RCLA: A New Approach to Guaranteed Income for Life

Posted at Advisors4Advisors.com on December 22, 2009

You don’t have to buy your house from an insurance company in order to get homeowners insurance, and you don’t have to buy your car from an insurance company in order to get automobile insurance. So why should you have to buy your investments from an insurance company in order to get longevity insurance?

That question lies behind the ruin-contingent life annuity, a product concept introduced by Huaxiong Huang, Moshe A. Milevsky and Thomas S. Salisbury in 2007 and further explained in a 2009 paper, “Mortality Derivatives: Valuation and Hedging of the Ruin-Contingent Life Annuity (RCLA).” Articles have also appeared in the Journal of Wealth Management, Research, and Retirement Income Journal.

In today’s marketplace, the insurance product that most people buy to get a lifetime income is a variable annuity with a guaranteed lifetime withdrawal benefit. That offers a package of mutual funds combined with a guaranteed minimum amount that you can withdraw each year for life, regardless of the future performance of the funds.

In contrast, the RCLA lets you invest anywhere. It provides a guaranteed minimum lifetime income that is linked to the performance of a reference portfolio, such as the S&P 500 or Russell 3000, adjusted for a specified withdrawal rate, such as 4%. The RCLA’s guaranteed income is paid when two events occur: (1) you remain alive, and (2) the reference portfolio is exhausted.

The insurance company bears the risk that a well-diversified investor with a constant spending rate will run out of money. You bear the tracking risk that your portfolio’s performance will differ from the reference portfolio’s performance, and you bear the decumulation risk that your spending rate will differ from the specified rate.

The RCLA’s benefits can be expressed in nominal or inflation-adjusted dollars, although it will be easier for insurers to manufacture RCLAs in nominal dollars.

Because the RCLA pays off only upon the occurrence of two events — survival and poor investment performance — it has a relatively low cost.

There are four types of insurance products that provide a guaranteed lifetime income. Let’s look at the benefits and costs for a 65-year-old man.

1. Immediate annuity. According to immediateannuities.com, a $100,000 single premium would provide a $632 monthly income with no guarantee period or inflation adjustment. (A woman would receive $591.)

2. Deferred income annuity (also called an advanced life delayed annuity, or, confusingly, longevity insurance, which is a broader concept). This is similar to an immediate annuity, but the income payments do not start until a later age. Using Integrity Life’s IncomeSource Select, a $632 monthly income starting at age 85 would cost $11,827, with no death benefit or inflation adjustment. (A woman would pay $13,005 for a $591 monthly income.)

3. Ruin-contingent life annuity. The fair value of a RCLA depends on the withdrawal rate of the reference portfolio, the volatility of the portfolio, and the valuation rate (among other variables). For a 7.6% withdrawal rate (matching the immediate annuity “yield”), a 10% volatility, and a 5% valuation rate, Huang, Milevsky and Salisbury estimate that a RCLA that pays $7,600 a year would be worth about $9,200. If you add 25% for the insurance company’s loading (producing an 80% money’s-worth ratio), that’s $11,500.

4. Deferred annuities (variable or indexed) with guaranteed living benefits. Huang, Milevsky and Salisbury show that these benefits can be analyzed as a RCLA embedded in a portfolio that provides systematic withdrawals. Previous research has shown that guaranteed living benefits are generally underpriced, although insurers have been increasing fees recently.

Adequately-priced standalone RCLAs might cost more than underpriced RCLAs in deferred annuities, but they would provide greater investment and income tax flexibility. The risk of default by the insurer would presumably be lower as well.

While you’re waiting for insurance companies to offer RCLAs, you can track one set of reference portfolios (the QWeMA Sustainable Portfolio Withdrawal Index) at www.qwema.ca/SPindex.htm.