It might not qualify as a brand-new hot-off-the-press idea. Academics, actuaries, regulators and others have been talking about contingent deferred annuities (CDAs) for more than a decade.
But CDAs are enjoying a resurgence of late, in large part because this product can help retirees and would-be retirees manage two of retirement’s biggest risks: longevity risk (the risk of outliving one’s assets) and sequence-of-returns risk (the risk of withdrawing assets in down markets early in retirement, which can ravage a portfolio).
There are already plenty of well-known and time-honored strategies, tactics and tools to manage longevity risk and sequence-of-returns risk.
Retirees and preretirees could, for instance, purchase a deferred income annuity (DIA) or a qualified longevity annuity contract (QLAC), or ladder single premium immediate annuities (SPIA), or purchase to manage and mitigate longevity risk.
A DIA is a type of annuity that starts paying out guaranteed income for life starting at age 85, for instance. A QLAC is a type of DIA that one would purchase inside an IRA. A SPIA, meanwhile, is an annuity that starts paying out guaranteed income for life starting as soon as you buy it.
But investors are not so fond of those solutions, chiefly because they must give up control of their assets. They are buying guaranteed future income that they may or may not (should they die before life expectancy) need.
In the case of sequence-of-returns risk, retirees and preretirees could, for instance, use either a bucket strategy or a dynamic spending strategy. But using the bucket strategy means that money earmarked for the first years of retirement will likely sit in low interest-bearing accounts instead of in the market where it might earn higher returns. And using a dynamic spending strategy, where one adjusts their spending strategy based on market conditions, might mean they have a lower standard of living than desired when the market has down years.
Enter the contingent deferred annuity, or CDA, which the National Association of Insurance Commissioners defined in 2015 as “an annuity contract that establishes a life insurer’s obligation to make periodic payments for the annuitant’s lifetime at the time designated investments, which are not owned or held by the insurer, are depleted to a contractually defined amount due to contractually permitted withdrawals, market performance, fees and/or other charges.”
In other words, it’s an insurance policy that will pay you income should your retirement portfolio — after you’ve abided by all the terms and conditions — no longer provide the income desired. In fact, despite having the word annuity in its title, it’s more like all other types of insurance you might buy, such as home and auto, to manage risks that might have a low probability of happening (fires and car accidents) but have huge negative consequences.
“The reason it’s called a CDA is that the contingency is the ruin of the account,” said Tamiko Toland, director of retirement markets at CANNEX Financial Exchanges. “The life annuity is the part that the insurance company is guaranteeing. It’s just that tail.”
And unlike other products that have the word annuity in them — DIA, QLAC, or SPIA — you are not giving up control of your assets. Plus, you can stop paying “premiums” whenever you want without having to pay a penalty.
“If a retiree wants to create a stable income from a risky investment portfolio, they face the possibility that they will have to cut back on their spending if their investments don’t perform as well as expected or if they live too long,” said Michael Finke, a professor of wealth management and the Frank M. Engle Distinguished Chair in Economic Security at The American College of Financial Services. “A CDA is an insurance policy that guarantees to continue making income payments if you run out of savings. You pay an annual fee for the insurance and spend your money free of the fear that a stock market crash will ruin your retirement. This is especially important early in retirement when retirees spend the most and a down market has the biggest impact on lifestyle. A retiree can buy portfolio insurance for a decade and if they get lucky and markets do well, they can drop the insurance and live happily ever after.”
CDAs also work well for financial advisers who are uncomfortable using annuities with their clients. “You apply the guarantee some amount of time before retirement and then if you reach the threshold on the other side of the sequence-of-returns risk you can just discontinue the guarantee and you don’t have to move the assets,” Toland said. “The assets still sit in the same place. So, it’s more natural for a lot of advisers.”
CDAs are similar in some respects to at least one type of annuity. “A CDA is essentially a stand-alone guaranteed living withdrawal benefit (GLWB), thus providing many of the same benefits and sharing many of the same risks associated with the guaranteed living benefits issued as part of variable annuity (VA) contracts with living benefits,” according to the American Academy of Actuaries.
An annuity with a GLWB, according to the Insured Retirement Institute, is an annuity option that provides a specified percentage of a guaranteed benefit base that can be withdrawn each year for the life of the contract holder, regardless of market performance or the actual account balance.
Now, if you decide to buy a CDA, you won’t be able to invest in anything you want nor will you be able to withdraw however much money you want. The CDA contract will establish what you can and cannot invest in, and how much you can withdraw.
But, according to David Stone, the CEO and founder of RetireOne, there are plenty of investments from which to choose, including mutual funds and separately managed accounts. Most recently, for instance, RetireOne partnered with Dimensional Fund Advisors, which manages assets exclusively for institutional investors and the clients of a select group of fee-based advisers, and Midland National Life Insurance Company to offer three asset allocation models and 38 institutional-class mutual funds and exchange-traded funds (ETFs) covered by “Constance,” a zero-commission CDA designed for registered investment advisers.
So how does the CDA work?
Finke gave this example:
Let’s say you are 65 and have a $1 million portfolio, 60% of which is invested in stocks and 40% in bonds, and you don’t have a CDA. You would have about a 77% chance of being able to withdraw $45,000 each year from that portfolio till age 95. Note, that this is a nominal amount fixed at $45,000.
Now, let’s say your portfolio declines 20% and then you start withdrawing $3,750 from your nest egg each month. At the end of year one, you would have a nest egg of just $755,000 and face some hard choices.
You could continue to withdraw $45,000 per year and accept a much higher probability of running out early (51.8%). Or you could try to maintain the same 77% chance of success. But to do this, you’d have to cut your spending from $45,000 to $34,456 per year. And that could mean having a lower standard of living than desired.
And that’s the effect sequence-of-returns risk would have on your withdrawals and portfolio. In down years, you’d face either spending less or increasing the odds of running out of money later in retirement.
What if you don’t want to face that risk? You could buy income insurance, a CDA, at 1.5% per year ($15,000 per year on a $1 million portfolio) that guarantees to continue paying $45,000 of income even if you run out of savings, said Finke. “This frees the retiree to spend $45,000 each year without the very real worry that by doing so they’ll have to cut back later,” he said.
Now, if your portfolio does great during the first five years of retirement you might have a 98% chance of being able to withdraw $45,000 of income till age 95, said Finke. And should that happen, you may decide that you no longer need the CDA because you have such a high probability of success.
“At this point, you can drop the insurance that has only created a 1.5% annual drag on the portfolio that may have gone up by, say, 50% over the five-year period,” he said.
|Year one investment returns||Year two probability of spending $45,000 to age 95||Year two spending with same success as year one|
So, all this sounds great on paper. What are the downsides?
Well, very few advisers are currently using CDAs with their clients. And it’s unlikely that a direct-to-consumer market will ever develop. A consumer would need to determine how the CDA fits into their overall retirement plan, said Toland. “I think most consumers don’t know how it fits into (their) plan,” she said. “Most advisers don’t have good tools to integrate annuities as it is. How is the consumer supposed to do that?”
Plus, there’s the cost of the insurance on top of what an adviser might charge to manage a client’s portfolio. Now, best case, you own the CDA during the first five to 10 years of retirement and then drop the coverage. But worst case, you might have to own the CDA over the course of your retirement. And that cost would not be insignificant. For instance, it would cost $525,000 in total over the course of 35 years to purchase a CDA on a portfolio with an initial value of $1 million. That fee drag, according to some, does lower the portfolio’s overall total return. Then add the cost of the CDA to the fee an adviser charges to manage a client’s portfolio, say 1%, and you’re looking at annual expenses of 2.5% before taxes and inflation.
Of course, that’s what risk protection is all about, said Finke. “You give up some upside in order to protect yourself against the worst possible downside,” he said.
Costs for the CDA can also vary depending on the design. A step-up to the current account value will cost more than insuring the initial account value. “The lowest cost means the least benefit,” said Toland. When you pay less, you get less. Less isn’t bad. Less might be preferable. It might be suitable. But there’s a direct correlation between how much you pay and what you’re getting.”
Those contemplating buying a CDA versus, say, using a bucket strategy will have to evaluate the cost of low returns versus the fee paid for the CDA. “There’s a cost to both,” said Toland.
Besides the cost, there’s also the potential to incur capital-gains tax as one rejiggers their portfolio to comply with the rules of the CDA, said Toland. For instance, the insurance company behind the CDA will have rules about how your assets can be allocated and invested. And if your portfolio doesn’t match up, you will likely have to buy and sell certain assets.
Another factor to consider is something called counterparty risk. That’s the risk that the insurance company behind the CDA may not fulfill its part of the deal and may default on the contractual obligations. “That’s why the financial strength of the insurance company is incredibly important,” said Finke.
So, what does the future hold in store for CDAs?
Well, it’s a bit uncertain. And much depends on whether advisers will embrace CDAs as a cost-effective and valuable way to manage and mitigate sequence-of-returns risk and longevity risk. “My hope is that an advising firm will recognize the value of providing retirement income insurance as an option to investors,” said Finke. “When I buy a plane ticket, I can tick a box if I want to insure my vacation. Why wouldn’t I also want the ability to insure my spending in retirement?”