What Percent of Retirement Assets Should be in a Variable Annuity?

For many retirees and near-retirees, variable annuities (VAs) have become a key element in a comprehensive income plan composed of taxable investments, retirement assets, cash holdings and Social Security.

Research has shown that VAs with guaranteed withdrawal benefits can enhance an individual’s overall retirement income strategy by providing its two most important ingredients: lifetime income and growth of capital.

Determining the appropriate allocation toward VAs, however, is less studied and more predisposed to subjective judgment.

Developing an Appropriate Allocation for Variable Annuities

As might be expected, the optimal VA allocation is specific to each individual and his or her circumstances and retirement objectives. To build a framework for arriving at the most appropriate allocation for each investor, Morgan Stanley analyzed the optimal level of VA exposure based on a variety of factors.

In its analysis, Morgan Stanley’s study^* compared two basic strategies:

1. Portfolio A—Comprised of a 50 percent stocks/50 percent bonds allocation
2. Portfolio B—Comprised of a 50 percent VA allocation, with the remaining assets equally divided between stocks and bonds

Using a hypothetical scenario in which an investor with $1 million of retirement assets had an inflation-adjusted annual income goal of $50,000, its findings showed that:

• Portfolio B had a substantially lower probable failure rate (2.9 percent versus 5.6 percent for Portfolio A).
• Portfolio B had a smaller average downside deficit of 1.3 years versus 5.8 years.
• Portfolio A offered a significantly higher medium cumulative surplus potential ($1.03 million versus $705,000).

Since investor variables will affect the optimal allocation of VAs, it’s crucial for advisors to understand each client’s specific needs and objectives with respect to:

• Relative retirement funding (i.e., under or over)
• Desired income
• Discretionary expenses
• Legacy objectives
• Current age
• Retirement age
• Investment portfolio mix

These factors must then be weighed in the context of a client’s risk tolerance. The white paper authored by Morgan Stanley illustrates precise optimal allocations for a wide set of scenarios, which the reader is welcome to review. However, some general rules of thumb apply:

• The greater the risk aversion, the higher the VA allocation.
• The period before beginning VA withdrawals is a key influence on VA optimization.
• Deeply underfunded investors may be better off not allocating funds to VAs.
• Overfunded retirement situations lessen a VA allocation.
• The VA allocation may be reduced for individuals looking to make bequests.

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* http://stchristopherschatham.org/wp-content/uploads/2015/09/Morgan-Stanley-on-Annunities.pdf

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