yield and downside protection that bonds provide?

The first step would be to utilize bonds in a manner that helps defer the taxation on the bond gains, protects them from interest rate risk, and adds risk-adjusted yield. The more bonds are used for yield, the less has to be withdrawn from the tax-efficient, higher earning stock portfolio.

This is exactly what guaranteed lifetime income annuity products provide.

Furthermore, since these products aren’t underwritten, and wealthier people live longer than non-wealthy individuals, wealthier clients in good health can essentially receive a pricing benefit at the expense of less wealthy and less healthy individuals who purchase these products.

There is a pricing arbitrage here for wealthy people who are in good health that they cannot as easily replicate in capital markets.

Furthermore, while traditional retirement accounts like IRAs allow for tax-deferred or tax-free growth, HNW clients are usually phased out from utilizing them.

Insurance products like guaranteed lifetime income annuity products are one of the few vehicles HNW clients can utilize to benefit from tax-deferred growth.

Another key problem with traditional retirement models is that they seek to protect against downside risk by regularly rebalancing the portfolio between stocks and bonds.

While this reduces risk in the portfolio, it also reduces long-term after-tax wealth.

Shifting assets away from an equity portfolio that is earning 8% tax-efficiently towards a bond portfolio that is earning 4% in a tax-inefficient manner may provide downside protection, but it also hurts long-term after-tax wealth as a byproduct.

Using a lifetime income product like a guaranteed lifetime income annuity allows the stock portion of the portfolio to grow at a faster rate without the constraints of rebalancing. This is due to the fact that the lifetime income product is generating a much higher after-tax income yield than the equivalent taxable bond portfolio which means less of the higher earning, tax-efficient stock portfolio has to be sold to generate this retirement income yield.

This allows the stock portfolio to grow at a faster rate—without the limitations of rebalancing the portfolio bonds—since the stock portfolio is only sold to fill-in gaps to the extent that the income yield from the guaranteed lifetime income annuity falls short of the desired retirement income goal.

And as we mentioned previously, part of the guaranteed lifetime income annuity is a return of principal that is being given back to the client which essentially means that the client is getting the benefit of investing in long-term bonds and having their principal returned over time without the interest rate risk that comes with investing in those bonds. This allows the yield portion of the portfolio to cover the sequence of return risk in the early years while allowing the stock portfolio to generate wealth over the long-term.

The compound effect here is that the higher-earning, tax-efficient part of the portfolio coming from the unrealized growth of the equity portfolio is allowed to compound in a way that is not possible with a traditional retirement portfolio model.

This is why the after-tax wealth at age 95 was so much higher in the scenarios in Table 3 when a guaranteed lifetime income annuity was used in place of a bond allocation.

The Guaranteed Lifetime Income Annuity provides qualitative benefits that taxable bonds cannot provide

In addition to the quantitative benefits provided as described above, there are a number of qualitative benefits not accounted for in our analysis that should be taken into consideration:

• Insurance protection/guarantees vs credit risk of bonds
  Investing in long-term bonds via an insurance company via an insurance product comes with significantly higher default protections than investing in other investment-grade long-term bond portfolios. The insurance company is well-regulated and required to have sufficient reserves to back the payments they are making on top of being protected via state guarantee associations and general prevailing economic interest that protect insurance companies from failing to deliver on their obligations. No such protections come with corporate bonds. Investment in corporate bonds come with the full credit risk of the companies offering the bond without such protections. Investing directly in an A-rated corporate bond is not the same risk as buying an insurance product from an A-rated company.
• Pricing arbitrage
  As mentioned previously, most lifetime income products don’t require underwriting. As a result, clients in good health can receive more of the mortality credit from these products than clients in worse health who also buy the product. Since wealthier people have better access to healthcare and live longer than their non-wealthy counterparts, there is an opportunity for wealthy clients to benefit from the guarantees provided at the expense of other purchasers.
• Probability vs Certainty and Volatility Reduction
  A Monte Carlo simulation projecting a probability of success (including the analysis we did in this article) is heavily dependent on the capital market assumptions assumed. While we know in hindsight what the capital markets have returned historically, we have no idea how they will perform over the next 30 years or so of a client’s retirement. Using insurance products like guaranteed lifetime income annuities helps to reduce volatility in the portfolio to a significantly larger extent than direct bond investments. Furthermore, in a world in which defined benefit plans are disappearing and being replaced by defined contribution plans, consumers at large are wanting some form of protection and guaranteed income that they can rely on.
  

Conclusion

The use of taxable bonds as a diversifier of risk in retirement is heavily flawed due to the fact that bonds are lower yielding, highly taxable, subject to interest rate risk, and can be positively correlated to stock returns when bond returns are negative (eg like in 2022 when both bonds and stocks took losses).

Insurance products like guaranteed lifetime income provide a way for individuals to invest in bonds with enhanced protections and mortality credits in a way that allows the portfolio to grow at a faster rate than would otherwise be possible if tax-efficient assets like stocks were constantly being sold and rebalanced with a bond portfolio as a way to meet retirement income goals and solutions.

The downside with insurance products is that they often come with heavy surrender charges if clients choose to exit the investment early.

But then so do traditional retirement vehicles like 401ks and traditional IRAs—which most high net worth earners are either phased out of contributing to completely or limited in the contributions they can make.

These retirement plans are trying to encourage long-term wealth building through retirement plans in exchange for asking participants to forego liquidity.

Insurance products that provide retirement solutions are asking for the same thing.

While the surrender penalties for using insurance products are more severe, they are also providing significantly higher retirement benefits than can be achieved from investing in bonds through either taxable accounts or retirement vehicles alone.

As more and more “fee-only” guaranteed lifetime income annuity products come on the market, more RIAs will be able to use these products in a way that both compensates them for using the products while also creating better retirement solutions for their clients.