Risk wrap decumulation

Risk wrap decumulation is one of the ways that financial wealth can be turned into retirement income. This group of strategies allows investors to maintain significant stock market exposure during retirement to benefit from potential upside. But to provide downside protection, a safety net is metaphorically ‘wrapped’ around this ‘risk’ (i.e., risky strategy), to supply a secured retirement income in case stock markets don’t deliver. This retirement income style is difficult to implement in Canada at present but is included here for completeness.
==Who would choose this style?==
Murguia and PfauMurguia A, Pfau WD (2021a) A Model Approach to Selecting a Personalized Retirement Income Strategy, working paper available on SSRNMurguia A, Pfau WD (2021b) Selecting a personalized retirement income strategy. Retirement Management Journal 10:46-58, available on SSRN have developed a four quadrant matrix of retirement income styles. "Risk wrap" fits in the lower-right corner:
:
In this quadrant, investors have probability-based tendencies (they want to use stocks for their potential upside and maximize the odds of reaching a certain retirement lifestyle), yet they have a commitment orientation as well. They are therefore potentially interested by a hybrid approach that combines the high stock allocations often seen in the total return decumulation style (upper-right quadrant) with the ideas of longevity insurance and downside protection more typical of the income protection style (lower-left quadrant).McCarthy E (2022) Wade Pfau Speaks Out on Retirement Product Some Advisors Love to Hate, Think Advisor, July 22, 2022, viewed February 8, 2024.
Direct access to the four strategy groups:
:
 
Bucketing 	Total return
Income protection	Risk wrap
==How it works in the US==
In a US context, the risk wrap group of strategies involves certain types of complex annuities, including deferred variable annuities and registered index-linked annuities, with "living benefits" or "lifetime income benefits".Pfau WD (2022) The Role and Inner Workings of Variable Annuities with Guaranteed Lifetime Withdrawal Benefits in Retirement, The Journal of Retirement, DOI 10.3905/jor.2022.1.113 
===The annuities involved===
In very approximate terms, variable annuities (VAs) are similar to mutual funds, but are offered by insurance companies; the closest Canadian equivalent would be segregated funds. The investor's money is actually invested in stocks and bonds.
Registered index-linked annuities (RILAs) behave like stuctured products that provide exposure to the price returns of an index, typically an equity index like the S&P500, but with floors and caps.Securities and Exchange Commission (SEC), Office of the Investor Advocate, Investor Testing Report on Registered Index-Linked Annuities, OIAD Working Paper 2023-01, September 2023, viewed Februay 15, 2024 Think market-linked GIC but with some possibility of negative returns in exchange for more upside. Financial derivatives like options are involved. The US Securities and Exchange Commission (SEC) warns that these are very complex products and that "there is very limited research on RILA products, their performance, and the extent to which they serve investors’ needs".
This presentation focusses on the better researched variable annuities with living benefits. Unlike fixed immediate annuities such as SPIAs, variable annuities are not irrevocable decisions: "these strategies can also be reversed with remaining assets returned to those who decide they no longer want or need the lifetime spending protection". There is still a level of commitment needed, however, because if the retiree stops the strategy (to move back to a total return strategy for example), all of the extra fees involved in variable annuities and the living benefits rider will be lost.
Or these annuities can provide a bequest, although the remaining amount is likely to be smaller, on average, than in a total return strategy.Blanchett DM (2011) The Expected Value of a Guaranteed Minimum Withdrawal Benefit (GMWB) Annuity Rider, Journal of Financial Planning, July 2011, viewed February 3, 2024.
===Example: deferred variable annuity with GMWB rider===
Blanchett (2011) gives the US example of a (deferred) variable annuity with a guaranteed minimum withdrawal benefit (GMWB) rider. In such a product, there is a guaranteed percentage (or "lifetime distribution factor") based on age at the time of the first withdrawal. This percentage applies to a "benefit base", which might involve "the greater of the current policy total dollar value or the maximum value at each of the previous policy anniversary dates". 
For instance, a 65-year-old might be promised a 5% withdrawal rate, which translates into $5k per year on $100k of assets; if the contract value is higher at the end of the year, the second year withdrawal will be 5% of that new "high-water mark". A 75-year-old just starting withdrawals might get 6% instead. 
This yearly withdrawal amount is guaranteed for life, but note that there is no explicit adjustment for inflation, unlike in the constant real dollar withdrawal method, and this has a big impact over time. In Blanchett's median simulation, by the time the retiree is 90 years old, "the GMWB annuity annual income is only approximately 68 percent of the inflation-adjusted value" (see his Fig. 1). 
The contract value of the variable annuity might become depleted over time, if stock returns are too low, and/or the lifetime distribution factor turned out to be too optimistic and/or the retiree lives longer than average. This means that at some stage, the contract value is no longer able to support the guaranteed withdrawals; in the absence of insurance, the retire would be ‘ruined’ (the self-managed portfolio would have gone to zero). 
This is where the GMWB rider kicks in, ensuring that income continues. Blanchett compares the GMWB annuity with a total return decumulation approach based on the same withdrawals. In his simulations, the odds that a retiree will actually benefit from the GMWB rider (based on his assumptions) are 3% for a male, 5% for a female, and 7% for a male-female couple. In the other cases where the GMWB feature was not needed, the retiree has paid for insurance but got nothing back, just like most people who buy fire insurance never make a claim.
So is the cost of this insurance reasonable? Blanchett assumes a total fee of 2% per year for variable annuities with a GMWB rider, as a rough estimate, compared to, for example, 0.3% per year in fees on the self-managed total return approach. These fees sound very high, especially is there are advisory fees of 1% or more per year on top. But one has to take into account the expected additional cash flows from the GMWB rider (in the scenarios where these additional cash flows occur because the rider kicks in), as well as the possibility of opting for a higher equity allocation, based on the reassuring presence of a minimum income guarantee.Milevsky MA, Kyrychenko V (2008) Chapter 12 Asset Allocation within Variable Annuities: The Impact of Guarantees, In: Recalibrating Retirement Spending and Saving Recalibrating Retirement Spending and Saving, Oxford Academic, p. 276-294, DOI 10.1093/acprof:oso/9780199549108.003.0012
When those aspects are accounted for, minus the "net present value of the expected decrease in the account value due at death to the additional costs" (the 2% total fee, ignoring advisor fees), the net costs of the insurance can be calculated. Blanchett arrives at an average net cost of 6-7% of the original portfolio in today’s dollars; this will take the form of a lower average contract balance at death, compared to the total return approach. Blanchett concludes that is a relatively inexpensive form of longevity insurance for US investors.
==What about in Canada?==
The types of complex annuities required for a risk wrap approach exist in the US, but much less so in Canada, where the annuity market is significantly less developed. Some segregated funds called GMWB products are partly similar to the variable annuities described in the US example, but are only offered by a few insurers in CanadaInsurance Portal, Guaranteed Withdrawal Benefit: just 3 players still in the game, November 20, 2020, viewed April 27, 2023. (the market is not necessarily competitive), and require the use of an advisorMorningstar, Are guaranteed minimum withdrawal benefits worth their fees?, September 22, 2015, viewed April 27, 2023., further adding to fees. 
==Alternatives==
In a Canadian context, products to implement a risk wrap style remain underdeveloped. So perhaps the investor can find a more straightforward and lower-cost solution in the total return or income protection quadrants. Which of those will be more attractive depends on the investors preferences. If what they mostly want is the potential upside of stocks, in order to maximize the odds of reaching certain lifestyle in retirement, they should look mainly in the total return quadrant. If they care enough about longevity risk to want to build a safe income floor, then they should investigate the income protection quadrant.
==See also==
*Canada's retirement income system
==References==
==External links==
* Retire with style podcast, Episode 72: Variable Annuities (US content)
* Retire with style podcast, Episode 74: Variable Annuities and their practical considerations (US content)
Category:Retirement planning
Category:Retirement living