The Guaranteed Lifetime Income Annuity: The Optimal Retirement Planning Tool for Bond Investing

Original article posted on "Separating Value From Bias" Substack here: #15: The Guaranteed Lifetime Income Annuity: The Optimal Retirement Planning Tool for Bond Investing

The GLI provides a more tax-efficient, risk-adjusted way to invest in bonds for retirement planning purposes than a taxable account does

So, in my last post I showed how using taxable bonds as a retirement planning solution doesn’t make much sense if you’re in a high tax bracket.

The high taxation bonds expose these clients to negates any diversification value these bonds would have in their retirement planning.

Clients in high tax-brackets would be better off taking 100% equity risk over the long-run than trying to use bonds to offset this risk.

Effect of Taxation on Retirement Outcomes

So what is a better way for clients to use bonds as a retirement planning tool?

The answer is to use bonds in a way such that clients achieve higher yields, reduced risk, and tax-benefits that they can’t get elsewhere.

A guaranteed lifetime income annuity is a retirement planning tool that allows clients to accomplish all of these benefits while allowing the equity side of the portfolio to compound to greater extent than it otherwise would have.

So clients get a higher chance of meeting their retirement goals AND their beneficiaries get significantly higher after-tax wealth when they pass away.

To understand why all of this is we’ll be looking at a case study and then explaining the reasons for the results.

What is a Guaranteed Lifetime Income Annuity and How Does It Help Optimize Retirement Outcomes?

A guaranteed lifetime income (GLI) annuity provides a set level of income every year to a client for as long as that client lives in exchange for an upfront payment amount that the client provides to the insurance company.

The insurance company then invests that money in its long-term bond portfolio and when the client decides that they want to start receiving the income (often a number of years after they purchased the annuity), they tell the insurance company, and the insurance company starts paying the client a set amount every year for as long as that client is alive.

So, in order to see the value of using a guaranteed lifetime income annuity to invest in bonds instead of investing in bonds directly, it’s helpful to look at a case study.

In this example our case study involves a married couple (John and Sally) in California which is a state with a high-income tax. John and Sally are both 55 and earning $500k in W2 income with a $3M portfolio. They want to retire at age 65 and withdraw $250k a year in retirement that increases at 2% a year to keep up with inflation.

Currently they have a 60/40 portfolio with 60% of their assets in stocks and 40% in bonds. What are their current chances of meeting their retirement income goals with this asset allocation? What would their chance of meeting their retirement income goals look like if they replaced the bond side of their portfolio with a guaranteed lifetime income annuity?

Doing a Monte Carlo simulation helps us answer that question as shown in the table below:

Effect of Replacing Taxable Bond Part of Portfolio with a GLI Annuity

In the table above John and Sally, we can see that John and Sally increase their chance of meeting their retirement income goals from 56% to 74% while also increasing the amount of after-tax wealth that they leave to their beneficiaries nearly 5 times from $1.5 million to $7.1 million simply by using a GLI annuity in place of their bond portfolio.

How is the GLI annuity able to do this?

Well, the reason has to do with the fact that while the GLI annuity also invests in bonds, it does so while providing higher risk-adjusted yields in a more tax-efficient way while allowing greater compounding benefits for the equity side of the portfolio.

There are 4 key benefits that the GLI annuity provides which we’ll be talking about here:

1) Achieve higher pre-tax yields

2) Reduced risk in its bond portfolio via guarantees

3) Reduced tax liabilities on bond gains

4) Allow the equity portfolio to compound to a higher extent

1) Achieve higher pre-tax yields

The table below shows the corresponding pre-tax yields to age 93 of a traditional bond benchmark that would be used in a typical GLI annuity.

Pre-Tax Yields of Bond Investing via Taxable Bond Funds vs GLI Annuity

You’ll notice that the GLI annuity’s pre-tax yield is more than double that of the bond benchmark.

The reason for this is due to 2 reasons:

1. The GLI annuity returns part of your principal each year as opposed to a regular bond which requires you to wait until the end of the term to get your principal back.

To understand this in greater detail imagine you spend a $1,000 to purchase a 20 year bond that pays 4% each year. That means that at the end of the first 19 years you would receive $40 and at the end of the 20th year you would receive your $40, plus the $1,000 principal.

However, what if you were to receive 1/20th of the principal back each year? So instead of receiving just the $40 coupon at the end of the year you would also receive $50 worth of principal. This would mean you are getting $90 back each year. And remember that principal isn’t taxed, so only $40 of that $140 would be taxable.

Effect of Return of Principal on Pre-Tax and After-Tax Bond Yields

2. The GLI annuity has higher yields due to arbitrage

While the return of principal part increases the yield of the GLI annuity the biggest contributor to the high GLI yields are due to behavioral economics as a result of everyone paying for the GLI annuity, but only a portion of those people actually exercising the benefits of the annuity.

It’s kind of like 100 people who sign up for a gym membership, but only 40 of them actually go. Those 40 people are getting a cheap price because of the other 60 who are not going. If all 100 of them actually were to go to the gym, then the gym would have to lease a bigger place and buy more equipment and would pass those costs on to all 100 members via a higher membership price. But the gym knows that a large number of people who sign up won’t ever go to the gym. This allows to set a low price for the gym because they know everyone won’t actually show up.

The same thing applies for a GLI annuity.

The insurance company is able to offer high yields for their products because they know that people will sign up for the benefit, pay for it in full, and then forget to actually use it years down the line. But the fact that they do this allows those who do use the benefit to get significantly higher yields than they would otherwise.

Clients who pay for the GLI annuity—and then actually utilize the benefit—are receiving benefits that otherwise would have had to be shared with other clients who either forgot to use the benefit or simply chose not to use it.

There’s a benefit to systems that create inequality here for people at the top that I’ve written about previously. It’s just the people at the bottom that get exploited here as a result.

2) Reduced risk in its bond portfolio via guarantees

This part is fairly straightforward. Part of the risk of investing in bonds is the credit and interest rate risk they pose. If the economy goes south or interest rates rise, then the value of these bond funds will decrease, and clients will absorb the loss.

But when you purchase a guaranteed lifetime income annuity, the insurance company is guaranteeing this yield for the rest of your life—regardless of market conditions.

3) Reduced tax liabilities on bond income

As we talked about in our previous post, not only do you lose out on the equity risk premium when you shift assets away from stocks and towards bonds, but bonds are subject to extremely high ordinary income taxation. This high taxation not only reduces the diversification ability of bonds but also increases the taxation on realized equity gains since it pushes clients income up into higher tax brackets.

A GLI annuity allows clients the ability to defer the taxation on these bond gains until they are in retirement and in a lower tax bracket.

Furthermore, as we talked about previously, not all of this income is taxable since a portion of it is return of principal.

The end result is that not only are clients getting higher pretax yields as we discussed earlier, they’re also paying less taxes on this yield which means they’re getting more after-tax income in their pocket from investing in bonds via a GLI annuity than they would be if they were to invest directly in taxable bonds.

And this is all coming at reduced risk since the insurance company is providing guaranteed yields that that clients can’t get in the corporate bond markets.

In the above table we can see that the client is getting an expected 6.26% after-tax return to their joint life expectancy of age 93 whereas they would only be getting 3.45%-3.75% if they invested in underlying bond funds.

4) Allow the equity portfolio to compound to a higher extent

The greatest impact of the use of the GLI annuity on client’s after-tax wealth actually doesn’t come as a direct result of the GLI annuity. It comes as a result of the GLI annuity allowing the higher earning equity side of the portfolio to compound to a greater extent than it would otherwise.

With a 60/40 portfolio, the portfolio is rebalanced every year. So every year in retirement that the client is withdrawing income, they are essentially taking 60% of that income from the equity portfolio and 40% of the income from the bond portfolio. This continues ad nauseum until the client passes away.

However, with a 60% stock/40% GLI annuity, the client is drawing more of the income from the GLI annuity and only using the stock side of the portfolio as needed to cover the shortfalls.

This means that over time the client’s portfolio slowly drifts upward from a 60% stock portfolio to an 80%-90% stock portfolio over time. This is what leads the portfolio that used the GLI annuity in place of bonds to have almost 5 times more wealth than a portfolio that just uses taxable bonds and rebalances every year ($7.1 million vs $1.5 million).

As we’ll see in the graph below, in the later years the 60/40 portfolio (blue line) is not earning a significant after-tax yield to support the withdrawals of the client and so starts to rapidly deplete in the later years. This is because the 40% bond portfolio is significantly lowering the return on the portfolio since it’s not as high-earning or tax-efficient as the 60% equity portfolio.

The portfolio that uses the GLI annuity on the other hand (orange line) is not only able to support the withdrawals but is able to continue to compound and grow in the later years unlike the 60/40 portfolio. This is because the GLI annuity has a higher after-tax yield in comparison to its 60/40 bond counterpart as well as the fact that the portfolio with the GLI annuity has a larger allocation to the higher earning, tax-efficient equity portfolio.

This means that the portfolio that use the GLI annuity is able to support larger withdrawal rates than the portfolio with a taxable bond allocation.

So not only is the increasing their chances of meeting their retirement goals as we showed previously (from 56% to 74%) but they are also significantly increasing the after-tax wealth they leave to their beneficiaries (from $1.5 million to $7.1 million).

The GLI Annuity: Profiting off Behavioral Economics and the Tax-Code

People make bonehead decisions every day. Many of whom do so under the guise that they are making the right economic decision, when in reality they are heeding an emotional call to their own personal biases.

And every day other people profit off our emotional biases. In fact, entire economic systems and products are designed to redistribute wealth from those heeding their emotional biases and towards those who have made more calculating—and sometimes ruthless—choices.

It's on us to be able to separate the true value being offered by these products from the direction our emotional biases pull us in.

The GLI annuities benefits derive from 3 key elements:

1) Poor policyholder behavior as a result of people who sign up and pay for a feature that they never use which allows those who use it optimally to achieve outsized returns;

2) The tax-code that allows GLI annuities to defer taxation on their bond gains until they’re in a lower tax-bracket in retirement while also making less of that income taxable via the return of principal feature;

3) Smart financial planning which realizes that drawing down on the GLI annuity for income while allowing the higher-earning, tax-efficient equity portfolio to compound for the long-run creates both a higher chance of meeting retirement income goals AND significantly higher after-tax wealth for beneficiaries.

Launch of Guaranteed Annuity Experts

We’ve now migrated to the sales pitch part of this newsletter. For those of you who have been following this newsletter for a while, you know that I spend a lot of time talking about the value of life insurance and annuity products in financial planning. That’s partly because I’m an actuary in the space who has a deep understanding of these topics, but also as a former teacher I love the educational element of it.

But I am trying to be better about monetizing my efforts here especially since I realize that Kevin Costner’s famous “Build it And They Will Come” line from Field of Dreams really only applies to dead baseball players in a fictional movie and not sustaining a living in a capitalistic system in which no one actually comes if you are not explicit in intentionally asking them to.

So I’ve decided to a launch a site explicitly aimed at people in high tax brackets who are looking for the most optimal way to optimize their retirement outcomes through the use of annuities.

The site is called Guaranteed Annuity Experts and we can help you do the following:

1) Do this same case study presented in this Substack with your own numbers to show you the value of using a GLI annuity in your own retirement planning in place of your existing bond portfolio;

2) See how much income you could get in retirement by investing in a GLI annuity today;

3) Purchase a GLI annuity.

So I’m hoping those of you who see value in this and are in your 50s or 60s and are planning for retirement will reach out to see how we can help you both increase your chance of meeting your retirement spending goals while also significantly increasing the amount of after-tax wealth you leave to your beneficiaries.