An important feature of the proposed Investment/Insurance system is the use of graded and variable annuities in determining retirement benefits. Both are designed to provide an increasing income during the retirement years as a way of countering the effects of inflation. In the proposed system, they are intended to replace the Cost of Living Adjustments (COLAs) which are a part of the current system for those whose Social Security benefits are above the insured minimum income level.

The traditional fixed annuity, such as those normally sold by insurance companies, provides a fixed income for the life of a person based on his life expectancy. (It is like a reverse mortgage in the sense that the retiree loans the insurance company the amount of the mortgage and is paid periodic mortgage payments which would pay off the mortgage in during the life expectancy.) For example, $150,000 would buy a fixed lifetime annuity of about $12,000 for a twenty year life expectancy. In a graded annuity, rather than starting the annuity at $12,000, the starting payment would be based on the annuity the $150,000 would buy at 2%, about $9,000) and increased over the years as if it were a 5% annuity yielding an increase of slightly less than 3%, as shown in Figure 1C. (The actual rate of increase would be 1.05/1.02 - 1, or 2.94%.) The red line in Figure 6 shows value of the fixed annuity over the twenty years and the green line shows the increasing income stream produced by the graded annuity. Also plotted on the figure in blue is the way the $9,000 annuity would have to increase to keep up with inflation at 3%. The graded annuity almost matches the 3% inflation increases. The proposed Investment/Insurance system uses a graded annuity based on a 5% return beginning with a 2%, twenty year annuity.

A variable annuity is of the same form, but the actual returns for each year depend on the stock market. Like the graded annuity, the first year payment is that which an annuity based on a return which is lower than the expected actual return would pay and the periodic increases are governed by the actual returns from the stock fund. The proposed Investment/Insurance system uses an assumed 10% rate of return with the first year benefit based on a 5%, twenty year annuity.) Figure 2C shows how such a variable annuity would work. The red line shows the value of a fixed 10% twenty year annuity which could be bought for $150,000, about $17,500. The green line shows the annual payments a graded annuity based on an initial 5%, twenty year annuity with a return of 10% per year would produce. The $150,000 would purchase a 5%, twenty year annuity of $12,000, the first year payment. The rate of increase in payments would be 4.76% (1.10/1.05-1). It is obvious that a rate of increase of 4.76% would assure that such payments would exceed a 3% inflation rate. The blue line shows the $12,000 as it is increased by 3% inflation. Any fixed yearly rate of return above 8.2% should equal or exceed the 3% inflation rate (1.082/1.05 - 1 = 3%). This not the case for a variable annuity, however. If the actual yearly CREF returns were as depicted in Figure 3, page 8a, the yearly payments from the variable annuity would be as shown by the irregular yellow line. Note that even though the twenty year annual return is 10.15% and would produce an income of about $43,000, well above the $29,000 produced by the graded annuity, it produces income below the inflation level in years 9 through 14.

To show how low yearly returns can affect retirement income based on variable annuities, Figure 3C shows how the above variable annuity would perform if the CREF returns A and B shown in Figure 5, page 10. These returns both have a twenty-one year annual return of approximately 7.7%, but the pattern of yearly returns are quite different. Returns A are high in most years but decline rapidly in the last few years. This pattern leads to retirement income which is considerable higher than inflation throughout the retirement years. Returns B are relatively low, of negative during the first part of the period and rise gradually to reach a last year income equal to that of Returns A. Returns B lead to retirement income below inflation in most years. This confirms the fact that actual yearly returns, not the long range annual return, which is the primary determinant of income during the retirement years and reinforce the argument for income maintenance insurance for those with low retirement incomes.

Figure 4C shows the components of the retirement benefits of those retirees in Group 1 of Table 1. The graded annuity paid by the bond fund was set at $6,942, the sum of the bond annuity value of $2,447, income insurance of $3,789 and a dividend of $706. The annuity payment increases over the 20 years of retirement at a rate of 2.94%. It increases at a constant rate as shown in the green bar in Figure 4C. The variable annuity, shown in blue begins at $11,764 (the annual payment produced by the twenty-year annuity the $146,609 accumulated in the retirees? stock fund accounts would purchase at 5%). The payments vary as those shown in Figure 3C. The red bars in the last 9 years show the yearly income maintenance insurance payments required to meet the minimum insured income of $18,000.

Variable annuities have had a great deal of bad press during the past few years, mostly because the commissions paid to sales agents are high, administrative cost high and they have often been sold to individuals who would benefits more from other forms of investment. But in this application, it seems to be an entirely appropriate. There should be no sales commissions and administrative costs should be low. Moreover, Social Security benefits in an Investment/Insurance would have to be determined in the form of an annuity. The variable annuity, structured as proposed here, would provide an annuity which tends to increase over the years to counter inflation. And, of course, retirees who were very uncomfortable with taking any market risk at all could be offered the alternative of buying a graded or fixed annuity based on the bond fund.

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