By Richard Gilman, CFP®

After the stock market crash in 2000 and “Great Recession”, investors have justifiably become more concerned about their retirement. Many people no longer trust Wall Street.  Having suffered through dramatic market swings, they are unwilling to keep putting their savings at risk. They worry about exploding health care costs and outliving their money. They know they need to do something — but what?

Annuities of all kinds are being positioned by insurers, the government, the media and financial planning community as part of the solution.  And annuities may very well be one part of the solution.  The insurance industry has had great success with traditional annuitization strategies and in 1996 introduced variable annuities (VA) with guaranteed income and withdrawal benefits. The income benefit quickly became a key selling feature that offered investors a level of certainty that is hard to find in other financial products.  Investors could now create their own pension by allocating a portion of their money to provide a future income.

By 2008 about 80% of new VA sales included an income benefit and the majority of sales were in qualified as opposed to non-qualified accounts.  In conjunction with this shift, the share of VA assets that were invested in equities increased from around 50% in 2002 to more than 80% in 2007.  Income benefits have been a home run for the industry and sales have continued to explode.  According to LIMRA (formerly known as Life Insurance and Market Research Association), US insurers sold about $147 billion of VAs in 2012 with 73% of investors purchasing an income rider.

VAs are a complex product that comes with a confusing, jargon laden prospectus. Most investors don’t fully understand the intricacies of how the products work or what happens if the insurer can’t meet future financial obligations. Disclosures on VA sales literature clearly state that the financial guarantees (the living and death benefits) are the responsibility of the issuing insurance company. There is no FDIC or SIPC coverage.  Money invested in sub-accounts is held separately from the insurer’s general account and would be segregated should an insurer fail.  However, the investments are still subject to market risk.

In the US, when an insurer fails the company is either acquired or taken over by a state guarantee fund.  Rules and coverage vary by state.  In Massachusetts, the maximum amount of protection provided by the state guaranty association is $100,000 per contract owner. However, the associations do not guarantee the income rider will be paid.

As with many financial products, there is a lot of focus on the benefits and less conversation about the risks and expenses.  Americans (and investors in other countries around the world where VAs are sold) who purchase these products assume, at some point in the future, they will receive guaranteed lifetime payments.  To help meet these obligations insurers rely on innovative product designs as well as risk management and hedging strategies.

However, VAs with income benefits are a relatively new and untested product.  Changes in the reinsurance market and actual experience during bear markets have already forced many insurers to modify contract guarantees and to enhance their financial risk management capabilities by setting up in house hedging groups. Yet many hedging strategies are based on back tests against what we do know or have experienced. The problem is we really can’t predict unforeseen or extreme future events.

Some other potential problems for insurers and investors include:

• Most large insurers are now global companies. Events occurring around the world can affect the stability of these companies.
• In this period of extended low interest rates some insurers have come to dominate the marketplace, while others have elected to trim back or stop writing VA guarantees. Low interest rates can leave insurers with a mismatch between risk-free rates and higher roll-up rates and result in embed­ded losses every year that are not sustainable.
• The design, effectiveness and cost of hedging strategies. Economic conditions change daily and hedging costs generally are not locked in over the lifetime of the product. Unlike traditional insurance liabilities, which are not leveraged to the market and can be managed by pooling risk, derivatives have to be managed differently. The goal is for the fees to exceed the cost of hedging. Yet some risks, such as policy holder behavior, mortality or currency volatility, may not be hedgeable.
• Actuarial pricing assumptions that may not hold up over the long term.  Any drop in the equity markets reduces the fees that insurers earn from underlying variable annuity accounts.  Mortality and expense (M&E) fees, rider fees, redemption penalties, etc. have to cover the cost of hedging.  However, fees are tied to the net asset value in a contract.
• Longevity risk and assumed contract lapse rates.  Higher contract retention normally helps boost revenue and profitability on most base VA contracts.  However, guarantees (death or living benefits) are derivatives.  Investors living longer and holding onto contracts may affect profitability because over- or under-hedging can result in losses.
• Unlike other insurance products VAs are not underwritten. Companies have limited ability to manage who purchases a contract and when they decide to exercise the income rider. Early exercise of income riders and longevity could be a future problem and affect an insurer’s profits.

Based on demand, investors want these products to help insure future income.  The challenge for the industry is how to design and market products that strike a reasonable balance between how much risk the insurer absorbs and how attractive a product’s benefits are to investors. Many insurers have already made changes to their products including reducing income guarantees, increasing rider fees and restricting investment.  And the likelihood is that we will see the introduction of additional annuity product to fill this need.

Like many experiments we won’t know how this all works out for many years. Investors, who have already purchased or may be considering the purchase of a VA with a guaranteed income rider  need to understand how the product fits into their investment and income strategy.  Annuities should be part of an overall strategy that also includes Social Security, investments and other income sources.

ABOUT THE AUTHOR

Richard Gilman, CFP® is an adjunct faculty member at Northeastern University and has developed curriculum for the Certified Financial Planner® program at Boston University, as well as training programs for several national financial companies.