annuities in a portfolio solution context: introducing a ......morgan stanley wealth management...

GLOBAL INVESTMENT COMMITTEE OCTOBEr 2014

INTrOduCTION AuThOrS

LISA SHALETT Head of Investment and Portfolio Strategies Morgan Stanley Wealth Management

DAnIEL HunT, CFASenior Asset Allocation StrategistMorgan Stanley Wealth Management

ZI YE, CFAQuantitative StrategistMorgan Stanley Wealth Management

Annuities in a Portfolio Solution Context: Introducing a New Framework

The current backdrop of low growth, low interest rates and increasing life expectancy creates a daunting challenge for investors saving for retirement. In this paper, we examine how investors can use annuities as part of a broader portfolio strategy aimed at supporting lifetime income needs. To analyze individual situations and recommend specific wealth allocations within a broader portfolio context, we have crafted a proprietary framework driven by three fundamental variables: savings, time horizon and the preference for income security relative to growth. Annuities are not without their drawbacks. They are complex, tend to have higher fees than other retirement investment vehicles and are generally less liquid than marketable securities. We attempt to quantify some of these considerations by client situation to deliver optimal recommendations.

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Please refer to important information, disclosures and qualifications at the end of this material.

Annuities in A Portfolio solution Context: introduCing A new frAmework morgAn stAnleY weAltH mAnAgement

The Global Investment Committee (GIC) believes annuities can help investors meet this challenge. In this paper, we explain how annuities with optional protection features can supplement or, in some cases, replace the income once provided by DB plans. Such annuities make it easier to know what sustainable income will be even during stressful periods in the markets. Of course, annuities have drawbacks: Fees are generally higher than for traditional retirement accounts and they are relatively illiquid.

We evaluate the way in which the current low-return en-vironment affects the value proposition of both annuities and traditional investments, and build a new framework that integrates annuities into a retirement strategy. Our model determines allocations based on an investor’s relative savings, time to when distributions will begin — the so-called deferral

period — and risk tolerance. The optimized solution can be visu-ally described with an “allocation cube” (see pages 12 and 13).

What we learn from this work — and will describe in detail in this paper — is that annuities can serve as a critical retirement income tool, especially for investors with low and moderate risk tolerance and investors with low-to-adequate savings. Broadly speaking, variable annuities appear attractive for those who defer taking the income while fixed annuities look more attractive for those who want to draw funds immediately. When investors are underfunded relative to their income needs, we find that immediate fixed annuities that offer no death benefits or cost-of-living adjustment can be a smart solution — especially when coupled with a smaller equity portfolio.

Executive SummaryPlanning for a comfortable and secure retirement has never been more challenging. Employer-sponsored defined benefit (dB) pension plans, which provide retirees with a guaranteed lifetime income, have largely vanished from the private sector. replacing them are defined contribution (dC) plans, which shift to employees the decision of how to invest the assets and the risk of poor results. Making the task tougher is the current low level of interest rates, the result of unprecedented central-bank policies engineered in hopes of reviving economic growth in the aftermath of the financial crisis and the Great recession.

2Please refer to important information, disclosures and qualifications at the end of this material. OCTOBEr 2014

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OCTOBEr 2014Please refer to important information, disclosures and qualifications at the end of this material.

Introduction: The Retirement Planning Challenge

The radical realignment in retirement savings toward self-directed 401(k)s and

Individual Retirement Accounts (IRAs) has increased risk and complexity for investors in ways both obvious and subtle. The most obvious dimension is that in traditional DB pension plans, the plan absorbed the con-siderable risks associated with retirement investing, backstopped by the employer’s bal-ance sheet and the Pension Benefit Guaranty Corp. Today, retirees assume the risks asso-ciated with investment of their retirement savings, and must do so without recourse to a corporate balance sheet or to an insurance fund should their decisions ultimately do damage to their financial position.

A more subtle but equally substantial component of today’s retirement challenge is the planning itself. Often lost in discussions around investment strategy is that the most important determinant of the success or failure of a retirement plan is the amount of savings before retirement and portfolio distributions after, both of which are a function of lifetime spending decisions and the timing of retirement. A DB pension plan takes most of the guesswork out of this process. Retirement date and sustainable distributions can each be read directly from plan documents that spell out the benefit calculation.

By contrast, retirees or near-retirees with self-directed retirement accounts must infer from a statement balance when they can retire and how much they can sustainably spend in retirement, which is hardly a back-of-the-envelope calculation. The ambiguity that arises from this complexity opens the door to damaging overspending

or a premature retirement, as it is easy to overestimate the degree to which an investment portfolio can be stretched.

Added to the new risks and logistical challenges facing today’s retirees is the adversity facing the global economy and capital markets. As a consequence of the central-bank policies instituted to manage the deleveraging of the global economy after a multidecade debt binge, interest rates and expected returns have collapsed across the board. These policies, which have introduced the term “financial repression” to the lexicon, are useful when managing down the global debt burden and overall economic leverage, but they come at a substantial cost for retirement savers.1

Exhibit 1 (below) tallies that cost for a hypothetical 65-year-old individual on the eve of retirement, assuming several different levels of savings adequacy. Displayed on the vertical axis is the percentage of initial portfolio value

the retiree expects to distribute from the portfolio annually to satisfy the retirement plan. The plan’s probability of failure, denoted on the horizontal axis, can be thought of as its margin for error. It is defined as the probability that a portfolio invested 60% fixed income and 40% equities, a fairly representative allocation for retirees based on the empirical data, will not be able to furnish the required income throughout retirement.2

The probabilities of failure are calculated based on thousands of different scenarios of future capital market returns. The first set of simulations, summarized in the dark blue line in the chart, assume that the average returns of the past 50 years will prevail going forward. The second set of simulations, summarized by the light blue line, use the Global Investment Committee’s current forward-looking return forecasts (see Annual Update of Capital Market Assumptions, March 2014). Our forecasts capture the effects

1 Central-bank policies and the current low interest rate, low-growth environment are not the only factors that weigh against our forecasts of prospective returns. Other factors, such as unfavorable global demographic and productivity trends, also challenge the capability of the capital markets to repeat their historical performance.2 The analysis is based on a Monte Carlo simulation of 10,000 scenarios of potential future market returns. It assumes a planning horizon of 25 years with mortality probability-adjusted income withdrawals thereafter, that income needs are increased for forecasted inflation throughout the planning horizon, and that the portfolio is rebalanced annually back to the target 60% bond/40% equity allocation. Monte Carlo simulation involves repeated sampling of asset class returns from a known distribution. It is used here to estimate thousands of different potential future evolutions of various portfolios employing different strategies, from which we can infer the likelihood of various outcomes.IMPORTAnT: The projections or other information generated by this Monte Carlo simulation analysis regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results. Results may vary with each use and over time. For more information about the risks to hypothetical performance, please see the Risk Considerations section beginning on page 19 of this report.

Exhibit 1: The Cost of Financial Repression

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6.5

7.5

8.5%

0 10 20 30 40 50 60 70%

Annu

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Probability of Failure for a 60% Bond, 40% Equity Portfolio2

50-Year Average Returns

Forecasted Future Returns

} 15% Less Income Is Available Now Than inPrior Decades Given a 5% Probability of Failure

Example used for illustrative purposes only. Source: Ibbotson Associates, Standard & Poor’s, Morgan Stanley Wealth Management Global Investment Committee (giC) as of dec. 31, 2013source: Calculated by morgan stanley wealth management using data provided by morningstar. (c) 2014 morningstar, inc. All rights reserved. used with permission. this information contained herein: (1) is proprietary to morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information.

4OCTOBEr 2014Please refer to important information, disclosures and qualifications at the end of this material.


of prospective headwinds for the capital markets such as the effect on valuations of central-bank policy and a deceleration in global growth due to demographic and productivity trends, whereas historical returns arose in a very different context.

As shown by Exhibit 1, wealth isn’t likely to pay like it once did. To quantify that cost more succinctly, note that, for the same 5% probability of failure of retirement savings to meet needs, today’s retirees could only generate around 85% of the income that they could have if the markets could be expected to repeat their performances of the past two generations. That is no small pay cut for anyone.

Daunting though these challenges may seem, you go into retirement with the circumstances you’ve got. The good news is that identifying the nature of the new challenges points up opportunities to redress them. Recalibrating savings and spending behavior or devising innovative strategies are better-suited to the problem than boilerplate advice involving static allocations to stock and bond investments. In this vein, last year we undertook a study about dynamic portfolio strategies for retirement, which held out efficiency gains relative to more simplistic strategies (see Building a Dynamic Retirement

Plan: Time-Segmented Bucketing Revisited, November 2013). Here we examine more closely the role of guaranteed lifetime income as a component of an optimized retirement strategy, in the context of insurance annuities.

What Are Annuities?

A nnuities are issued by insurance com-panies and shift risk in some form or

fashion from the purchaser of the annuity to the insurer. Most annuities share the fun-damental capability to provide a continuous stream of income for the life of the annuity owner, much like a traditional DB pension plan or Social Security.

Depending on when payments are scheduled to begin, annuities fall into one of two categories: immediate and deferred. Immediate annuities are annuities whose payout phase begins immediately; they begin making income payments to the contract holder shortly after purchase. The simplest of all annuities is the single premium immediate annuity (SPIA). SPIA investors make a single lump-sum payment up front and are guaranteed to receive predictable income payments for life or for a given term

or both, according to the terms of the annuity contract. Exhibit 2 presents a stylized illustration of a SPIA’s income benefits in comparison with a strategy in which distributions are taken from a portfolio of financial assets, which involves a substantial variability based on investment performance and investor longevity. Greater income uncertainty is expressed as increasingly lighter shades of blue.

The simplest type of SPIA is known as a “life-only” SPIA, which pays its contract holder for the duration of his or her life regardless of how long that is. This form of SPIA cannot be reversed or modified after purchase, which can create liquidity constraints within a retirement plan. A slightly more complex version of a SPIA is one that has a “life with period certain” payout option, which pays its contract holder or contract holder’s beneficiaries for a specified number of years should the contract holder pass before the term is up.

In addition to providing for some return of capital to beneficiaries in the event of the contract holder’s early death, a “period-certain” provision enhances the annuity contract’s liquidity, as it is often possible to exchange period-certain income payments

Exhibit 2: Portfolio Income Is Uncertain, SPIA Income Is Known

The blue bars representing income derived from an investment portfolio have more upside potential, but are uncertain and exposed to longevity risk. The orange bars, representing SPIA derived income, are steady and for life.

Longevity RiskInvestment Portfolio Derived IncomeSPIA Derived Income

99% 80 60 40 20 5Probability

Time

Inco

me

Example used for illustrative purposes only.Source: Morgan Stanley Wealth Management GIC



for a lump-sum distribution. Period-certain annuities typically have lower payout rates than those without such a provision, with the payout rate decreasing more as the length of the period-certain term increases.

The second major type of annuity we will evaluate is the variable annuity (VA), specifically, variable annuities with guaranteed lifetime withdrawal benefits (GLWB). Cash placed in VAs is invested through subaccounts into both f ixed income and equity investments. While SPIAs pay a predictable fixed income stream, the contract value of a VA, and therefore its payouts, can increase based on the performance of the underlying investments of the annuity. Although the payout rate is lower than those of a comparable SPIA, VA payments have the potential to increase as the value of the underlying investments moves higher. This offers the annuity owner the potential to participate in upside market moves while still receiving a minimum income stream.

In contrast to immediate annuities, deferred annuity payments begin on a date some years in the future. During the intervening period, known as the accumulation phase, the value of the annuity can grow. Deferred fixed annuities (DFAs) grow at a fixed interest rate for a stated “guarantee period” after which the growth rate depends on the value of future interest rates. Deferred income annuities (DIAs) involve even less guesswork, as their payment terms, and thus accumulation phase growth rates, are fixed in the contract at the outset and depend largely on long-term interest rates.

In contrast to a DIA, the contract of a deferred VA with guaranteed lifetime withdrawal benefits will change in value depending on the performance of its underlying investments. Note that a VA’s minimum withdrawal benefits are calculated using a separate metric known as the benefit base, which is distinct from its contract value. A VA’s benefit base will typically grow at a fixed rate known as a “roll-up

rate” during the accumulation phase unless strong investment performance propels the contract value above the benefit base on a specified date. In that scenario, the benefit base will reset higher to the contract value. A VA’s benefit base typically will not decline regardless of what happens to the contract value, which is how the market protection feature works. Thus, once a benefit base is reset higher, those gains are locked in. This is what’s known as a “high-water mark” provision.

During the life of the annuity and subject to any restrictions, deferred fixed and variable annuity owners have the option to take a lump sum or scheduled withdrawals or simply “annuitize” the value into an annual payment stream similar to an immediate annuity. DIA owners generally do not have the option to cash out, though as discussed in the context of a SPIA, DIA contracts with period-certain provisions tend to have greater liquidity (Exhibit 3 summarizes the information in the above section).

Source: Morgan Stanley Wealth Management GIC

Types of Annuities Key Characteristics

Single Premium Immediate Annuity (SPIA), Life-Only

• Highest payout rate of all immediate annuities. Payments made for the duration of contract holder’s life

• irreversible after purchase

Single Premium Immediate Annuity (SPIA), Life with Period Certain

• Payments made for the greater of the duration of the contract holder’s life and a set period of time

• lower payout rate than life-only sPiA in exchange for increased liquidity and protection for early mortality

Variable Annuity with Guaranteed Lifetime withdrawal Benefits

• Premiums invested in stock and bond investments through subaccounts. rider provides a guaranteed payout rate for life which may be significantly lower than a comparable sPiA

• income resets higher if contract value is higher than benefit base at anniversary—the “high-water mark”

deferred Fixed Annuity (dFA)• Value grows at a fixed rate for a “guarantee period” and resets thereafter based on prevailing interest rates

• option to take a lump sum, scheduled withdrawals, defer further or begin taking payments, i.e., “annuitize” value to an immediate annuity, at the end of the accumulation phase

deferred Income Annuity (dIA)

• High payout rate, like sPiA, beginning at least a year after the annuity purchase. Payment schedule and growth rates set at the time of purchase

• “life-only” version is irreversible with no death benefits in the event of early mortality

• “life with Period Certain” version provides more liquidity and protection for early mortality but has a lower payout rate

Variable Annuity with Guaranteed Lifetime withdrawal Benefits

• Premiums are invested in stock and bond investments through subaccounts. rider provides a guaranteed minimum payout rate for life which is significantly lower than a comparable diA

• Benefit base grows at fixed “roll-up” rate during the accumulation phase regardless of investment performance and resets higher at any time if the contract value is higher at anniversary—the “high-water mark”

• option to take a lump sum or scheduled withdrawals or “annuitize” the value at end of accumulation phase

Exhibit 3: Annuities With Lifetime Income Payments

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Beneficial Features of Annuities

The most attractive feature of annuities is their ability to provide lifetime income

at a time when few retirees have one due to the demise of DB pension plans. Like tradi-tional pension plan sponsors, annuity providers absorb several of the considerable risks asso-ciated with retirement investing. Two of the most important of these risks are market risk, or the risk that the performance of a retiree’s investment portfolio will be poor, and longevity risk, the risk that a retiree lives a long life, and thus will have substantially more expenses to cover. Like pensions, income generated from annuities or variable annuity income riders that provide lifetime income payments are typi-cally guaranteed for life regardless of market performance. Also like pensions, the annuity providers’ “guarantee” is typically backed by a large corporate balance sheet and a separate insurance plan funded by the providers.3

Another type of risk is the risk that poor decision-making can damage the viability of an investment strategy. These errors of judgment can take several forms, the most straightforward of which, alluded to previously, involves overspending. A side effect of the purchase of an annuity with guaranteed lifetime withdrawal benefits is that, like pensions, their fixed payments provide some degree of enforced budgeting. People know how to manage their finances in the context of a set income. It’s harder to figure out what to spend when you have a pot of money with uncertain returns and an unknown number of years that it has to last.

An equally deleterious form of judgment risk is the risk of not being able to stick with a plan through periods of market drawdowns and volatility. Investment returns can fluctuate widely, and the only way a portfolio can meet its projected return, assuming that it is measured accurately, is if the investor can hold on through all of the twists and turns.

Note that sticking to the plan means more than just refraining from selling investments during major market drawdowns; it means purchasing more of them during those periods to maintain target portfolio weights. As it happened during the financial crisis, many investors not only failed to rebalance, but were heavy sellers of risk assets, only to wait until after the relief rally had passed to reestablish their target portfolios. Ironically, such risk-averse behavior substantially exacerbated their losses and the attendant damage to their retirement finances.

By allocating a portion of retirement assets to an annuity that guarantees a certain level of income for life, an investor effectively hedges, or removes from worry, a component of his retirement expenses. Exhibit 4 illustrates the effect of hedging a portion of projected expenses with an annuity. With known income from an annuity, retirees can be more confident they will be able to cover their basic, or nondiscretionary, expenses. Without an annuity, income can be higher if investment performance is good, but there’s more uncertainty. Apart from its

effect on the theoretical efficacy of a retirement strategy (which we will evaluate in some detail later in this paper), this approach holds out some hope for helping retirees to implement a strategy when it matters most.

As an example of just how important strict implementation can be to the success of a retirement plan, Exhibit 5 charts the performance of three separate strategies over the 10 years starting in January 2000. The first of the strategies is the static, 60% bonds and 40% equities portfolio rebalanced monthly. The second, labeled “Inopportune Rebalancing,” has the same 60% bonds/40% stocks portfolio, but in this case the investor is given to panic liquidation of equity investments following an equity market downturn of 30% or more and only returns to the market slowly, after a 20% recovery from the point of liquidation. The final strategy, “Variable Annuity Benefit Base,” is a proxy for the value of the VA’s benefits assuming no step-ups. The benefits for a variable annuity4 with guaranteed lifetime withdrawal benefits5 are indexed to the benefit base.

3 In the case of annuities, insurance coverage is managed by state governments rather than the federal government, and liability is typically limited to anywhere from $100,000 to $500,000 in the event of an issuer’s insolvency. An investor should know the coverage rules and legal technicalities relevant to their state, which can include residency restrictions and limits on claims in regard to contract values versus benefits, before making a decision to purchase an annuity.4 Assumes a simple 7%, noncompounded, annual roll-up rate and that the owner delays withdrawals during the 10-year holding period such that, on the 10th contract anniversary, the benefit base will be no less than the original benefit base at contract issuance plus a simple 7% of the original benefit base for each of the 10 years. For the contract described, the contract owner will also be restricted to a limited set of investment options. The terms on offer to investors in both in the annuities and capital markets, on which this analysis and that throughout this paper depend, change over time.5 A VA with guaranteed lifetime withdrawal benefits was used for this illustration given the difficulty in attributing a DIA’s income benefits to its deferral period gains, especially in the context of mortality credits, which will be discussed in more detail later in this paper.

Exhibit 4: Annuity Income Can Provide Security for the Basics

With known income from an annuity, retirees can be more confident they will be able to cover their basic expenses. Without an annuity, income can be higher if investment performance is good, but there’s more uncertainty.

Income Without Annuity Income With Annuity

Discretionary Expenses

NondiscretionaryExpenses

Likely

Highly Probable

Income From Annuity

PotentialUpside

Example used for illustrative purposes only. The ability of annuities to provide the income security illustrated above will depend on their payout rates and client-specific circumstances.Source: Morgan Stanley Wealth Management GIC



Not surprisingly, inopportune rebalanc-ing is particularly damaging, costing its investor 20% cumulative return and the same amount of wealth relative to the

formulaically implemented strategy. Such a loss is more than sufficient to cause an otherwise successful retirement plan to fail. The VA benefit base performs more strongly

than the investment portfolio strategy, notwithstanding that the assumptions used to estimate its contractual roll-up do not take to account of the fact that interest rates at the turn of the millenium were much higher than they are today. This points to — and, in fact, understates — the value of the market risk hedge in periods of poor equity market returns, independent of its value as a hedge against longevity and judgment risks as discussed.

As illustrated in Exhibit 6, the protections in a deferred VA can extend to gains realized in the VA investment portfolio. As the annuity contract was initiated at the end of 2002 — instead of before the end of the technology, media and telecom bubble at the start of the decade — subsequent market returns were sufficient to provide a “step up” to the benefit base, which in fact increased more in value than the 60% bonds/40% stocks portfolio because of its higher allocation to equities. The upside exposure did not extend to the downside, however, as can be seen when the financial crisis hits in 2008, and the benefit base increased even as the value of the 60%/40% portfolio declined sharply.6 As we’ll see later in the results of our optimization model for deferred VAs, the value of this type of market risk protection will depend on the contract’s upside potential, which will vary based on the length of the deferral period.

Drawbacks of Annuities

Offsetting the attractive features of annui-ties in a post-pension world are several

drawbacks that must be considered. The first of these, and a substantial part of the reason annuities have been underutilized compared to what economic models would predict,7 is the loss of liquidity and control over one’s savings. The alternative to purchasing an annuity is to leave retirement savings in marketable financial investments, typically in a retirement account. These investments can be converted to cash in their entirety

6 The insulation of a VA’s income-generating capacity is affected through its benefit base. The contract value is not insulated against market declines, so such events will impact the likelihood of future upward resets in the benefit base.7 This is known in the economic literature as the “annuity puzzle”, and generally refers to the fact that economic models of utility maximizing behavior pro-duce high allocations to annuities, and in some cases full annuitization. See Peijnenburg, Kim and Nijman, Theo and Werker, Bas J. M., “The Annuity Puzzle Remains a Puzzle” Feb. 7, 2011). Available at SSRN: http://ssrn.com/abstract=1341674 or http://dx.doi.org/10.2139/ssrn.1341674

Exhibit 5: A Variable Annuity With a Benefit Base Can Protect Against Poor Equity Markets

With guaranteed lifetime withdrawal benefits, the benefit base of a deferred variable annuity can continue to increase even when the markets decline. Future payments are indexed to the benefit base.

’00 ’01 ’02 ’06 ’07 ’08 ’09750,000850,000950,000

1,050,0001,150,0001,250,0001,350,0001,450,0001,550,0001,650,000

$1,750,000

’03 ’04 ’05

60% Bonds / 40% Equity PortfolioInopportune RebalancingVariable Annuity Benefit Base

Example used for illustrative purposes only. source: Barclays Capital, standard & Poor’s, morgan stanley wealth management giC as of dec. 31, 2009

Exhibit 6: Variable Annuity Benefits Will Step Up When Investment Performance Is Strong

Because the benefit base can increase with good market returns but not decrease with bad performance, variable annuities with guaranteed lifetime withdrawal benefits are an attractive way, in particular, for near-retirees to get exposure to the equity market.

’03 ’04 ’06 ’07 ’08 ’09’05

Variable Annuity Benefit Base60% Bonds / 40% Stocks PortfolioContract Value

DownsideProtection

Step-Up850,000950,000

1,050,0001,150,0001,250,0001,350,0001,450,0001,550,0001,650,000

$1,750,000

Example used for illustrative purposes only. source: Barclays Capital, standard & Poor’s, morgan stanley wealth management giC as of dec. 31, 2009



strategy will eventually cause its value to dip beneath the value of the portfolio that has been paired with a SPIA, assuming portfolio returns remain beneath the required spending rate. Where there will be substantial loss of bequest is when the retiree’s life is shorter. This phenomenon helps to explain the popularity of period-certain provisions within fixed annuities like SPIAs. Note that since the contract value of a VA with a guaranteed lifetime withdrawal benefit generally passes to heirs upon the death of the annuitant, bequest is less of a concern for this type of annuity. There will be some loss of bequest in the case of an earlier-than-average mortality because with the VA’s higher fees, the contract value will grow more slowly and draw down more rapidly than the account value of comparably invested financial assets held in traditional retirement accounts.

VA fees pay for many of their features, most notably minimum lifetime withdrawal benefits and step-up provisions. Generally speaking, the effect of those fees is to reduce the upside potential relative to an investment-only strategy. There are several caveats to that generalization. For example, the market protection feature within a VA allows for a more aggressive allocation than might be prudent otherwise; in fact, it is advisable to maximize the aggressiveness of an allocation within a VA with minimum lifetime withdrawal benefits. During buoyant equity markets, that positioning can provide the VA upside relative to a more conservatively invested portfolio not subject to the same fee structure. There is also the path-dependency of a VA, wherein the locking in of gains allows annuitants to benefit from market outperformance without suffering in downturns if the high returns come first. But generally speaking, the cost of the protection a VA affords is higher fees, and higher fees generally result in some loss of upside. And because fees are deducted from a contract’s value, the compound effect of fees over time is a drain on what’s left for the heirs as well as on its liquidity.

The last two drawbacks of annuities that should be highlighted are more significant issues for fixed annuities than VAs. The first and most significant of these is inflation risk. There are fixed annuities whose cost-of-living adjustment (COLA) is tied to an

Exhibit 7: Annuities’ Effect on Bequest Depends on Longevity and Performance

In the early years after purchasing an annuity without death benefits, a retiree’s bequest will generally be less than that of an investment portfolio. The longer the annuitant lives, the greater the probability that a portfolio with an annuity will leave the greater bequest.

Portfolio A: Investment Portfolio OnlyPortfolio B: Investment Portfolio and Annuity

Reduction to BequestAdditional Bequest

Break-EvenPoint

Age at Death Portfolio A* Portfolio B*

Portfolio A

Portfolio B

Annuity Cost

Example used for illustrative purposes only. *Assumes portfolio return < distribution rateSource: Morgan Stanley Wealth Management GIC

very rapidly, in some cases instantaneously, depending on the specific investments. By contrast, both deferred and immediate an-nuity contracts have provisions that impede rapid withdrawal of the value of the contract, in some cases significantly. These provisions include early withdrawal limits and penal-ties, surrender charges and complex rules and processes regarding reversibility. Some contracts, such as life-only SPIAs, are both irreversible and highly illiquid.

There are several valid reasons why the liquidity profile of retirement savings is important. One of these is the need to allow for unforeseen expenditures, such as medical emergencies and legal troubles. Another is the value of being able to manage spending for reasons unrelated to emergencies, including to accelerate it, for example as a consequence of a reduced assessment of life expectancy. These types of reasons are often cited as justification for the common practice of limiting a retiree’s maximum annuity allocation to some fraction of their retirement assets.

The importance of liquidity extends further, however, as it also facilitates portfolio rebalancing. As in the example

discussed in the previous section, portfolio rebalancing tends to help reduce the volatility of overall returns relative to a buy-and-hold strategy, thereby improving efficiency. Liquidity also allows a retiree to be opportunistic, which can be meaningful if opportunistic trading is a part of his strategy. Regardless, when retirement assets are entirely illiquid, rebalancing is impossible. As we will see with the results of our optimization work, liquidity is one of the primary advantages of marketable securities in the trade-off between fixed annuities like SPIAs and bond allocations.

Another of the potential drawbacks of annuities is the compromise of bequest motives — what retirees intend to leave for their heirs. The way in which bequest motives relate to retirement strategy is complex. Even a strategy involving the purchase of a SPIA with no period certain or death benefit will not necessarily lead to a loss of bequest for a retiree’s heirs. As illustrated in Exhibit 7 above, whether it will depends substantially on the length of the retiree’s life and the performance of their investment portfolio.

In a longer life, the cost of sustaining income for the investment-portfolio-only



inflation index, similar to Social Security’s COLA, but those are the exceptions.

VAs are far less exposed to inflationary risk than fixed annuities, but higher-than-anticipated inflation will erode the VA’s minimum lifetime withdrawal benefits. The final drawback of annuities is interest rate risk. Interest rate risk is not a substantial risk to a retiree’s standard of living so much as it is a potential opportunity cost. In particular, if an investor were to purchase an annuity before interest rates rise, she would likely have less attractive terms than she would have if the timing had been more favorable. For a VA, the better deal would typically take the form of more attractive roll-up rates on the lifetime withdrawal benefits, while for fixed annuities it would imply higher overall payout rates.

Exhibit 8 above summarizes much of the information of the prior two sections regarding the features and drawbacks of annuities and competing sources of income.

Defining Objectives

We have used the term “failure rate” to describe the probability that a given

strategy will be unable to meet its objectives, but this metric is not, by itself, sufficient to measure the effectiveness and implicit

trade-offs of any given strategy. Here’s why: Consider an investor approaching retire-ment with an abundance of savings relative to his retirement needs, that is to say an investor who has a high funding ratio (see box). If minimizing the failure rate was the lone objective, this investor ought to fully annuitize his retirement assets, or at the very least reallocate them into highly conservative cash and bond-centric investments. For an overfunded investor, dramatic de-risking to that extent would drive the retirement plan’s failure rate down toward zero.

A model that recommends that any overfunded investor cash out of the market entirely is suspect because, as we all know implicitly, investor objectives go beyond just income security, even in retirement. In particular, growth potential does matter. And while it is true that cashing out is an option for this investor, it’s also true that strategy would cause him to forgo an opportunity to increase his wealth, notwithstanding that he is in a better position than most to bear that risk.

Clearly, it is necessary to measure both the upside potential and downside risk dimensions of a strategy independently, in order to evaluate how effective and suitable it is for investors. A surplus affords retirees a menu of good options, such as increasing

their spending or earmarking more for their heirs. By contrast, a deficit imposes a menu of poor choices, such as cutting discretionary spending or taking more investment risk to try to close the funding gap. We evaluate the potential for both upside and downside using a tool known as a “Monte Carlo simulation” that simulates thousands of potential future evolutions of market returns that are plausible given our forecasts of asset-class risks/returns, as well as macroeconomic variables like inflation (see Annual Update of Capital Market Assumptions, March 2014). Each simulation also tracks expenses, associated distributions and retirement assets to monitor strategy performance. The analysis reveals the cumulative surplus or deficit of the strategy when returns are average, which represents upside potential, and when returns are poor, which represents downside risk. The cumulative surplus and deficit are calculated as the difference between income needs and distributions over the entire planning horizon.

Note that measuring surplus or deficit in the downside of a simulation is a departure from the typical approach of many practitioners of simply calculating the probability that a strategy will succeed or fail. The problem with probability of failure as a measure of risk is that it neglects to take account of the magnitude of failure. For example, a shortfall of income that causes some reduction of spending in the monthly discretionary budget is of a different order of magnitude to one that requires a drastic reduction in planned expenditures, such as downsizing one’s home.

Example used for illustrative purposes only.*Based on minimum withdrawal **Based on total returnSource: Morgan Stanley Wealth Management GIC

Source of Income

Manage Longevity Risk

Manage Inflation Risk

Manage Market Risk Liquidity

Level of Income

Social Security Yes high high Low Varies

Traditional Pension Plan Yes Low high Low Varies

“life-only” sPiA/diA Yes Low high Low high

VA With GLWB Yes Medium Medium Medium Medium*

TIPS No high high high Low

high Quality Bonds No Low high high Medium

High Yield Bonds No Medium Low high high

equities Partially Medium Low high high**

Exhibit 8: Benefits and Drawbacks of Various Sources of Retirement Income

yOUR FUnDIng RATIOHow much you have saved relative to your retirement plans is a critical variable in the retirement investment problem, which is called the “funding ratio.” Specifically, it is the market value of retirement savings divided by the present value of retirement liabilities. We believe it is a powerful tool that allows investors to evaluate their current financial position relative to their anticipated retirement needs regardless of age or other circumstances.



Case Study Analysis

T o demonstrate how adding annuities to an overall strategy can impact its

efficacy for various investors, we con-sider a simple case study: a hypothetical 55-year-old woman planning to retire at age 65. She has $1 million in a 401(k) plan and seeks an annual, inflation-adjusted pretax income of $50,000 in addition to her Social Security payments. This makes her reasonably well-funded, with a fund-ing ratio of 96% of projected liabilities,

assuming a 25-year retirement horizon. We also consider a partial income after age 90 based on the probability of her liv-ing a longer life. In this case study, we examine three simple strategies using a Monte Carlo simulation: (1) an invest-ment portfolio equally divided between stocks and bonds; (2) a 50% allocation to a “life plus 25-year period certain” DIA plus a 50% allocation to the investment portfolio in Strategy 1; and (3) a 50% allocation to a VA with guaranteed lifetime withdrawal benefits plus a 50% allocation to the investment portfolio in Strategy 1.

Additional assumptions that were applied in this case study are itemized in the end-notes of this paper.i

Exhibit 9 (below) summarizes the results. Note that in addition to our chosen strategy metrics, we have included the probability of failure for each strategy. Given that it is aggressively postured for a retirement portfolio, the investment-portfolio-only option exhibits the strongest upside potential. The cost of that potential upside is steep in the context of risk, as the potential downside deficit is more than double that of the DIA strategy and more than four times that of the VA strategy. Essentially, if markets perform particularly poorly, an individual choosing the investment-portfolio approach would face a much more significant income hole than what individuals choosing to partially annuitize would face.

In addition to the downside protection afforded through partial annuitization, the case study highlights the attractiveness of a deferred VA relative to the DIA. The strategy containing the VA has both a higher median cumulative surplus and a lower downside deficit than the DIA strategy in this specific context, a well-funded individual with 10 years until retirement. There are three reasons for this. First, the lengthy deferral period increases the attractiveness of holding equities, including through a deferred VA,8 and lengthier holding periods increase the probability of equities outperforming bonds. Second, baked into our assumptions about the risk and return of capital markets is some normalization of interest rates. Assuming that occurs, bond returns would be low during that process, but once rates returned to more sustainable levels, bond returns should become more attractive. This represents future upside potential for bonds that a DIA would not capture as it locks in rates at initiation, and thus is a drag on relative performance. Given that a VA derives much of its benefits from the performance of equity and, to a lesser extent, fixed income investments, it is relatively insulated from this dynamic. Finally, the DIA with period-certain and the VA with GLWB have commensurate liquidity and death

8 We assume that the VA allocates 70% of its underlying subaccounts to equities. Generally speaking, a VA with minimum withdrawal benefits should be invested to the maximum allowable equity allocation.

Example used for illustrative purposes only. *Average downside deficit is the average income shortfall in the worst 5% of projected outcomes, expressed in years.Source: Morgan Stanley Wealth Management GIC

50% Stocks / 50% Bond Portfolio

DIA + 50/50 Portfolio

VA With GLWB + 50/50 Portfolio

Median Cumulative Surplus $1,030,468 $563,395 $705,311

Average downside deficit* (income Years) 5.8 Years 2.1 Years 1.3 Years

Probability of Failure 5.6% 4.2% 2.9%

Exhibit 9: Annuities Can Reduce Downside Risk and Probability of Failure

With Deferred Variable AnnuityWith Deferred Income AnnuityWithout Annuities 100% Equities

0 2 6 164 8 12100

500,0001,000,0001,500,0002,000,0002,500,000

$3,000,000

100% Bonds

Average Downside Deficit (years of income)

Med

ian

Cum

ulat

ive

Surp

lus

14

Example used for illustrative purposes only.Source: Morgan Stanley Wealth Management GIC

Exhibit 10: Optimizing the Risk/Return Tradeoffs With and Without Annuities

This chart shows the potential upside strategies for our 55-year-old with $1 million in retirement assets with and without annuities. We conclude that annuities can add value, and variable annuities are preferable for this investor.



benefits in the event of an early mortality. However, the DIA without the period-certain provision, which is less liquid and has no death benefit, would increase the risk/upside attractiveness of the DIA strategy.

Exhibit 10 (see page 10) answers the question of what happens when we don’t assume a specific allocation to an annuity or asset class, but use a computer to determine which combinations of each solve for the strategy that provides the greatest surplus at different levels of downside risk, as measured by median cumulative surplus and average downside deficit, respectively. For levels of downside risk consistent with the tolerance of most near-retirees, strategies that include annuities have a clear advantage over investment-only plans.

Toward a Retirement Framework

While it helps to illustrate how an annuity might improve a strat-

egy, one case study does not a retirement framework make. Client circumstances and preferences vary greatly and many will look quite different than our hypothetical near-retiree. Even in our case study, we need to know how this person values up-side versus downside avoidance — her risk tolerance — in order to determine what level of risk she should undertake, and therefore which strategy is best for her. Given a risk tolerance, we can solve for which unique strategy offering peak efficiency for a given

Exhibit 11: Investor Circumstances and Priorities Determine Optimal Strategy

Optimal RetirementStrategy

Multi-Period Simulation

All Retirement Strategies

MedianCumulative

Surplus

AverageDownside

Deficit

Client Circumstances

RiskTolerance

Quantity of Savings

Desired Income

Discretionary Expenses

Bequest Objectives

Current Age

Investment Portfolio Mix

Retirement Age

Low

LifetimeIncomeSecurity

UpsidePotential

LifetimeIncomeSecurity

Upside Potential

Lifetime Income Security

UpsidePotential

Priorities*

Moderate

High

Risk Tolerance

Low High

Example used for illustrative purposes only. *These priorities are relative to those of an average retiree.Source: Morgan Stanley Wealth Management GIC

level of risk can also offer the best trade-off for the individual.

As you can see in Exhibit 11 (below), our framework has high, moderate and low risk tolerances. The higher the priority for lifetime income security, the more important the objective of reducing average downside deficit becomes in determining optimal strategy. This framework gives us the ability to create strategies for individuals of varying circumstances, including insufficient savings and different ages. In doing so, we assume the individual’s risk tolerance is reflected in their portfolio investments, such that a conservative risk tolerance investor will hold a less volatile portfolio, with a higher allocation of bonds than an investor with a more moderate tolerance for risk and so on.



Exhibit 12 (above) and Exhibit 13 (page 13) contain heat-map cubes representing the optimal allocation to annuities along each permutation of funding ratio, deferral period and risk tolerance. In Exhibit 12, each point in the cube depicts the optimal allocation to a VA with guaranteed lifetime withdrawal benefits. Exhibit 13 does the same for a DIA/SPIA. Red-to-dark-red areas indicate large annuity allocations, while light-yellow-to- white areas represent smaller or zero allocations. The contracts employed have the same specifications as those used in the case study, with modifications for differing deferral periods as appropriate. The full set of assumptions for the analysis are spelled out in the endnotes together with tables detailing the full list of model results.ii

Here are some observations about the results summarized in the two exhibits: First, circumstances matter. Along each of the three dimensions, allocations to

annuities vary by large amounts, suggesting that each of the three factors is important in determining an optimal strategy. The second thing to note is what the model is telling us about where annuity allocations can add value. For example, as you would anticipate, risk aversion is important, and more of it could mean a larger annuity a llocation. There are exceptions to that, which we will discuss in the next section, but generally our work indicates that annuities can work best to mitigate downside risk in a retirement plan. The relationship between savings adequacy and annuity allocation is more nuanced, but generally very high savings tend to correspond to lower annuity allocations. We will also discuss this relationship further in the next section.

Deferral affects the two different types of annuities differently. For DIA/SPIAs, less deferral means a larger allocation and

Exhibit 12: Optimal Allocations to a Deferred Variable Annuity With guaranteed Lifetime Withdrawal Benefits

The darkest regions on the cube are where the allocation to deferred VAs are highest. For example, you will find the darkest colors at the intersection of low risk tolerance, a 90% funding ratio and a seven-year deferral period. Low allocations are found where risk tolerance and funding are high and deferral is zero to three years.

Weights

Weights

0

3

5

7

10

Def

erra

l Per

iod

(yea

rs)

Initial Funding Ratio

HighModerate

Low

Risk Tolerance

120%100 90 80 70

110

0

3

5

7

10

Def

erra

l Per

iod

(yea

rs)


HighModerate

Low

Risk Tolerance

120%100 90 80 70

110

Example used for illustrative purposes only. Source: Morgan Stanley Wealth Management GIC

vice versa. This is due to the declining value of an income guarantee’s hedge against market risk over time, as well as the benefits of liquidity in portfolio management. VAs without deferral are generally unattractive. This is a consequence of the fact that VAs’ minimum payout rates are low compared to fixed annuities, and the real opportunity for capturing market upside takes place before withdrawals begin to deplete contract value. With a deferral period, VAs appear attractive, due both to the inherent market upside potential that can be locked in through step-up provisons and the related greater value of market risk hedges. That said, at some point a longer deferral period begins to reduce the attractiveness of a VA, as the value of the market protection can peak around five to seven years; after that, the protection may become less valuable because it’s unlikely equities will decline substantially over longer periods of time.



A Special Case: Underfunding

O ur framework takes a liquidity profile and bequest objectives as inputs. Our

choice of a DIA/SPIA contract with a life-plus, 25-year period-certain provision can have substantial ramifications for the terms of a contract and hence its effectiveness in a retirement strategy. As an approximation of what investors value, the flexibility to be able to avoid significant cash flow con-straints and provide substantial bequests in the case of an early mortality is a reason-able default choice, but it certainly would not be appropriate for all circumstances.

One circumstance that merits special consideration is that of underfunding. One of the interesting results of the model is that deeply underfunded investors are not advised to use DIAs and SPIAs. Deferred VAs merit modest allocations for underfunded conservative and moderate

Exhibit 13: Optimal Allocations to Deferred Income and Single Premium Immediate Annuities

The darkest regions on the cube are where the allocation to DIAs/SPIAs are highest. For example, you will find the darkest colors at the intersection of low risk tolerance, a 90% funding ratio and a no deferral period. Little or no allocations are found where risk tolerance and funding are high and deferral periods are long.

Weights

Weights

0

3

5

7

10

Def

erra

l Per

iod

(yea

rs)


HighModerate

Low

Risk Tolerance

120%100 90 80 70

110

0

3

5

7

10

Def

erra

l Per

iod

(yea

rs)


HighModerate

Low

Risk Tolerance

120%100 90 80 70

110

Example used for illustrative purposes only. Source: Morgan Stanley Wealth Management GIC

Source: Morgan Stanley Wealth Management GIC

Deferral Period Risk ToleranceBalanced

Portfolio (%)All-Equity

Portfolio (%)

10 Years Low 76 74

Moderate 58 56

high 18 18

7 Years Low 96 90

Moderate 82 76

high 50 46

5 Years Low 92 94

Moderate 90 86

high 66 62

3 Years Low 80 92

Moderate 80 88

high 72 72

Immediate Low 58 82

Moderate 60 80

high 58 70

Exhibit 14: Optimal Allocation to Life-Only Deferred Income and Single Premium Immediate Annuities for Underfunded Investors



investors when deferral periods are longer, but there is no solution for underfunded investors who do not have the advantage of lengthy deferral periods.

Our analysis indicates that the allocation to the DIA/SPIA is highly sensitive to payout rates. When payout rates are more attractive, the value-added of fixed annuities and the allocations to them can jump dramatically. Since underfunding is a circumstance in which investors are likely to be amenable to altering their liquidity and bequest objectives, a life-only DIA or SPIA may become a more reasonable option for underfunded investors. The model results for allocations to a life-only DIA and SPIA are tallied in Exhibit 14 (see page 13).

Note that the all-equity column in Exhibit 14 corresponds to complementing a DIA/SPIA allocation with an all-equity portfolio. Where you see the biggest differences in the allocations is in the case of immediate

9 Horizon length is key to the attractiveness of equities. To see why, consider that annual returns to the S&P 500 since 1926 have a realized volatility of 20.2%, while annualized 10 year S&P 500 returns have a realized volatility of 4.5%. The difference in the variability in the two series holds across global equity markets and time, and is consistently dramatic.

annuities. The reason for that is a DIA or SPIA with no period-certain or COLA generally has a high initial payout rate. Its fixed income payments have the greatest purchasing power early in retirement before the compound effect of inflation has gnawed away at them. When the allocation to the DIA or SPIA is large, those income payments can cover a greater share of a retiree’s expenses. Thus, the retiree should not have to sell equities at inopportune times just to pay the bills.9 Later in retirement, the equity portfolio can be drawn on more heavily to replace the lost purchasing power of the DIA/SPIA.

Conclusion

P lanning for a comfortable and secure retirement in a world of low interest

rates is difficult enough, but doing so with-out an employer-sponsored defined ben-

efit pension can make the challenge even more daunting. To that end, we have built a robust framework that employs annuities and their various guarantee, deferral and payout features to optimize a solution. We believe our framework is comprehensive. It consid-ers the annuities recommendation against a dynamic measure of a client’s retirement funding ratio, the time until withdrawals are needed, a client’s risk tolerance and ambitions around legacy planning. Importantly, our approach sizes and optimizes the annuities allocation within the context of a traditional stock-and-bond portfolio. Combining annui-ties with a diversified portfolio can often increase both the probabilities of maintain-ing sufficient funds throughout retirement and generating a bequest.

Also contributing to this paper is Tae Kim, CFA, FRM, an asset allocation strategist for Morgan Stanley Wealth Management.

15OCTOBEr 2014


Note: Numbers in the grid are percentages of total retirement assets. Source: Morgan Stanley Wealth Management GIC

Deferral PeriodFunding Ratio/Risk Tolerance 60% 62% 64% 66% 69% 71% 74% 77% 80% 84% 88% 92% 96% 101% 107% 113%

10 Years Low 0 0 0 14 24 36 48 64 70 72 64 44 24 14 0 0

Moderate 0 0 4 16 24 34 44 48 54 42 26 8 0 0 0 0high 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0

7 Years Low 0 0 0 2 14 26 40 52 64 74 78 62 46 26 8 0

Moderate 0 0 0 10 20 30 40 50 58 60 52 26 14 2 0 0

high 0 0 0 0 8 14 18 24 16 10 0 0 0 0 0 0

5 Years Low 0 0 0 0 0 10 24 38 52 64 76 76 58 40 20 2

Moderate 0 0 0 0 4 18 30 40 52 60 66 48 30 10 0 0

high 0 0 0 0 2 6 18 24 26 24 12 2 0 0 0 0

3 Years Low 0 0 0 0 0 0 0 8 24 40 58 74 72 48 26 4

Moderate 0 0 0 0 0 0 2 16 30 42 54 60 38 22 0 0

high 0 0 0 0 0 0 0 2 14 14 12 0 0 0 0 0

Immediate Low 0 0 0 0 0 0 0 0 0 0 0 12 34 56 52 12Moderate 0 0 0 0 0 0 0 0 0 0 0 14 32 24 2 0high 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0

Exhibit 15: Optimal Allocations to Variable Annuities with Guaranteed Lifetime Withdrawal Benefits

Endnotesi Additional Case Study Assumptions: (1) The GIC’s strategic (seven years) and secular (20-plus years) assumptions are as of March 2014, and represent reasonable and unbiased estimates of future returns. (2) The GIC forecast assumptions of volatility, skewness, kurtosis and the correlations of asset classes represent reasonable and unbiased estimates of future variability of asset class returns and the potential for diversification.(3) Returns are assumed to be independent and accurately described by our forecast distribution, calibrated to the empirical data based on their variance and lower partial moments. (4) Assumes a simple 7%, noncompounded, annual roll-up rate and that the owner delays withdrawals during the 10-year holding period such that, on the 10th contract anniversary, the benefit base will be no less than the original benefit base at contract issuance plus a simple 7% of the original benefit base for each of the 10 years. For the contract described, the contract owner is restricted to a limited set of investment options. We assume to hold the maximum equity allocation of 70%, with the remaining 30% invested in bonds. The terms on offer to investors in both in the annuities and capital markets, on which this analysis and that throughout this paper depend, change over time. (5) The DIA’s annual payout rate after a 10-year deferral and income payments starting at 65 is 8.1%, net of fees, assuming no COLA to distributions. (6) Portfolios are rebalanced annually. (7) Withdrawals are funded by all asset classes in their proportion in the portfolio. (8) Withdrawals are made at the end of the year. (9) Distributions grow at the forecast rate of inflation, assumed to be 2% over the horizon, to ensure retirement income retains purchasing power. ii Framework Assumptions: Framework assumptions include all of those in the case study analysis, and the following additional assumptions: (1) The invest-ment portfolio for conservative risk tolerance investors is 60% bonds, 40% equities, corresponding to the strategic GIC Model 3 portfolio benchmark. The portfolio for moderate investors is 50% bonds, 50% stocks, corresponding to the strategic GIC Model 4 portfolio benchmark. The portfolio for aggressive investors is 60% stocks, 40% bonds, corresponding to the strategic GIC Model 5 portfolio benchmark. (2) For simplicity, and also due to the varying tax treatments that will be faced by clients, for example, the extent to which savings are held in tax-deferred retirement vehicles such as 401(k)s and IRAs, tax and transactions costs are not considered in the analysis. (3) With a 25-year period certain, no COLA is applied to distributions, income payments start at 65 and are net of fees; The DIA’s annual payout rate after a seven-year deferral is 7.20%, after a five-year deferral is 6.65%, and after a three-year defer-ral is 6.11%. The SPIA’s annual payout rate is 5.52%. (4) With no period-certain or COLA applied to distributions, income payments starting at age 65 and net of fees: The DIA’s annual payout rate after a 10-year deferral is 9.84%; after a seven-year deferral, 8.34%; after a five-year deferral, 7.57%; and after a three-year deferral, 6.83%. The SPIA’s annual payout is 6.48%. (5) The fees and roll-up rate assumed for the VA with GLWB is the same simple 7% rate assumed in the case study for the 10- , seven- , five- and three-year deferral periods. The fees for VAs with no acuumulation period or roll-up are assumed to be 1.85%. (6) Investors are assumed to retire at age 65 and to begin taking payments at that time. (7) The discount rate used to calculate the funding ratio is the prevailing 30-year Treasury yield.

Variable Annuity with guaranteed Minimum Withdrawal Benefits Results:


Note: Numbers in the grid are percentages of total retirement assets.Source: Morgan Stanley Wealth Management GIC

Exhibit 16: Optimal Allocations to Deferred Income and Single Premium Immediate Annuities With 25-year Period Certain

Deferral PeriodFunding Ratio/ Risk Tolerance 74% 77% 80% 84% 88% 92% 96% 101% 107% 113%

10 Years Low 0 12 26 34 32 12 0 0 0 0

Moderate 0 0 0 0 0 0 0 0 0 0high 0 0 0 0 0 0 0 0 0 0

7 Years Low 0 10 26 44 56 36 26 2 0 0

Moderate 0 4 14 14 0 0 0 0 0 0

high 0 0 0 0 0 0 0 0 0 0

5 Years Low 0 6 24 42 58 68 44 18 0 0

Moderate 0 10 20 32 36 20 0 0 0 0

high 0 0 0 0 0 0 0 0 0 0

3 Years Low 0 0 12 32 50 68 62 32 6 0

Moderate 0 0 14 30 40 38 18 0 0 0

high 0 0 0 0 0 0 0 0 0 0

Immediate Low 0 0 6 28 48 70 80 48 20 0Moderate 0 0 14 32 48 60 50 20 0 0high 0 0 4 18 20 12 0 0 0 0

DIA/SPIA with 25-year Period Certain Results:

16OCTOBEr 2014



17OCTOBEr 2014


ACCUMULATIOn PHASE: The period in an annuity contract prior to the point at which distributions to the annuitant begin. In this period, the value of the annuity can grow.

AnnUITy: A contract in which an insurance company agrees to provide a periodic income payable for the lifetime of one or more persons, or for a specified period.

AnnUITAnT: The person or persons whose age and life expectancy the payments are based on during the payout phase.

AnnUITIZATIOn: The practice of converting an annuity into a fixed series of periodic income payments over the span of one’s life or for a specified period.

AVERAgE DOWnSIDE DEFICIT: This is the average income shortfall in the worse 5% of projected outcomes in a Monte Carlo simulation of a retirement strategy, measured in years. This calculation can serve as a metric in comparing the downside risk within a retirement strategy.

BEnEFIT BASE: The benefit base is used to index the payments from a variable annuity with an income rider such as a guaranteed lifetime withdrawal benefit. By contrast with the contract value, defined below, the benefit base does not represent the annuity owner’s equity in the contract, but is rather an accounting construct by which minimum withdrawal benefits are calculated. During the deferral period, a benefit base will typically grow by a preset “roll-up” amount regardless of what happens to the investments in the annuity. This feature provides protection from market risk. Most typically, if a contract value increases above the benefit base on the contracts reset date, the benefit base will reset higher to the contract value, proportionally increasing future benefits.

COnTRACT VALUE: The contract value of an annuity represents the equity the annuity owner holds in that contract. The initial contract value is equal to the initial premium paid, and it will fluctuate subsequently based on the net of additional premiums, withdrawals and the investment performance net of fees. Contract value defines the upside, liquidity and death benefit dimensions of a variable annuity with guaranteed lifetime withdrawal benefits. This contrasts with the benefit base, which is used only to index regular payments, and cannot be liquidated or transferred to a beneficiary upon death.

DEATH BEnEFIT: The money passed from an annuity contract to its beneficiary upon the death of the owner and/or annuitant. This can include specific death benefit provisions for which the annuity holder pays a fee, or the period-certain provision of a single-premium immediate annuity or a deferred income annuity, or simply the residual contract value of a variable annuity upon death of the owner and/or annuitant.

DEFERRAL PERIOD: The time in between when an investor originally purchases an annuity and when distributions commence. See accumulation phase.

DEFERRED AnnUITy: An annuity contract with a deferral period. For some annuities, such as deferred fixed or variable annuities, the length of the deferral period is flexible. For deferred income annuities, it is set at contract initiation.

DEFERRED FIXED AnnUITy (DFA): A type of deferred annuity that grows during the deferral period based on prevailing short-term interest rates, which can fluctuate after an initial guarantee period.

DEFERRED InCOME AnnUITy (DIA): A class of annuities whose payment schedule and growth rates are determined at the time of the initial purchase.

DEFInED BEnEFIT PEnSIOn PLAn: An employer-administered pension plan in which the retired employee receives lifetime payments based on salary, years of service and age at retirement. The employer bears the investment and longevity risk.

DEFINED-CONTRIBUTION PENSION PLAN: An employer-administered retirement plan in which the contribution, rather than the benefit, is defined. Under a 401(k) type of defined contribution plan, the employee is allowed to channel part of his/her income into the plan on a pretax basis. A percentage of employee contributions may be matched by the employer, but the employee bears the investment risk. The final benefit consists solely of assets (including investment returns) that have accumulated in these individual accounts. Depending on the type of defined contribution plan, contributions may be made either by the company, the participant, or both. In some DC plans, income distribution options in the form of life annuities are available.

DRAWDOWn This term refers to the largest cumulative percentage decline in net asset value or the percentage decline from the highest value or net asset value (peak) to the lowest value net asset value (trough) after the peak.

FAILURE RATE: The probability that an investment strategy has failed to provide for the desired level of income throughout the retirement horizon defined in the study.

FUnDIng RATIO: The present value of retirement liabilities divided by the current market value of an investor’s retirement savings. In essence, this ratio measures how sufficient a person’s savings are relative to projected retirement needs.

gUARAnTEED LIFETIME WITHDRAWAL BEnEFIT: A type of variable annuity income rider that promises a certain percentage of a guaranteed benefit base, either paid premiums

or a stepped-up base, can be withdrawn annually, regardless of market performance or the actual account balance.

gUARAnTEE PERIOD: The period of time a deferred fixed annuity grows at the rate stated when the annuity was purchased, after which its growth rate will depend on the prevailing level of short-term interest rates.

HIGH-WATER MARK PROVISION: When the contract value of a variable annuity with a guaranteed lifetime withdrawal benefit rider is higher than the contract’s benefit base at anniversary, the benefit base will be reset higher to the contract value. Even if the performance of the underlying investments then deteriorates and the contract value falls precipitously, the contract’s benefit base will not reset lower, and any guaranteed roll-ups will accrue from that level. In other words, the ‘high water mark’ refers to the fact that, once the benefit base has been reset higher, these gains are considered ‘locked-in’.

KURTOSIS: A statistical measure of the “peakedness” of a distribution. In a return series that is leptokurtic, i.e., one that exhibits higher kurtosis than the normal distribution, risk is manifested through low frequency high impact ‘events’, both positive and negative, measured as returns several standard deviations away from the average. These distributions are called “fat tailed” because their extremes are thick with probability (the normal distribution is “thin tailed” such that returns three or more standard deviations away from the average are exceedingly rare). In “low kurtosis” return series, i.e., kurtosis less than or equal to normal, risk is manifested through high frequency deviations close to the average. The vast majority of financial return series are leptokuric; however some investments, e.g., hedge funds, are significantly more so than other investments, which is an unfavorable attribute of their profile.

IMMEDIATE AnnUITIES: A class of annuities whose payments begin immediately after the initial purchase.

MEDIAn CUMULATIVE SURPLUS: This is the cumulative difference between required income and distributions plus remaining portfolio value in the median simulation of a Monte Carlo simulation of a retirement plan. For this paper, we used 10,000 simulations based on our forecasts of the risk and return of the equity and bond markets.

PAyOUT PHASE: The period during which the money accumulated in an annuity is paid out to an annuitant.

PERIOD CERTAIn: A type of guarantee that if the annuitant dies before payments have been made for a minimum number of years, payments to the beneficiary will continue until the end of the stated period.

glossary



OCTOBEr 2014 18

RISK TOLERAnCE: In this paper, risk tolerance is defined as an investor’s ability and willingness to bear risk within a retirement strategy, in particular the risk of a shortfall in income relative to needs.

ROLL-UP RATE: The roll-up rate is the guaranteed percentage that the benefit base of a variable annuity increases by each year during the accumulation stage.

SIngLE PREMIUM IMMEDIATE AnnUITy (SPIA): An annuity purchased with a single premium on which income payments begin within one year of the contract date. With fixed immediate annuities, the payment is based on a specified interest rate. Payments are made for the life of the annuitant(s), for a specified period, or both (e.g., 10 years certain and life).

SKEWnESS: A statistical measure of asymmetry of an asset class or portfolio return distribution. Negative skew is an undesirable characteristic of some investments, e.g., private real estate, indicating that left hand tail of a return distribution (representing the likelihood of downside deviation from average) is ‘longer’ than the right hand, i.e., that downside events are bigger than their reciprocally plausible upside ones. By corollary, the bulk of the values of negatively skewed distributions lie above the average. Positive skewed distributions, such as private equity and managed futures, exhibit the opposite behavior, and distributions with zero skew are balanced about the average.

STEP-UP PROVISION: An optional feature of variable annuities which increases the amount of the benefit base if, due to strong performance, the annuity’s contract value surpasses its benefit base on specified dates determined by the Annuity Contract.

SURREnDER CHARgE: The surrender charge is levied against annuitants who withdraw an amount that exceeds a specific percentage. New owners of recently purchased annuities may also be subjected to a surrender charge if they decide to cancel an annuity contract within a specific timeframe.

TERM CERTAIn AnnUITy: See period certain.

VARIABLE AnnUITy: An annuity contract into which the buyer makes a lump-sum payment or series of payments. In return, the insurer agrees to make periodic payments beginning immediately or at some future date. Purchase payments are directed to a range of investment options, which may be mutual funds or direct investment into the separate account of the insurance company that manages the portfolios. The value of the account during accumulation, and the income payments after annuitization vary depending on the performance of the chosen investment options.

VARIABLE AnnUITy BEnEFIT BASE: The payment benefits within a variable annuity to which guaranteed lifetime withdrawal benefits are indexed. A benefit base can grow as a result

of roll-ups or growth in the contract value due to performance of the underlying investments.

VARIABLE AnnUITy COnTRACT VALUE: The net asset value to the annuity owner of the annuity contract.

VARIABLE AnnUITy InCOME RIDER: The optional feature or benefit that an annuity owner may opt to purchase to supplement annuity income: for example, a guaranteed lifetime withdrawal benefit.

VARIABLE AnnUITy SUBACCOUnT: A portfolio that is comprised of stocks, bonds, or money market securities. Subaccounts can either be actively or passively managed.

VOLATILITy: A measure of the magnitude of variability of the returns of an asset class or security. It is generally the case that a larger dispersion of return implies greater risk, as this implies more substantially adverse outcomes for a given level of likelihood of their occurrence. Volatility is measured statistically as the forecasted standard deviation of return. Standard deviation can be thought of as the average difference between an individual data point (in this case an observed investment return) and the average value of all data points under consideration.



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Risk ConsiderationsMorgan Stanley Smith Barney LLC offers insurance products in conjunction with its licensed insurance agency affiliates.Variable annuities are sold by prospectus only. The prospectus contains the investment objectives, risks, fees, charges and expenses, and other information regarding the variable annuity contract and the underlying investments, which should be considered carefully before investing. Prospectuses for both the variable annuity contract and the underlying investments are available from your Financial Advisor. Please read the prospectus carefully before you invest.Variable annuities are long-term investments designed for retirement purposes and may be subject to market fluctuations, investment risk, and possible loss of principal. All guarantees, including optional benefits, are based on the financial strength and claims-paying ability of the issuing insurance company and do not apply to the underlying investment options.Optional riders may not be able to be purchased in combination and are available at an additional cost. Some optional riders must be elected at time of purchase. Optional riders may be subject to specific limitations, restrictions, holding periods, costs, and expenses as specified by the insurance company in the annuity contract.If you are investing in a variable annuity through a tax-advantaged retirement plan such as an IRA, you will get no additional tax advantage from the variable annuity. Under these circumstances, you should only consider buying a variable annuity because of its other features, such as lifetime income payments and death benefits protection.Taxable distributions (and certain deemed distributions) are subject to ordinary income tax and, if taken prior to age 59?, may be subject to a 10% federal income tax penalty. Early withdrawals will reduce the death benefit and cash surrender value.

Hypothetical PerformanceGeneral: Hypothetical performance should not be considered a guarantee of future performance or a guarantee of achieving overall financial objectives. Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets. Hypothetical performance results have inherent limitations. The performance shown here is simulated performance, not investment results from an actual portfolio or actual trading. There can be large differences between hypothetical and actual performance results achieved by a particular asset allocation. Despite the limitations of hypothetical performance, these hypothetical performance results may allow clients and Financial Advisors to obtain a sense of the risk / return trade-off of different asset allocation constructs. Investing in the market entails the risk of market volatility. The value of all types of securities may increase or decrease over varying time periods.This analysis does not purport to recommend or implement an investment strategy. Financial forecasts, rates of return, risk, inflation, and other assumptions may be used as the basis for illustrations in this analysis. They should not be considered a guarantee of future performance or a guarantee of achieving overall financial objectives. No analysis has the ability to accurately predict the future, eliminate risk or guarantee investment results. As investment returns, inflation, taxes, and other economic conditions vary from the assumptions used in this analysis, your actual results will vary (perhaps significantly) from those presented in this analysis. The assumed return rates in this analysis are not reflective of any specific investment and do not include any fees or expenses that may be incurred by investing in specific products. The actual returns of a specific investment may be more or less than the returns used in this analysis. The return assumptions are based on hypothetical rates of return of securities indices, which serve as proxies for the asset classes. Moreover, different forecasts may choose different indices as a proxy for the same asset class, thus influencing the return of the asset class.Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bond’s maturity, the more sensitive it is to this risk. Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer. Bonds are subject to the credit risk of the issuer. This is the risk that the issuer might be unable to make interest and/or principal payments on a timely basis. Bonds are also subject to reinvestment risk, which is the risk that principal and/or interest payments from a given investment may be reinvested at a lower interest rate.Bonds rated below investment grade may have speculative characteristics and present significant risks beyond those of other securities, including greater credit risk and price volatility in the secondary market. Investors should be careful to consider these risks alongside their individual circumstances, objectives and risk tolerance before investing in high-yield bonds. High yield bonds should comprise only a limited portion of a balanced portfolio. Treasury Inflation Protection Securities’ (TIPS) coupon payments and underlying principal are automatically increased to compensate for inflation by tracking the consumer price index (CPI). While the real rate of return is guaranteed, TIPS tend to offer a low return. Because the return of TIPS is linked to inflation, TIPS may significantly underperform versus conventional U.S. Treasuries in times of low inflation.Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.Rebalancing does not protect against a loss in declining financial markets. There may be a potential tax implication with a rebalancing strategy. Investors should consult with their tax advisor before implementing such a strategy.Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets. Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies.

© 2014 Morgan Stanley Smith Barney LLC. Member SIPC. CS 7992505 10/14

DisclosuresMorgan Stanley Wealth Management is the trade name of Morgan Stanley Smith Barney LLC, a registered broker-dealer in the United States. This material has been prepared for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security or other financial instrument or to participate in any trading strategy. Past performance is not necessarily a guide to future performance.The author(s) (if any authors are noted) principally responsible for the preparation of this material receive compensation based upon various factors, including quality and accuracy of their work, firm revenues (including trading and capital markets revenues), client feedback and competitive factors. Morgan Stanley Wealth Management is involved in many businesses that may relate to companies, securities or instruments mentioned in this material.This material has been prepared for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security/instrument, or to participate in any trading strategy. Any such offer would be made only after a prospective investor had completed its own independent investigation of the securities, instruments or transactions, and received all information it required to make its own investment decision, including, where applicable, a review of any offering circular or memorandum describing such security or instrument. That information would contain material information not contained herein and to which prospective participants are referred. This material is based on public information as of the specified date, and may be stale thereafter. We have no obligation to tell you when information herein may change. We make no representation or warranty with respect to the accuracy or completeness of this material. Morgan Stanley Wealth Management has no obligation to provide updated information on the securities/instruments mentioned herein.The securities/instruments discussed in this material may not be suitable for all investors. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives. Morgan Stanley Wealth Management recommends that investors independently evaluate specific investments and strategies, and encourages investors to seek the advice of a financial advisor. The value of and income from investments may vary because of changes in interest rates, foreign exchange rates, default rates, prepayment rates, securities/instruments prices, market indexes, operational or financial conditions of companies and other issuers or other factors. Estimates of future performance are based on assumptions that may not be realized. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates. Other events not taken into account may occur and may significantly affect the projections or estimates. Certain assumptions may have been made for modeling purposes only to simplify the presentation and/or calculation of any projections or estimates, and Morgan Stanley Wealth Management does not represent that any such assumptions will reflect actual future events. Accordingly, there can be no assurance that estimated returns or projections will be realized or that actual returns or performance results will not materially differ from those estimated herein. This material should not be viewed as advice or recommendations with respect to asset allocation or any particular investment. This information is not intended to, and should not, form a primary basis for any investment decisions that you may make. Morgan Stanley Wealth Management is not acting as a fiduciary under either the Employee Retirement Income Security Act of 1974, as amended or under section 4975 of the Internal Revenue Code of 1986 as amended in providing this material. Morgan Stanley Wealth Management and its affiliates do not render advice on tax and tax accounting matters to clients. This material was not intended or written to be used, and it cannot be used or relied upon by any recipient, for any purpose, including the purpose of avoiding penalties that may be imposed on the taxpayer under U.S. federal tax laws. Each client should consult his/her personal tax and/or legal advisor to learn about any potential tax or other implications that may result from acting on a particular recommendation. This material is disseminated in Australia to “retail clients” within the meaning of the Australian Corporations Act by Morgan Stanley Wealth Management Australia Pty Ltd (A.B.N. 19 009 145 555, holder of Australian financial services license No. 240813).Morgan Stanley Wealth Management is not incorporated under the People’s Republic of China (“PRC”) law and the research in relation to this report is conducted outside the PRC. This report will be distributed only upon request of a specific recipient. This report does not constitute an offer to sell or the solicitation of an offer to buy any securities in the PRC. PRC investors must have the relevant qualifications to invest in such securities and must be responsible for obtaining all relevant approvals, licenses, verifications and or registrations from PRC’s relevant governmental authorities.If your financial adviser is based in Australia, Dubai, Germany, Italy, Switzerland or the United Kingdom, then please be aware that this report is being distributed by the Morgan Stanley entity where your financial adviser is located, as follows: Australia: Morgan Stanley Wealth Management Australia Pty Ltd (ABN 19 009 145 555, AFSL No. 240813); Dubai: Morgan Stanley Private Wealth Management Limited (DIFC Branch), regulated by the Dubai Financial Services Authority (the DFSA), and is directed at Professional Clients only, as defined by the DFSA; Germany: Morgan Stanley Private Wealth Management Limited, Munich branch authorized by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Bundesanstalt fuer Finanzdienstleistungsaufsicht; Italy: Morgan Stanley Bank International Limited, Milan Branch, authorized by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority, the Banca d’Italia and the Commissione Nazionale per Le Societa’ E La Borsa; Switzerland: Bank Morgan Stanley AG regulated by the Swiss Financial Market Supervisory Authority; or United Kingdom: Morgan Stanley Private Wealth Management Ltd, authorized and regulated by the Financial Conduct Authority, approves for the purposes of section 21 of the Financial Services and Markets Act 2000 this material for distribution in the United Kingdom.Morgan Stanley Wealth Management is not recommending an action to any municipal entity or obligated person. Morgan Stanley Wealth Management is not acting as an advisor to any municipal entity or obligated person and does not owe a fiduciary duty pursuant to Section 15B of the Securities Exchange Act of 1934 to any municipal entity or obligated person with respect to the information and material contained in this communication. Morgan Stanley Wealth Management is acting for its own interests. 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