Living benefit riders to life insurance policies: Pricing considerations and strategy
Adding benefit riders to policies provides meaningful coverage for those who need it, and carriers usually can do so at a relatively low cost.
Back in February last year, very early into the Covid-19 sell-off–Milliman published an article on why investors need to be extra careful when it comes to sequencing risk. In that article, we gave a clear example of why older investors are significantly more impacted by market downturns.
We showed that a retiree with $500,000 earning a steady benchmark return of CPI + 3.5% will run out of money in just over 30 years, assuming they draw down $26,000 each year, increasing with CPI.
We then presented the fact that if a 19% portfolio loss were to happen in the first year of retirement, that same retiree will run out of money almost a full decade earlier than they expected.
Being an inquisitive actuary at heart, and now wise enough to have managed risk through both the fastest drawdown and one of the fastest recoveries in history, I thought there was no better time to find an even stronger way to quantify sequencing risk and its impact on actual outcomes.
Did you know that the widely quoted and compared “net investment returns” (same measure used by the much publicised ‘Your Future, Your Super’s annual performance test) is really only useful for investors who don’t make any contributions or withdrawals from their investment?
Let’s illustrate this with two retirees on $500,000 balance, and both withdrawing $26,000 each year:
Invested in equities. Has a horror first year, experiencing -20% returns, but recovers in year two with +30% return. She ends with a balance of $460,200 after the two years. From the fund manager’s perspective, the fund managed to yield a “net investment return” of 1.98% per annum.
Invested in a stable cash fund, earning an equivalent, but stable 1.98% per annum each year ends up with a balance of $467,480 at the end of year two. That’s $7,280 higher than Sally’s.
In fact, Rachel only needed 1.24% per annum return to match Sally’s ending balance over these two years.
Because Sally continued to withdraw from her fund after experiencing the -20% fall, she had less capital to participate in the +30% recovery. As a result, she experienced a return of just 1.24% per annum, or 74bps per annum lower than her fund manager’s headline ‘net investment return’ of 1.98%.
Let’s call this 1.24% the “actual return” (the one that you actually experience).
To illustrate this, we’ve generated 1,000 random scenarios of equity market returns over 10 years, but we have ensured that for each scenario, the same ‘net investment return’ of 4% per annum was achieved at the end of the 10 year period.
From the typical fund manager’s perspective and in a world where the investments were left untouched, each of these scenarios would have generated a perfect 4% return per annum (green).
However, assuming 12.5% portfolio volatility and the same $500,000 balance with $26,000 per annum withdrawals, the average ‘actual return’ experienced by Sally is 3.88%, that is, 12bps per annum lower than the ‘net investment return’. Further, the “actual return” experienced by Sally in these scenarios can be highly variable, ranging between 2.04% and 5.11% (blue).
This variability of the “actual return” is one way of quantifying the impact of sequencing risk.
Finally, if I haven’t lost you already. I would like to finish up by making this multi-dimensional by adding volatility.
At Milliman, as the experienced risk managers that we are, we will endlessly hone down on the importance of controlling and managing the volatility of investments, especially for retirees. Why do we do this? Well, it is not because we dislike risk. On the contrary, it is because we know increased volatility can exacerbate the negative impact of sequencing risk on retirement outcomes.
Let’s look at Sally’s example once more.
By raising the volatility of her equity portfolio from 12.5% to 20% to reflect a more tumultuous market, the average “actual return” experienced reduces even further to 3.74% per annum, now 26bps below the net investment return. The possible range of outcomes for her can be much worse, now ranging between -0.49% and 5.72%.
It is clear, combining sequencing risk with volatile markets can lead to detrimental outcomes. This is one of the key reasons why older investors need to be particularly cognisant of controlling volatility and minimising the impact of sustained market drawdowns.
Portfolios built for retirees or those approaching retirement need to robustly manage market risk, and in particular, stabilise the level of volatility experienced in tumultuous markets – like those witnessed last year.
The combination of sequencing risk and volatile markets can lead to a material difference in the actual returns experienced by retirees compared to headline performance figures.
We launched our SmartShield series of Managed Account portfolios on HUB24 and Netwealth in March last year. These portfolios have been built from the ground up to offer a low cost and flexible solution to specifically tackle sequencing risk, whilst enabling investors to remain invested in growth assets.
The in-built risk management strategy demonstrated its efficacy by more than halving the initial Covid-19 sell-off in 2020 for the High Growth fund.
If you would like to find out more about our SmartShield Managed Account portfolios, please visit https://advice.milliman.com/en/ or call us on +61 (0)2 8090 9100
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