WEALTHCARE CAPITAL

MANAGEMENT EDUCATIONAL EMAIL

HOW MUCH IS THAT GUARANTEE IN THE WINDOW?

By David B. Loeper, CIMA®, CIMC®

"The fact that a great many people believe something is no guarantee of its truth.”
- W. Somerset Maugham

Guaranteed income for life! This is the marketing cry of the insurance industry, and emotionally it
has a lot of appeal. The soothing comfort implied is so enticing that there are actually proposals
from the Obama administration to encourage Americans to buy annuities with their retirement
savings (see: Retiree Annuities May Be Promoted by Obama Aides – Bloomberg, January 8,
2010). I guess this is what happens when the government owns an insurance company.

Even The Wall Street Journal has fallen prey to this marketing ploy as exemplified in the story,
Locking in Future Income – December 9, 2009. In this story about variable annuities, the WSJ
does a reasonable job of disclosing the “very steep fees” (the price of the guarantee? ...not really as
you will learn) and that you can’t get the guaranteed amount in a lump sum. They also warn about
the complexity of these products and offer a summary of additional warnings. But, a favorable
message about the value of the guarantees in the “timing” section of the article stated: “If, for
instance, the market falls sharply just after you buy and your underlying funds take a dive, the
guarantee could prove quite valuable.”

Let’s examine this “quite valuable” benefit the WSJ article highlighted. What happens if the
markets fall sharply just after you buy? This is after all one of the two main things you are trying to
protect yourself from by buying an annuity (the other is the risk of outliving your wealth).

The example the article used was a 60 year old who put $100,000 in a variable annuity in 2000 just
as the bear market at the beginning of the decade started. Fortunately, the annuity had an annual
“guarantee” of 5% growth per year for the benefit base. As of October 31st 2009, this means the
benefit base (not available in a lump sum) would entitle the annuity buyer to an annual lifetime
income of $7,500 because of the guarantee that protected his benefit base. That $7,500 annual
benefit is based on a 5% payout rate for the annuitant who is now 69 years old and a benefit base
that has grown to $150,000 (according to the article). At normal life expectancy (50/50 odds), the
annuitant would receive $120,000 in annuity payments for tying up $100,000 for 26 years. Care to
calculate the IRR on that? The consumer (and most agents that sell these things) would believe
they were getting a 5% return because of how the insurance company promotes the 5% guaranteed
increase to the benefit base and the 5% payout rate. In reality though, this is the equivalent of
getting a 1.84% return for the first 10 years and zero for the next 16 years. Does this sound like a
good deal to you? Sure doesn’t seem anywhere close to 5%.

…………………………………………………………………………………................................
600 East Main Street, Suite 1240, Richmond, VA 23219 p 804.644.4711 f 804.644.4759 www.wealthcarecapital.com
W EALT HCARE CAPITAL MANAGEMENT ®
: EDUCATIONAL EMAIL
…………………………………………………………………………………................................

Let’s back test all of these cash flows historically. We have a 60 year old who invests in a simple
60/40 portfolio (60% domestic equities, 37% government bonds, and 3% cash) and pays an advisor
a 1% annual advisory fee. Each year we will calculate and tax his investments assuming moderate
Virginia state income taxes and current Federal tax rates. We will assume annual rebalancing plus
20% annual turnover and 80% of capital gains being realized as long term. Also, we will withdraw
the same $7,500 a year (but in our case net after tax and after expenses) starting at age 69 and
continuing to death at normal life expectancy.

Going back to 1926, there were 697 twenty-six year periods for us to back test based on monthly
data. If this investor started in September, 1929 right before the Crash of ’29 and the ensuing
Great Depression, he would have ended up with $42,241 left over versus ZERO in the annuity at
normal life expectancy. In fact, in EVERY ONE of the historical periods, the annuity guarantee
that the WSJ called “quite valuable” cost the investor at least $42,241 or more. At the 90th
percentile outcome, the guarantee cost the investor $250,089. At the 75th %-tile, the guarantee of
the annuity cost the investor a whopping $339,068, more than three times the initial investment.
There was a 50 percent chance the guarantee would cost the investor an incredible $441,896!

But, these ending values of what is leftover in the portfolio are not all profit for the insurance
company. That’s because there is a 50% chance the investor will live past normal life expectancy.
Before we examine the effect of the value of the lifetime income guarantee though, objectively
think about this example and what the insurance company is coercing agents to sell. Half of all of
the clients sold this product will end up dying before normal life expectancy and if the Crash of ’29
and the Great Depression were to start the month following each of their initial investments, the
annuity would cost all of them AT LEAST 42% of their initial investment; MORE if they die
before normal life expectancy or if the markets aren’t as bad as the Great Depression.

As would be expected though, the insurance company actuaries have designed the product to have
very favorable odds for them to profit. There is a risk that many of the annuitants (about half) will
live past normal life expectancy and the insurance company needs the “premiums” of the other
half of the annuitants who lose out on this bet to insure this longevity risk they are taking with the
other half. Do not assume that the actuaries haven’t figured out how to still profit on this risk.

The 60 year old in our example has a 71% chance of being dead by age 90 (you may wish to find a
better way of articulating this). Running the same historical back test for the 637 thirty-one year
periods back to 1926, we find that the simple balanced portfolio STILL exceeded the cash flow
from the annuity in every historical period. In the worst historical period starting with the ’29
Crash, the guarantee of the annuity cost the investor $14,758. Starting in December, 1926 (the
95%-tile outcome) the guarantee of the annuity cost the investor $213,447. Starting in June of
1926 (the 87th %-tile outcome) the guarantee of the annuity cost the investor $403,385. Remember,
the investor only has a 29% chance of living this long.

Extending the life expectancy to age 97 (less than a 10% chance of the investor living this long) we
see where the risk is for the insurance company (note…this is sarcasm). Of the 553 thirty-eight year
historical back tests going back to 1926, there were TWO of the 553 periods where the balanced
portfolio would have run out of money. The cost of the annuity guarantee, IF the investor lives to
age 97 (less than 1 in 10 chance of this) had a 95% chance of costing the investor more than
$238,561.
………………………………………………………………………………………………………
“H o w M u c h I s T h a t G u a r a n t e e I n T h e W i n d o w ? ” June 2nd, 2010 © Wealthcare Capital Management ®

All Rights Reserved

PAGE 2
W EALT HCARE CAPITAL MANAGEMENT ®
: EDUCATIONAL EMAIL
…………………………………………………………………………………................................

A one in ten chance of outliving your money is still scary…or so the insurance company would like
to have their agents and annuitant victims believe. There is essentially no chance (at least from
actuarial tables less than a 1 in 1,000 chance) of the annuitant living to 111. Back testing the
balanced portfolio back to 1926 once again sheds light on how conservative actuaries are in
ensuring profits for the insurance company at the expense of their customers.

There were 385 fifty-two year periods for us to test going back to 1926. In about 2% of those
(seven to be exact), the investor would have run out of money IF he or she lived to 111. If he
started in July of 1929 (the 95th %-tile outcome), just a few months before the ’29 Crash and the
Great Depression and he lived to age 111, the cost of the guarantee of the annuity would have
been $230,526.

Understanding the combination of how unlikely the perfect storm of remote odds are can be
daunting because we have uncertain market returns, uncertain timing of returns that can impact the
wealth, and uncertain mortality. Our company has the rights to a patent to assess these risks
together using Monte Carlo simulation so we can come to one simple probability of the odds of
whether or not the annuity guarantee has value.

Out of 1,000 random lifetimes with simulated random returns even more extreme than have been
historically observed, in 997 of the outcomes the annuity had a negative relative value to the simple
balanced portfolio. There was a 90% chance the annuity guarantee would cost the investor more
than $149,000 (about 1.5 times the initial investment) and a 75% chance it would cost more than
$243,000.

Does this sound “quite valuable” to you? Think about the other factors on top of this. The cash
flows we modeled for spendable income were net after taxes and fees versus the annuity that would
likely have some portion of the payment being taxed at ordinary income rates. The annuity has
zero liquidity where the balanced portfolio offered flexibility to adjust future income withdrawals if
there was an unexpected immediate cash need. Of course, we are also assuming the insurance
company financially survives a Great Depression environment and can honor its promise to pay.

In the Wealthcare process we avoid needless risk so in reality it is unlikely we would recommend a
portfolio with 60% equity exposure to the client if it wasn’t needed to confidently fund their
income need. In fact, the Monte Carlo simulation with random returns and life spans actually
showed the annuity guarantee costing the investor in 999 of 1,000 simulations if the portfolio had
45% equity exposure (our balanced income allocation) and 997 simulations for our 30% equity
exposure (our risk averse allocation), the same odds of the balanced portfolio.

Do the odds against the annuity having value sound like the kind of recommendations someone
would give in a practice that is beyond reproach?

………………………………………………………………………………………………………
“H o w M u c h I s T h a t G u a r a n t e e I n T h e W i n d o w ? ” June 2nd, 2010 © Wealthcare Capital Management ®

All Rights Reserved

PAGE 3
W EALT HCARE CAPITAL MANAGEMENT ®
: EDUCATIONAL EMAIL
…………………………………………………………………………………................................

…………………………………………………………………………… 
 
A popular industry speaker and writer, DAVID B. LOEPER is the CEO and founder of Financeware, Inc. in Richmond, 
VA. He is author of the top selling book Stop the 401(k) Rip‐off!, three other books released in 2009 by John Wiley & 
Sons (Stop the Retirement Rip‐off, Stop the Investing Rip‐off and The Four Pillars of Retirement Plans) and 
numerous whitepapers. He has appeared on CNBC and Bloomberg TV, served on the Investment Advisory 
Committee of the $30 billion Virginia Retirement System, and was chairman of the Advisory Council for the 
Investment Management Consultants Association (IMCA). Before founding Financeware in 1999 he was Managing 
Director of Strategic Planning for Wheat First Union. He earned the CIMA® designation (Certified Investment 
Management Analyst) from Wharton Business School in 1990 in conjunction with IMCA. 
 
…………………………………………………………………………… 
 
WEALTHCARE RESOURCES 

New Books Available on Amazon and Barnes & Noble, and Borders! 
Stop the Retirement Rip‐Off  
Stop the Investing Rip‐Off  
The Four Pillars of Retirement Plans  

No Time to Read Loeper’s Books? Listen to our free webinars! 
David Loeper hosted three 30 minute webinars; each one covering the key information from each of his books. 
To listen to the recordings, click on the links below. 

Stop the Investing Rip‐off 
 
The Four Pillars of Retirement Plans 
 
Stop the Retirement Rip‐off 
 
 
The Wealthcare Movement In the News 
Read about how our advisory board members are changing financial services to make the most of their clients’ 
lives, and their own. 

Mowry Young – Building a Practice in America’s Fastest Dying City 

David Loeper – The Compound Return Shell Game 

Russ Thornton – The Levers to Financial Freedom  

Updated Value Proposition Power Point Available 
We’ve updated the look and feel of our popular Wealthcare value proposition presentation for clients. Click here 
to open it. 

………………………………………………………………………………………………………
“H o w M u c h I s T h a t G u a r a n t e e I n T h e W i n d o w ? ” June 2nd, 2010 © Wealthcare Capital Management ®

All Rights Reserved

PAGE 4