Seller’s Remorse: What Annuity Companies Are Doing
to Mitigate Their Risk
ETHAN YOUNG
It was, and still is, for most everyone but the insurance
companies that have insured tens of billions of dollars via
such contracts. The severe market downturn in 2008 coupled
with the years-long period of low interest rates has some
insurance companies concerned that their richest guarantees
may have been a little too aggressive. Recently, we’ve seen
a trend of annuity carriers taking steps to mitigate the risk
posed by long-term obligations such as living benefit and
enhanced death benefit riders. The financial risk hasn’t
simply disappeared; in many cases, it’s been transferred
back to the consumer.
Underpriced and Over-Delivered
Individual companies have approached de-risking in a
number of ways. Let’s take a look at some of the most
common risk mitigation strategies used by the biggest
issuers of variable annuity contracts over the last 10 years.
Managed volatility funds.
The most common tactic has
been a switch to managed volatility funds, which are
designed to minimize the effect of severe market declines
and generate more consistent returns over time. The
objective sounds appealing—who wouldn’t want a smoother
ride in volatile markets? But, along with mitigating the
effect of serious downturns, these hedging strategies also
cost clients some upside performance. This is problematic
for a product whose value proposition is guaranteed income
with an inflation hedge during retirement.
With most of these products, a rising income guarantee
during distribution is predicated on an account value that
rises above the existing income benefit base on some
predetermined contract anniversary. In most cases, that
would require a gain that—at the very least—is just higher
than the expenses and fees coming out. Given that most
of these contracts have an all-in cost between 3 percent
and 4 percent, when factoring in distributions in the range
of 5 percent to 6 percent, you’d need gross returns to
average around 10 percent over time to get any dependable
income step-ups. While not impossible, it’s unlikely that
clients will regularly see these double-digit returns in
policies that employ managed volatility hedging as a
de-risking strategy.
At least a few carriers appear to have changed the rules
of investment post-issue. One company recently forced
clients into a significantly more conservative set of funds
under the threat of losing an income guarantee if they
didn’t comply. This seemingly extreme approach to risk
mitigation could only be pursued by a company that had
already decided to exit the variable annuity marketplace,
as the backlash from such a tactic would almost certainly
hamstring new sales.
Higher fees.
A second de-risking method that also
involves manipulating contracts already on the books is
to increase fees. Excepting some of the early iterations of
these living benefit riders, many guarantees came with
variable pricing structures. Insurers have been able to go
back to existing contracts and increase the costs on some
of the riders. In some cases, policyholders can opt out of
the price increases by agreeing to forgo future increases
to the guarantees’ benefit base.
For more modern riders, the proposition isn’t as flexible
and essentially allows the company to increase the costs
for all policyholders at its discretion. To be fair, some
variable pricing is pegged to a known quantity, like the
10-year Treasury. Other riders put limits on the amount
the price can increase in a calendar year. For many contracts,
however, there are no hard and fast rules governing
increases or decreases to the rider charge. It’s imperative
that advisors and clients understand the cost structures
of these underlying guarantees.
An insurance rider that promises a 7-percent compounded interest step-up on an
income benefit base, a 6-percent income distribution guaranteed for life, and the
ability to invest in equities while transferring most, if not all, of the investment risk
to the issuing company—and all this for the low cost of just 60 basis points a year!
Sounds like a pretty good deal, doesn’t it?
26
For Advisor Use Only
January/February
2014
Wealth Management
/ Investments & Research
